Introduction: Alternatives and Hedge Funds

Despite the veneer of secrecy, fortune and mass success, for most people the concept of hedge funds is still misunderstood. Specifically, from the fact that it contradicts it’s namesake by not hedging and actually speculating; and the move away from its cult-like image built by the media, to hedge fund strategies now being implemented by household asset managers and pension funds, exacerbates this identity crisis. Furthermore, with unprecedented economic environment with political instability and artificial low yields, the once unimpeachable return to risk capabilities of hedge funds are now under scrutiny. As high profile pension funds such as Calpers and PFA drop hedge funds from their asset mix, coupled with the rise of demand for the cheaper passive funds and the innovation within smart beta and ETFs, questions on whether hedge funds should belong in portfolios, and if their fee structure is justified, highlights the threat on it’s legacy.

What are Alternatives and why invest in them?

On the buy side, most people’s assets are managed by an institutional investor who has access to the markets and can benefit from a fully diversified portfolio of securities. This includes institutional asset managers, wealth managers, sovereign wealth funds, pension funds, insurance firms, family offices, endowment funds and many more. For example, if you own an insurance policy then the insurance firm manages your money. In order for the insurance firm to hedge themselves and ensure they can pay you out in case of making a claim, the insurance firm will invest the premium you paid now into the market and will aim to grow the assets in line with how they perceive liabilities to grow. However, the insurance firm will have to be shrewd in how it manages the money and could not be over exposed to one asset class or strategy, hence the importance of tactical multi-asset allocation.

Institutional investors will usually have a strategy to invest in a multitude of asset classes, to keep them well positioned during market changes and to hold an ideal risk-return profile. The choice of securities to invest in usually falls into either of these asset classes: equity, fixed income, commodities and alternatives. Further, rather than simply investing in a bucket of stocks for its equity exposure, the investor could subscribe into an equity-only mutual fund, where you can target a specific expertise on demography and style (Japanese Small Value stocks for example).

The alternative investment space is broadly made up of three types: private equity, hedge funds and real assets (or real estate). Although these three types of alternatives are intrinsically very different to each other, they share some common characteristics that appeal to investors building a multi-asset portfolio. More specifically, alternative investments provide access to an investment landscape outside of the traditional asset classes, and therefore have a lower beta (beta is the systematic risk of an asset relative to the market).

What is a Hedge Fund?

A broad definition for a hedge fund is an actively managed and pooled investment vehicle that is open to only a limited group of investors. However, this simple definition excludes some hedge funds and includes some funds that are clearly not hedge funds. Although there is no simple and all-encompassing definition, there are some key characteristics that all hedge funds hold.

First of all, the legal structure of a hedge fund is intrinsic in its identity. Most people think hedge funds are unregulated, however it is more accurate to say hedge funds are structured to take advantages of exemptions from regulation. Therefore, as regulation is largely in place to protect the general public, hedge funds are intended for highly sophisticated and well-informed private investors. The United States has been the centre of hedge fund activity, but about two thirds of all hedge funds are domiciled outside the USA. Often these “offshore” hedge funds are established in tax-sheltering locales, such as the Cayman Islands, the British Virgin Islands, Bermuda, the Bahamas, Luxembourg, and Ireland, specifically to minimise taxes for non-US investors.

Moreover, the structure of hedge funds contributes to their flexibility, opaqueness and aggression in style. They usually seek exemption from registration and disclosure requirements in the Securities Act of 1933, to prevent revealing proprietary trading strategies to competitors. Secondly, hedge funds’ investment universe are only limited by their own mandate, meaning unlike traditional funds, hedge funds are able to invest in any type of security in any region. The significance of this is highlighted by mutual funds that are not able to invest in complex securities such as derivatives, whereas hedge funds can aggressively take this opportunity. Finally, hedge funds can take opportunity of a fall in the price of a security by holding a “short” position, a privilege not permitted in mutual funds (hence why you hear long-only mutual funds).

Another key characteristic of hedge funds is that they employ leverage. This means they borrow money in order to enhance the size of their positions, thus magnifying the returns or losses of each trade. Since leverage allows hedge funds to trade in greater volume, some argue this renders price more stable and efficient. However, leverage also makes hedge funds more vulnerable to market shocks, as trades that move against them could burn through thin cushions of capital at a fast rate, causing them to dump positions – hence destabilizing prices.

You cannot discuss hedge funds without a mention of their fee structure, a topic that enrages investors and also attracts worldwide talent to join the business. Two types of fees compensate hedge fund managers: a management fee, usually a percentage of the size of the fund (measured by AUM), and a performance fee on the returns. Most hedge funds still hold 2 – 20 fee structure that A W Jones implemented on the very first hedge fund, that is 2% performance fees and 20% management fees. Given the asymmetric nature of performance fees, meaning hedge fund managers profit from their fund performing but bear no costs of the losses, many managers have now introduced “high water marks”, which means that managers only earn a fee when they outperform themselves.

Finally, the arguably most important aspect of the allure of hedge funds: their investment strategies and the personalities who manage them. The flexibility and high rewards in the hedge fund business has attracted the most intelligent minds from a variety of backgrounds to attempt to create alpha in innovative ways. Due to the sheer number of hedge funds nowadays, it would be a lie to say all of them are unique, and we will go through the types of generic strategies in more detail in forthcoming articles – however one must admire the ways successful managers navigate through the markets.

Alfred Winslow Jones, the man accredited for creating the first ever hedge fund in 1949, comes from an unusual background of journalism, having studied at the Marxist Workers School in Berlin and being a member of the clandestine anti-Nazi group called the Leninist Organization, gave his hand at placing long and short positions in the stock market. Following his success today, a breadth of admirers focus on a more traditional path, such as studying quantitative finance and working at established firms such as Goldman Sachs or Morgan Stanley. For example, Cliff Asness, who has a PhD in quantitative finance and did work for Goldman Sachs, managed to raise 1 billion dollars for his start-up, which is known today as AQR Capital.

The firm is littered with world-renowned academics such as John Cochrane and Asness himself, and the fund gained popularity during the financial crisis for its uncorrelated returns. In a similar fashion to Silicon Valley tech giants being born out of garages, Ken Griffin of Citadel started out by trading convertible bonds from his dorm room at Harvard; and then went on to forge one of the most successful multi-strat hedge funds known for it’s state-of-the-art technology and risk management. And last but not least, a personality unimaginable behind the desk of a bank, Jim Simons of Renaissance Technologies, arguably the most successful hedge fund of all time. Jim Simons is a Mathematics professor at Stony Brooks University who does not take orders from anyone, rarely wears socks, got fired from the Pentagon’s code-breaking centre after denouncing his bosses’ Vietnam policy, and contributed to the development of string theory in Physics. His flagship Medallion Fund, which employs roughly 90 PhDs from fields such as physics and computational linguistics, returned just under 50% in the year 2008 (whereas the S&P 500 returned -38.49% for that same year). As Sebastian Mallaby aptly put it in his book More Money Than God, “hedge funds are the vehicles for loners and contrarians, for individualists whose ambitions are too big to fit into established financial institutions.”

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1 comment

  1. Jahid Rahman

    Amazing article. Very talented writer. Need more truth and wisdom like this, spoken more often. Knowledge is key, door is the mind.

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