Hedge Fund Strategies: A Global Outlook

Hedge Fund Strategies: A Global Outlook

Edited by Brian R. Bruce, PanAgora Asset Management

An Examination of Hedge Fund Return Distributions 14

Mark J.P. Anson

This article examines the return distributions associated with hedge funds. It classifies hedge fund investment strategies into two groups: those with exposure to credit risk, and those with exposure to market risk. Hedge fund strategies with exposure to credit risk demonstrate large downside tails in the distributions of their returns, consistent with distributions of high-yield bonds. Hedge funds that take market risk have a return distribution consistent with that of large-capitalization stocks. Hedge funds with limited or no market and credit risk (market-neutral) have returns that approximate a normal distribution.

The Role of Hedge Funds in a World of Lower Returns 28

Robert D. Arnott

From current valuation levels, it is implausible that stock or bond investors can see long term returns above about 3% to 4%. Indeed, if there is any "reversion to the mean," returns could be a good deal worse. However, in any market environment, there are interesting ways to make money. TIPS, timber, absolute return strategies, arbitrage strategies, and several categories of hedge funds may produce far better returns than stocks or bonds. If all investors seek these opportunities, the opportunities will vanish. But, for the select few who are prepared to venture away from the crowd, there are (and always will be) opportunities for solid profits. This is the role that many hedge funds may serve in the years ahead.

Market Neutral Strategies and the Underfunded Plan 37

Rick Arney, Laurent Dubois, and Asriel Levin

Many plan sponsors are challenged with a required rate of return for their plan that is higher than what the current markets are expected to deliver. This article outlines the severity of the current underfunding problem and evaluates potential solutions with an emphasis on the benefits of market neutral strategies as an alternative to traditional long only management. The authors demonstrate how the use of a market neutral overlay can greatly expand the potential solution set for the plan sponsor and allow a potentially more efficient and lower risk opportunity for closing the underfunding gap.

What the "Indexes" Don't Tell You about Hedge Funds 44

Leola B. Ross and George Oberhofer

A striking limitation of much hedge fund analysis to date is its focus on so-called indexes, which in reality reflect the average returns of peer managers categorized by investment style. The authors focus instead on individual manager return histories and investigate the relationship between individual manager performance and investible equity or fixed-income market indexes. The principal finding is that there is substantial variation in market-relative risk across managers within hedge fund style universes. Many of the style-level effects reported by other researchers are not observed in a majority of individual managers. Further, the dramatic asymmetry noted elsewhere is largely a function of volatility induced by the 1998 Russian debt crisis, rather than some inherent asymmetry in hedge fund return patterns. The upshot is that designing a hedge fund strategy is a bottom-up exercise. Generalizations at the style level are of little use to a hedge fund strategy.

Hedge Fund Investments: Do It Yourself or Hire a Contractor? 60

Ken Stemme and Peter Slattery

This article covers two main topics revolving around the decision to build a hedge fund investment program. The first question an allocator must answer is if a successful hedge fund program can be built with internal resources. This takes into consideration such factors as size of the allocation, budget available for this part of the portfolio, existing resources and expertise, and the time involved in performing first-hand analysis. It is demonstrated that the cost of a consultant or a fund of funds does not differ dramatically from the internal costs once time is factored into the equation. The second portion of the article discusses some questions to consider in choosing a professional allocator such as a consultant or fund of funds. Among these issues are past performance (and how to evaluate it), the role of luck, personnel turnover, motivation, size of team, size of assets, business risk, capacity, the role of asset allocation, hiring and firing discipline, risk management and transparency. The article

Institutionalization of Hedge Funds 69

Leslie Rahl and Stephen Rahl

Funds are in the process of being "institutionalized" both from the inside out and the outside in. Whereas traditionally, hedge funds have been small boutiques with one or more "star" traders and little infrastructure to support them, they have grown in many cases to a size and scope that necessitates infrastructure-the antithesis of what many of the managers wanted when they left large bureaucracies to start hedge funds. At the same time, the mix of investors and, therefore, the requirements of investors have evolved. While for many years it was high net worth individuals who were the primary investors in hedge funds, institutional investors are increasingly investing in them. As a result, it is rapidly becoming an imperative for the hedge fund industry to strike a balance between the changing needs of its growing community of institutional investors against the often times conflicting needs of the hedge fund managers. This article will explore the shifting trends in the hedge fund space and their implicatio

Implementation of Hedge Fund Strategies 74

Ananth Madhavan

Hedge funds expend considerable time and energy in developing investment strategies to generate alpha. The implementation of these ideas, however, is also of critical importance. Transaction costs can substantially reduce and perhaps even eliminate the paper returns to a particular strategy. High turnover and aggressive trading on short-lived information accentuate these problems for hedge funds. This article discusses the essential elements of implementing hedge fund strategies, focusing on all aspects of the investment cycle.

Portfolios of Hedge Funds 81

Gaurav S. Amin and Harry M. Kat

The authors investigate the performance of baskets of hedge funds ranging in size from one to twenty fund s. The analysis shows that increasing the number of funds can be expected to lead not only to a lower standard deviation but also to the less attractive result of lower skewness and increased correlation with the stock market. Most of the change occurs for relatively small portfolios. Holding more than fifteen funds changes little. An efficiency test indicates that one needs to combine only a small number of funds to obtain a much more efficient risk-return profile than that offered by the average individual hedge fund.

Addressing Risks in Hedge Fund Investments 89

Sandeep A. Patel, Bhaskar Krishnan, and Jacqueline Meziani

Like any asset class, hedge fund investment risks can be divided into systematic and unsystematic risks. Systematic risks refer to non-diversifiable risk factors and are compensated by an expected risk premium. Unsystematic risks, or those particular to specific investments, are idiosyncratic and can be minimized through diversification. In this paper, we discuss key systematic and unsystematic risks in hedge fund investments and present the manner in which the S&P Hedge Fund Index (S&P HFI) construction methodology addresses them. The S&P HFI controls exposures to the systematic risks through a disciplined index construction process that incorporates a stratified sampling technique to diversify the sector risk to construct a representative portfolio of hedge funds. We describe the broad sectors and strategies of hedge funds and illustrate the difference between random and stratified sampling. To understand and manage unsystematic risks, the S&P HFI Committee stipulates that an independent, rigorous, and stan

Hedge Fund Organization 98

Gerald T. Lins

This article explores various organizational and structural issues in setting up hedge funds and offshore funds. Among the areas covered are the major issues to consider when choosing a form and/or jurisdiction of organization for domestic funds, primary documents involved, and the relative advantages and disadvantages in making these decisions.

A Matter of Trust: The Issue of Risk Transparency 103

Ted Seides

Poor returns from traditional asset classes, a concurrent bear market for private equity, and acceptance of hedge funds have all led institutions to adopt hedge fund investments in search of returns they once expected from public and private equities. And for many large institutions to invest in hedge funds, trustees must be comfortable with lack of transparency in this industry.

Hedge fund managers have conflicting interests. The author contends that transparency correlates directly with trust and understanding between a manager and an investor. While attempts by industry associations and intermediaries to address transparency issues are commendable, only interpersonal trust and understanding can address the cause.

Hedge Fund Index Returns 111

Anne-Sophie Van Royen

Hedge fund managers generally claim to share one common characteristic: a low correlation with long-only traditional asset classes. The author examines this claim by analyzing conditional correlations between hedge fund return indexes and a conventional bond-stock reference portfolio, using a measure free from conditioning bias, "exceedance correlations." If hedge fund style indexes take advantage of both rising and falling markets, we should observe a stable pattern of conditional correlations over both negative and positive returns. The results in fact suggest otherwise. Fixed-Income Arbitrage and Statistical Arbitrage display a certain degree of independence from the market. For Event-Driven, Fixed-Income, Convertible Arbitrage, and Distressed Securities, there is a disconnection from market conditions, but when markets go up, not when they fall. Correlations between hedge fund styles and the market are far from close to zero under all market conditions.

Direct Investing in Hedge Funds versus Fund of Hedge Funds Products 118

E. Lee Hennessee and Charles J. Gradante

Investing in hedge funds through a public fund of funds or directly investing (i.e. a private fund of funds) are the two core alternatives for investing in the booming hedge fund market. Each has its own advantages and disadvantages and is structured very differently from one another. Which investment strategy is most suitable for the size of your hedge fund allocation and most appropriate for your investment guidelines is the question all investors must answer.

Maximizing Hedge Fund After-Tax Returns 124

Gina Biondo and Maureen Sawyer

With the new SEC rules requiring mutual funds to report after-tax performance, hedge fund managers need to turn their attention to their after-tax returns. This article discusses various strategies to enhance investor after-tax returns and emphasizes the need for hedge fund managers to be aware of all relevant tax issues.

Private Investment Funds and the New Anti-Money Laundering Requirements 133

Roger G. Coffin

The USA Patriot Act imposes anti-money laundering compliance obligations on a broad range of financial institutions. While it is generally agreed that this applies to banks and their affiliates, there is a reason to believe this could be focused on private equity, hedge funds and venture capital firms. Even before that might happen, these firms should consider compliance as an act of good citizenship. This article discusses these compliance issues.

The Hedge Fund Manager's Guide to Equalization 138

Fergus Healy and Cary M. Klivan

A key concern for hedge fund managers globally is the calculation and apportionment of the manager's performance (or incentive) fee. This article reviews the different accounting techniques that hedge fund managers use. The authors show that without the use of certain accounting techniques such as equalization or series accounting the performance fees paid can be disproportionate to the performance turned in over a specific period of investment.

Corporate Resource Directory 144