Investment Strategies of Hedge Funds

Filippo Stefanini

• Publisher: Wiley
• Year: 2010
• ISBN:
  9781119995289
• Edition: 1
• Topic: Commerce
• Subtopic: Finance

One of the fastest growing investment sectors ever seen, hedge funds are considered by many to be exotic and inaccessible. This book provides an intensive learning experience, defining hedge funds, explaining hedge fund strategies while offering both qualitative and quantitative tools that investors need to access these types of funds. Topics not usually covered in discussions of hedge funds are included, such as a theoretical discussion of each hedge fund strategy followed by trading examples provided by successful hedge fund managers.

1

A Few Initial Remarks

1.1 WHAT IS A HEDGE FUND?

In the United States, the country where they first appeared and enjoyed the greatest development, there is no exact legal definition of the term “hedge fund” that outlines its operational footprint and gives a direct understanding of its meaning.

Yet, to rely on the literal meaning of hedge fund, i.e. “investment funds that employ hedging techniques”, could be misleading, because it relates merely to just one of the many traits of hedge funds and makes reference to only one of the many investment techniques they deploy.

A more fitting definition in our opinion is the following: “A hedge fund is an investment instrument that provides different risk/return profiles compared to traditional stock and bond investments”.

To appreciate the meaning fully, however, it is necessary to remark that hedge funds make use of investment strategies, or management styles, that are by definition alternative, and that they do not have to fulfill special regulatory limitations to pursue their mission: capital protection and generation of a positive return with low volatility and low market correlation.

Hedge funds are set up by managers who have decided to take the plunge into selfemployment, and whose backgrounds can be traced to the world of mutual funds or proprietary trading for investment banks.

The differences between hedge funds and mutual funds are manifold.

The performance of mutual funds is measured against a benchmark, and as such it is a relative performance. A mutual fund manager considers any tracking error, i.e. any deviation from the benchmark, as a risk, and therefore risk is measured in correlation with the benchmark and not in absolute terms. In contrast, hedge funds seek to guarantee an absolute return under any circumstance, even when market indices are plummeting. This means that hedge funds have no benchmark, but rather different investment strategies.

Mutual funds cannot protect portfolios from descending markets, unless they sell or remain liquid. Hedge funds, however, in the case of declining markets, can find protection by implementing different hedging strategies and can generate positive returns. Short selling gives hedge fund managers a whole new universe of investment opportunities. It is not the general market performance that counts, but rather the relative performance of stocks.

The future return of mutual funds depends upon the direction of the markets in which they are invested, whereas the future return of hedge funds tends to have a very low correlation with the direction of financial markets.

Another major difference between hedge funds and mutual funds is that the latter are regulated and supervised by Regulatory Authorities, and are bound by limitations restricting their portfolio makeup and permitted instruments. Moreover, investors are further protected by obligations burdening the management company in terms of capital adequacy, proven robust organization and business processes. On the contrary, the absence of a stringent regulatory framework for hedge funds leaves the manager with greater latitude to set up a fund characterized by unique traits in terms of the financial instruments to be employed, the management style, the organizational structure and the legal form.

Therefore, the hedge fund industry is marked by a great heterogeneity, in that it is characterized by different investment strategies and by funds of a wide variety of sizes.

Although hedge funds immediately bring to mind the image of innovative investment strategies within the financial landscape, the first hedge fund came into existence more than half a century ago.

1.2 HISTORY OF HEDGE FUNDS

This section details some of the important events in the history of hedge funds.

Back in 1949, Alfred Winslow Jones, a former reporter for Fortune, started the first hedge fund with an initial capital of only US$100 000. Jones’ core intuition was that by correctly combining two speculative techniques, i.e. using both short sales and leverage, it would be possible to reduce total portfolio risk and construct a conservative portfolio, featuring a low exposure to the general market performance. Jones also had two other major ideas: to cater to investors, he had invested all his savings in the fund he managed, and his profit came from a 20 % stake in the generated performance rather than from the payment of a fixed percentage of assets under management. This approach made it possible to bring the interests of manager and investor together.

Today, the archetype described above characterizes only a small number of hedge funds: the term is now used to refer to a vast realm of different management models.

At present, a hedge fund has five main characteristics:

• The manager is free to use a wide range of financial instruments.

• The manager can short sell.

• The manager can use leverage.

• The manager’s profit comes from a management fee, which is fixed and accounts for 1.5-2.5 %, and from a 20-25 % fee on profits. Generally, the performance or incentive fee is applied only if the value of the hedge fund unit grows above the historical peak in absolute terms or over a one-year period.

• The manager invests a sizable part of his personal assets in the fund he manages, so as to bring his own interests in line with those of his clients.

In 1952, Jones opened up his partnership to other managers and started to hand over to them the management of portions of the portfolio, and within a short period of time he assigned them the task of picking stocks. Jones would allocate the capital among his managers, monitor and supervise all investment activities and manage the company’s operations. The first hedge fund in history turned into the first multi-manager fund in history.

In 1967, Michael Steinhardt started Steinhardt, Fine, Berkowitz & Company with eight employees and an initial capitalization of $7.7 million. Steinhardt began his career as a stock picker and then, as his hedge fund grew, shifted to a multi-strategy fund. In the 1980s Steinhardt became head of a hedge fund group with roughly US$5 billion of assets under management and with over 100 employees. Steinhardt ended his hedge fund career in 1995 after suffering big losses in 1994.

By 1969, the US Securities and Exchange Commission (SEC) had started to keep a watchful eye over the blossoming industry of hedge funds as a result of the rapid growth in the number of new hedge funds and of assets under management. At that time, the commission estimated that approximately 200 hedge funds were in existence, with $1.5 billion of assets under management. 1969 was also the year that George Soros created the “Double Eagle” hedge fund, the predecessor of the more renowned Quantum Fund.

The first fund of hedge funds¹ was Leveraged Capital Holdings, created in Geneva in 1969 by Georges Karlweis of Banque Privée Edmond de Rothschild, which had the purpose of investing in the best single-managers of the time. Leveraged Capital Holdings also represents the first European hedge product.

In 1971, the first US fund of funds was started by Grosvenor Partners, and in 1973, the Permal Group launched the European multi-manager and multi-strategy fund of funds, called Haussmann Holdings N.V. The people who were given the task of creating the investment team for Permal were Jean Perret and Steve Mallory (hence the name Permal).

Then, in 1980, Julian Robertson and Thorpe McKenzie created Tiger Management Corporation and launched the hedge fund Tiger with an initial capital of $8.8 million. In 1983, Gilbert de Botton started Global Asset Management (GAM), a company specializing in the management of funds of hedge funds, which in 1999 was acquired by UBS AG and by the end of 2004 had some €38 billion of Assets under Management (AuM).

At the beginning of the 1990s, Soros, Robertson and Steinhardt managed macro funds worth several billion dollars and invested in stocks, bonds, currencies and commodities all over the world, trying to anticipate macro-economic trends.

In 1992, alternative investment instruments started to draw the attention of the press and of the financial community, when George Soros’s Quantum Fund made huge profits anticipating the depreciation of the British pound and of the Italian lira.

The early 1990s were the heyday of macro funds. The exit of the British pound and the Italian lira from the European Monetary System in September 1992 allowed Soros to cash in an incredible profit of $2 billion.

On 4th February 1994, the Fed unexpectedly introduced the first rate hike of one quarter of a percentage point, which caused US treasuries to topple and led to a temporary drain of liquidity on the markets. The twin effect of panic on the markets and leverage proved disastrous for Steinhardt Partners, which in 1994 suffered a loss of 31 %. Steinhardt decided to retire at the end of 1995, despite the fact that during that year he had been able partly to recover the 1994 losses, ending 1995 up 26 %.

Later on, hedge funds bounced back into the headlines when in the first nine months of 1998 Long Term Capital Management, managed by John Meriwether and a think tank including two Nobel laureates in Economics (Myron Scholes and Robert Merton), generated a staggering $4 billion loss, starting a domino effect that left many banks, financial institutions and big brokers in many countries teetering on the brink of default. Only the prompt intervention of a bail-out team led by the Federal Reserve of Alan Greenspan avoided the onset of a systemic crisis.

In October 1998, when the Japanese yen appreciated against the dollar, Robertson suffered a loss of about $2 billion. In 1999, his long/short equity strategy, based on the analysis of fundamentals of listed companies, did not work at all in...