* Multi-factor approach

In contrast to long-only fund management, where investment strategies are often tethered to benchmarks and usually employ linear trading strategies, hedge funds can invest in a vast range of opportunity sets through a wide array of instruments, often employing complex non-linear or levered trading strategies, or potentially illiquid positions. Furthermore, these investment themes and niche opportunities are often turned over on a much more frequent basis, and hence the historic return profile will inevitably lag the changing dynamics of the investment basis.

Accounting for all of the above, it is evident that, relative to long-only strategies, the presence of these additional degrees of freedom in alternative strategies invariably means that traditional, return-analysis based, risk. Compounding matters, this discrepancy is widely understood to be of greatest significance in the extreme downside tail of the prevailing risk profile.

Detail: Hedge fund risk drivers from a fund of funds perspective

* Hedge Fund unique?

By dynamically trading futures in very much the same way as investment banks hedge their OTC option positions it is possible to generate returns that are statistically very similar to the returns generated by hedge funds but without any of the usual drawbacks surrounding alternative investments, i.e. without liquidity, capacity, transparency or style drift problems and without paying over-the-top management fees.

Hedge fund returns may be different, but they are certainly not unique.


Detail: Hedge Fund Returns: You Can Make Them Yourself!

* Cardboard collateral

“Cardboard collateral” refers to illiquid securities and investments that are deposited as collateral by hedge funds with prime brokers and, in the first instance, not given a “haircut” commensurate with the nature of the instrument and the inability to gain a price or to sell it.

In the opening phases of the sub-prime/credit crisis, prime brokers were forced to revalue downwards the value of illiquid instruments they held, resulting in margin calls and drops in hedge fund AUMs.

* Due diligence

Due diligence is an important source of alpha in a well designed hedge fund portfolio strategy. It is generally understood that the high returns possible in investing in hedge funds are somewhat offset by the relative lack of transparency on operational issues. The performance of a diversified hedge fund portfolio can be enhanced by excluding those funds likely to do poorly - or fail - due to operational risk concerns.

However, effective due diligence is an expensive concern. This implies that there is a strong competitive advantage to those funds of funds sufficiently large to absorb this fixed and necessary cost. The consequent economies of scale that researchers document in funds of funds are quite substantial and support the proposition that due diligence is a source of alpha in hedge fund investment.

Detail: Hedge Fund Due Diligence: A Source of Alpha in a Hedge Fund Portfolio Strategy

* Categorise gatekeepers

A gatekeeper can be defined as anyone who is responsible for selecting, screening and eventually allocating capital on behalf of others. Many gatekeepers exhibit similar qualities in the way they view and evaluate hedge fund investments and this has led to categorise gatekeepers as follows:

1. The Good
– forward thinking, sophisticated and independent thinkers.

2. The Bad
– unsophisticated, alarmists and having a tendency to generalise.

3. The Ugly
– sophisticated, crowd followers and often victims of their large size.

* Taking Advantage

This following paper explores the question of whether hedge funds engage in front-running strategies that exploit the predictable trades of others. One potential opportunity for front-running arises when distressed mutual funds - those suffering large outflows of assets under management - are forced to sell stocks they own.

The researchers document two pieces of evidence that are consistent with hedge funds taking advantage of this opportunity. First, in the time series, the average returns of long/short equity hedge funds are significantly higher in those months when a larger fraction of the mutual-fund sector is in distress. Second, at the individual stock level, short interest rises in advance of sales by distressed mutual funds.

Detail: Do Hedge Funds Profit from Mutual-Fund Distress?

* Misreport Returns?

Some researchers find a significant discontinuity in the pooled distribution of reported hedge fund returns: the number of small gains far exceeds the number of small losses.

The discontinuity is present in live funds, defunct funds, and funds of all ages, suggesting that it is not caused by database biases. The discontinuity is absent in the three months culminating in an audit, funds that invest in liquid assets, and hedge fund risk factors, suggesting that it is generated neither by the skill of managers to avoid losses nor by nonlinearities in hedge fund asset returns. A remaining explanation is that hedge fund managers avoid reporting losses to attract and retain investors.

Detail: Do Hedge Fund Managers Misreport Returns? Evidence from the Pooled Distribution

* Convergence & Divergence

Hedge Funds and Private Equity Funds have long been treated as two distinct alternative invesment categories. However, these two styles of investing may be converging, some hedge fund advisers are taking a more active role in their investments and directing fund assets to areas that were traditionall occupied by private equity advisers. At the same time, the securities regulation framework under which these two types of funds operate has recently begun to diverge.

Detail: Convergence and Divergence: Blurring the Lines Between Hedge Funds and Private Equity Funds

* Relative performance matters

Some research papers that are related to the relative performance: (it will be updated regularly)

1. Compensation Option, Managerial Incentives and Risk-Shifting in Hedge Funds
They find that compared to absolute performance, relative performance has a stronger influence on the risk-taking behavior of hedge fund managers. This result is not uniform over all strategies.

* Selection Criteria

Institutions’ Hedge Fund Selection Criteria - What are the Most Critical Factors in Selecting a Hedge Fund and/or Fund of Hedge Fund?

^{Source: Bank of New York and Casey, Quirke and Associates.
Institutional Demand For Hedge Funds 2
October 2006}

^Details:

Communication has never been so important

* Hedge Fund Regulation

This paper "Capital Flows and Hedge Fund Regulation" introduces a cross-country law and finance analysis of the flow-performance relationship for hedge funds. The data indicate that distribution channels in the form of private placements and wrappers mitigate the impact of performance on fund flows. Distribution channels via investment managers and fund distribution companies enhance the impact of performance on fund flows.

Funds registered in countries which have larger minimum capitalization requirements for funds have higher levels of capital flows. Funds registered in countries which restrict the location of key service providers have lower levels of capital flows. Further, offshore fund flows and calendar effects evidenced in the data are consistent with tax factors influencing fund flows. Our findings are robust to Heckman-selection effects for offshore registrants, among other robustness checks.

Details: Capital Flows and Hedge Fund Regulation

* Benefits of Bond ETFs

Recent market difficulties have drawn attention to the risk management practices of institutional investors. particularly significant was the fact that negative equity market returns were eroding plan assets at the same time as declining interest rates were increasing benefit obligations. these events have spotlighted the weakness of current funding standards for corporate defined benefit pension plans. They have also emphasized the weakness of investment practices.

There are readily available tools that can allow institutional investors in general, and pension funds in particular, to implement a more structured investment and risk management process. More specifically, it can be shown the benefits that institutional investors can gain from the implementation of active and passive asset allocation decisions cast in the context of core-satellite portfolio management and implemented by dynamic trading in bond Exchange Traded Funds. (ETFs)

Details: Benefits of bond ETFs for institutional investors, The Natural Vehicle for a core-satellite approach

* Autocorrelation, bias & fat tails

In Martin Eling literature (2006), hedge funds often are evaluated by Markowitz portfolio selection theory, under which hedge funds appear to be a remarkable opportunity, seeing as they are characterized by low correlations to stock and bond markets and therefore offer the chance of better portfolio diversification.

However, this approach neglects three problems concerning the returns of this alternative type of investment. When comparing the returns of hedge funds to those of traditional investments, the former show a significant extent of autocorrelation, bias, and fat tails. When these problems are incorporated in a performance evaluation of hedge funds, this type of fund loses most of its attraction.

see detail: Autocorrelation, Bias, and Fat Tails - Are Hedge Funds Really Attractive Investments?

* Assessing the suitability for individuals

When assessing the suitability of hedge funds for individuals, an assumption about taxes must be part of the consideration. Hedge funds by their very nature are tax-inefficient investments. Because of their opportunistic nature, most hedge funds tend to turn over their positions well before they become long-term for tax purposes. Shorting is also tax-inefficient because it always results in short-term gains or losses, regardless of how long a fund holds the position.

The criteria for determining whether a hedge fund would be appropriate for a wealthy investor really come down to a few critical factors. Firstly, after accounting for fees and taxes, what does the investors get to keep? Hedge funds, unlike individual stocks, bear hefty management fees (typically 2%) and carried interest (usually 20%).

Secondly, can the investor get the same risk-return profile through a traditional investment vehicle? Hedge funds, especially long/short equity funds, are not a separate asset class but rather an alternative approach to investing in a traditional asset class. So when considering investing in hedge funds, the investor also needs to be aware of the traditional investment options.

Because hedge funds are largely unregulated investments, there is a certain degree of business risk on the part of the underlying manager. This risk can be mitigated by proper manager research, but it can never be completely eliminated. There is no need to engage in this risk if it is possible to get a similar risk/reward tradeoff in a traditional investment vehicle.

The decision to include hedge funds in the portfolio of wealthy individuals is ultimately determined by their individual circumstances. Hedge funds only become appropriate when the risk/return tradeoff is unavailable through traditional investment options.

see detail: Are hedge funds suitable for individual investors?

* Good ethics is good business

Business management studies over the years have shown that between 65% and 75% of all managers will face major ethical dilemmas (e.g. situations in which knowing what the ‘right thing’ to do may not be clear or certain) in the course of their careers. An important indicator of the alternative investment industry’s maturation and development is its embrace of formalised expressions of ethical behavior.

Horizon Cash Management's survey (2006) reveals that 84% of respondent firms have a written Code of Ethics and/or Code of Conduct. A like-minded number (85%) maintain a Policies and Procedures Manual. Importantly, rather than existing merely as an internal document, each is highly likely to be shared with investors.

While it’s a truism that ‘good ethics is good business’, the survey provided significant evidence that investors have enormous influence in helping hedge fund firms shape their ‘best practices’. Eighty percent of respondents stated that their investors believe it to be ‘important or very important’ that the firm’s operational controls be sound and effective; 75% reported that investors placed the same high values (‘important or very important’) on regulatory controls being sound and effective.

see detail: Alternative investment community embraces sound practices

* (The future of) the fund of funds

For many years, industry observers have been confidently predicting the eventual demise of the fund of funds sector on the basis that, given the extra layer of fees, investors would sooner or later cut out the middle man and go direct to the funds they want. The statistics continue to show this simply is not happening – or at least not yet.

Ironically, the biggest negative news event of the year 2007, (the sudden collapse of Amaranth), in some ways demonstrated, yet again, just why funds of funds continue to be the most popular route for end-investors. While it could certainly not be described as good news for those fund of funds groups who allocated to Amaranth, their end-investor (Accredited investor) clients will generally have lost a lot less than investors who went direct. For most fund of funds groups affected, it ultimately became a performance issue, taking some of the shine off gains made elsewhere, rather than a life-threatening blow.

Investors in hedge funds can be categorised in many ways but the most clear distinction is between fund of hedge funds managers and direct investors: 1. Fund of hedge funds managers: These entities manage diversified portfolios of hedge funds (usually in the form of collective investment schemes), and provide their investors with services such as fund selection and risk management in return for a fee. 2. Direct investors: Hedge funds are aimed primarily at institutional and sophisticated investors. Direct investors include pension funds (public and private), endowments, foundations and family offices.

see detail:
(1) Alternative becomes ever more mainstream
(2) Are Funds of Funds Simply Multi-Strategy Managers with Extra Fees?

* Investors' funding strategy

Some researchers find a significant and positive relation between aggregate cash flows and past aggregate hedge fund returns, indicating that hedge fund investors as a group chase past aggregate performance. However, as common investment textbook argued that past information may not be able to reflect who is a Star or just a Monkey.

These researchers also report a significant and positive relation between aggregate cash flows and contemporaneous aggregate hedge fund returns. However, they find marginal evidence on a negative relation between aggregate fund flows and subsequent hedge fund returns, suggesting that hedge fund investors as a group are unable to successfully time hedge fund returns.

In fact, they state that investors put money into the hedge fund sector following high stock market returns and low returns on Treasury bills, while stock and bond market returns are not related to past aggregate hedge fund flows.

see detail: Aggregate Hedge Fund Flows and Asset Returns

* 130/30 funds

130/30 funds are similar to long-only funds to the extent that they build a portfolio as normal, allocating 100% of net asset value to long positions. They differ, however, from traditional long-only portfolios to the extent that they then short sell securities to the value of 30% of net asset value. The proceeds from the short sale are then used to acquire additional long positions, thereby bringing the total exposure to 130% long and 30% short. The 130/30 product provides market exposure or “beta” but also enables the fund to generate additional “alpha”.

The introduction of a product which incorporates a mechanism for generating alpha has got to be an appealing proposition for investors. There is, however, a real danger that managers with little or no experience in shorting will bring products to the market which underperform the market and not only fail to deliver alpha but also have a negative impact on the managers’ ability to produce beta.

Furthermore, in current market situation, eliminating short selling, will have direct effect on this investment strategy. However, hedge funds will come up with other innovative strategies to counter this move.

see detail:
(AIMA) 130/30 funds - a new middle ground?
Hedgeweek Comment: Short selling ban not the solution

* Three common myths

AIMA explains to us three common myths persist about hedge funds in the policy debate.

(1) Hedge funds are unregulated
(2) They pose a risk to Europe's financial stability
(3) They caused or exacerbated the current financial crisis

The reasons for causing these misunderstanding seem to be the lack of : transparency of investment strategies and risk management, reporting obligations, disclosure of shareholder structure, supervision by public agencies, also the role of rating agencies and the danger of money laundering.

In reality, hedge funds and hedge fund managers are extensively regulated in Europe, and they neither pose threat to Europe's financial stability nor exacerbated the current crisis. In fact, the great diversity of asset classes and investment strategies used by hedge fund managers spreads the risk, they are also adding liquidity to markets under stress and cushioning market falls.

See detail: (AIMA) Hedge Funds: Is Regulation Needed?

* A simple explanation from Wikipedia

An alternative investment is regarded as an investment product other than traditional investments such as stocks, bonds, money markets, and/or cash.

As the definition of Institutional Investor magazine's Alternative Investment Newsletter indicates, alternative investments include commodities, financial derivatives, hedge strategies (or absolute return strategies), real estate, and private equity, as well as venture capital. They are supposed to have very low correlation with traditional investment products. However, this definition may not be suitable due to a fast-changing investment environment and should be reconsidered over time.

Some alternative investment managers, such as hedge funds, cannot advertise or announce their performance under U.S. and European law. Most hedge funds or private-equity groups accept investments from only high-net-worth individuals or institutions.

Although many hedge funds cannot advertise, accredited investors, in accordance with Rule 501a of Regulation D of the U.S. Securities Act of 1933, can access the BarclayHedge databases of 6,400 hedge funds and download fund information, including AUM, contact information, and full performance data since inception.