Chapter 11

Hedge Funds 101

What exactly is a hedge fund? My favorite definition was provided by Cliff Asness, one of the founding partners of the hedge fund AQR:

Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years they deliver a one-in-a-hundred-year flood. They are generally run for rich people in Geneva, Switzerland, by rich people in Greenwich, Connecticut.1

This definition is humorous precisely because it is true, or at least more true than most hedge fund managers would care to admit.

There is no absolutely precise definition of a hedge fund because they are so heterogeneous. Most definitions focus on hedge fund structure and fee arrangement rather than the composition of the investments. Perhaps the best way to get a basic understanding of hedge funds is to compare their primary characteristics with the plain-vanilla investment structure of long-only mutual funds.

Differences between Hedge Funds and Mutual Funds

The following are the essential differences between mutual funds and hedge funds:

Types of Hedge Funds

There is a wide range of hedge fund strategies, but absolutely no consensus on how they should be categorized. Even the number of hedge fund strategy categories differs widely among different hedge fund data providers. The fact that hedge funds can trade virtually any type of financial security and in any combination complicates their classification into strategy styles. Also, many managers use strategies that overlap several classifications, while other hedge funds don’t fit neatly into any classification.

The most basic, as well as most prevalent, hedge fund strategy is the equity hedge fund, which takes both long and short equity positions. The typical equity hedge fund is similar to the classic Jones model described in Chapter 10. Figure 11.1 illustrates how the exposure of an equity hedge fund differs from the exposure of the standard mutual fund. For simplicity of exposition, we ignore the small percentage of cash held by mutual funds to meet normal redemptions or anticipated near-term purchases. Mutual funds are essentially 100 percent long and 0 percent short, implying that both the gross (long plus short) and net (long minus short) exposures are also equal to 100 percent. In the example in Figure 11.1, the equity hedge fund is 110 percent long and 60 percent short. The gross exposure is much greater than the mutual fund (170 percent versus 100 percent), but the net exposure is much smaller (50 percent versus 100 percent). This comparison illustrates a very important point: although most equity hedge funds have total exposure significantly higher than 100 percent, their risk is usually much lower than mutual funds because of the smaller net exposure.

Figure 11.1 Exposure: Mutual Funds versus Equity Hedge Funds

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Similar to the fund depicted in Figure 11.1, most equity hedge funds will usually have a larger long than short exposure (i.e., a positive net exposure). The ranges for both gross and net exposures can vary widely between different equity hedge funds and also within the same fund over time. Some hedge funds will keep their net exposure within a moderate range (e.g., between 20 percent and 60 percent net long), whereas others may shift their net exposure in a much broader range, increasing to near 100 percent (or even higher) if they are very bullish on the market and shifting to net short if they are bearish. The performance of an equity hedge fund will be a function of both the manager’s market-timing skill (the ability to vary net exposure in a beneficial way) and stock-selection skill.

Figure 11.1 also illustrates the equity market neutral fund, which is a close cousin of the equity hedge fund. In the equity market neutral fund, the long and short exposures will be near equal, but not necessarily exactly equal, leading to a net exposure near zero. The equity market neutral hedge fund completely removes the market as a performance-determining factor and instead makes performance entirely dependent on stock-picking skill—the ability to select longs that will go up more or down less than the selected short positions. Since it is common for shorts to be more volatile than longs, most market neutral funds will neutralize the portfolio in beta-adjusted terms rather than dollar terms. For example, if the beta of the short position (the ratio of expected percentage change in value relative to the percentage price move in the market) is equal to 1.25 times the beta of the long position, then the long exposure will be 25 percent larger, simply to target neutrality.

Some equity hedge funds are long only or consistently maintain a large net long bias. A long-only hedge fund is a bit of an oxymoron. These funds are “hedge” funds in name and structure (e.g., legal structure, incentive fees, redemption terms, etc.), but more like mutual funds in investment composition and strategy. Presumably, one investment strategy difference between long-only hedge funds and mutual funds is that the former strive to be different from the indexes (hopefully in a positive way), whereas the latter generally seek to avoid deviating too far from the benchmark index. An investor would need to have a fairly strong conviction about the skill of a long-only equity manager to justify paying much higher fees and accepting far worse investor terms for an investment that is similar in composition to an equity mutual fund. Some hedge fund databases define long bias equity hedge funds as a separate category. Although long-only equity hedge funds are unambiguously long biased, there is no specific definition of what minimum percentage net long exposure constitutes a fund as being long biased. The line between equity hedge and long bias equity hedge can be murky and differ between the different data sources.

Short bias equity hedge funds either implement only short equity hedge positions or always maintain a net short equity exposure. Because the equity market has a long-term secular uptrend, it is difficult for hedge funds of this type to compile good stand-alone track records, and performance can be particularly poor during protracted bull markets. For this reason, many hedge funds in this category tend to fail, and their percentage representation in the hedge fund universe is small. Sophisticated investors, however, view these funds as potent portfolio diversifiers rather than stand-alone investments. Short and short-biased funds will typically do best when equity markets and hedge funds as a group are witnessing their largest losses. They will do worst when other investments are doing best. In this context, the inclusion of short bias funds can be used to smooth portfolio performance, exchanging windfall profits in strong months for loss mitigation in the most negative months. For this reason, the inclusion of a fund in this strategy group in a portfolio is likely to increase the portfolio’s return/risk ratio, even if the fund itself is not profitable, and in some cases, even if it generates a net loss. Some investors will use short bias funds opportunistically, adding them to a portfolio when they believe the risk of an equity market decline is greater than normal and liquidating these holdings when their concern over declining equity prices is low.

The sector fund is a hedge fund strategy category that is very similar to the equity hedge fund (long and short positions combined with leverage), with the one defining exception that the manager specializes in a specific sector (e.g., technology, health care). Although the sector fund sacrifices the benefits of diversification and a broader universe of opportunities, the idea is that managers who focus on a single sector will obtain a greater level of expertise and investment accuracy in their group of stocks than equity hedge managers, who invest across a broader spectrum of equities. Some fund of funds managers prefer to apportion their equity-based strategy allocation to multiple sector funds (selecting one manager for each major sector) rather than to multiple equity hedge funds.

In addition to the foregoing equity long/short strategies (i.e., equity hedge, market neutral, long bias, short bias, and sector), there is a broad range of other hedge fund strategy categories. These include:

The majority of CTAs, and especially a majority of the CTAs who manage the most assets, utilize systematic trend-following approaches. This strategy employs systems that generate buy signals when an uptrend is defined and sell signals when a downtrend is defined. As implied by the word following, these systems will enter the market after the trend is already under way. The advantage of the systematic trend-following approach is that it is likely to capture sustained long-term trends in markets, which can be very profitable. A major drawback of the approach is that it can experience many false signals when markets are in wide-swinging trading range patterns, leading to large cumulative losses. Another drawback is that these systems are often prone to surrendering large open profits before a liquidation or reversal signal is triggered. System modifications designed to mitigate the surrender of open profits will usually come at the expense of increasing premature exit signals from unfinished trends.

Although there is a perception that managed futures or CTAs are synonymous with systematic trend following, this view is wrong. There are many CTAs who use a discretionary rather than systematic approach. Also, many CTAs use strategies that have nothing to do with trend following. A partial sampling of alternative approaches includes:

Managed futures are often categorized as a separate asset class rather than as a hedge fund category. One reason for this distinction is that managers who trade futures markets for U.S. clients are subject to mandatory registration and strict regulation, neither of which is true for hedge funds. Another factor is that many CTAs manage money only through managed accounts (see Chapter 16) and do not offer a fund structure. However, the line between hedge fund managers and CTAs has become increasingly blurred over the years. There is no difference between global macro managers who execute trades only in the futures and FX markets and CTAs. Although it is true that most CTAs pursue systematic, trend-following approaches and most global macro funds (including those that trade only futures and FX) are primarily discretionary, there are discretionary CTAs and systematic global macro funds. In this light, the distinction between the groups as separate asset classes appears artificial. If anything, it makes more sense to differentiate along strategy approaches, such as systematic macro versus discretionary macro (with each group containing both CTAs and global macro hedge funds), rather than between global macro managers and CTAs.

This list is by no means exhaustive and it differs from the categorization used by hedge fund databases, as they differ from each other. The scope of the list, however, should demonstrate the wide variety of strategies available via hedge fund investment and illustrate why it is possible to achieve significant diversification by combining different hedge fund strategies in a single portfolio—a goal that is impossible to achieve by using traditional investments only.

Correlation with Equities

The degree of correlation between different hedge fund strategies and equities varies widely. At one extreme, long-only hedge funds would be highly correlated with equities, and at the other extreme, short-selling strategies would be negatively correlated. Some strategies, such as global macro managed futures, are completely unrelated to equities and tend to have near-zero correlation over the long term. Most hedge fund strategies would have only moderate positive correlation to equities across most months. There is, however, one important exception: During flight-to-safety market liquidations, most markets and most hedge fund strategies (with the exception of highly liquid strategies, such as managed futures) will witness significant losses simultaneously. A classic example of such an event was the financial panic that gripped world markets in late 2008. During such events, it is said that “correlations go to one.”3

1 Clifford Asness, “An Alternative Future: Part 2,” Journal of Portfolio Management (Fall 2004): 8–23.

2 Almost all hedge fund documents will specify that incentive fees are charged only on the portion of the gain that exceeds the prior high net asset value (NAV) on which an incentive fee was paid (the high-water mark). This restriction is necessary to avoid a manager getting paid twice on the same gain. For example, assume a manager collects an incentive fee when the NAV is at 2,000, and in the next two periods the NAV falls to 1,800 and then rises to 2,100. At the end of the second period, an incentive fee would be charged only on one-third of the 300 gain (the portion above the prior NAV high of 2,000). Investors should avoid any hedge fund that does not include a high-water mark provision.

3 One (1.0) is the highest possible correlation value and indicates that two variables are perfectly correlated. The phrase is not meant literally, but rather is a deliberate overstatement meant to imply that markets become very highly correlated.