A Primer on Hedge Funds
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怡宝广告by
女生尿血William Fung*
David A. Hsieh**
August 1999
* Principal, Paradigm Financial Products.
** Professor of Finance, Fuqua School of Business, Duke University.
Plea nd correspondence to David A. Hsieh, Fuqua School of Business, Duke University, Box 90120, Durham, NC 27708-0120. Email: david.a.hsieh@duke.edu. Home page:
www.duke.edu/~dah7/index.htm. Fax: 919-660-7961.
Abstract
In this paper, we provide a rationale for how hedge funds are organized and some insight on how hedge fund performance differs from traditional mutual funds. Statistical differences among hedge fund styles are ud to supplement qualitative differences in the way hedge fund strategies are described. Risk factors associated with different trading styles are discusd. We give examples where standard linear statistical techniques are unlikely to capture the risk of hedge fund investments where the returns are primarily driven by non-linear dynamic strategies.
1. Introduction
Institutional investors and wealthy individuals have long been interested in hedge funds as alternative investments to traditional portfolios of asts. For over half a century of its existence, the hedge fund industry has stayed opaque to the general investing public. Increasingly, spectacular hedge fund activities in the last decade, such as the attack on the British Pound led by George Soros and the recent collap of Long Term Capital which prompted the intervention from federal regulators, have heightened the public’s interest in the hedge fund industry. The literature on the industry has grown substantially. The depth of the literature is still limited to showing readers “how” hedge funds are organized juxtapod with stylized facts that are often hard to piece together into a coherent framework. In depth discussions can be found but are typically limited to the philosophy of
a single investment style such as the work by George Soros.
In this paper, we attempt to provide a rationale on how hedge funds are organized, and provide some insight as to why one should expect hedge fund performance to differ from traditional mutual funds. Statistical differences among hedge fund styles are ud to supplement qualitative differences in the way hedge fund strategies are described. Although one is constrained by space limitations, we hope to convey to the reader that hedge funds differ from each other not just becau they describe themlves differently but their strategies and therefore their return characteristics do indeed differ.
2. A Brief History of Hedge Funds
Hedge funds are generally regarded as private investment vehicles for wealthy individuals or institutional investors. They are typically organized as limited partnerships, in which the investors are limited partners and the managers are general partners. As general partners, the fund managers usually invest in a significant portion of their personal wealth into the partnership to ensure the alignment of economic interests among the partners. Investors to the partnership are charged a performance-bad fee where the potential payout to successful managers can be signific张晓曦
antly higher than the fixed management fee. To date, this organization structure has survived for almost half a century of growing
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寓言故事三年级hedge fund activities and still continues to be the dominant organization format. Before discussing the economic rationale for choosing this particular form of organization, a brief history on the evolution of hedge funds helps to motivate our analysis.
According to Caldwell (1995), the first hedge fund was formed by Albert Wislow Jones in 1949. The primary strategy ud long-short equity positions and leverage. The fund also carried an incentive fee bad on performance.1 Hedge funds remained relatively obscure to the investment world until 1966, when an article in Fortune described Jones' funds to have returns (net of fee) substantially higher than the best performing mutual funds.2 This led to a flurry of interest in hedge funds and many were formed in the next two years. Caldwell (1995, p. 10) stated that "the SEC found 215 investment partnerships in a survey for the year ending 1968 and concluded that 140 of the were hedge funds, with the majority formed that year."
After the rapid expansion in 1967-68, the hedge fund industry experienced a substantial tback duri
炸油条ng the bear markets of 1969-70 and 1973-74, when many funds suffered loss and capital withdrawals. Hedge funds faded back into obscurity until 1986, when an article in Institutional Investor reported that Julian Robertson's Tiger Fund had compounded annual returns of 43% during its first six years of existence, after expens and incentive fee.3 This reignited interests in hedge funds, with the formation of many new hedge funds.
Another group of funds that is often regarded as part of the same investment univer as hedge funds are commodity trading pools. The investment pools are often structured in a similar way as hedge fund partnerships but are typically operated by commodity trading advisors (CTAs). CTAs are firms or individuals who handle customer funds or provide advi for trading futures contracts or options on futures contracts. CTAs are required to register with the Commodity Futures Trading Commission (CFTC) through the National Futures Association, a lf-regulatory body for the futures industry. Traditionally, CTA funds are distinguished from hedge funds bad on a simplistic notion that they are limited to trading primarily futures contracts. However, the growth of financial derivatives, the globalization of markets, and the reduction in regulatory restraints have given CTAs the ability to take
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exposure in financial instruments such as interest rates, currencies, and stock indices, in addition to commodities. Nowadays, CTAs often transact in the over-the-counter curities market especially in derivative instruments. This has blurred the distinction between hedge funds and CTA funds. Parallel to this, the growth of the futures markets globally has pushed futures contracts into the forefront as esntial risk management tools for hedge fund managers. Over the years, hedge funds have become significant participants in most global futures exchanges. Conquently, many funds have found it necessary to comply with the CFTC reporting requirements and to register with the CFTC as either CTAs or commodity pool operators (CPOs). Nowadays a fund’s regulatory registration is no longer a meaningful indication of a fund’s activities. For instance, it was reported that Long-Term Capital Management (LTCM) was registered as a commodity pool operator. As later facts revealed, the majority of LTCM’s risk exposure was in the over-the-counter (OTC) curities markets. We believe that the distinction between different categories of funds lies in their performance characteristics, not with the licens they hold. We shall refer to both groups of funds, traditional hedge funds and CTA funds, as “Hedge Funds” and make a distinction between them only when it is economically meaningful to do so. Next, we tabulate some stylized facts that are relevant to our discussions.
Table 1 shows the rapid growth in asts managed by an increasing number of hedge funds and CTA funds in the 1990s. At the end of 1997, there were 987 hedge funds with around $65 billion of asts under management. CTA funds have grown somewhat less rapidly. At the end of 1997, there were 291 CTA funds with $17 billion of asts under management.
Table 2 provides the distribution of management fees and incentive fees. For both hedge funds and CTA funds, the management fee is typically 1-2%, and the incentive fee is 15-20%.
Table 3 provides the annualized returns and standard deviations of equally weighted portfolios of hedge funds and CTA funds. They have slightly lower returns than the S&P 500, but much lower volatility. In addition, they have low correlation with the S&P.
Fung and Hsieh (1997a) showed that the returns of hedge funds and CTA funds are very different from tho of US mutual funds. Figure 1 reports the distribution of the R2s of the regressions of
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the monthly returns of hedge funds and CTA funds versus mutual funds on the returns of eight standard ast markets: short term interest rates, US stocks, non-US stocks, emerging market stock
s, US government bonds, non-US government bonds, gold (as a proxy for commodities), and the traded weighted US Dollar (as a proxy for foreign currencies). While more than half the mutual funds have R2s above 75%, nearly half (48%) of the hedge funds have R2s below 25%. Figure 2 reports the distribution of the (statistically) most significant ast market in each regressions. Mutual funds are strongly positively expod to US stocks and bonds. In contrast, hedge funds have exposures in all ast markets, and a substantial fraction (25%) of the are negative exposures (i.e. short positions).4
3. The Legal Environment of Hedge Funds
We believe the difference in return characteristics between hedge funds and mutual funds is primarily due to differences in their trading strategies. One fundamental difference is that hedge funds deploy dynamic trading strategies whereas most mutual funds employ a static buy-and-hold strategy. Another fundamental difference is the u of leverage. Hedge funds typically leverage their bets by margining their positions and through the u of short sales. In contrast, the u of leverage is often limited if not restricted for mutual funds. It is important to explore the differences in order to provide a rationale for the way hedge fund partnerships are organized.
In the US, three ts of regulators overe the financial industries. The Securities Exchange Commission (SEC) overes publicly traded curities, including the corporations that issue them, and the broker-dealers that help make markets for them. The Commodity Futures Trading Commission (CFTC) overes the futures industry. The Federal Rerve, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision overe the commercial banking and thrift industry. The agencies were created bad on the philosophy that government should regulate institutions that deal with the general public. Hedge funds do not deal with the public. They are private investment vehicles for wealthy investors and most institutional investors who are regarded as “sophisticated” and are treated differently from the general investing public. Thus hedge funds fall outside the direct
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