P2.T8. Risk Management & Investment Management

Transcription

1 P2.T8. Risk Management & Investment Management Constantinides, Harris & Stulz, Handbook of the Economics of Finance Fung & Hsieh, Chapter 17: Hedge Funds Bionic Turtle FRM Study Notes Reading 72 By David Harper, CFA FRM CIPM

2 Fung & Hsieh, Chapter 17: Hedge Funds DESCRIBE THE CHARACTERISTICS OF HEDGE FUNDS AND THE HEDGE FUND INDUSTRY, AND COMPARE HEDGE FUNDS WITH MUTUAL FUNDS EXPLAIN BIASES WHICH ARE COMMONLY FOUND IN DATABASES OF HEDGE FUNDS

3 Fung & Hsieh, Chapter 17: Hedge Funds Describe the characteristics of hedge funds and the hedge fund industry, and compare hedge funds with mutual funds. Explain biases which are commonly found in databases of hedge funds. Explain the evolution of the hedge fund industry and describe landmark events which precipitated major changes in the development of the industry. Evaluate the role of investors in shaping the hedge fund industry. Explain the relationship between risk and alpha in hedge funds. Compare and contrast the different hedge fund strategies, describe their return characteristics, and describe the inherent risks of each strategy. Describe the historical performance trend of hedge funds compared to equity indices. Describe the market events which resulted in a convergence of risk factors for different hedge fund strategies, and explain the impact of such a convergence on portfolio diversification strategies. Describe the problem of risk sharing asymmetry between principals and agents in the hedge fund industry. Explain the impact of institutional investors on the hedge fund industry and assess reasons for the growing concentration of assets under management (AUM) in the industry. Describe the characteristics of hedge funds and the hedge fund industry, and compare hedge funds with mutual funds. Hedge funds are distinct from mutual funds in several important respects: Private versus public: Historically, hedge funds are private investment vehicles not open to the general investment public. Consequently, hedge funds face less regulation than publicly traded mutual funds. Ability to take short positions: Typically hedge fund managers generate profit from both long as well as short positions. Some specialist hedge funds are primarily short sellers. They are skilled in identifying over-priced assets and have the infrastructure to carry short positions over an extended period of time. The ability to take short positions allows managers to take large bets on perceived relative price discrepancies of assets. Freedom to use high leverage: It is common to find hedge fund balance sheets that substantially exceed in size the equity capital of the vehicles. It is the practice of shorting and the leveraging of investors capital that distinguish hedge funds from conventional long-bias funds. Managing leveraged positions in volatile markets to preserve capital calls for skillful management of position size. Ability to employ derivatives: many authors would add the use of derivatives as another key difference. Please note that derivatives tend to imply leverage. 3

4 Hedge fund manager skill sets The defining characteristics of a hedge fund manager s skill set are: An ability to identify profitable long as well as short opportunities in a range of asset categories The organizational structure to carry short positions for extended periods of time, The know-how to fund leveraged positions, and The risk management skill to maintain complex positions during volatile markets Private nature benefits both investors and managers The private nature of hedge funds often suits both the needs of investors and managers. While wealthy investors of early hedge fund vehicles rarely impose specific mandates on how their investments should be managed, most if not all of these investors will demand their investment in the vehicle be kept private and carry limited liability. In addition, as individual capital commitments to a hedge fund manager tend to be small in relation to the investor s overall portfolio, it is critical that a hedge fund investment carries the same limited liability protection as buying shares of a public company. This is especially important given the leverage used by most hedge fund managers. Hedge fund managers often claim to have complex proprietary strategies to generate outsized profits. To keep other traders from mimicking or front running their trades, they offer very little transparency, even to their investors. The opacity of hedge fund vehicles persisted for over half a century until the arrival of institutional investors in the new millennium. Flexibility in compensation Another benefit of being lightly regulated investment vehicles is that hedge funds in the US are not subject to the legal restrictions on compensation that govern publicly traded mutual funds. A typical hedge fund charges a fixed management fee, which usually ranges between one and two percent per annum, based on the value of assets they manage. The lower end of this range is comparable to the management fees charged by actively managed mutual funds. Unlike mutual funds, hedge funds generally charge an incentive fee typically between 10 and 20% of new profits of the fund. Incentive fees are only payable when new profits are made. This means that losses have to be carried forward until they are recouped and the previous level of investors capital is restored this level of capital is often referred to as the High Water Mark. 4

5 Explain biases which are commonly found in databases of hedge funds. Hedge fund databases usually suffer from four major biases which impact different performance metrics in different ways and the analysis of these biases is an integral part of how historical hedge fund returns are assessed: 1. Measurement Bias: Hedge funds are not required to disclose information to the general public. While some hedge fund firms consistently report data on their funds to multiple databases, many report only selected samples of their funds to one database, and an unknown number do not report to any database, past and present. This lack of a performance reporting standard creates some unique challenges. Because the hedge fund industry is lightly regulated, performance records of hedge funds are typically not standardized and available reports are prone to measurement errors. 2. Backfill Bias: When funds begin reporting to databases, its prior returns will become available and can be incorporated into an index after-the-fact, this will expose the index returns to backfill bias. For example, most of the Hedge Fund Research (HFR) indices have histories dating back to However, HFR itself only started collecting data from hedge fund managers sometime around Therefore, pre data is mostly backfilled. Coupled with the fact that reporting performance to databases is voluntary, the risk exists that observable data are biased in favor of good performance. 3. Selection Bias: This is also known as self-reporting bias. During the period 1997 to 2010, the average annual entry rate for hedge funds into commercial databases was 9% whereas the exit rate was much higher at 21% per year. Exiting a database does not necessarily mean the termination or liquidation of a hedge fund. Since hedge funds voluntarily report to commercial databases, they can also choose to stop reporting for a variety of reasons. When a fund stops reporting to a commercial database, whenever possible the database vendor provides an explanation of this event. In about one third of cases, a fund stops reporting because it has lost so many assets that it is no longer a viable business and the fund is liquidated by the manager. However, in the other two thirds of cases, the explanation of the exit is incomplete at best. For example, it is entirely possible that an operating fund may elect to stop reporting to databases because it has attracted sufficient capital and the hedge fund manager no longer seeks new investors. Then disclosing the fund s statistics becomes a costly exercise with little benefit. Add to the fact that there are those hedge fund firms that never disclosed their information to commercially available databases. It is far from obvious that what we learn about hedge funds in these databases applies to the whole population of hedge funds. 4. Survivorship Bias: Since many of the hedge funds that have poor performance stop reporting to databases due to either liquidation or cost constraints, the databases are sometimes skewed towards funds that have good performance that is, funds that survive. This phenomenon is now widely recognized in the hedge fund industry as survivorship bias. 5