Chapter

III The Hedge Fund Industry: Structure, Size, and Performance

Author(s):
Anne Jansen, Donald Mathieson, Barry Eichengreen, Laura Kodres, Bankim Chadha, and Sunil Sharma
Published Date:
May 1998
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Author(s)
Bankim Chadha and Anne Jansen 

This section presents an overview of the hedge fund industry, focusing on its current structure and recent performance. It provides a brief history of the evolution of hedge funds, considers available data on the size and structure of the industry, examines the performance of hedge funds, and discusses the behavior and individual performance of some of the large macro hedge funds against the backdrop of major macroeconomic events in which these funds have been ascribed key roles. The section ends with a summary of the main conclusions.

Evolution of Hedge Funds

Since the term “hedge fund” is currently applied to a wide variety of funds, and popular notions often depict hedge funds as highly leveraged risk-takers or speculators rather than as risk-averse hedgers, it is useful to begin with a little history.

In 1949, A.W. Jones established in the United States—first as a general partnership, later converted to a limited partnership—what is regarded as the first hedge fund.1 At the time, short-selling, which is the sale of a borrowed asset on the expectation that its price will decline by the time of repayment, thus yielding a capital gain to the seller, appears to have been used largely for short-term speculation in transitory opportunities. Similarly, the use of leveraging as an investment strategy, which entails the use of credit to increase the value of investments, appears principally to have been used to “raise the stakes,” that is, for increasing profits but amplifying, of course, also the size of possible losses. Jones combined the two investment tools—short-selling and leveraging—to create what was in fact a conservative investment system. One of his insights was that there were two distinct sources of risk in equity investment: from individual stock selection and from general market risk. He sought to separate out the two. He viewed maintaining a basket of shorted stocks as a required asset allocation to hedge against a drop in the general level of the market. Thus controlling market risk, he used leverage to amplify his returns from picking individual stocks. The strategy was to buy particular stocks, that is be long these stocks, and sell others short. By going long on stocks that were “undervalued” and short on those that were “overvalued,” the expectation was that the fund would gain regardless of the direction in which the market moved. The fund was considered “hedged” to the extent that the portfolio was split between stocks that would benefit if the market went up, and short positions that would gain if the market went down. Thus the term “hedge funds.” Although Jones valued stock picking over market timing, he increased or decreased the net market exposure of his portfolio based on his forecast for the market. As the long-term trend in equity prices is a positive one, Jones was generally “net long.”

There were two other notable characteristics of Jones’s fund: an incentive fee structure and all of his own investment capital was kept in the fund. The fees payable to the general manager were set at 20 percent of realized profits. Unlike mutual funds of the time—and for that matter of today—there was no asset-based management fee.

Jones operated his fund with spectacular success and in relative secrecy until the mid-1960s. The publication in April 1966 of an article in Fortune magazine on Jones’s fund detailing rates of return—net of fees—that exceeded those of the most successful mutual fund (Fidelity Trend Fund) over the previous five years by 44 percent, and over the previous ten years (Dreyfus Fund) by 87 percent, led to a proliferation of hedge funds.2 While no data are available on the number of hedge funds that were established in the ensuing period, a survey by the Securities and Exchange Commission (SEC) found 215 investment partnerships for the year ended 1968, concluding that 140 were hedge funds, with the majority having been formed in that year. As the rapid growth of hedge funds coincided with a strong equity market, many managers found that hedging a portfolio with short sales was difficult, time consuming, and costly. Consequently, many managers increasingly resorted to strategies of using high margins to leverage up their long equity positions, with only token hedging. The subsequent decline in the equity market (1969–70) wreaked havoc on the industry. It is reported that for the 28 largest hedge funds in the SEC survey at the end of 1968, assets under management declined by 70 percent (from losses and withdrawals) by the end of 1970, while 5 of them were closed.3 The smaller funds fared worse. The stock market decline of 1973–74 then caused another sharp contraction of the hedge fund industry.

In the decade following 1974, hedge funds appear to have returned to operating in relative obscurity. Just as the financial press played an important role in spurring the first growth cycle in the hedge fund industry during 1966–68, so it appears to have played a similar role in the next cycle that began in the late 1980s, focusing attention in particular on the “macro” hedge funds.4 The macro hedge funds increasingly departed from the traditional hedge fund strategies that had focused on stock picking, to take positions on the overall direction of broad global shifts in stock markets, currencies, and interest rates. The growth of the hedge fund industry since the late 1980s has not, however, been limited to the macro funds, which, if anything appear to have declined in importance (see below), and the present hedge fund industry is comprised of a diverse set of funds. Hedge funds are now probably best described as eclectic pools of capital created as private limited investment partnerships, with a performance-based compensation scheme for the principal partners or managers who are free to use a variety of investment techniques and leverage to raise returns and cushion risk. Their small size and internal organizational structure permit rapid decision making. It is important to recognize that the line dividing hedge funds and certain other types of institutional investors is an arbitrary one. In particular, the operations of the proprietary trading desks of large commercial and investment banks resemble those of hedge funds.5

Characteristics of the Industry

The Data

Considerable caution needs to be used in examining statistics for the hedge funds industry and its various segments. The available data offered by a number of vendors—Managed Account Reports Inc. (Mar/Hedge), Hedge Funds Research (HFR), Van Hedge Fund Advisors (VHFA)—all of which were examined in writing this paper, aim to provide information useful for portfolio selection to investors in hedge funds. For present purposes, however, where the objective is to get a broader perspective on the size, structure, and returns in the hedge fund industry, they suffer from a number of deficiencies. Since all information available on these databases is voluntarily reported by hedge fund managers to these services and is not based on any publicly disclosed information, funds whose managers choose not to report are necessarily missing from the databases, and the data are obviously, therefore, incomplete. It is unclear what, if any, “due diligence” is exercised in data collection by the vendors on reporting hedge fund managers. Voluntary reporting means also that all statistics suffer from a self-reporting bias, as hedge fund managers would have an incentive to report results in a favorable light. The fact that a fund manager’s choice to start reporting may not coincide with the date of its inception distorts statistics on the growth in the number and size of funds. Return statistics suffer from a strong survivor bias, in that only returns of funds that remain in business are reported.

The line between what is and what is not a “hedge fund” is a hazy one, with different vendors employing alternative definitions, which results in varying estimates of the universe of hedge funds. Mar/Hedge defines a hedge fund as one that “charges a material incentive fee (usually in the 15–25 percent range) and meets at least one of the following criteria: the fund invests in multiple asset classes; in the case of a long-only fund, uses leverage; or the fund uses hedging techniques within its portfolio.” HFR includes in its universe of hedge funds a “structure that is normally a private investment partnership or offshore fund that charges a performance fee, and that encompasses a broad definition of investment strategies. Investment strategies range from the non-leveraged, hedged and arbitraged to highly leveraged and directional.” VHFA defines U.S. hedge funds as “limited partnerships or limited liability companies invested primarily in public securities or in financial derivatives.” While VHFA does not explicitly take into account whether or not the fund hedges its portfolio, over 90 percent of the U.S. funds in that database are estimated to actually hedge. For offshore funds, VHFA’s universe includes “mutual fund companies domiciled in tax havens which can utilize hedging techniques to reduce risk.”

This section focuses on the data reported by Mar/Hedge. The choice of this data set was largely arbitrary, though it does represent the first commercially available database on hedge funds and has the advantage of having longer time series. This is particularly useful in examining the performance of the large macro hedge funds (see below). While some of the differences in estimates of industry size and structure among vendors are noted below, the data from Mar/Hedge conform with both broad impressions gained from discussions with hedge fund managers and with press reports.

Investment Styles

The Mar/Hedge database classifies hedge funds into eight broad categories of investment styles, as reported by the managers of the hedge fund. These are6

  • Macro funds that take positions on changes in global economic conditions as reflected in equity prices, currencies, and interest rates.

  • Global funds include those investing in emerging markets and those dedicated to specific regions in the world. While they take positions on directional moves in particular markets as the macro funds do, they tend to be more bottom-up oriented in that they pick stocks in individual markets they favor. They tend to use index derivatives much less so than the macro funds.

  • Long only funds are traditional equity funds that are structured like hedge funds, that is, they have an incentive fee and use leverage.

  • Market-neutral funds attempt to reduce market risk by taking offsetting long and short positions, and are, in this sense, perhaps most closely related in investment philosophy to the old-style hedge fund (such as Jones’s). They now encompass funds that invest in a wide variety of instruments, including convertible arbitrage funds that take offsetting positions in convertible securities and the underlying equity, those that arbitrage stocks and index futures, or those that take positions on yield curves in bond markets.

  • Sectoral hedge funds have an industry focus that includes a wide set of industries: health care, financial services, food and beverages, media and communications, natural resources, oil and gas, real estate, technology, transportation, and utilities.

  • Dedicated short sales funds borrow securities they judge to be “overvalued” from brokers and sell them on the market, hoping to buy them back at a lower price when repaying the broker. Such funds attract investors wishing to hedge traditional long-only portfolios, or those wishing to take a position that the market is likely to decline.

  • Event-driven funds’ investment theme is to capitalize on events that are seen as special situations. They encompass distressed securities funds that focus on securities of companies in reorganization or bankruptcy, and risk-arbitrage funds that take a position on the likelihood of an announced merger or acquisition going through by simultaneously buying stocks in a company being acquired and selling stocks in the acquiring company.

  • Funds of funds are hedge funds that allocate their portfolio of investments, sometimes with leverage, among a number of hedge funds.

Number, Size, and Location of Funds

All estimates suggest that the hedge fund industry has experienced explosive growth since the mid-1980s, measured either by the number of funds or by assets under management, and continues to grow robustly.7 The number of hedge funds in the Mar/Hedge database increased uninterruptedly from a total of 127 in 1990 to reach 1,115 by the fourth quarter of 1997 (Table 3.1). During this period the number of global funds, which have consistently represented between 40–50 percent of all hedge funds, rose almost tenfold from 40 to 404, and such funds now account for about half the industry. Market-neutral funds, which currently represent about a quarter of the funds in the industry, also grew tenfold in the 1990s, rising from 18 in 1990 to 201 in 1997. Event-driven investment funds, which represent about 15 percent of funds, experienced only slightly more modest (sevenfold) growth in the number of funds during the 1990s. Macro funds have represented a relatively small fraction of the funds in the hedge fund industry, and though the number of such funds has grown over time from 13 in 1990 to 61 in 1997, the share of such funds in the industry has been declining steadily. Macro funds currently represent only 7 percent of the funds in the industry. One other notable area of expansion has been the funds of funds category, with such funds currently representing—after the global category—the second largest concentration of funds.8

Table 3.1. Hedge Funds: Number of Funds by Investment Style1
1980198519901991199219931994199519961997
(In numbers)
Global19406190127191248334404
Macro021314192834405061
Market-neutral051822406493123159201
Event-driven0217212239487395120
Sector00112610162340
Short sales00667810101112
Long only000025671115
Fund of funds0432456384134181221262
Total (including fund of funds)1221271702453615266989041,115
Total (excluding fund of funds)11895125182277392517683853
(In percent of total)2
Global100504249494649484947
Macro011141110109877
Market-neutral0281918222324242324
Event-driven0111817121412141414
Sector0011123335
Short sales0065433221
Long only0000122122
Total (excluding fund of funds)100100100100100100100100100100
Notes: Global—invest in emerging markets and other specific regions of the world. Macro—take positions on changes in global economic conditions. Market-neutral—attempt to reduce market risk by taking offsetting long and short positions. Event-driven—attempt to capitalize on events that are seen as special situations. Sector—have an industry focus. Short sales—borrow securities they judge to be “overvalued” from brokers to sell them on the market, hoping to buy them back at a lower price when repaying the broker. Long only—traditional equity funds structured like hedge funds. Fund of funds—allocate their portfolio of investments among a number of hedge funds.Source: Mar/Hedge.

At end-period.

Excluding fund of funds.

Notes: Global—invest in emerging markets and other specific regions of the world. Macro—take positions on changes in global economic conditions. Market-neutral—attempt to reduce market risk by taking offsetting long and short positions. Event-driven—attempt to capitalize on events that are seen as special situations. Sector—have an industry focus. Short sales—borrow securities they judge to be “overvalued” from brokers to sell them on the market, hoping to buy them back at a lower price when repaying the broker. Long only—traditional equity funds structured like hedge funds. Fund of funds—allocate their portfolio of investments among a number of hedge funds.Source: Mar/Hedge.

At end-period.

Excluding fund of funds.

Most of the hedge funds in the Mar/Hedge database are registered in the United States (51 percent), or in one of the Caribbean offshore centers such as the British Virgin Islands (17 percent), the Cayman Islands (13 percent), Bermuda (9 percent), The Bahamas (5 percent), and the Netherlands Antilles (2 percent), a choice determined by the relative advantages these domiciles offer individual funds (table 3.2)9 When the domicile of hedge funds is considered by the size of assets under management rather than by the number of funds, an alternative pattern emerges (Table 3.3). When measured by assets under management, the importance of U.S.-based funds falls to only a third of the total. This difference is accounted for mostly by the large macro funds, over 45 percent of whose assets under management are in funds registered offshore in the Netherlands Antilles.

Table 3.2Hedge Funds: Number of Funds by Domicile, 1997
GlobalMacroMarket-NeutralEvent-DrivenSectorShort SalesLong OnlyFund of FundsTotal
(In millions of U.S. dollars)
Austria010000001
Bahamas, The1821050111653
Bermuda38429250023101
British Virgin Islands679211732066185
British West Indies002000002
Canada000100023
Cayman Islands731531142229148
Channel Islands000200002
Curaçao010000001
Guernsey4000000610
Hong Kong SAR010000001
Ireland411000017
Isle of Man00000001
Luxembourg304000007
Netherlands201000003
Netherlands Antilles5401000919
Turks and Caicos000000011
United Kingdom001000001
United States190231017830712128569
Total404612011204012152621,115
(In percent of total)
Austria020000000
Bahamas, The435408765
Bermuda97142130099
British Virgin Islands1715101481702517
British West Indies001000000
Canada00010000
Cayman Islands1825151251713313
Channel Islands000200000
Curaçao020000000
Guernsey100000021
Hong Kong SAR020000000
Ireland120000001
Isle of Man000000000
Luxembourg102000001
Netherlands000000000
Netherlands Antilles170100032
Turks and Caicos000000000
United Kingdom000000000
United States473850657558804951
Total100100100100100100100100100
Note: For definitions, see notes to Table 3.1.Source: Mar/Hedge.
Note: For definitions, see notes to Table 3.1.Source: Mar/Hedge.
Table 3.3. Hedge Funds: Assets Under Management by Domicile, 1997
GlobalMacroMarket-NeutralEvent-DrivenSectorShort SalesLong OnlyFund of FundsTotal
(In millions of U.S. dollars)
Austria010000001
Bahamas, The9771624120702811,1812,649
Bermuda3,4271191,53117451001,0576,602
British Virgin Islands6,2592,4941,4212,0451511603,45215,801
British West Indies0030800000308
Canada00019000236255
Cayman Islands4,1867,5254,44099712121877217,440
Channel Islands0003720000372
Curaçao04,0000000004,000
Guernsey1,0830000006401,723
Hong Kong SAR020000002
Ireland895110000119223
Isle of Man0000000110110
Luxembourg30401,292000001,597
Netherlands300240000054
Netherlands Antilles5,19614,04507870006,54826,576
Turks and Caicos00000003333
United Kingdom00420000042
United States9,3111,5548,6634,1581,2752732896,26931,792
Total30,86229,75917,9708,6021,75253837619,717109,575
(In percent of total)
Austria000000000
Bahamas, The301205062
Bermuda11090260056
British Virgin Islands20882412201814
British West Indies002000000
Canada000000010
Cayman Islands1425251212323016
Channel Islands000400000
Curaçao0130000004
Guernsey400000032
Hong Kong SAR000000000
Ireland000000010
Isle of Man000000010
Luxembourg107000001
Netherlands000000000
Netherlands Antilles1747090003324
Turks and Caicos000000000
United Kingdom000000000
United States30548487351773229
Total100100100100100100100100100
Note: For definitions, see notes to Table 3.1.Source: Mar/Hedge.
Note: For definitions, see notes to Table 3.1.Source: Mar/Hedge.

The size of assets under management by the hedge fund industry reveals the same explosive growth as that evidenced by the number of hedge funds. Much of this has been due to the increase in the number of funds, but it has also been, though to a lesser extent, due to increases in the average size of individual funds, which rose from $76 million in 1990 to $105 million in 1997. From a relatively modest $7 billion of assets under management in 1990, this figure had grown to $90 billion (excluding funds of funds) by the fourth quarter of 1997 (Table 3.4 and Figure 3.1).

Table 3.4Hedge Funds: Assets Under Management by Investment Style1
1980198519901991199219931994199519961997
(In millions of U.S. dollars)
Global1935171,2882,2383,9456,57312,24914,93120,40130,862
Macro004,7006,8279,39618,93020,16518,80725,51029,759
Market-neutral0786389251,6713,3754,7205,70710,31717,970
Event-driven0293795507841,7502,8863,8275,5748,602
Sector00238481071876911,752
Short sales00187239226244403432488538
Long only000014304485180376
Fund of funds01901,3391,9413,0756,4688,1679,41613,16319,717
Total (including fund of funds)1938148,53212,72219,12237,41848,74153,39276,325109,576
Total (excluding fund of funds)1936247,19310,78216,04630,95040,57443,97663,16289,859
(In percent of total)2
Global100831821252130343234
Macro006563596150434033
Market-neutral01299101112131620
Event-driven05555679910
Sector0000000012
Short sales0032111111
Long only0000000000
Total (excluding fund of funds)100100100100100100100100100100
Fund of funds30301918192120212122
Note: For definitions, see notes to Table 3.1. Source: Mar/Hedge.

At end-period.

Excluding fund of funds.

Proportion of assets channeled through fund of funds.

Note: For definitions, see notes to Table 3.1. Source: Mar/Hedge.

At end-period.

Excluding fund of funds.

Proportion of assets channeled through fund of funds.

Figure 3.1.Hedge Funds: Assets Under Management by Investment Style1

(In billions of U.S. dollars)

Note: For definitions, see notes to Table 3.1.

Source: Mar/Hedge.

1 Excluding fund of funds.

Unlike the picture that emerged in Table 3.1 based on the number of funds, macro hedge funds are much more important in terms of the share of the hedge fund industry’s assets under their management (Table 3.4). There has, however, been a secular decline through the 1990s in the share of assets under their management, which fell from 65 percent in 1990 when they clearly dominated the industry, to 33 percent by 1997. Despite this secular decline, the macro hedge funds continued to have the largest share of the industry’s assets under management until 1996, being overtaken only in 1997 by the global funds. With $30 billion of assets under management at the end of the fourth quarter of 1997, representing about a third of the industry, the macro funds continue to manage a sizable share of the industry’s assets. The secular decline in the share of macro funds has been offset by increases in importance of global ($31 billion, 34 percent), market-neutral ($18 billion, 20 percent), and event-driven ($9 billion, 10 percent) funds. It is notable that assets under management by funds of funds is sizable, and at $20 billion in 1997, over 20 percent of investment in hedge funds was intermediated by these funds.

The stark difference in the importance of the macro hedge funds in the industry when measured by the number of funds and size of assets reveals, of course, that the funds in this segment of the industry have tended on average to be much larger than in the rest of the industry. In 1997, the average size of macro funds was $488 million, while it was some $76 million for global funds. The macro segment of the industry is in fact highly concentrated, with the eight largest (reporting) funds, ranging in size from $1 billion to $6 billion under management, representing over 80 percent of macro hedge fund assets.

It should be noted that the estimates reported above based on Mar/Hedge’s database of the number of hedge funds and the size of assets under management by the industry are at the lower end of available estimates. Compared with the 1,115 funds with assets under management of $110 billion (including funds of funds) in Mar/Hedge’s database, HFR’s database has 1,561 funds with assets under management of $189 billion, while VHFA reports it has 1,990 funds in its database with assets under management of $146 billion. Because of the problem of voluntary self-reporting and, therefore, of missing funds from the databases noted above, the vendors were asked to provide estimates of the universe of hedge funds. HFR estimated the current universe of hedge funds, arrived at by conversations with industry participants to be 3,000 funds with $368 billion in assets under management, while VHFA estimated the number of hedge funds at 5,500.

Survival Rate

While there have been a number of well-publicized failures of hedge funds over the years, the available evidence does not suggest that the industry is characterized by a spectacular or even high failure rate. HFR estimates, for example, that in any given year during 1994–97, the peak proportion of hedge funds in existence that closed was 7 percent. VHFA estimated that 10 percent of the funds in its current sample (built up over the 1990s) were defunct. Closures of these funds have occurred for a number of reasons unrelated to performance, including mergers or restructurings of partnerships into new or existing partnerships, managers or general partners leaving the fund for a new one, and managers retiring. There are in fact limited examples of hedge funds closing after incurring large losses.

Manager Compensation and Incentives for Risk Taking

Two key features of Jones’s pioneering hedge fund have endured. First, as the definitions of hedge funds used by all of the vendors of hedge fund data discussed above make clear, the one—and perhaps the only—characteristic that all “hedge funds” have in common is that managers are compensated on the basis of performance and not as a fixed percentage of assets under management. While there are variations, the industry norm appears to be that hedge fund managers receive 15–20 percent of the funds’ realized trading profits, plus a management fee of 1 percent of assets annually. Some hedge funds have “hurdle”-based incentive fees, which reward the general partner or manager for performance in excess of an agreed benchmark. Others have “high watermark” provisions requiring the general partner to make up losses prior to being able to receive additional incentive fees. This contrasts with the mutual fund industry, where manager compensation is typically determined as a fixed percentage of assets under management. Second, hedge fund managers, as partners in the limited investment partnerships, have their own capital invested in the funds they manage. This is again in sharp contrast to the mutual fund industry, where managers typically do not have any of their capital invested in the funds they manage. Moreover, while hedge fund managers as partners in the hedge fund must invest at least the minimum investment requirement of the fund, the norm would appear to be that most put in substantially in excess of the minimum, with many investing most, if not all, of their own investment capital in the funds they manage.

Both features have important implications for the behavior of hedge fund managers, that is, in affecting the return objective of managers and in their tolerance for risk. First, since hedge fund managers are compensated on the basis of the absolute size of the realized returns of the funds, they tend to be oriented toward achieving the highest absolute return, rather than focusing on performance measures based on averages in the fund management industry, as mutual fund managers tend to do. Second, they have a stronger incentive to minimize the possibility of losses, since there are no fees to be earned in that event. Third, the investment of the fund manager’s own capital in the fund reduces the inducement for managers to take on risk. This is particularly important when the fund is losing money. As is well known from the example of commercial banks with guaranteed deposits, as capital falls, the incentives for bank managers to take on higher risk and higher yield endeavors—“betting the house”—increase, since the upside potential begins to rapidly dominate the limited downside where the liabilities are limited by the guarantee. Similarly, potential perverse incentive problems arise for a manager of other investors’ funds—and who, therefore, bear the loss. These problems are avoided in the case of a hedge fund, since the fund managers have their own money at risk in the funds they manage.

It is frequently argued that hedge funds, because they are unregulated, take on more risk than, say, banks, which are regulated and supervised, and in particular are subject to minimum capital requirements. Again, it is noteworthy that while the proprietary trading desks of banks are—since they are on the bank’s balance sheet—subject to minimum capital requirements that impose, in principle, a limit on the extent of leverage they can take on, the trader is essentially trading on the institutions’ capital, and internal controls are necessary to limit a trader increasing risk in the face of losses. A trader who gets fired because of substantial losses incurred from taking on high-risk investments does, of course, lose flow income. He does not, however, typically suffer an immediate loss in the stock of his existing wealth as does a hedge fund manager.

Redemption Policies and Implications for Market Dynamics

Redemption periods for investors in hedge funds vary considerably but are well in excess of those for mutual funds.10 Some hedge funds allow quarterly redemptions without notice, while “lock-out” periods of as long as a year are common. One prominent hedge fund has recently instituted a staggered redemption schedule over a three-year period. The substantially longer redemption horizon permits hedge fund managers to have longer investment horizons than, say, managers of open-end mutual funds. The predictability of purchases and redemptions by small retail investors in mutual funds depending on market conditions makes their managers particularly prone to “momentum trading,” that is, buying into a rising market and selling into a falling market, increasing market volatility. Consider a mutual fund manager in a bull market, for example. He is aware that funds will be flowing in at a robust pace. It is, therefore, in his interest to reduce his average holdings of cash balances, and increase, for example, the proportion of his portfolio devoted to equities. The opposite is true in a falling market when the manager is aware that there will be a substantial outflow. It is then in his interest to increase holdings of cash balances, that is, sell in a falling market. Hedge funds, with longer redemption horizons, have fewer incentives to engage in such momentum selling.

Decision-Making Process

The decision-making process of most conventional organizations—including financial institutions—often requires several stages and is often opaque to the outsider. The process is also typically time-consuming, with certain investment decisions requiring the approval of fiduciary or oversight committees. The decision-making process of hedge funds, in contrast, is relatively straightforward, with the general partner and portfolio managers exercising considerable, if not total, discretion. This leaner institutional structure increases the ability of hedge funds to move quickly.

The Investor Base

No formal information is available on the composition of the investor base for hedge funds. Discussions with hedge fund managers and investors in hedge funds, particularly fund of funds managers, reveals, however, a clear trend toward an increasingly diversified investor base. While growth in the absolute number of “high net worth individuals” has provided a steady source of investors in hedge funds, institutional investors have shown a growing interest in investing in hedge funds. These institutional investors include the more traditional pension and mutual funds, insurance companies, endowments, foundations, universities, and commercial and investment banks.11 As an asset class, investment in hedge funds has increasingly become mainstream, being viewed less and less as a high return–high risk investment, but increasingly as providing fair or superior returns for risk, and as a tool for portfolio diversification. This trend is likely to continue.

Leverage

A feature of hedge funds’ investment strategies that has always attracted attention has been their use of leverage. Since successful hedge funds have excellent (internal) credit standings with banks and brokers, they have access to, and are extensive users of, leverage. It has been argued that a fund that begins with a pool of, say, $1 billion in equity may actually have $10 billion to play with in the market, thanks to its bank credit. Leveraging therefore greatly magnifies the economic clout of these funds, at the same time amplifying their returns and losses. Clout, of course, matters in itself in that hedge funds could corner and/or move markets. It can also create a multiplier effect in the event of losses, which could exacerbate market movements. For example, if losses lead to an increased demand by creditor banks or brokers for collateral on money lent to the hedge funds—a margin call—the funds may need to sell some of their other holdings to raise cash. This can also transmit negative shocks across markets. In the turmoil in U.S. bond markets during 1993–94, the macro hedge funds were ascribed an important role in exacerbating market volatility due to the substantially leveraged positions they held. Attention was focused first by the financial press, followed by investigations by various regulatory authorities in the United States, and with formal hearings by the Committee on Banking, Finance and Urban Affairs of the U.S. House of Representatives.12 It was argued at the time that the “deleveraging” of large positions built up by the macro hedge funds in the face of increases in interest rates by the Federal Reserve had magnified the effect on interest rates. It was also argued that the margin calls on hedge funds’ U.S. bond positions caused them to liquidate positions in European bond markets, causing a spillover into these markets, which would otherwise have been unaffected by developments in U.S. interest rates.13

Because of both conceptual problems in how precisely to measure the total use of leverage in a portfolio and self-reporting biases, the available data on the reported use of leverage by hedge funds is particularly unsatisfactory. In the Mar/Hedge database, half of the hedge funds (measured by asset size) either report not using leverage at all or do not report their use of leverage (Table 3.5). Of the macro hedge funds, 80 percent fall into this category, while of the global funds about 45 percent fall into this category. This lack of coverage effectively renders any discernible patterns on the use of leverage across segments of the industry and their effects on risk and return as unrepresentative. The Mar/Hedge data do suggest, however, that at least 50 percent do use leverage. HFR estimates that during the 1990s, between 60–70 percent of hedge funds used leverage, while 15–20 percent did not, and the remainder did not report. The HFR data reveal a modest increase in the proportion of firms using leverage during the 1990s, though this increase largely offsets a decline in the share of nonreporting funds, suggesting that this increase may simply reflect improved reporting. HFR estimates suggest that over 80 percent (of the total number) of macro hedge funds use leverage. VHFA reports that an estimated 70 percent of hedge funds use leverage, about half of all hedge funds have leverage ratios of less than 2, and only 15 percent have leverage ratios in excess of 2.

Table 3.5. Leverage by Investment Style, December 1997(In millions of U.S. dollars)
GlobalMacroMarket-NeutralEvent-DrivenSectorShort SalesLong OnlyFund of FundsTotalPercent of Total
Not reported13,91223,7425,1653,27515610708,91755,27450
Minimal10481572922577191216014475,9735
1–100%6,1608001,4441,859421491854,23715,15514
101–200%4,5672141,9722,1499565114349,9579
201–300%19073711516000371,5271
More than 300%661,8454,1135000726,1016
Medium2,874006042002,9403
Maximum0024000060
Varies2,0451,5133,641157241131774,97312,64312
Total30,86229,75917,9708,6021,75253837619,717109,576100
Note: For definitions, see notes to Table 3.1.Source: Mar/Hedge.
Note: For definitions, see notes to Table 3.1.Source: Mar/Hedge.

It should be emphasized that there are some fundamentally unresolved issues in how to appropriately measure the extent of leverage used by investors. While the measurement of the extent of leverage used by an investor in a single instrument class or, say, by an institutional investor that specializes in one instrument class such as an equity or bond mutual fund is straightforward, the issue is considerably more complicated for investors in a portfolio of securities. Most popular notions of the use of leverage—by hedge funds or anyone else for that matter—tend to gross up notional positions and compute a ratio relative to capital, which for hedge funds is total assets under management. Investment strategies employed by hedge funds—and in particular the taking of short positions—make this measure not only less than ideal but, in principle, highly mis-leading. What is the leverage ratio, for example, of a market-neutral equity fund established with $50 of investor capital that, using the common 2 to 1 leverage ratio available for highly rated borrowers on blue-chip equities in the United States, takes a long equity position of $50 (using $25 of capital) and simultaneously a short equity position of $50 (using the other $25 of capital)? Traditional measures of leverage that grossed up the notional value of each position (sum of $100) and divided by capital ($50) would place the leverage ratio of the fund at 2. However, this ignores the fact that the market risk in the long and short positions actually offset each other. If the short position is subtracted from the long position in calculating market exposure or what could be described as a “risk-adjusted” measure of leverage, the leverage in the portfolio would in fact be calculated as zero. In reality, of course, the evaluation of the extent of leverage employed in actual portfolios is substantially more complicated when there are a variety of long and short positions in different instruments—in equities, bonds, currencies, commodity futures, and derivative instruments.

It is misleading to single out hedge funds because of the use of leverage in their investment strategies. Other institutional investors, as noted above—in particular the proprietary trading desks of commercial and investment banks—use leverage in investment activities, much as hedge funds do. The traditionally more conservative institutional investors such as mutual and pension funds have also begun to increasingly employ currency and market-risk hedges. These instruments inherently create leverage. Finally, it should be noted that traditional commercial banks are some of the most leveraged players in financial markets. With commercial banks’ average capital ratios (unadjusted for credit risk) ranging in the industrial countries between 3.5 percent and 8 percent, their implied gearing or leverage ratios are between 12 and 29.14 The bottom of this range exceeds the highest reported leverage ratios for any hedge fund.

Performance: Return, Risk, and Diversification Comparisons

Over the 1990s, average annual compound returns of the majority of hedge fund investment styles—sectoral (30 percent), macro (28 percent), event-driven (19 percent), and global (18 percent)—have handily exceeded those on the mature equity markets as measured by the Standard & Poor’s 500 index (S&P 500) (16 percent), and on bond markets as measured by J.P. Morgan’s Government Bond Index (GBI) (8 percent) (Table 3.6, panel 1, and Figure 3.2).15 With returns on sectoral and macro funds almost double those of the S&P 500 on an average annual compounded basis, they have yielded cumulative returns over the 1990s of 695 percent and 625 percent, respectively, compared with 242 percent on the S&P 500. Returns on funds of funds were very similar over the period to those of the S&P 500, while those of market-neutral funds, and—as would be expected—those of dedicated short-sales funds were well below those of the S&P 500.

Table 3.6. Returns, Volatility, and Risk-Adjusted Returns by Investment Style(In percent)
1990–911992–931994–951996–971990–97
Compound annual returns by investment style
Global13.227.79.121.717.7
Macro45.531.711.126.528.1
Market-neutral5.18.77.313.68.6
Event-driven17.328.510.120.518.9
Sector30.227.618.043.929.6
Short sales3.28.18.97.87.0
Long only24.630.0
Fund of funds13.821.83.518.714.2
J.P. Morgan GBI11.58.56.66.38.2
S&P 50010.88.617.426.715.7
Standard deviations of monthly returns by investment style
Global3.51.82.52.72.7
Macro5.55.63.24.04.7
Market-neutral0.60.40.70.30.6
Event-driven2.11.51.41.51.7
Sector5.13.42.86.34.6
Short sales5.13.04.05.34.4
Long only4.44.5
Fund of funds1.31.51.82.01.7
J.P. Morgan GBI1.11.11.31.21.2
S&P 5005.01.92.73.83.5
Risk-adjusted annual returns by investment style1
Global1.14.51.12.31.9
Macro2.41.61.01.91.7
Market-neutral2.36.03.112.34.3
Event-driven2.35.32.14.03.2
Sector1.72.41.92.01.9
Short sales0.20.80.60.40.5
Long only1.61.9
Fund of funds3.04.30.62.72.4
J.P. Morgan GBI3.02.21.51.62.0
S&P 5000.61.31.92.01.3
Note: For definitions, see notes to Table 3.1.Sources: Bloomberg; and Mar/Hedge.

The risk-adjusted rate of return is calculated as the ratio of the average annual compound return divided by the annualized volatility (standard deviation).

Note: For definitions, see notes to Table 3.1.Sources: Bloomberg; and Mar/Hedge.

The risk-adjusted rate of return is calculated as the ratio of the average annual compound return divided by the annualized volatility (standard deviation).

Figure 3.2.Monthly Total Returns by Investment Style1

Sources: Bloomberg; and Mar/Hedge.

1 Weighted by assets under management.

2July 1992 = 100.

Only some of the higher returns on hedge funds have been associated with higher volatility (Table 3.6, panel 2). The investment styles with the highest returns, the sectoral and macro funds, have indeed been associated with the highest volatility of returns, exceeding that of the S&P 500, as has that of dedicated short-sales funds. The volatility of the event-driven, global, market-neutral, and funds of funds categories, on the other hand, has been below that of the S&P 500. The remarkably low volatility of returns of market-neutral funds is notable at a sixth that of the S&P 500, as is that of event-driven funds and funds of funds at less than half that of the S&P 500.

On a risk-adjusted return comparison, each of the segments of the hedge fund industry—with the exception of dedicated short-sales funds—outperformed the S&P 500 during the 1990s (Table 3.6, panel 3). The high volatility of returns of the sectoral and macro funds offsets to a considerable extent their high returns, but still yields a favorable comparison with the S&P 500. Event-driven and market-neutral funds provide, on the other hand, a return-risk combination that exceeds that on the S&P 500 by a factor of around three, while that on funds of funds is only modestly below this.

Because of the differences in strategies of hedge fund investments with traditional long portfolios of stocks and bonds, and the resulting lack of systematic correlation with returns from these traditional sources, investments in hedge funds provide a powerful tool for portfolio diversification. The low correlations of hedge fund returns by investment styles with returns in bond and equity markets reveal the tremendous advantages of portfolio diversification—raising returns without increasing risk—available to a bond or equity only investor by allocating a proportion of his portfolio to hedge funds (Table 3.7). The highest correlation of hedge fund returns with the S&P 500 over the period is that of the global funds at 0.7. It is 0.4 for event-driven funds and 0.3 for macro funds. As would be expected, the correlation of dedicated short-sales funds with the S&P 500—and this is, of course, the reason for the existence of such funds—is strongly negative at -0.5.

Table 3.7Correlations of Hedge Fund Returns with Benchmark Indices, January 1990–December 1997
S&P 500Morgan Stanley Capital International IndexJ.P. Morgan Government Bond Index
Global0.70.50.3
Macro0.30.20.4
Market-neutral0.20.20.0
Event-driven0.40.40.2
Sector0.50.30.2
Short sales-0.5-0.30.0
Long only0.50.40.3
Fund of funds0.60.50.4
S&P 5001.00.70.5
Morgan Stanley Capital International Index0.71.00.4
J.P Morgan Government Bond Index0.50.41.0
Upper Mutual Funds10.50.70.2
Note: For definitions, see notes to Table 3.1.Sources: Bloomberg; and Mar/Hedge.

Global Equity Index.

Note: For definitions, see notes to Table 3.1.Sources: Bloomberg; and Mar/Hedge.

Global Equity Index.

Macroeconomic Events and the Performance of Macro Hedge Funds

The macro hedge funds have on several occasions been ascribed important roles in affecting aggregate market dynamics, and their reported investment activities routinely attract considerable attention. They could play a pivotal role in affecting market dynamics by either taking quantitatively important positions in a market, thereby moving prices, or they could be market leaders with other investors following. Because of their use of leverage and their potential ability to mobilize large pools of capital, market participants have argued that when the hedge funds are buying into a market, they push prices to high, perhaps unsustainable levels, and when they sell, the complaint is that they exaggerate the speed and extent of the price adjustment. Unless one is to argue that each one of the macro funds can mobilize huge amounts of capital, these arguments also reflect the implicit belief that many of the macro hedge funds have simultaneously taken similar positions. Their consistently high rates of return have also, on occasion, led to reports that the hedge funds, ahead of the investor pack, tend to “get it right” almost always.

Figure 3.3 plots the returns of the two largest macro hedge funds (Fund A and Fund B) in the periods surrounding the 1987 stock market crash, the 1992 exchange rate mechanism (ERM) crisis, the turbulence in U.S. bond markets in early 1994, and the July 1997 collapse of the Thai baht, respectively. Ideally one would want to examine the returns of more than two funds. Longer time series of returns are, however, only available for these two funds. Both are prominent funds, run by different general partners and managers and, each with assets under management of a little less than $6 billion, together account for almost half the macro hedge fund industry’s assets.

Figure 3.3.Large Macro Hedge Fund Returns and Macroeconomic Events

Both funds made good returns at the time of the devaluation of the Thai baht, though at around 10 percent these returns were much more modest than at the time of the pound sterling’s devaluation (Figure 3.3D). Brown, Goetzmann, and Park (1998), estimated the changing positions of the ten largest currency funds in a basket of Asian currencies. Their evidence suggests that the net positions of the funds were not unusual over the period surrounding the Asian currency crises, and neither were their profits, arguing that the hedge funds were not responsible for the crises.

Clearly neither of the two funds predicted the September 1987 stock market crash, and were not in any sense ahead of the curve. Both funds made substantial losses of about 30 percent during the month (Figure 3.3A). The turbulence in U.S. bond markets in early 1994 does not appear to have had a severe effect on the returns of either fund. Both funds made modest losses at the time, with one losing a cumulative 11 percent during February–April of the year and the other losing 8 percent (Figure 3.3B). Only one of the funds made substantial gains at the time of the devaluation of the pound sterling in September 1992, of about 25 percent, while the other made relatively modest gains of around 5 percent (Figure 3.3C). In this case, it is notable that the fund that made the large gains suffered large losses a few months later of almost a similar magnitude. This suggests that the high profile events such as the ERM crisis have not been the only events from which the hedge funds gained or lost.

Returns of both of the funds were clearly affected, albeit to varying degrees by the four events. The extent of correlation in returns among the two funds varies across the events. In some instances it has been high. However, much of this correlation comes, no doubt, from movements in the general level of the market. In Figure 3.3A, for example, the quick rebound in returns of both funds in the lower panel by December 1987 is associated with a rebound in the U.S. equity market. The correlation of returns in the two funds between January 1986 and September 1997 is 0.4, which is relatively modest. Correlations between five of the largest funds run by different general partners over the more recent period from September 1993 to November 1997, for which data are available, range from a high of 0.6 to a low of -0.1, again suggesting a diversity of investment strategies (Table 3.8).

Table 3.8Correlation of Returns Among Large Macro Hedge Funds, September 1993–November 1997
Fund AFund BFund CFund DFund E
Fund A1.0
Fund B0.41.0
Fund C0.30.61.0
Fund D-0.10.00.01.0
Fund E0.50.30.2-0.11.0
Source: Mar/Hedge.
Source: Mar/Hedge.

Conclusions

Hedge funds have been in existence for some time. Since their inception in the late 1940s, however, as funds that held a substantial portion of their portfolios in offsetting long and short equity positions, the industry has grown rapidly since the late 1980s, evolving into a diverse set of funds offering several distinct specialized investment strategies. Two characteristics, namely a performance-based fee structure for managers and the investment of the general partner and fund manager’s own capital in the funds they manage, have endured. These features encourage fund managers to seek the highest absolute returns while at the same time they limit the incentives for taking on risk. During the 1990s, returns of the majority of hedge fund investment styles substantially exceeded those in the mature equity markets, and only some of the higher returns have been associated with higher volatility. When adjusted for risk, returns in each segment of the hedge fund industry exceeded those on mature equity markets such as the S&P 500. The use of leverage by hedge funds is often cited as a primary factor behind hedge funds’ high returns. Hedge funds, however, are neither the sole users of leverage in investment strategies nor, it would appear, are they the most leveraged players in financial markets. The ability of hedge fund managers to use leverage and a variety of other investment tools such as short selling, their small size, and internal structure makes them more agile and quick in responding to new information than other institutional investors. The high returns for risk and low correlations with traditional benchmark portfolios offered by hedge fund investments have caused a growing interest in the industry. Investment in hedge funds has gradually become mainstream, with increasing institutional investor participation, and the industry appears set to continue to grow rapidly.

See, for example, Rohrer (1986).

Their potentially different appetites for, and incentives to take on, risk are discussed in the next subsection.

A fuller description can be found in the next section, which discusses in depth hedge fund investment strategies. It should be noted that there is obviously some overlap in types of investment activities.

While data in the tables are presented from earlier periods, the focus is on developments since 1990 because there appear to have been substantial improvements in reporting since this time.

In keeping with the following tables on assets under management in the hedge fund industry, where the funds of funds are excluded from the totals to prevent double counting, such funds are also excluded from the percentages calculated in the lower panel of Table 3.1.

Section V discusses the regulation of hedge funds and the regulatory advantages of registering onshore and offshore.

These comparisons are only valid, of course, for open-end funds.

While data are hard to come by, there are some well-publicized reports of institutional investments in hedge funds. White (1995), for example, reports that the Rockefeller Foundation allocated 5 percent of its portfolio to hedge funds.

The New York Federal Reserve and the Bank of England both reportedly undertook investigations of the terms, conditions, and quantity of leverage extended by banks in their jurisdictions to hedge funds.

In March 1994 the central bank governors of the Group of Ten countries, at their monthly meeting at the Bank for International Settlements, were reported, however, to have judged the movements in markets as a justified “correction.” See The Banker (1994).

Ackerman, McEnally, and Ravenscraft (1997) also examine the performance of hedge funds.

References

    AckermanCarlRichardMcEnally andDavidRaven-scraft1997The Performance of Hedge Funds: Risk, Return and Incentives” (unpublished; Chapel Hill, North Carolina: University of North Carolina).

    BrownStephen J.WilliamGoetzmann andJamesPark1998Hedge Funds and the Asian Currency Crisis of 1997” (unpublished; New York: NYU Stern School of Business, New York University).

    CaldwellTed1995Introduction: The Model for Superior Performance,” inHedge Funds: Investment and Portfolio Strategies for the Institutional Investored. byJessLederman andRobert A.Klein (New York: McGraw Hill).

    ChadhaBankim andDavidFolkerts-Landau1997The Evolving Role of Banks in International Capital Flowspaper presented at NBER conference on international capital flows held in Woodstock VermontOctober 17–181997.

    LoomisCarol J.1966The Jones Nobody Keeps Up WithFortune(April) pp. 237–47.

    RohrerJulie1986The Red-Hot World of Julian RobertsonInstitutional Investor(May) pp. 86–92.

    WarnerAlison1994Hedging and DitchingThe Banker(April) pp. 43–48.

    WhiteDavid A.1995Investing in Hedge Funds: Investment Policy Implications,” inHedge Funds: Investment and Portfolio Strategies for the Institutional Investored. byJessLederman andRobert A.Klein (New York: McGraw-Hill).

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