Hedge funds

I’ve found at least one good piece on them, by Rene Stulz, in the Spring 2007 Journal of Economic Perspectives.  I learned or reaffirmed the following:

1. Hedge funds have existed since at least 1949.

2. Hedge funds exist because mutual funds do not deliver "complex investment strategies."  In part this is because mutual funds are regulated.

3. The largest mutual fund is about six times larger than the largest hedge fund.  Marketing constraints also encourage very large funds to adopt simpler and easier-to-explain strategies.

4. Investment advisors with fewer than 15 clients do not have to register with the SEC.

5. Regulations restrict the compensation of mutual fund advisors in various ways, typically requiring symmetric treatment of gains and losses (if a dollar of profit leads to a bonus, a dollar of loss must lead to a penalty).  That is why mutual fund managers are compensated in proportion to the size of their funds, not their performance.  This is not obviously efficient, and of course hedge funds pay for performance.

6. Hedge funds don’t have to disclose information to investors, other than by contractual agreement.

7. Diversification and redemption requirements make it harder for mutual funds to exploit some profit opportunities, or to hedge in particular manners.

8. The number of mutual funds that try to replicate hedge fund strategies is growing rapidly.

9. Available data on hedge fund returns are nearly worthless.

Overall I was struck by how much hedge fund activity is an artifact of regulations, and not necessarily beneficial regulations.  Deregulating some aspects of mutual funds may be an alternative to regulation of hedge funds.

Here is one version of the paper (click through to working papers), definitely recommended.  Here is Stulz’s paper on hedge fund contagion.

Comments

Spot on.

First, hedge funds are a regulatory exception, not a regulated category; basically
the SEC has had thresholds for oversight based on (I recall) either over 100
investors or any 'unsophisticated' clients. As it is possible to raise large amounts
of equity within these limits and (absent regulation) leverage it as far economically
feasible, the hedge fund has become the easiest vehicle in which to conduct investment
business.

Second, following the integration of commercial and investment banking and the movement
of banks from long term spread lending to short term transactional business in the 1990s,
there has been a need for new vehicles to pick up levered institutional investment asset
holding businesses. These have been filled largely by hedge funds and collateralized
debt obligations (CDOs). In both cases banks are the primary providers of fee services
and leverage to the vehicles, but do so in an efficient manner under current regulatory
and economic capital models.

The fact that hedge funds have historically had fee structures orders of magnitude
greater than other investment management businesses has certainly been a help in attracting
managers to the business model. So far, investors are going along with this.

You have to click through to "working papers"...then the one on hedge funds...there is no more direct way to do it.

A very good summary of the hedge fund world.

A good first approach to hedge funds is the "Hedge funds" book written by Francois-Serge Lhabitant. It addresses everything from the first hedge fund, founded by Alfred W Jones in 1949, to some basic stats concepts and multifactor models. More sophisticated insights are available in Fung and Hsieh's papers (LBS and Duke, respectively). Tarun Ramadorai has a couple of interesting papers too (Oxford Univ, Said Business School).

A possible source of controversy; do you people think that the average hedge funds 'delivers alpha'? I think that the only thing that most hedge fund do is to create exposures to alternative sources of risk -- this means they do not actually deliver alpha when enough risk sources are taken into account. This goes pretty much in line with the seven factor model of Fung and Hsieh, but I would love to read opposing views.

TC is at last getting near the main points about hedge funds, instead of gushing about the managers. Now, look at the demand side restrictions and regulations on pension fund investments [by far the biggest hedge fund investors] and why most of them are willing to pay high fees for leverage in LLCs that they can't get in other ways, like managed accounts or funds.

JPC,

They are not paying for leverage. The leverage of the hedge fund industry in general is far less than you would imagine - it is about 1.5:1 if I remember the figure from Leslie Rahl Hedge Fund Risk Transparency.

What they want is the diversification. The weak correlation of HF returns to traditional asset classes is what is bringing the institutions to the hedge funds. Even after the huge fees - which are coming down - finance theory 101 demands that you invest significant percentages of capital in hedge funds, simply due to the return structure that hedge funds offer.

You should read Harry Kats work to see the next frontier. Its soo good I am thinking of starting a business on it.

Israel,

Your point about exposure to alternitive sources of risk is spot on. One of the big ideas in the industry in the last few years has been "alternative betas", and is the industry providing alpha or just exposure to difficult to find betas. I am a firm beliver in this, alternative betas explain much of the excess returns of HFs. I haven't read F&H on this particular topic but they are excellent in general. You can also look to Seigle for more information on this.

Diversification and redemption requirements make it harder for mutual funds to exploit some profit opportunities, or to hedge in particular manners.

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