WHAT IS HEDGE FUND
Hedge funds are alternative investments using pooled funds that employ numerous different strategies to earn active return, or alpha, for their investors. Hedge funds may be aggressively managed or make use of derivatives and leverage in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). It is important to note that hedge funds are generally only accessible to accredited investors as they require less SEC regulations than other funds. One aspect that has set the hedge fund industry apart is the fact that hedge funds face less regulation than mutual funds and other investment vehicles.
Hedge fund investors typically include high net worth individuals (HNIs) and families, endowments and pension funds, insurance companies, and banks. These funds work either as private investment partnerships or offshore investment corporations. They are not required to be registered with the securities markets regulator and are not subject to the reporting requirements, including periodic disclosure of NAVs.
There are many strategies a hedge fund may use to generate returns. One such strategy is global macros, where the fund takes long and short positions in large financial markets based on the views influenced by economic trends. Then there are funds that work on market-neutral strategies. Here, the goal of the fund manager is to minimize market risks by investing in long/short equity funds, convertible bonds, arbitrage funds, and fixed income products.
Each hedge fund is constructed to take advantage of certain identifiable market opportunities. Hedge funds use different investment strategies and thus are often classified according to investment style. There is substantial diversity in risk attributes and investments among styles.
Legally, hedge funds are most often set up as private investment limited partnerships that are open to a limited number of accredited investors and require a large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year, a time known as the lock-up period. Withdrawals may also only happen at certain intervals such as quarterly or bi-annually.
However, as hedge fund trends evolved, in an effort to maximize returns, many funds turned away from Jones’ strategy, which focused on stock picking coupled with hedging and chose instead to engage in riskier strategies based on long-term leverage. These tactics led to heavy losses in 1969-70, followed by a number of hedge fund closures during the bear market of 1973-74.
The industry was relatively quiet for more than two decades until a 1986 article in Institutional Investor touted the double-digit performance of Julian Robertson’s Tiger Fund. With a high-flying hedge fund once again capturing the public’s attention with its stellar performance, investors flocked to an industry that now offered thousands of funds and an ever-increasing array of exotic strategies, including currency trading and derivatives such as futures and options.
High-profile money managers deserted the traditional mutual fund industry in droves in the early 1990s, seeking fame and fortune as hedge fund managers. Unfortunately, history repeated itself in the late 1990s and into the early 2000s as a number of high-profile hedge funds, including Robertson’s, failed in spectacular fashion. Since that era, the hedge fund industry has grown substantially. Today the hedge fund industry is massive—total assets under management in the industry is valued at more than $3.2 trillion according to the 2016 Preqin Global Hedge Fund Report. The number of operating hedge funds has grown as well. There were around 2,000 hedge funds in 2002. That number increased to over 10,000 by 2014. However, in 2017, the number of hedge funds is currently on a decline again according to data from Hedge Fund Research.
How to Pick a Hedge Fund
With so many hedge funds in the investment universe, it is important that investors know what they are looking for in order to streamline the due diligence process and make timely and appropriate decisions.
When looking for a high-quality hedge fund, it is important for an investor to identify the metrics that are important to them and the results required for each. These guidelines can be based on absolute values, such as returns that exceed 20% per year over the previous five years, or they can be relative, such as the top five highest-performing funds in a particular category.
Absolute Performance Guidelines
The first guideline an investor should set when selecting a fund is the annualized rate of return. Let’s say that we want to find funds with a five-year annualized return that exceeds the return on the Citigroup World Government Bond Index (WGBI) by 1%. This filter would eliminate all funds that underperform the index over long time periods, and it could be adjusted based on the performance of the index over time.
This guideline will also reveal funds with much higher expected returns, such as global macro funds, long-biased long/short funds, and several others. But if these aren’t the types of funds the investor is looking for, then they must also establish a guideline for standard deviation. Once again, we will use the WGBI to calculate the standard deviation for the index over the previous five years. Let’s assume we add 1% to this result, and establish that value as the guideline for standard deviation. Funds with a standard deviation greater than the guideline can also be eliminated from further consideration.
Unfortunately, high returns do not necessarily help to identify an attractive fund. In some cases, a hedge fund may have employed a strategy that was in favor, which drove performance to be higher than normal for its category. Therefore, once certain funds have been identified as high-return performers, it is important to identify the fund’s strategy and compare its returns to other funds in the same category. To do this, an investor can establish guidelines by first generating a peer analysis of similar funds. For example, one might establish the 50th percentile as the guideline for filtering funds.
Here is a sound list of primary metrics to use for setting guidelines:
• Five-year annualized returns
• Standard deviation
• Rolling standard deviation
• Months to recovery/maximum drawdown
• Downside deviation
These guidelines will help eliminate many of the funds in the universe and identify a workable number of funds for further analysis. An investor may also want to consider other guidelines that can either further reduce the number of funds to analyze or to identify funds that meet additional criteria that may be relevant to the investor. Some examples of other guidelines include:
Fund Size/Firm Size
The guideline for size may be a minimum or maximum depending on the investor’s preference. For example, institutional investors often invest such large amounts that a fund or firm must have a minimum size to accommodate a large investment. For other investors, a fund that is too big may face future challenges using the same strategy to match past successes. Such might be the case for hedge funds that invest in the small-cap equity space.
If an investor wants a fund to have a minimum track record of 24 or 36 months, this guideline will eliminate any new funds. However, sometimes a fund manager will leave to start their own fund and although the fund is new, the manager’s performance can be tracked for a much longer time period.
This criterion is very important for smaller investors as many funds have minimums that can make it difficult to diversify properly. The fund’s minimum investment can also give an indication of the types of investors in the fund. Larger minimums may indicate a higher proportion of institutional investors, while low minimums may indicate of a larger number of individual investors.
These terms have implications for liquidity and become very important when an overall portfolio is highly illiquid. Longer lock-up periods are more difficult to incorporate into a portfolio, and redemption periods longer than a month can present some challenges during the portfolio-management process. A guideline may be implemented to eliminate funds that have lockups when a portfolio is already illiquid, while this guideline may be relaxed when a portfolio has adequate liquidity.