Hedge Funds: Challenges in Assessing Risk and Performance

Eduardo Schwartz

UCLA Anderson School

Hedge funds as legal entities

� Unregulated private investment vehicles for wealthy individuals and institutional investors (“accredited investors”)

� Structured in a way that exempts them from most of the laws and regulations that apply to other investment vehicles

Hedge funds are allowed to operate with lots of freedom and flexibility

� They can:

� trade any type of security or financial instrument

� operate in any market anywhere in the world

� make unlimited use of any kind of derivatives instrument

� engage in unrestricted short-selling

� employ unlimited amounts of leverage

Hedge funds are allowed to operate with lots of freedom and flexibility

� They can:

� hold concentrated positions in any security

� restrict the redemption of assets

� charge their investors whatever fees they want to

� compensate their managers in any way

� have only limited disclosure and reporting obligations to regulators, the public, or their own investors

Hedge funds as investment vehicles

� First hedge fund began in 1949 (long/short equity strategy)

� 1985: 40 hedge funds

� 1995: 1,000

� 2007: 9,000

� US hedge funds manage approx. $1.4 trillion in assets (1/8 of mutual funds)

� Europe - $325 billion

� Asia - $115 billion

Hedge fund performance

� Performance statistics suggest that hedge funds have generally been able to outperform traditional investment strategies by a wide margin� 1990–2006 period: many hedge fund strategies had higher average returns and higher Sharpe ratios than did the traditional benchmarks.

� “Long and short” hedge fund strategies generally had lower return volatilities.

� Several hedge fund strategies performed well during the three year bear stock market

Questions of concern regarding hedge funds performance

� Is hedge fund performance being measured correctly on a risk-adjusted basis?

� How can the persistence of high hedge fund returns be reconciled with the widely accepted view that financial markets are efficient?

Data on hedge funds returns

� Evaluating hedge funds performance is complicated by the lack of good data on returns

� Three important data biases have been identified in the literature� Survivorship bias

� Selection bias

� Backfilling bias

Data on hedge funds returns

� Survivorship bias

� May inflate historical returns if reported index do not include the returns of funds that have not survived

� The failure rate is very high: about 30% of new funds do not last more than three years

Data on hedge funds returns

� Selection bias � Voluntary nature of reporting. If only hedge funds with good performance choose to report to data vendors, this will result in an upward bias in reported average returns

� Backfilling bias� Arises because hedge funds are typically added to a database with an instant history

Reasons for disappearance from database

� 612 hedge funds disappear from the data set (1994-2000)� low past returns combined with a net money outflow increase the

likelihood that a fund will liquidate� 360 funds disappear due to liquidation, while 210 funds self-select

themselves out of the database.

Hedge fund study

� Funds that liquidate during the sample period have substantial lower average returns and net money flows than funds that self-select or survive

� Average quarterly returns� Liquidate: 0.50%� Self-select: 2.04% � Survive: 3.59%

� Average quarterly net money flows � Liquidate: 2.49%� Self-select: 7.47% � Survive: 9.07%

� Conclusion: average hedge funds returns may be overestimated by as much as 7.6%.

Why should hedge funds be able to earn excess returns?

� Substantially higher compensation (though asymmetric incentive fee structure) attracts ‘best’ managers

� Better-informed or more highly skilled managers may be able to outperform other managers

� Exodus of successful mutual fund managers� Several investment companies have had to launch their own hedge funds in an attempt to keep their best managers

Why should hedge funds be able to earn excess returns?

� Asset mispricings may persist because of a shortage of “arbitrage capital”

� Hedge funds employ investment strategies that mainstream investment institutions are unable to pursue due to regulatory constraints

Understanding return, risk and fees

� Worry that investors in hedge funds do not fully understand the true returns and the risks they bear (big failure rate)

� Fees are high. � The management fee to the general partner usually is 1-2 % of assets +20% of profits with ‘high water mark’

� The asymmetric fee structure creates an incentive for the general partner to adopt a high-risk investment strategy

� The returns on many strategies are not normally distributed

� Average returns tend to be overstated (biases)

Concerns: systemic risk

� Systematic risks means the risk that failure of one counterparty to a transaction will trigger failure of other counterparties (Long Term Capital Management)

� Bank regulators now monitor the credit and counterparty exposure of financial institutions to hedge funds much more carefully

� Tougher oversight?

Risk management

� The dangers created by hedge funds need to be balanced against the many ways in which the funds actually reduce risk

� Because they can go short as well as long they can be less volatile than individual stocks or standard mutual funds

� Hedge funds help large investors to hold a diversified portfolio of investments

Risk management

� Hedge funds are willing and able to take risks that others wish to avoid (buy credit and currency derivatives)

� “Lock-up" rules prevent investors from withdrawing money on short notice; when crises strike, the funds have the freedom to be buyers

The biggest hedge-fund failure ever: Amaranth Advisors

� US-based hedge fund lost more than $6 b on investments in natural gas futures in September 2006.

� Amaranth's case reflects an incentive structure that can tempt some to assume heavy risk.

� Fee: 1.5% of assets + 20% of investment gains. � Star energy trader Brian Hunter won an estimated

$75 m bonus after his team produced a $1.26 b profit in 2005.

� Chief risk officer Robert Jones got a bonus of $5 m� Nicholas Maounis -- founder, majority owner, and

chief executive -- got an estimated $70 m plus some of Amaranth's $200 million-plus in performance fees.

The biggest hedge-fund failure ever

� Natural gas futures is a highly volatile market, where the price can move swiftly on changes in gas available in storage and on shifts in the weather

� Amaranth made a stunning $1.5 billion in six weeks last spring, mostly on energy trades

� But gains that big in a single market can portend swings just as fast the other way

The biggest hedge-fund failure ever

� In the last week of August, the value of the fund's assets reached $9.2 b, up about 27% since Jan. 1

� Weather-forecasting centers made two predictions: that the hurricane season would pass without major storms, and that the winter would be mild

� By the end of September, Amaranth was down more than $6 billion (65% of their assets) from its August value.

� Other market players profited handsomely from Amaranth’s debacle (Merrill Lynch, J.P. Morgan, Citadel) but there were no disruptions in the financial markets

Fortress Investment Group goes public

� Manages $30 billion, first private-equity and hedge fund manger to sell shares on U.S. markets

� Note that the shares are on the management company

� Private-equity funds averaged 39.7% annual returns since 1999

� Hedge funds have averaged 14% annual returns since 2002

� From $1.2 billion in 2001 to $30 billion last year—a 97% compound annual growth rate

Fortress Investment Group goes public

� Shares traded at roughly 40 times last year’s earnings

� About its IPO� Issued at $18.50 a share

� Opened for trading at $35

� Closed at $31—68% higher than its IPO price

� The five Wall Street veterans who built Fortress finished the day with holdings in the company worth about $10 billion

References

� Jenke ter Horst, 2006, Fund liquidation, self-selection and look-ahead bias in the hedge fund industry, WP.

� Ann Davis, Gregory Zuckerman, Henny Sender. Amid Amaranth’s Crisis, Other Players profited. The Wall Street Journal January 30, 2007.

� Gregory Zuckerman, Henny Sender, Scott Patterson. Hedge-Fund Crowd Sees More Green As Fortress Hits Jackpot With IPO, WSJ, Jan 2007.

� Sebastian Mallaby, 2007, Hands off hedge funds, Foreign Affairs.� Franklin Edwards and Stav Gaon, 2003, Hedge funds: what do

we know?, Journal of Applied Corporate Finance.