insights growth and size by triphon phumiwasana, tong li, james r. barth and glenn yago

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1 by triphon phumiwasana, tong li, james r. barth and glenn yago In September 2006, the high-flying Amaranth Advisors hedge fund unraveled in spectacular fashion. Its assets fell by a reported 65 percent in a month and fully $6 billion for the year. But the financial markets barely reacted to Amaranth s meltdown counterpoint to the convulsions after the near collapse of Long-Term Capital Management in Nonetheless, the dramatic fall of Amaranth does raise serious issues about the performance and risk of hedge funds, and their potential to affect the broader economy. Here, we use a comprehensive data source to gain some insight into the workings of these largely unregulated investment vehicles. Hedge funds are set up as limited partnerships and are thus not constrained by the elaborate rules that circumscribe the behavior of publicly registered mutual funds. Furthermore, although the word hedge generally refers to the hedging of financial risk through the use of derivative instruments or the simultaneous use of long positions and short sales of securities, most hedge funds employ strategies that do not involve hedging. Indeed, many funds profit through investment leverage of one form or another, which is how bad bets led to the collapses of Amaranth and LTCM. Thus, along with outlining the dimensions of the industry, one of our goals is to get TRIPHON PHUMIWASANA and TONG LI are economists at the Milken Institute. JAMES R. BARTH is Lowder Eminent Scholar in Finance at Auburn University and senior fellow at the Milken Institute, where GLENN YAGO is the director of capital studies. A version of this paper was presented at the Conference on International Financial Instability at the Federal Reserve Bank of Chicago in October a sense of the relationship between risk and expected return in hedge fund portfolios. Several sources of hedge fund data are available, with varying coverage. We used hedgefund.net, which starts with eight hedge funds with $57 million in assets in 1981 and grows to 6,445 funds with $969 billion in assets as of June This data permitted us to examine differences in important characteristics of hedge funds both over time and by the types of strategy that funds employ. We also used regression analysis to examine the association between various characteristics of a fund and its performance and risk, and to examine the association between fund characteristics and the likelihood that a fund has survived in the marketplace. growth and size The recent flurry of interest in hedge funds might lead some to think that such funds are a relatively new development. In fact, the first dates back to It successfully employed First Quarter

2 a long/short equity strategy and operated on the basis of leverage, which also describes the strategies of many hedge funds today. The number of funds grew rapidly for a few years before retreating in the face of falling equity markets. But the industry rebounded in the 1980s, spurred in part by press reports of extraordinary returns available only to the rich and connected. As the table on the next page documents, the industry experienced rapid growth in both assets and numbers of funds until the decline in the latter during the first half of From 1981 to June 2006 the number of funds grew at a 30 percent average annual rate, while total assets grew at a blistering 47 percent average annual rate. Of course, not all funds that entered the industry during this period remained alive until the ending date. Indeed, by June 2006, some 3,100 funds with nearly $260 billion in assets had been liquidated. Despite these exits, though, 6,445 funds remained at midyear, with $969 billion in assets. Their average age: 5.3 years. differences in size, domicile and asset location The average size of hedge funds increased more than twenty-fold in the quarter century since 1981 $7 million to $150 million despite the fact that the average size of exiting funds is greater than the average size of entering funds. Funds with $1 billion or more in assets account for only 3 percent of the total number of funds, but more than one-third of the industry s total assets. Conversely, funds with $100 million or less in assets account for nearly 70 percent of the total number, but only 12 percent of the total assets. Another perspective is provided by the domicile (headquarters location) of hedge funds and the location of their assets. Slightly more than half the funds are domiciled in the United States, and of these about half have their assets located in the United States. Europe is second to the United States in terms of numbers of domiciled funds, accounting for approximately one-third of the total. And these European-based funds hold only about 20 percent of their assets in Europe. The ma- the new yorker collection BJJI robert mankoff from cartoonbank.com. all rights reserved. 82 The Milken Institute Review

3 TWENTY-FIVE YEARS OF HEDGE FUNDS OF WHICH GRAVEYARD (ACCUMULATION OF TOTAL CHANGES IN ENTERING EXITING EXITING FUNDS) NUMBER ASSETS ($MILLION) NUMBER ASSETS ($MILLION) NUMBER ASSETS ($MILLION) NUMBER ASSETS ($MILLION) NUMBER ASSETS ($MILLION) $57 na na na na na na na na $78 4 $21 4 $8 na na na na $228 6 $151 6 $157 na na na na $531 9 $302 9 $8 na na na na $944 6 $413 6 $37 na na na na $1, $ $35 na na na na $1, $ $68 na na na na $2, $ $104 na na na na $3, $ $259 na na na na $5, $1, $726 na na na na $7, $2, $976 na na na na $9, $1, $1,248 na na na na $17, $7, $1,596 na na na na $19, $2, $894 na na na na $25, $5, $2,008 na na na na ,117 $35, $10, $2,952 na na na na ,522 $58, $22, $4,793 na na na na ,041 $76, $18, $5,565 6 $125 6 $ ,733 $140, $63, $15, $2, $2, ,250 $170, $30, $21, $12, $14, ,825 $237, $67, $18, $10, $24, ,596 $281, $43,966 1,117 $25, $25, $50, ,333 $508, $226,974 1,176 $59, $15,552 1,402 $65, ,235 $698, $189,783 1,372 $50, $74,791 1,872 $140, ,526 $839, $140,476 1,057 $45, $67,725 2,638 $208,256 june ,445 $968, $129, $16, $48,582 3,100 $256,838 note: Data on exiting funds only became available since source: Hedgefund.net jority of the funds (64 percent) have global portfolios. It s worth noting that the European-domiciled funds invest more in Asia than their American counterparts. Globally, the top 1 percent of hedge funds control 19 percent of all fund assets. The top 5 percent control 47 percent, while the top 10 percent control 63 percent. However, there is wide variation in concentration ratios with respect to the location of fund assets. The top 1 percent of funds with assets located in South America, for example, account for 58 percent of all hedge fund assets located on that continent, and the top 1 percent of funds with assets located in Africa account for 46 percent of all hedge fund assets located in Africa. Similarly, there are substantial differences in the concentration ratios with respect to fund domiciles. The top 1 percent of funds in Africa and the Middle East account for 72 percent of all assets of funds in the regions. In Europe and the United States, however, the concentration in the top 1 percent is a relatively low 18 percent. fund strategies Our data lists 42 different strategies for the hedge funds being examined, including other and unknown. We combined similar categories to create a more manageable 12 strategies (including one for other and unknown): Multi-strategy fund of funds, combining stakes in multiple hedge funds with multiple strategies. Long-short equity, buying some stocks long First Quarter

4 and selling others short. Common strategy fund of funds, combining stakes in multiple funds with a common investment strategy. Event-driven, taking positions in special situations, including distressed stocks, and merger and takeover candidates. Market-neutral, taking positions where the profit depends on technical arbitrage rather than betting on gain or loss in security value. Commodity trading advisor, buying or selling commodity futures or option contracts. Multi-strategy, using eclectic strategies to produce returns. Global, basing investment on geopolitical insights. Macro, basing investment choices on macroeconomic variables such as interest rate trends, and international financial and trade flows. Sector, focusing on specific industries, such as biotech or defense. Directional, using straightforward long or short positions. Other The dominant categories are the multistrategy fund of funds (25 percent of funds) and the long-short equity strategy (20 percent of funds). These two categories account for 30 and 17 percent of the total fund assets, respectively. Not surprisingly, the relative popularity of strategies is always in flux. For example, the commodity trading and directional funds accounted for large shares in the 1980s, but have declined sharply since. Assets are fairly concentrated in the large funds. Asset concentration in the top decile varies from 50 percent in sector strategy funds to 71 percent in macro strategy funds. management fees and service providers The magnitude and incentive structure of hedge fund fees have become hot issues. A modest minority funds controlling only 5 percent of the industry s assets set fees at 0.75 percent or less, while funds accounting for 55 percent of total assets set fees at 1.25 percent or higher. There has been a general increase in management fees, but substantial variation remains. Some 60 percent of all hedge funds charged incentive fees (on top of management fees) of 15 percent or higher that is, managers stand to take home more than 15 percent of TOTAL NUMBER AND ASSETS OF HEDGE FUNDS BY STRATEGY TOTAL SHARE OF TOTAL NUMBER (%) MULTI-STRATEGY LONG-SHORT COMMON STRATEGY COMMODITY FUND OF FUNDS EQUITY FUND OF FUNDS EVENT-DRIVEN MARKET-NEUTRAL TRADING ADVISOR NUMBER ASSETS PERCENT ASSETS PERCENT ASSETS PERCENT ASSETS PERCENT ASSETS PERCENT ASSETS PERCENT ASSETS ($MILLION) ($MILLION) ($MILLION) ($MILLION) ($MILLION) ($MILLION) ($MILLION) $57 0% $0 0% $0 13% $0 25% $0 0% $0 50% $ $ $3 12 $4 3 $22 15 $2 6 $0 27 $ $5, $7 14 $11 6 $3 22 $9 4 $1 18 $ $25, $16 16 $15 9 $9 14 $8 10 $9 12 $ $170, $14 20 $21 9 $8 15 $13 11 $14 9 $ $237, $17 21 $21 9 $8 13 $13 11 $14 8 $ $281, $22 20 $19 10 $8 12 $10 12 $14 8 $ $508, $29 20 $14 9 $8 10 $10 11 $12 8 $ $698, $27 20 $16 9 $8 10 $10 10 $12 8 $ $839, $30 20 $17 9 $8 9 $10 9 $9 7 $5 june $968, $30 20 $17 10 $9 9 $10 9 $8 7 $5 source: Hedgfund.net 84 The Milken Institute Review

5 fund profits. Moreover, performance incentives have been rising since the early 1980s despite the tremendous increase in the number and assets of hedge funds. PricewaterhouseCoopers, Ernst & Young and KPMG are the accounting firms of choice for 54 percent of all hedge funds, and those funds account for 65 percent of total assets. Nearly 40 percent of the funds (with 41 percent of assets) do not report information about which brokerage firms are used. Of those that do report this information, Morgan Stanley, Goldman Sachs and Bear Stearns are the top three brokers, servicing about one-fourth of all funds. lockup periods Hedge fund investors are generally required to remain in funds for a specified minimum time called the initial lockup period. For nearly half the funds the lockup is quite short 30 days or less. Most others lock up investments for less than one year. But the trend is toward longer lockups, reducing the funds need for liquidity. Average lockup periods vary with the fund category, with the shortest for commodity trading and longest for the sector funds. ASSET CONCENTRATION RATIOS OF FIRMS OWNING HEDGE FUNDS BY STRATEGY STRATEGY TOP 1% TOP 5% TOP 10% Fund of funds multi 16% 43% 57% Long-Short 13% 38% 54% Directional 21% 41% 55% Fund of funds common 13% 36% 52% Event-driven 18% 45% 61% Market-neutral 21% 46% 59% CTA 19% 47% 64% Multi-strategy 23% 47% 64% Global 19% 42% 56% Macro 32% 58% 71% Sector 8% 31% 50% Other 32% 48% 64% All Strategies 19% 47% 63% source: Hedgefund.net performance and risk of hedge funds The average annual return of hedge funds from 1981 to June 2006 ranges from a low of 4.8 percent in 1994 to a high of 32.4 percent in The volatility of average monthly returns, as measured by the standard deviation of returns, has decreased with time, but differs widely among fund categories. The most volatile returns were reported by those funds employing a macro strategy in 1987, while the lowest volatility was reported in 1982 by SHARE OF TOTAL NUMBER (%) MULTI-STRATEGY GLOBAL MACRO SECTOR DIRECTIONAL OTHER PERCENT ASSETS PERCENT ASSETS PERCENT ASSETS PERCENT ASSETS PERCENT ASSETS PERCENT ASSETS ($MILLION) ($MILLION) ($MILLION) ($MILLION) ($MILLION) ($MILLION) % $0 0% $0 0% $0 0% $0 0% $0 13% $ $1 0 $0 0 $0 0 $0 18 $58 3 $ $1 1 $0 5 $6 0 $0 7 $31 5 $ $2 3 $1 3 $3 3 $3 4 $12 5 $ $4 4 $2 3 $2 4 $3 3 $3 5 $ $5 3 $2 3 $2 4 $2 2 $2 4 $ $7 3 $2 3 $2 3 $2 2 $2 3 $ $6 3 $2 4 $4 3 $1 2 $2 3 $ $6 3 $3 4 $4 3 $2 2 $1 3 $ $6 4 $4 3 $3 3 $2 2 $1 3 $5 june $7 4 $5 3 $3 3 $2 2 $1 4 $5 First Quarter

6 multi-strategy fund of funds. It is also useful to examine the persistence of both positive and negative returns. By our calculation, 1,559 funds with $442 billion in assets (as of June 2006) reported positive returns over the previous five years. In contrast, only two funds reported consecutive negative returns. However, as of June 2006, there were 1,128 funds with $104 billion in assets that reported negative returns in the previous year. As economic theory would predict, there is a positive statistical relationship between return and risk within categories. Note, however, that some of the strategies employed by funds have substantially underperformed compared to others in terms of generating a return that compensates for the associated risk. NUMBER OF HEDGE FUNDS WITH PERSISTENT POSITIVE RETURNS NUMBER AND ASSETS OF FUNDS WITH CONSECUTIVE POSITIVE RETURNS FOR: FIRST YEAR PAST 2 YEARS PAST 3 YEARS PAST 4 YEARS PAST 5 YEARS NUMBER ASSETS ($MILLION) NUMBER ASSETS ($MILLION) NUMBER ASSETS ($MILLION) NUMBER ASSETS ($MILLION) NUMBER ASSETS ($MILLION) $ $78 9 $ $ $33 9 $ $ $ $34 7 $ $ $ $ $57 7 $ $1, $1, $ $750 9 $ $1, $1, $1, $ $ $2, $2, $1, $1, $1, $2, $2, $2, $2, $1, $2, $1, $1, $1, $ $7, $3, $2, $2, $1, $8, $7, $3, $2, $1, $16, $13, $9, $5, $3, $8, $7, $5, $4, $2, $24, $11, $10, $8, $5, ,061 $39, $30, $15, $12, $9, ,390 $56, $51, $42, $21, $16, ,480 $59, $53, $45, $39, $20, ,459 $130,467 1,325 $83, $71, $54, $46, ,698 $136,988 1,863 $121,890 1,004 $84, $68, $56, ,137 $204,820 2,040 $166,155 1,398 $137, $88, $71, ,218 $219,303 2,072 $186,291 1,386 $151, $125, $74, ,161 $490,756 2,746 $356,276 1,766 $276,249 1,174 $223, $184, ,728 $635,840 4,316 $580,046 2,293 $432,469 1,494 $337, $269, ,177 $788,039 4,743 $713,267 3,549 $610,264 1,867 $424,411 1,222 $333,090 june ,573 $864,344 4,862 $819,711 3,814 $741,505 2,861 $623,579 1,559 $442,443 We also compared the annualized return on hedge funds to the rate on one-year U.S. Treasury securities. The spread between the two returns has narrowed over the past 25 years, though there is a lot of noise in the trend. Moreover, the 60-month rolling annualized return correlations between the CSFB Tremont Hedge Fund Index and indexes for both stocks and bonds have tended to increase significantly in recent years. This implies that hedge funds have become less well suited to serve as hedges against the volatility of traded securities. Hedge funds (both as a group and by categories) have performed well over various periods compared to the major benchmark indexes. There is, however, a substantial difference in performance depending on the stratsource: Hedgefund.net 86 The Milken Institute Review

7 egies that the funds employ. Furthermore, no single strategy dominates all others for the periods examined. Relationship between the return and selected characteristics of a hedge fund There have been a number of rigorous studies of the performance and risk of hedge funds in recent years. Our goal is more modest: to examine the relationship between returns and selected characteristics of hedge funds. We found that the magnitudes of management fees and performance incentives, the length of lockup periods and age of funds are not statistically related to risk-adjusted return. Regression analysis does suggest a significant positive relationship between the risk-adjusted return and the size of funds. However, this positive relationship between risk-adjusted return and asset size appears to be solely due to the negative relationship between the standard deviation of returns and asset size. Relationship between fund longevity and fund characteristics The data allow us to examine the relationship between selected characteristics of a fund and its likelihood of remaining in existence. The results of our statistical analysis: The more volatile the return, the greater the likelihood of the fund not surviving. The greater the average monthly returns over the period 1997 to 2005, the higher probability of the fund being alive. The bigger and older the fund, the greater the chance it will still be in existence. NUMBER OF HEDGE FUNDS WITH PERSISTENT NEGATIVE RETURNS NUMBER AND ASSETS OF FUNDS WITH CONSECUTIVE NEGATIVE RETURNS FOR: FIRST YEAR PAST 2 YEARS PAST 3 YEARS PAST 4 YEARS PAST 5 YEARS NUMBER ASSETS ($MILLION) NUMBER ASSETS ($MILLION) NUMBER ASSETS ($MILLION) NUMBER ASSETS ($MILLION) NUMBER ASSETS ($MILLION) $ $ $ $ $ $61 1 $ $ $ $2, $178 2 $ $1,257 7 $ $419 7 $25 4 $ $11,519 6 $240 1 $ $1, $ $ $ $1,738 9 $16 5 $ $17, $499 2 $2 2 $ $9, $989 6 $38 2 $16 2 $ $33, $1,825 8 $21 1 $ $33, $8,032 7 $ ,511 $62, $14, $4,740 2 $ $17, $1, $304 1 $ $62, $8, $416 5 $ $50, $9, $1, june ,128 $103, $10, $3, $ source: Hedgefund.net First Quarter

8 Larger management fees and performance incentives are associated with fund survival. The longer the initial lockup period, the greater the likelihood of a fund being alive. Funds domiciled outside of the United States and funds with assets located outside of the United States are more likely to remain in existence, even after controlling for different fund strategies. conclusions With nearly $1 trillion in assets, hedge funds have become key investment alternatives for wealthy investors. That is good news for the global economy, since funds seek out and eliminate exploitable inefficiencies and thereby raise the productivity of capital. The returns of hedge funds have been relatively high over the years, but so, too, have the risks. Indeed, the returns for some fund categories have not adequately compensated for their risks. This should not necessarily be a cause for societal alarm, however, since the investors putting money into hedge funds can bear high risks. What is cause for concern here is the degree to which hedge funds pose risks to the stability of financial markets and economic activity. But since the industry has thus far operated without causing serious systemic disruptions, there seems no compelling case for introducing new governmental regulation. After all, investors and lenders can always exert discipline on industry risk-taking practices by going elsewhere. M AVERAGE MONTHLY (ANNUALIZED) RETURNS OF HEDGE FUNDS (PERCENT) MULTI- STRATEGY FUND OF FUNDS COMMON STRATEGY STRATEGY LONG- COMMODITY SHORT FUND OF EVENT- MARKET- TRADING MULTI- ALL EQUITY DIRECTIONAL FUNDS DRIVEN NEUTRAL ADVISOR STRATEGY GLOBAL MACRO SECTOR OTHER STRATEGIES 1981 na na na 1.6% 1.6% na 2.4% na na na na 0.2% 2.2% % na na % % na na na % 1.3% na na na na na na na na na na na na na 1.9% na na 0.9 na na 2.5 na % 5.2 na % june source: Hedgefund.net 88 The Milken Institute Review