A Primer on Hedge Funds

APrimeronHedgeFundsbyWilliamFung*DavidA.Hsieh**August1999*Principal,ParadigmFinancialProducts.**ProfessorofFinance,FuquaSchoolofBusiness,DukeUniversity.PleasesendcorrespondencetoDavidA.Hsieh,FuquaSchoolofBusiness,DukeUniversity,Box90120,Durham,NC27708-0120.Email:[e-mail]:~dah7/index.htm.Fax:[phone].AbstractInthispaper,weprovidearationaleforhowhedgefundsareorganizedandsomeinsightonhowhedgefundperformancediffersfromtraditionalmutualfunds.Statisticaldifferencesamonghedgefundstylesareusedtosupplementqualitativedifferencesinthewayhedgefundstrategiesaredescribed.Riskfactorsassociatedwithdifferenttradingstylesarediscussed.Wegiveexampleswherestandardlinearstatisticaltechniquesareunlikelytocapturetheriskofhedgefundinvestmentswherethereturnsareprimarilydrivenbynon-lineardynamicstrategies.-1-1.IntroductionInstitutionalinvestorsandwealthyindividualshavelongbeeninterestedinhedgefundsasalternativeinvestmentstotraditionalportfoliosofassets.Foroverhalfacenturyofitsexistence,thehedgefundindustryhasstayedopaquetothegeneralinvestingpublic.Increasingly,spectacularhedgefundactivitiesinthelastdecade,suchastheattackontheBritishPoundledbyGeorgeSorosandtherecentcollapseofLongTermCapitalwhichpromptedtheinterventionfromfederalregulators,haveheightenedthepublic’sinterestinthehedgefundindustry.Theliteratureontheindustryhasgrownsubstantially.Thedepthoftheliteratureisstilllimitedtoshowingreaders“how”hedgefundsareorganizedjuxtaposedwithstylizedfactsthatareoftenhardtopiecetogetherintoacoherentframework.IndepthdiscussionscanbefoundbutaretypicallylimitedtothephilosophyofasingleinvestmentstylesuchastheworkbyGeorgeSoros.Inthispaper,weattempttoprovidearationaleonhowhedgefundsareorganized,andprovidesomeinsightastowhyoneshouldexpecthedgefundperformancetodifferfromtraditionalmutualfunds.Statisticaldifferencesamonghedgefundstylesareusedtosupplementqualitativedifferencesinthewayhedgefundstrategiesaredescribed.Althoughoneisconstrainedbyspacelimitations,wehopetoconveytothereaderthathedgefundsdifferfromeachothernotjustbecausetheydescribethemselvesdifferentlybuttheirstrategiesandthereforetheirreturncharacteristicsdoindeeddiffer.2.ABriefHistoryofHedgeFundsHedgefundsaregenerallyregardedasprivateinvestmentvehiclesforwealthyindividualsorinstitutionalinvestors.Theyaretypicallyorganizedaslimitedpartnerships,inwhichtheinvestorsarelimitedpartnersandthemanagersaregeneralpartners.Asgeneralpartners,thefundmanagersusuallyinvestinasignificantportionoftheirpersonalwealthintothepartnershiptoensurethealignmentofeconomicinterestsamongthepartners.Investorstothepartnershiparechargedaperformance-basedfeewherethepotentialpayouttosuccessfulmanagerscanbesignificantlyhigherthanthefixedmanagementfee.Todate,thisorganizationstructurehassurvivedforalmosthalfacenturyofgrowing-2-hedgefundactivitiesandstillcontinuestobethedominantorganizationformat.Beforediscussingtheeconomicrationaleforchoosingthisparticularformoforganization,abriefhistoryontheevolutionofhedgefundshelpstomotivateouranalysis.AccordingtoCaldwell(1995),thefirsthedgefundwasformedbyAlbertWislowJonesin1949.Theprimarystrategyusedlong-shortequitypositionsandleverage.Thefundalsocarriedanincentivefeebasedonperformance.1Hedgefundsremainedrelativelyobscuretotheinvestmentworlduntil1966,whenanarticleinFortunedescribedJones'fundstohavereturns(netoffee)substantiallyhigherthanthebestperformingmutualfunds.2Thisledtoaflurryofinterestinhedgefundsandmanywereformedinthenexttwoyears.Caldwell(1995,p.10)statedthattheSECfound215investmentpartnershipsinasurveyfortheyearending1968andconcludedthat140ofthesewerehedgefunds,withthemajorityformedthatyear.Aftertherapidexpansionin1967-68,thehedgefundindustryexperiencedasubstantialsetbackduringthebearmarketsof1969-70and1973-74,whenmanyfundssufferedlossesandcapitalwithdrawals.Hedgefundsfadedbackintoobscurityuntil1986,whenanarticleinInstitutionalInvestorreportedthatJulianRobertson'sTigerFundhadcompoundedannualreturnsof43%duringitsfirstsixyearsofexistence,afterexpensesandincentivefee.3Thisreignitedinterestsinhedgefunds,withtheformationofmanynewhedgefunds.Anothergroupoffundsthatisoftenregardedaspartofthesameinvestmentuniverseashedgefundsarecommoditytradingpools.Theseinvestmentpoolsareoftenstructuredinasimilarwayashedgefundpartnershipsbutaretypicallyoperatedbycommoditytradingadvisors(CTAs).CTAsarefirmsorindividualswhohandlecustomerfundsorprovideadvisefortradingfuturescontractsoroptionsonfuturescontracts.CTAsarerequiredtoregisterwiththeCommodityFuturesTradingCommission(CFTC)throughtheNationalFuturesAssociation,aself-regulatorybodyforthefuturesindustry.Traditionally,CTAfundsaredistinguishedfromhedgefundsbasedonasimplisticnotionthattheyarelimitedtotradingprimarilyfuturescontracts.However,thegrowthoffinancialderivatives,theglobalizationofmarkets,andthereductioninregulatoryrestraintshavegivenCTAstheabilitytotake-3-exposureinfinancialinstrumentssuchasinterestrates,currencies,andstockindices,inadditiontocommodities.Nowadays,CTAsoftentransactintheover-the-countersecu