Hedge Fund Studies

Modern Hedge Fund of Funds for Well Informed Investors

Hedge funds pool money from wealthy individuals and institutional investors in order to invest in stocks, bonds, foreign currency and derivatives. They are organized as limited partnerships, and the minimum investment is usually set at $1 million in order to avoid regulation by the Securities and Exchange Commission. Some hedge funds pursue highly leveraged investment strategies that take on high risk in order to gain a higher rate of return. Others employ more conventional approaches to investing.

There are an estimated 5,800 hedge funds worldwide, most of which are operated out of the U.S. even though they are often registered off-shore to avoid taxation, with $311 billion in capital.

The name hedge fund is somewhat of a misnomer. It originated in 1949 to describe the investment strategy of Alfred Winslow Jones. His idea was to take a long position by purchasing certain stocks and at the same time take a short position by short-selling other stocks. The combined positioned balanced or hedged the investment fund against changes in the overall level of the market, and allowed him to profit from a change in the relative price of the two positions. Today, this is known as a "relative value" investment strategy. Thus the original meaning of the term "hedge fund" does not mean that the investment is completely hedged, but rather that it is hedged against the risk of a change in direction of the overall market.

There are several types of investment strategies pursued by hedge funds, the most common are described below.

In the words of hedge fund operator George Soros, Our type of hedge fund invests in a wide range of securities and diversifies its risk by hedging, leveraging and operating in many different markets. It acts more like a sophisticated private investor than an institution handling other people’s money.

Soros is known for several instances in which his fund profited heavily from directional investments by speculating against what he perceived was a weak currency. He is credited with the collapse in the value of the British pound in September of 1992, and accused of bringing down the Malaysian ringgit in 1997.

Australia’s central bank, the Reserve Bank of Australia, produced two reports in 1999 on the potentially destructive role of highly leveraged institutions such as hedge funds. The reports claims that hedge funds contributed to the instability of its exchange rate in 1998, and it describe how hedge funds can have a destabilizing impact on not only the currencies of emerging economies but also on currencies such as the Australian dollar which has the eighth largest global trading volume.

The most notorious hedge fund failure, Long Term Capital Management, involved a variety of investment strategies. They took a directional bet on Russian bonds, while the greatest share of their investments were relative value plays on the interest rates on various bonds and swaps. In one instance they went short the 30-year bond and long the 29-year bond in the expectation of profiting from a fall in the spread between their yields. In order to execute this strategy they made extensive use of leverage in the repurchase agreement or "repo" market by financing about 99% of their purchase of the 29-year bond and borrowing the 30-year bond in order to sell it short.

It is important to point out that other financial institutions, including investment banks and commercial banks, have 'proprietary trading desks' that often act in the same way as hedge funds. They take a "view" or "position" on the market that can involve a directional bet or a relative value play. However, instead of the partnership’s capital, they use the firm’s capital.

There are several regulatory issues involving hedge funds. One issue is their role in destabilizing or attacking foreign exchange rate systems. Although they have a small proportion of the capital in financial markets, they use leverage to take significantly large size positions in those markets. In addition, their market reputation creates followers and induces trend investors to take the same bets so that the combined effect is often the self-fulfilling investment strategy against the value of a nation’s currency.

Another issue is their use of direct credit from banks and broker-dealers to financial their trading operations, and the use of indirect credit through repurchase agreement and securities lending markets to take highly leveraged positions in securities and derivatives markets. These credit relationships mean that a failure of a hedge fund could undermine the solvency of banks which hold government insured deposits and money center banks which also serve critical roles in the economy’s cash payment and securities clearing systems.

Yet another issue raised by hedge funds is their lack of transparency. Not only do they participate in the non-transparent over-the-counter derivatives markets, but the hedge funds as financial institutions are not required to report their positions, trading activities or creditworthiness



Pension Funds Investment in Hedge Funds

Financial Policy Forum

Derivatives Study Center

Investors of many stripes – including pension funds – are moving away from traditional lines of investments in order to pursue potentially higher yielding investment opportunities. This has come to be known as “chasing yield.” In an efficient financial market, chasing yield means moving along the securities line so as to capture higher rates of return by taking on greater amounts of risk. As long as the rate of return is sufficient to justify the greater risk, then it is an efficient investment activity. Where an investor, even an institutional investor, chooses to be along that frontier of risk-return trade-offs depends on the needs and circumstances of the investor.

Whether certain levels of risk are suitable for a particular investor, or institutional investor, is an important policy decision. Given the importance of retirement income for economic and social stability, the decisions about risk and the prudential management of pension funds is paramount.

The public interest in pensions funds is clearly identified in the Employee Retirement Income Security Act of 1974 which stated the “national public interest” of pension funds and recognized that they “effect the well-being and security of millions of employees and their dependents” and are “an important factor affecting the stability of employment and industrial relations.” The Act also recognized that there is otherwise a lack of employee information and adequate safeguards in pension fund management.

Deciding the terms of what constitutes prudential pension fund investment is a matter of judgment for policy makers, and I hope this following insights into the concerns with high yield investments will help inform those decisions.

Potential Problems

One of the key policy issues raised by pension funds’ pursuit of higher yield has been the large rush into the area of hedge fund investments. According to a report by Greenwich Associates, “By far the biggest contributor to the current hedge fund boom is the widespread participation of pension funds.”1 Similarly, “The fastest growing share is pension funds,” stated a Hennessee Group report.

The benefits of investing in hedge funds are apparent. The table attached to end of this testimony includes data from the Hennessee Group which shows that hedge funds have generates risk-adjusted rates of return that are superior to traditional assets as measured by the major stock and bond indices. The comparison is truly impressive.

One should however approach the comparison with the following qualification. Although Hennessee does an excellent job in collecting this data there are inherently some problems. The data is reported on voluntary basis and tends to reflect the more successful funds rather than the laggards or failures. The risk on the returns is measured by a simple calculation of the standard deviation which does not distinguish between the same sized negative and positive changes in yield nor does it reflect whether the distribution of returns has a fat tail. Still, they are impressive figures.

The costs or potential problems with investment in this asset class known as hedge funds are not as apparent. The following identifies several types of potential problems arising from pension fund investment in hedge funds.

1. Fraud

Many hedge funds are under investigation, in court, or have settled charges of financial fraud. SEC Commission Campos stated, “Over the past seven years, the SEC has brought 96 enforcement cases against investment advisers for defrauding hedge fund investors, or using hedge funds to defraud others.”2 In addition to those charged there are many more under investigation by the SEC or States Attorneys General. The fraud usually involves the misuse of investor funds, and in some instances the fraud arises in response to crushing loses on investments that lead to outright embezzlement and flight.

There are two principle reasons that hedge fund investments are especially subject to financial fraud, and these are key features distinguishing hedge funds from other more established investments.

1. Fund managers are not subject to the same registration and reporting requirements as securities brokers and some other investment fund managers. They are not required to undergo background checks, pass series 7 exams, maintain records, and disclose reports from independent auditors.

– The Securities and Exchange Commission explained it like this. “Like mutual funds, hedge funds pool investors' money and invest those funds in financial instruments in an effort to make a positive return. However, unlike mutual funds, hedge funds are not registered with the SEC. This means that hedge funds are subject to very few regulatory controls. In addition, many hedge fund managers are not required to register with the SEC and therefore are not subject to regular SEC oversight.

This distinction combined with the fact that there are many new start-up hedge funds and hedge fund managers – creating what Forbes magazine called “amateur hour” in the hedge fund industry – means that other means of market discipline that come from reputation risk, references and referrals does not work as effectively as in traditional segments of financial markets.

HedgeFund.net reports that 10% of the hedge funds it tracks “became defunct” in the 12 months ending May 2004.

2. The investment strategies of many hedge funds – though certainly not all – make it difficult for the funds’ assets to be marked to market. This is known as the “valuation problem.”

3 When investors cannot effectively monitor the performance of fund managers by frequently observing the returns on the funds, then it decreases the ability to detect fraud and crippling loses that sometimes leads to fraud.

– One such example comes from Ohio Bureau of Workers’ Compensation which invested in MDL Capital Management and lost $215 million in just a few months.

2. Liability

Some hedge funds have engaged in illegal trading strategies, and these expose the investors not to the criminal liability but to substantial loses from the cost to the fund from fines, penalties, legal fees and restitution. These losses are in addition to any reputational loses to investors.

– Study by the Bank of New York surveyed market participants and found that over 50 percent of respondents identified hedge funds as “most likely to be at the center of an investment controversy” in the next five years.5

– SEC Final Rule on Hedge Fund Regulation stated “Our staff counts almost 400 hedge funds (and at least 87 hedge fund advisers) involved in these [mutual fund trading] cases and others under investigation.” That is a lot of potential investor losses from hedge funds’ illegal trading activities. – One current hedge fund investment strategy – in the merger arbitrage area – is to go after corporate governance control in a manner that treads on the edge of legality concerning the voting rights of encumbered shares. This may result in ‘headline risk’ as well as potential litigation costs.

3. Market Risk

Hedge funds are not like traditional asset classes. Here are some distinguishing features that raise concerns about the levels of risk and the ability to manage it.

The best hedge funds are closed to new investments or new investors. New entrants are often left to choose amongst the second tier fund managers and new start-up funds.

– “It’s amateur hour in the hedge fund business” – Hedge Fund Research reported that 900 hedge funds are less than one year old. That may be an understatement as the Cayman Islands Monetary Authority (CIMA) reports that over 900 new funds have registered with it in the first nine months of 2005. CIMA previously reported that hedge fund registrations was up 112% from 2003 in 2004.

– Moreover, as an increasing amount of new investment moves into this asset class, it not only must move into newer or lower tier fund managers but the amount of remaining high yield investment opportunities will be exhausted or will disappear from the greater inflow of funds.

– Given this characterization of the hedge fund industry, the following results should not be surprising:

A study by Brooks and Kat estimates that 30% of new hedge funds do not make it past 36 months due to poor performance.7

A study by Baquero, Horst, and Verbeek finds an annual attrition rate of 8.6% for the period 1994-2000.8

A study of 100 liquidated hedge funds by Feffer and Kundro shows that half of all failures are due to “operational risk alone" and that ”The most common operational issues related to hedge fund losses have been misrepresentation of fund investments, misappropriation of investor funds, unauthorized trading, and inadequate resources."

Fat tails. Some hedge funds take large naked positions in order to capture higher rates of return. As a consequence they are sometimes devastated by large but unlikely price movements. Just this Monday one of the world’s largest hedge funds, twice the size of Long Term Capital Management, suffered a 50% loss on its investments by taking the wrong position on changes in natural gas prices.

Those losses lead to intense “discussions” – read negotiations – with its primary broker Goldman Sachs and also affected one of its major investors Morgan Stanley. The fund is expected to close. The week before, it was reported that the $460 million hedge fund MotherRock – operated by a former NYMEX president – lost $230 million on energy trades in a few weeks.

See Hedge Fund Street for February 2006. Brooks, C. and H. Kat. 2002. “The Statistical Properties of Hedge Fund Index Returns and Their Implications for Investors." Journal of Alternative Investments 5 (2), 25-44. Baquero, G., Horst, J. and M. Verbeek. 2002. "Survival, Look-Ahead Bias and the Performance of Hedge Funds." Erasmus University Rotterdam Working Paper. Feffer, S. and C. Kundro. 2003. “Understanding and Mitigating Operational Risk in Hedge Fund Investments." Working Paper, The Capital Markets Company Ltd.

The investment strategies of hedge funds are often not well known, or are so lacking in transparency – even to their own investors (prospectuses are often written to allow funds a great deal of latitude in crafting their investment strategies) – that the investors cannot adequately assess the hedge fund investment’s contribution to their over portfolio risk. Without thorough knowledge of the hedge fund investment strategy, the investor can determine whether they are diversifying into independent, uncorrelated assets or not. Alternative investments are supposed to offer uncorrelated returns, but that investment property should not be – although it too often is – taken on faith. This is not consistent with the behavior of a prudent investor.

– According to the Financial Economists Roundtable, “available performance data make it difficult to judge true hedge-fund returns and risk for this high-cost vehicle.” The report goes on to advise fiduciaries, “The difficulties in assessing the full range of hedge-fund risks should dictate a limitation on investments in hedge funds to a modest proportion of the total assets under management.”10

Hedge funds charge high fees and sometimes incur large transactions costs. The risk-adjusted rates of return on these investments need to be considered net of these fees and costs. These fees are usually 1% to 2% of invested capital plus 20% (or more) of returns. Investing through a fund of hedge funds will cost another 0.5% of invested capital. If the investment strategy generates a return of 10%, then 2% fixed fees and 20% fee on returns leaves the investor with a 6% rate of return. A 20% rate of return on investment will leave the investor with a 14% rate of return – which is high compared with major market indices but is likely to involve greater risk. Their transactions costs are estimated to generate over 12% of all brokerage commissions.

As a consequence of the structure of these fees, investment managers have a great incentive to pursue high yield (and thus high risk) investment strategies since their 20% to 25% share of the returns sometime does not kick-in until the rate of return has exceeded a specified threshold.


The point here is not that all hedge funds are out to commit fraud. Nor is it to say that they do not offer in many instances a good risk-adjusted rate of return (see Table 1 below for some comparisons).

The point is that investing in hedge funds poses various potential problems and that these problems are different than those of traditional investment classes. The point is to recognize that this investment class is fraught with a different set of investment challenges – if not dangers – and that a different and more appropriate approach is needed in order to maintain fiduciary responsibilities towards pension fund investments.

In recognizing this distinction between hedge fund and traditional investment vehicles, the protection of the public interest inherent in pension funds requires that investments in hedge funds and similar alternative investment strategies should be treated withappropriately higher prudential concerns. One straight forward way to maintain this protection is limit the extent of such investments – a policy also recommended by the conservative Financial Economists Roundtable. Similarly, another way to maintain this protection is to continue to extend the ERISA prudential framework for fiduciary responsibility of funds to these new but increasingly important investment targets.


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