BEHIND THE HEDGE 18 By Chris Gan, Freelance Feature Writer Hedge funds have had their fair share of controversy. In the current financial crisis, hedge funds have been badly hit. The value of their investments have diminished with the equity market sell- down, while access to cheap leverage funding has disappeared, given the credit crunch. Long preferred by institutional and high net worth private investors, hedge funds began to gain popularity with more mainstream investors in the last few years, as seen by the increase in the number of hedge funds and fund of hedge funds. Asset under management (AUM) for hedge funds peaked at $1.9trillion in June 2008, but is expected to drop by 45% by the end of this year. This is a result of losses incurred by the funds, and also from heavy withdrawals by investors, hit by the on-going crisis. According to Hedge Fund Research, the average returns for hedge funds up to October 2008 are down 16% and this is reported to be one of the worst years in hedge fund history. Also, the number of hedge funds is expected to be reduced by half from a high of around 15,000 funds (in June 2008).
DEMYSTifYING HEDGE FUNDS HEDGE FUNDS ARE AMONG THE MOST MISUNDERSTOOD of INVESTMENT TYPES. IN a nutshell, hedge funds are private, largely unregulated pools of capital whose managers can buy or sell any assets, bet on falling as well as rising asset prices, and participate substantially in the profits derived from money invested. the latter s collapse. All these incidents have given investors a negative perception of hedge funds. However, like it or not, hedge funds are here to stay. It is likely that they will be more prevalent in the Malaysian investing landscape in the future as our capital markets liberalise and develop further. Long the purview of sophisticated investors, they also appeal to mainstream investors who seek alternative forms of investments. Hedge funds differ from the usual unit trust investments in that they are supposed to have low volatility (variability of returns) and are able to perform under all market conditions. By design they are able to generate returns in good or bad markets, given the sophisticated trading strategies employed and absolute return mandates. Contrary to popular belief, hedge funds are not obscure investments. They have been around for more than 50 years, and are often classified in the same category as private equity or real estate investments. In the past, hedge funds have also been in the spotlight. Long-Term Capital Management (LTCM) a U.S. hedge fund which used trading strategies such as fixed income arbitrage, statistical arbitrage, and pairs trading, combined with high leverage, collapsed and was subsequently bailout by the US Federal Reserve in 1998. It suffered severe losses due to trading related to the Russian Financial Crisis in 1998 and had caused systemic risk to the US financial system. Further, during the 1998 Asian financial crisis, billionaire financier George Soros (and his Quantum Fund) was blamed by then Malaysian Prime Minister, Dr. Mahathir Mohamad as the cause of the debacle. Soros had reportedly made huge bets against the Asian currencies, in particular, the Thai Baht, and was said to have gained a fortune from What Are Hedge Funds? Contrary to popular belief, hedge funds are not obscure investments. They have been around for more than 50 years, and are often classified in the same category as private equity or real estate investments. In general, as an alternative investment, they have gained better acceptance. Hedge funds can be defined as an investment structure for managing a private, less regulated investment pool that can invest in both physical securities and derivatives markets on a leveraged basis. Basically, hedge fund managers have the flexibility to manage their funds employing top sophisticated trading strategies (see discussion below) and 19
Table 1 Diversification Benefits from Low to Moderate Correlations to Traditional Assets Correlations Cash US bonds US large cap equities Managed futures Hedge funds LBO Real estate Cash 1.0 US bonds 0.13 1.0 US large cap equities 0.08 (0.01) 1.0 Managed futures 0.03 0.29 (0.03) 1.0 Hedge funds 0.06 (0.02) 0.53 0.21 1.0 LBO 0.04 (0.28) 0.74 (0.12) 0.58 1.0 Real estate 0.12 (0.09) 0.10 0.03 (0.03) 0.23 1.0 US Large Cap; S&P 500, US Bond; Lehman Aggregate Bond Index, LBO: Venture economics, Hedge funds: HFRI, Real estate: NCREIF Nat. prop index, Managed futures: CISDM Index. (1994 2006), Source: Citigroup Alterative Investments Research seek to generate absolute returns regardless of the direction of the capital markets. Names like Tudor, Citadel, D.E. Shaw, Farallon, Fortress, and Quantum are well known among hedge fund investors but are probably unheard of outside the circle of exclusive, private investors. Why Invest in Hedge Funds? Hedge funds are suitable for more sophisticated investors who seek higher returns (in absolute rather than relative terms) and are willing to accept a certain degree of risk to achieve this. They are also open to sharing the upside with managers who have good investment track record, and specialised skills. Normally, hedge fund managers consist of top-tier fund managers from investment houses such as Goldman Sachs, UBS and the like who strike out on their own after making a name for themselves managing money for their clients at these esteemed institutions. Hedge funds tend to have low correlation with other asset classes and as such, they would appeal to investors seeking portfolio diversification, that is, looking to reduce portfolio risks through adding funds with low correlation to their other assets. Who Invests in Hedge Funds? In the 1980 s, hedge funds were predominantly the domain of ultra high net worth individuals. These would probably have included names like Bill and Melinda Gates and others. In the 1990 s, the endowment funds for large universities like Yale and Harvard began to invest some money in hedge funds as means of diversifying their investments and also to gain higher returns. For example in July 1990, Yale University Endowment Fund became the first institutional investor to pursue absolute return strategies as a distinct asset class beginning with a target asset allocation of 15%. As of June 2005, the $15.2bn fund had a 25% allocation to these strategies. Since hedge funds are primarily private investment vehicles, they have been largely exempt from regulatory requirements of the likes of the Securities and Exchange Commission (SEC). However, as hedge funds now appeal to a broader scope of investors including the mass affluent investors, the industry is coming under more scrutiny, with regulators calling for added regulations and transparency. Currently, there are some specific limits placed on the number and types of investors that hedge funds can accept: further, only qualified investors and accredited investors are able to invest in some hedge funds registered with regulators like the SEC. What Are Strategies for Hedge Funds? There are many sophisticated trading strategies employed by hedge fund managers to generate absolute returns for clients. The most well known is the long-short equity strategy where 1 A measure of the gain or loss on an investment portfolio, typically expressed as a percentage of invested capital. This is as opposed to relative returns where returns are measured relative to a set benchmark. 20
you buy a stock and then sell a stock short (without owning it) to generate a profit. Another is relative value arbitrage which seeks to take advantage of specific pricing anomalies, while seeking to maintain minimal exposure to systematic market risk. This may be achieved by buying a security previously believed to be undervalued, while selling short another which is perceived to be overvalued. Included under this category are sub-strategies such as: equity market neutral, statistical arbitrage, convertible arbitrage and fixed income arbitrage. There are many other strategies which are employed by hedge fund managers, for example, global macro, emerging markets, equity non-hedge, event driven, credit strategies, distressed securities, and merger arbitrage. How Are Hedge Funds Structured? When considering hedge funds, qualified investors can choose between investing in funds managed by single managers or in portfolios containing multiple managers (fund of hedge funds). Single managers: the majority of hedge funds today run a single strategy, and as a result they can offer the greatest potential returns, although there are higher risks involved. However, some managers can run a multi-strategy approach that combines two or more strategies for example, fixed income arbitrage and convertible arbitrage, to obtain better diversification. Single manager funds are specialised funds and generally good managers are difficult to gain access to, even if you have $10 million to invest; they are normally selectively open, which often is by invitation or through referrals only. Fund of hedge funds: they offer investors access to a wide range of strategies and managers. The idea is to provide more consistent absolute returns and the added benefit of diversification. A fund of hedge funds is a more liquid platform than investing directly in hedge funds. Also, it has the flexibility to over-or-underweight certain strategies based on macroeconomic outlook or some optimisation techniques. A typical hedge fund employs 5 to 10 strategies with 30-40 managers in its portfolio. It also simplifies the process for investors to select a hedge fund because it can blend numerous funds to meet the investor s risk-return objectives. The fund of hedge funds also provides value-added services like performing due diligence, risk monitoring and others, on individual managers to ensure the success of the fund. Typically, the fund of hedge funds appeals to private investors as they tend to have lower investment minimums than single managers. However, investors would have to bear an additional layer of fees to access them. Fee Structures Hedge fund managers are typically rewarded based on annual management fees (a predetermined percentage of the asset under management), but what is more significant is the performance based fees. This is the hallmark of hedge funds, where managers are paid based on their absolute performance and not relative to any benchmarks. You will In the 1980 s, hedge funds were predominantly the domain of the ultra high net worth individuals. These would probably have included names like Bill and Melinda Gates. often come across terms like 2/20 or 1/15 when dealing with hedge funds; What that means is: 2/20 2% upfront fee, and 20% performance fees, 1/15-1% upfront fee and 15% performance fees. Hedge fund managers get to share 20% or 15% of the funds profit but are normally subjected to a hurdle rate and high water mark. The hurdle rate, usually around 5% per annum, is the established minimum return of what the managers need to achieve before the profit is shared. A high watermark is often enforced to make sure investors recoup any accumulated losses before the performance fees are paid out to managers. This fee is standard practice, and is what attracts high quality investment professionals into the business. It encourages them to generate maximum, absolute returns for investors. However, Diagram 1 Strategies Composition By Assets Under Management (2007) Sector (Total) 5.24% Relative Value Arbitrage 14.63% Regulation D 0.22% Market Timing 0.30% Merger Arbitrage 1.50% Macro 10.89% FI: MBS 1.84% FI: High Yield 1.55% Source: HFR, Q4, 2007 FI: Diversified 1.34% FI: Convertible Bonds 0.09% FI: Arbitrage 2.72% Short selling 0.28% Event Driven 13.20% Convertible Arbitrage 30.2% Distressed Securities 5.64% Emerging Markets (Total) 4.64% Equity Hedge 27.15% Equity Market Neutral 2.28% Equity Non-Hedge 3.73% 21
Pros and Cons of Hedge Funds Adding hedge funds to your investment portfolio may offer potential benefits (pros) but at the same time, investors need to be cognisant of some of the specific risks involved (cons). Pros Enhanced risk adjusted returns: Due to the use of value-added strategies like long-short and leverage, hedge funds can potentially enhance the risk adjusted returns to investors. Diversification: This is an often touted benefit - combined with other assets like bonds, stocks and others, hedge funds have the potential to diversify portfolio risks. This is given that they often exhibit historically low correlation with other asset classes (see Table 1). Diversification alone, however does not eliminate market risks. Broad investment universe, unconstrained by regulations: Hedge funds can invest in a wide variety of financial instruments like bonds, stocks, commodities, currencies, and investors can choose from different styles focusing on these assets classes. Alignment of interests: Compensation for hedge fund managers is closely tied to performance of the fund, thus aligning the interest of the fund manager and investor. As such, it tends to attract the best and brightest fund managers into the industry. However, it should be noted that sometimes this compensation structure may lead to excessive risk-taking and speculation by the hedge fund manager. 22 Wholesale fund and RIS A wholesale fund is a unit trust fund that is issued and offered by a unit trust management company (UTMC) to qualified investors. The investment limits and restrictions for a wholesale fund, including the parameters and types of investment made by the fund are determined by the fund manager. These are required to be clearly disclosed in the information memorandum of offering to potential investors. Only qualified investors may invest in a wholesale fund. The Capital Markets and Services Act 2007 defines qualified as investors that have a certain threshold of net personal assets. The current threshold is set at RM3 million for individuals as at the date of investment and RM10 million for corporations (based on the last audited report). Given the flexibility in structuring a wholesale fund, the fund manager is able to invest in alternative investments, including hedge funds. A wholesale fund however, is still subject to approval from the Securities Commission (SC) before they can be launched. An example of a wholesale fund launched in 2008 which invests in a hedge fund is the HLG Fixed Income Holdings Fund. It is a feeder fund into the Permal Fixed Income Holdings fund, which employs a fixed income arbitrage strategy, and is managed by one of the largest hedge fund managers in the world. There are many advantages and disadvantages involved in investing in hedge funds (some of which are outlined in the accompanying article); investors should clearly understand the risk and reward structure before investing in any such funds. The issuance of wholesale funds is governed by the SC s Guidelines on Wholesale Fund which was introduced on 18 February 2009. The new guidelines are designed to give greater flexibility for licensed fund managers to provide innovative new products to meet the requirements of high net worth individuals and institutional investors. It replaces the Guidelines on Restricted Investment Schemes (issued in April 2006) and the provisions for wholesale fund previously contained in Guidelines in Unit Trusts funds. Apart from relaxing some administrative requirements, the new guidelines has loosened the restriction on leverage, expanded the list of qualified investors and removed the limits to the number of investors for each wholesale fund. having this fee structure may also create an incentive for managers to make more speculative investments (as their remuneration is profit-based). Summary In this article, we aimed to educate readers on hedge funds, which have had their fair share of controversy. Long the purview of ultra high net worth investors, hedge funds are now becoming more accepted by mainstream investors. Despite some of the bad press, and news of their spectacular failures in the current financial crisis, they are here to stay. Going forward, as our capital markets further liberalise and continue to develop, hedge funds will become more prevalent in the Malaysian investing landscape. This introduction to hedge funds elaborates on why investors invest in hedge funds. It appeals to those who are seeking absolute returns (as opposed to relative returns), and also possible diversification benefits by adding hedge funds which historically have low correlation to other assets, the portfolio risks can be further reduced. Although hedge funds have been around for more than 50 years, most of the early investors were ultra high net worth investors. In the 1990 s, large university endowment funds like Yale and
CONS Lack of transparency: Since hedge funds are inherently less regulated compared to normal mutual funds, they have not met the levels of transparency and accountability demanded by institutional investors. However, in recent years, fund of hedge funds, and large institutional investors have exerted stronger pressure on hedge fund managers for greater transparency in their investments. Limited liquidity: Hedge funds tend to be illiquid investments with lock-up and liquidity provisions. It is common for hedge funds to institute lock-up periods of up to 1 year and redemption (withdrawals) may be on a quarterly basis. Often the liquidity provisions also allow the manager to restrict or halt redemptions to protect the fund s capital. Recently more than 80 hedge funds have imposed restrictions, known as putting up gates, so that they are not forced to liquidate investments at distressed prices to raise cash for redemptions. Difficult to access quality hedge funds: This is a considerable challenge as top quality managers are normally selectively open or have reached their capacity limits, closing the fund to new investments. Further, the relatively high minimums can make it difficult for small institutions or high net worth investors to gain access. Unreliable or incomplete return data: Unlike stocks and bonds which are normally listed on recognised exchanges, where valuations can be easily ascertained, the value of some investments held by hedge funds are difficult to ascertain. For some of the more illiquid strategies such as distressed debts, the positions cannot be marked-to-market on a regular basis given the lack of an open market. As private investment vehicles, and relatively being unregulated, hedge fund managers can pretty much report their returns as they choose, or the way they see fit. Valuation risk: Often hedge funds trade in obscure securities in illiquid markets. Under normal circumstances, it would be difficult to price these instruments accurately, causing fund managers to provide only best estimates. Under stressed conditions, like the current financial crisis, the problem is compounded, leaving investors, at best, with a very imprecise net asset value for the fund, if any. Counterparty risk (leverage): A unique, and value-added feature of hedge funds is that they employ leverage to enhance returns. This is usually achieved by borrowing (loan), buying securities on margin, or using derivatives. Although leverage may enhance potential gains, it also magnifies the potential for loss as well. In a financial crisis, providers of leverage may decide to call in the credit and thus force the fund to liquidate its position this may result in significant losses. In an extreme situation, investors may also decide to redeem their holdings to avoid further erosion in their value; this can require the fund to liquidate even more of its position, causing further losses. Such a sequence, known as critical liquidation cycle, may in the end, cause the fund to close and return whatever capital that is left in the fund to investors (which is what we have been witnessing in the current credit crisis). Harvard, started to inject funds into them. Today, judging by the number of funds and growth in assets under management, hedge funds are now gaining popularity as an alternative to mutual funds investing. We briefly discussed some of the trading strategies used by hedge fund managers like the long-short equity, and arbitrage relative value. When considering hedge funds, investors can choose between investing in funds managed by single managers or in fund of hedge funds: the features and benefits of each approach were clearly presented. We also addressed an Judging by the number of funds and growth in asset under management, hedge funds are fast gaining popularity as an alternative to mutual funds investing. important aspect of hedge fund investing the fees structure, which typically consist of annual management fees and also performance fees. The hallmark of hedge fund investing profit sharing between fund manager and investors has the benefit of aligning the interests, but sometimes also poses a danger, as it may encourage excessive risk taking by the fund manager. Lastly, hedge funds can potentially give better upside given the sophisticated trading strategies employed, and absolute returns mandate, but there are also some risks involved to guide investors, the pros and cons of hedge fund investing were presented and discussed in detail in the article. 23