1 Hedge Funds The good, the bad and the ugly

2 Hedge funds are relatively unregulated pools of money managed by an investment advisor, the hedge fund manager, who has a great deal of flexibility. ‑ Long and short positions, leverage, derivatives (from plain vanilla options to very exotic instruments), highly illiquid and OTC securities. ‑ Lack of regulation also implies intransparency, as there are no standards on the reporting of performance, etc. Hedge funds are in many cases relatively hard to get into (closed, minimum investments) but also hard to get out of (lock-up periods). Compensation of hedge fund manager more complex: fixed fee, performance fee, hurdle rates and high-water marks. Hedge funds are very heterogeneous and very different from mutual funds. T HINGS TO KNOW ABOUT HEDGE FUNDS

3 What do hedge funds do? ‑ Search for mispricings: asset selection (e.g. under- or overvalued stocks) or market timing. ‑ Generate returns from the correction of the mispricing. ‑ Engage in hedging trades (becoming market-neutral): general trends in the market should not affect the hedge fund’s performance. ‑ Depends highly on the skill of the hedge fund manager. ‑ Examples for strategies: long-short equity funds, event-driven (M&A or distressed securities), global macro, etc. These characteristics of hedge funds give rise to “the good, the bad and the ugly” of the hedge fund industry. T HINGS TO KNOW ABOUT HEDGE FUNDS

4 Hedge funds expand the investment opportunity set: ‑ Exposure to alternative assets such as non-exchange traded securities. ‑ Exposure to alternative trading strategies such as long-short strategies or option writing. An expanded investment opportunity set has several potential advantages: ‑ Creation of alpha relative to the equity market. ‑ Collection of non-standard risk premiums such as liquidity risk premium or volatility risk premium. ‑ Diversification and low correlation with traditional investments. Empirical evidence: ‑ Mixed! Early on strong support but more skepticism more recently. ‑ We will come back to this… H EDGE FUNDS : THE GOOD

5 Hedge funds are expensive: 1-2% fixed fee and 15-25% performance fee. Objective performance measurement is difficult: ‑ Only self-reported and not standardized. ‑ Problems of valuations: hedge funds often hold securities that are not traded on an exchange and, thus, closing prices are often not available. ‑ Danger of strategic return smoothing/massaging patterns to keep volatility low (or boost returns in December). Peso problem: ‑ During good/normal times relatively stable, good performance but sometimes disaster strikes (note that volatility of returns would still be low in this case). ‑ Empirical evidence suggests that hedge fund returns have “fat tails” and “longer negative tails”. ‑ Hedge funds might be more risky than they appear to be using standard metrics. ‑ E.g., collapse of LTCM. H EDGE FUNDS : THE BAD

6 Prominent cases of frauds in the hedge fund industry. For example: ‑ Bayou Hedge Fund Group: misreporting of performance. ‑ Bernie Madoff: Ponzi scheme. ‑ Raj Rajaratnam: insider trading. ‑ Etc. Given the lack of regulation and transparency hedge funds are prone to suffer from misbehavior. H EDGE FUNDS : THE UGLY

7 Hedge funds are certainly an interesting asset class. They might not be suitable for everyone: illiquid, medium-term/long-term investment horizon, lack of communication, etc. Standard performance/risk measures such as Sharpe ratios or volatility might be inappropriate to evaluate hedge funds. ‑ Instead look at Value-at-Risk or Expected Tail Loss. Due diligence and ongoing monitoring are key, as hedge funds are very heterogeneous, available information is challenging to interpret, and danger of fraud is rather high. C ONCLUSION