Hedge Funds, basic facts ?

[RedJoker]

Hi RedJoker

Hi Fintan, I've linked a lot of material here but there's some good reading in there.

To say a hedge fund is 50% long and 50% short is completely innacurrate,

It seems I've been focusing on market-neutral long/short equity hedge funds. According to Investopedia there are a number of other types of hedge funds. However, the ones I'm describing appear to be in the majority.

while some trading strategies still employ some sort of arbitrage using this technique, due to the large number of active hedge funds these techniques are less effective, therefore hedge funds have to become even more leveraged to makes gains which leads nicely onto my second point

If it's pure arbitrage then it doesn't matter how much you leverage it because, by definition, it is zero risk. The hedge funds I was describing weren't arbitrageurs.

To say hedge funds are low risk / low volaility again is extremely innaccurate eg. due to their high leverage small movements in prices will cause huge swings in P&L

According to [broken link removed] article market neutral funds "in general, leverage no more than three or four times capital, with most using significantly less leverage than that."

Maybe a read of a book on Long Term Capital Management would be in order. (LTCM was an Uber hedge fund that went bust and nearly collapsed the world econonmy).

From the same article:

"Quantitative funds were recently the target of negative media coverage following the severe losses by Long Term Capital Management, Ltd., a U.S. hedge fund. The negative attention focused on the fact that Long Term Capital failed despite the technical wizardry of its management team, which included Nobel Prize winners Robert Merton and Myron Scholes, and despite its claim of being market neutral. In fact, Long Term Capital was not market neutral in the sense in which I am defining the term. Rather than balance long and short equity positions, Long Term Capital bet on a convergence of spreads between various fixed income sectors, which is not a truly market neutral strategy, as prices of bonds can - and, in fact, did - diverge. Further, Long Term Capital Management’s losses were caused by the use of an extreme amount of leverage, up to 30 times its capital, which is atypical of market-neutral long/short equity funds."

TBH I have too many books I need to read before I could get to this. I checked up on Wikipedia though.

"As LTCM's capital base grew, they felt pressed to invest that capital somewhere and had run out of good bond-arbitrage bets. This led LTCM to undertake trading strategies outside their expertise."

This is another problem, diligent investors would have seen the signs in time and gotten out. I'd guess that most hedge fund blow-ups are caused by funds trading outside their area of expertise. Investors should have been able to see this beforehand.

 

[room305]

If it's pure arbitrage then it doesn't matter how much you leverage it because, by definition, it is zero risk. The hedge funds I was describing weren't arbitrageurs.

I think very few hedge funds employ this kind of strategy. With so many hedge funds, finding arbitrage opportunities is difficult.

A good example of the kind of hedging hedge funds do employ is the relatively recent GM credit downgrade. With rumours doing the rounds that GM debt was to be downgraded, GM bonds sold-off and the spread above US treasury bonds rose to a fairly juicy level. Hedge funds stepped in to pick up the attractive cashflow. However, they knew that if GM debt was actually downgraded they would be looking at a significant loss of capital. No problem they thought, if GM debt is downgraded the common stock will suffer correspondingly. Lets go long GM debt and short the common stock. This will cover our losses in the event a downgrade. They 'hedged' their position in GM debt.

The downgrade came but octogenarian billionaire Kirk Kerkorian launched a takeover bid at the same time and the shares rallied even as the bonds sold-off ... not a good day for hedge funds that one ;-)

 

[Guest126]

"As LTCM's capital base grew, they felt pressed to invest that capital somewhere and had run out of good bond-arbitrage bets. This led LTCM to undertake trading strategies outside their expertise."

This is another problem, diligent investors would have seen the signs in time and gotten out. I'd guess that most hedge fund blow-ups are caused by funds trading outside their area of expertise. Investors should have been able to see this beforehand.

You have dropped more than a few clangers, but this one beats the lot.

A "diligent investor" would not have the time nor knowledge to monitor the investment strategy of a hedge fund manager - that is the whole risk with them, they do not need to disclose information about their strategies.

These guys (LTCM) were financial academic geniuses, and they cost a fortune, so no "diligent investor" would have had the time nor level of knowledge to monitor their strategies.

 

[RedJoker]

You have dropped more than a few clangers, but this one beats the lot.

A "diligent investor" would not have the time nor knowledge to monitor the investment strategy of a hedge fund manager - that is the whole risk with them, they do not need to disclose information about their strategies.

These guys (LTCM) were financial academic geniuses, and they cost a fortune, so no "diligent investor" would have had the time nor level of knowledge to monitor their strategies.

Mutual funds are just as opaque with their holdings as well. Of course Hedge funds disclose their strategy, who would invest with a fund that didn't tell you what type of strategy they were using.

Again I haven't done much reading on LTCM but there are always signs. It's not like they blew up overnight, any diligent hedge fund investor would have spotted Amaranth well before they blew up as well. People are always shocked when big companies, Enron for example, blow up but you really have to be paying absolutely no attention not to realize there are problems.

Can you categorically say that the majority of hedge funds achieve positive alpha? - I think not!

I don't have any papers to back it up but I'd be confident saying yes; the majority of hedge funds achieve positive alpha.

According to Ibbotson's Study, Hedge Funds create a net alpha of 3.04% per year. For L/S only it's 5.41%

This has got to be the daftest thing I have ever heard. Hedge funds are not 50% long / 50% short (some may be but I doubt if they are in the majority).

As far as I'm aware the majority are 50% long, 50% short.

I was wrong on this point, according to the ISI weekly survey of L/S equity hedgefunds over the past 5 years, the avg hedge fund is btw 50-52% net long, with a range of 37-62% net long. So they are 50% net long and hence do get beta returns.

Another interesting thing to note from this is that if you were to use 2x leverage then they would be 100% net long, hence getting all beta returns and twice their alpha returns, i.e. 6.08%, hence comfortably beating the market with an approx net return after fees and leverage of 14.8%. 10.82% alpha with 23% net return for L/S only.

 

[RedJoker]

Key Characteristics of Hedge Funds
.............................

• Many hedge funds have the ability to deliver non-market correlated returns. Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns.

.......................

This is why they shouldn't be compared to standard market benchmarks.

This is why they are low risk (volatility).

 

[Guest126]

Garbage (again)!

It is why, when included as part of an overall portfolio (i.e. 10% of a portfolio) they can reduce rather than increase total volaitility.

On their own, they are exceptionally volatile.

Most hedge funds do not disclose their individual shareholdings - mutual funds do.

So, to say that they are equally transparent is another fallacy.

 

[charttrader]

Mutual funds are just as opaque with their holdings as well. Of course Hedge funds disclose their strategy, who would invest with a fund that didn't tell you what type of strategy they were using.

Hedge funds are very secretive, they have to be to as a strategy loses its edge once others get wind of it.

"With LTCM, they split their trades among numerous banks so that no-one could see their trading strategies. It might do one side of a trade with one bank and another with a different bank. It told its investors very little about its strategies and never released the details of specific trades." (taken from 'Infectious Greed' book by Frank Partnoy.

 

[samfarrell]

the general consensus seems to be that hedge funds are quite risky and not for the cautious investor. Just out of interest does anyone know what hedge funds are available in Ireland (if any) and how are they accessed?

 

[River]

the general consensus seems to be that hedge funds are quite risky and not for the cautious investor. Just out of interest does anyone know what hedge funds are available in Ireland (if any) and how are they accessed?

Hedge Fund's are usually restricted to allowing professional investors invest. The definition can change dependent on fund but generally it means that one would need an indept knowledge and understanding of hedge funds & a net worth of over 1 million. Basically you need to be able to afford to lose your investment. Both these points are due to the high risk & complex nature of hedge funds. It should also be mentioned that minimum subscriptions start at around $100,000 but can often be much more.

I do believe it is possible to have a Custodian invest on your behalf though and this may alleviate some of the minimum restrictions in place. I'm not too sure how this process works as would not have the funds myself to have looked into investing before. There is a large dutch bank in the IFSC though that would have more information on this.

 

[River]

This is why they shouldn't be compared to standard market benchmarks.

This is why they are low risk (volatility).

Joker by name......

 

[RedJoker]

Looking at pages 18, 24 & 25 of Kazemi and Schneeweis 2001, the standard deviation of nearly all types of hedge funds studied was lower than the SP-500 for the 5 year period 96 - 00. Specifically only CSFB Managed Futures had a higher standard deviation over the period. If anybody can find data for more recent years or data over longer time frames I'd be interested in reading it.

 

[RedJoker]

Garbage (again)!

I really don't see the need for people to make meaningless remarks like this at the start of posts. Please just attack the content with reasoned arguments in future.

It is why, when included as part of an overall portfolio (i.e. 10% of a portfolio) they can reduce rather than increase total volaitility.

This is true but is also true of all non-correllated assets. Is your 10% figure here an arbitrary one, did you mean e.g. instead of i.e.?

On their own, they are exceptionally volatile.

Please link proof of this statement.

Most hedge funds do not disclose their individual shareholdings - mutual funds do.

Mutual funds only do this at the end of the month and only to people who fit certain criteria:

as long as the recipient has a legitimate business need for the information and the disclosure of Fund portfolio holding information to that third party is:
- approved by an individual holding the title of Executive Vice President or above;
- approved by an individual holding the title of Chief Counsel or above; and
- subject to a written confidentiality agreement that includes provisions that restrict trading on the information.

Link

As you can see the information is not exactly an easy thing to get hold of.

So, to say that they are equally transparent is another fallacy.

I never said that. In fact I said exactly the opposite in my first post in this thread.

 

[RedJoker]

Mutual funds are just as opaque with their holdings as well. Of course Hedge funds disclose their strategy, who would invest with a fund that didn't tell you what type of strategy they were using.

Hedge funds are very secretive, they have to be to as a strategy loses its edge once others get wind of it.

"With LTCM, they split their trades among numerous banks so that no-one could see their trading strategies. It might do one side of a trade with one bank and another with a different bank. It told its investors very little about its strategies and never released the details of specific trades." (taken from 'Infectious Greed' book by Frank Partnoy.

I'm going to accept defeat on this LTCM argument as I do not know enough about the specifics to discuss it properly, and ye are probably right. It did lead to some interesting reading though, so thanks for that.

 

[Guest126]

Joker, at this stage I can only presume you are joking, you are making so many uninformed statements about hedge funds, I have neither the time nor the inclination to correct them.

 

[RedJoker]

Joker, at this stage I can only presume you are joking, you are making so many uninformed statements about hedge funds, I have neither the time nor the inclination to correct them.

I suppose the articles, surveys, studies and websites I've linked/cited are uninformed too.

Most of my 'uninformed' opinions on hedge funds have come from hedge fund managers I know. One retired hedge fund manager, who ran a global long/short equity fund, said that most of the hedge funds he knew where way underleveraged and had much less risk than the market. I trust his opinion but obv can't expect you to do the same which is why I tried to back up what I said. Fwiw his funds results (approx) after fees were:

95 +30%
96 +25%
97 +18%
98 +10%
99 +20%
00 +29%
01 +8%
02 +2%
03 -1%
04 +8%

They broke $1B in 99 and $3B in 2002, obv bigger is much harder so that explains some of the drop off in results.

 

[Guest126]

Ask your hedge fund manager friends about LTCM - the fact you know so little about LTCM would indicate you have done very little research into hedge funds...other than listen to what your hedge fund manager friends tell you.

 

[Sunny]

A good example of the kind of hedging hedge funds do employ is the relatively recent GM credit downgrade. With rumours doing the rounds that GM debt was to be downgraded, GM bonds sold-off and the spread above US treasury bonds rose to a fairly juicy level. Hedge funds stepped in to pick up the attractive cashflow. However, they knew that if GM debt was actually downgraded they would be looking at a significant loss of capital. No problem they thought, if GM debt is downgraded the common stock will suffer correspondingly. Lets go long GM debt and short the common stock. This will cover our losses in the event a downgrade. They 'hedged' their position in GM debt.

The downgrade came but octogenarian billionaire Kirk Kerkorian launched a takeover bid at the same time and the shares rallied even as the bonds sold-off ... not a good day for hedge funds that one ;-)

A perfect example of the danger of hedge funds and why trying to describe them as plain long/short or market neutral is completely mis-leading. Each one of those funds would have said to their investors that they were hedged. Good day alright!

 

[room305]

One retired hedge fund manager, who ran a global long/short equity fund, said that most of the hedge funds he knew where way underleveraged and had much less risk than the market.

Interesting that your friend seems to have only performed well from 00-02. Perhaps his fund leans on the bearish side too much? Nevertheless, this is a pretty strange statement to come out with. The definition of an "underleveraged" fund is of course, very subjective, but surely any leverage whatsover increases your risk? Even a market neutral, low volatility seeking strategy does not imply the absence of risk.

Subprime CDOs and corporate junk bonds may have low volatility (many subprime CDOs are not even marked-to-market) but that does not imply they have less risk than the general market.

 

[z108]

Interesting that your friend seems to have only performed well from 00-02..

Was that a typo ? Did you mean before 00 ?

 

[CCOVICH]

the general consensus seems to be that hedge funds are quite risky and not for the cautious investor. Just out of interest does anyone know what hedge funds are available in Ireland (if any) and how are they accessed?

I see a link on the Dolmen website for hedge funds-might be worth looking at if you are still interested.