to hedge funds
History and definition 3
Hedge fund styles 4
The myths and facts about hedge funds 6
Funds of hedge funds 8
Glossary of terms 10
The first hedge fund was developed in Jones’ dramatic outperformance of The term ‘hedge fund’ was initially used
the US in 1949 by doctor of sociology, mutual funds in the early-to-mid 1960s to describe a private investment fund
Alfred Winslow Jones. His pioneering sparked a wave of interest and by 1968, which followed Alfred Jones’ original
insight came from his appreciation of there were 200 hedge funds in operation strategy of using leverage to enhance
the complementary nature of leverage1 in the US. However, it was not until the returns and short selling to limit risk.
(investing borrowed money) and short early 1990s that the industry began to However, such a narrow definition is no
selling1 (borrowing stock to trade). Both grow in earnest. The real boom period longer appropriate due to the evolutionary
of these concepts were used widely in for hedge funds followed the bursting of nature of the industry. Trading techniques
isolation, often for speculative purposes. the technology bubble and the ensuing are constantly being redefined and
However, Jones discovered that they bear market. Investors were impressed enhanced and the number of sub-
could be effectively combined to produce by the ability of hedge fund managers to strategies is steadily expanding.
a conservative investment portfolio. preserve capital in such stark conditions
This strategy is known today as ‘equity and the number of hedge funds
Distinct characteristics of
long/short’. subsequently doubled between 2002
Jones stepped down from fund and 2007.
• Key performance driver is manager
management in the early 1980s. His track In recent years, the growth and
skill rather than market returns
record demonstrated that he lost money contraction of the industry has been
in only three years out of 34, while the driven by hedge fund performance. • Target consistent returns rather than
S&P 500 index recorded nine years of Although 2008 was a poor year for hedge outperformance of a benchmark
negative returns during the same period. funds in terms of meeting absolute return index
Significantly, Jones’ fund substantially objectives, the exceptionally difficult • Managers are unrestricted in their
outperformed the market during the trading conditions acted as a form of choice of investment strategies
boom years of the early 1960s and also quality control with many low-calibre • The ability to invest in any asset
provided resilience during the sharp hedge funds folding. class or instrument
downturn of 1973-74.
Growth of the hedge fund industry2
Number of funds
Index value USD
HFRI Fund of Funds Composite Index
94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
1. A more comprehensive definition of both techniques is provided in the glossary. 2. Source: Bloomberg and ‘HFR Global Hedge Fund Industry Report’, Q4, 2011. Hedge Fund Research, Inc.
There is no guarantee of trading performance and past performance is not necessarily a guide to future results. Please note that the HFRI Index data over the last four months may be subject
to change. Date range: 1 January 1994 to 31 December 2011.
Hedge fund managers employ a diverse and
constantly evolving range of trading strategies to
generate returns. These can be grouped into five
broad investment styles as illustrated below1.
Buying and short Equity hedged
selling of securities
of companies Pro ts from taking up
Global macro experiencing or long and offsetting
Analysis of shifts involved in substantial short positions in
Relative value in macroeconomic corporate changes undervalued and
trends to capitalise (merger, arbitrage, overvalued stocks
Exploitation of distressed securities with a xed or variable
mispricings and on upward
and special situations)
and downward underlying net long
changing price or short exposure
directional Global trading in futures
opportunities across and derivatives on
various markets, nancial instruments and
asset classes and goods (systematic,
arbitrage, xed income
nancial Instruments long-term trend-following
strategies and short-term,
active trading strategies)
The equity hedged style incorporates describe the exploitation of anomalies Global macro and managed futures
equity long/short which, as discussed, is stemming from the mispricing of related disciplines are based on the development
the founding strategy of the hedge fund assets and the potential convergence of of views on economic and market
industry. Equity hedged also constitutes prices. Relative value managers are able themes. They use highly liquid financial
the largest segment of the industry, to exploit such opportunities by taking a instruments such as futures contracts
accounting for approximately 30% of short position in the overvalued asset and to implement a strategy to reflect these
total assets. Similar to equity hedged, a long position in the undervalued asset. observations. The major difference
both the relative value and event driven Profits are generated if the prices of the between the two styles is that global
styles are concerned with the appraisal of two assets converge, regardless of the macro is a more discretionary discipline
underlying asset values. However, global overall direction of the market. which tends to produce portfolios that are
macro and managed futures disciplines Event driven managers identify specific quite concentrated. Conversely, managed
are based on the observation of market events with the capacity to trigger futures is almost completely systematic
trends and are therefore more tactical significant changes in the price of and typically takes a much larger number
than fundamental in their orientation. securities and seek to exploit the resulting of small positions.
Arbitrage can be an important investment opportunity. Consequently,
component of both the event driven these strategies are focused on corporate
and equity long/short investment actions, such as bankruptcies, mergers
philosophies, but it is the foundation of or takeovers.
relative value strategies, as the name
implies. Arbitrage is a term used to
Source: Bloomberg. Styles represented by HFRI Relative Value (Total) Index, HFRI Macro (Total) Index, HFRI Event Driven (Total) Index, Barclay BTOP 50 Index, HFRI Equity Hedge (Total) Index.
There is no guarantee of trading performance and past or projected performance is not a reliable indicator of future performance. Returns may increase or decrease as a result of currency
fluctuation. Please note that the HFRI index data over the last 4 months may be subject to change. Please note that the Barclay BTOP 50 Index data over the last 12 months may be subject
to change. 1. Schematic illustration adapted from Bloomberg data covering period 1 January 1994 to 31 December 2011.
and facts about
Traditional asset managers typically that hedge funds (in general) are riskier delivered. Conversely, a substantial
allocate capital to equities, bonds and than traditional investment strategies is proportion of hedge fund manager
cash on a ‘long-only’ basis. Although they misguided, especially considering that remuneration comes from performance
employ skill-based security selection, the long-only approach fails to make any fees which can only be charged when
they manage their portfolios against a provision against the fundamental risk of positive investment returns are generated.
passive benchmark (usually a familiar and market downturns. Furthermore, many hedge fund managers
established index which is representative The underlying philosophy of the invest their own capital in their funds,
of the markets and assets they invest hedge fund industry is that, the skill of meaning that their interests are aligned
in). Consequently, their scope is limited the manager (‘alpha’), rather than the with those of their investors.
to outperforming a benchmark index performance of a market or asset class
by an amount sufficient to justify their (‘beta’), should principally determine
management fees. If they diverge too far the success of the strategy. This
from the index the relative risk carried will key difference is also reflected in the
be considered unacceptably high. This remuneration of managers and the
makes it virtually impossible for traditional freedom that they are given to invest
managers to produce positive returns in a much broader range of financial
when markets are declining. instruments and assets.
In a financial context, the term ‘hedge’ Traditional investment funds typically
can be defined as ‘guarding against levy a flat fee for active management
risk of loss’. As such, any inference regardless of the level of performance
Hedge fund misconceptions Reality
They are unregulated Established providers are regulated at the manager level
They are very risky Provide superior diversification/downside protection
They are highly leveraged Leverage is typically low; many banks use significantly more leverage
They charge excessive fees Performance fees only levied when ‘earned’
They have long ‘lock-up’ periods Range of liquidity profiles available according to strategy
They lack transparency Disclosure is improving but data interpretation is complex
Consequently, hedge funds provide investors with a number of advantages relative to
Traditional investments Hedge funds
Restricted opportunity set 9 Can exploit wide range of price distortions
Mainly dependent on beta 9 Focused on alpha generation
Relative return objectives 9 Target consistent performance
Flat fee structure 9 Alignment of manager/investor interests
Limited diversification sources 9 Large number of strategies
Inefficient dispersion of risk 9 Enhanced risk/reward trade-off
Hedge funds are normally used in a The illustration below demonstrates how
portfolio context rather than being a 30% allocation to a fund of hedge funds
considered as stand-alone investments. can enhance the risk and return dynamics
As the performance of hedge funds is of a traditional investment portfolio
not closely correlated with traditional comprising equities, bonds and cash1.
asset classes – especially in declining
markets when correlations tend to be
low – they offer a tremendous source
of diversification for most investment
Traditional portfolio Enhanced portfolio
Fund of hedge fund
World bonds stocks
World hedge fund index
bonds 30% 60%
stocks index 30%
30% 60% 30% portfolio
Traditional portfolio Enhanced portfolio
Total return 142.5% Total return 150.1% Improvement of 7.6%
Annualised return 5.0% Annualised return 5.2% Improvement of 0.2%
Annualised volatility 8.7% Annualised volatility 7.5% Lowered by 1.2%
Worst drawdown -32.7% Worst drawdown -29.6% Improvement of 3.1%
Sharpe ratio 2
0.15 Sharpe ratio 2
0.20 Improvement of 0.05
1. Source: Bloomberg and MSCI. Date range 1 January 1994 to 29 February 2012. There is no guarantee of trading performance and past or projected performance is not a reliable indicator
of future performance. Please note that the HFRI Index data over the last four months may be subject to change. Hedge fund index: HFRI Fund of Funds Composite Index. World stocks:
MSCI World Net Total Return Index hedged to USD. World bonds: Citigroup World Government Bond Index hedged to USD (total return). Cash: 3 month USD LIBOR rate. 2. Sharpe ratio is
calculated using the risk-free rate in the appropriate currency over the period analysed. Because the Sharpe ratio is an absolute measure of risk-adjusted return, negative Sharpe ratios are
shown as n/a as they can be misleading.
The significance of the five hedge A low correlation coefficient between Funds of hedge funds allocate capital to a
fund styles is that they have different two elements of an investment portfolio number of different hedge fund managers
drivers of performance and therefore is highly desirable as it implies that one and strategies creating diversified
different return dynamics. This leads to component is an excellent diversifier for portfolios that can potentially deliver more
comparatively low correlation coefficients the other. Blending the two components consistent investment returns than stand
between different styles and traditional together in one portfolio provides a alone hedge funds. They can also be
assets (as illustrated below) and means superior risk-adjusted return than individually structured to meet specific
that portfolios composed of different either could provide as stand-alone risk, return and liquidity requirements and
hedge funds (funds of hedge funds) can investments. so offer widespread appeal to a broad
constitute a very attractive investment Notably, the correlation between range of investors.
proposition. managed futures and world stocks is The construction of a fund of hedge
Although global macro and managed slightly negative which signifies that an funds requires expertise and experience
futures have similar investment styles, allocation to managed futures could help in hedge fund research, manager
as discussed previously, the table counteract the negative performance selection, risk monitoring and quantitative
demonstrates that the correlation of world stocks in a bear market, rather analysis. A study published in September
between their returns is only 0.52. This than merely cushion the impact. This was 20061 found that larger funds of hedge
effectively means that only half of their the case in 2008 when managed futures funds tended to perform better than
performance can be attributed to their delivered positive returns while capital their smaller counterparts. This can be
similarities. markets collapsed. attributed to superior research and better
World World Equity Event Global Managed Relative
stocks bonds hedge driven macro futures value
Relative value 0.62 -0.15 0.72 0.82 0.32 -0.11 1.00
Managed futures -0.14 0.31 -0.02 -0.04 0.52 1.00
Global macro 0.38 0.21 0.56 0.52 1.00
Event driven 0.77 -0.19 0.87 1.00
Equity hedge 0.79 -0.17 1.00
1.0 = perfect correlation
World bonds -0.18 1.00 0 = no correlation
-1.0 = perfect inverse correlation
World stocks 1.00
1. Source: ‘The ABCs of Hedge Funds: Alphas, Betas and Costs’ published by Ibbotson Associates.
2. Source: Bloomberg, MSCI and Barclays BTOP 50 Index. There is no guarantee of trading performance
and past or projected performance is not a reliable indicator of future performance. Please note that the HFRI
Index data over the last four months may be subject to change. Please note that the Barclay BTOP 50 Index
data over the last twelve months may be subject to change. World stocks: MSCI World Net Total Return Index
hedged to USD. World bonds: Citigroup World Government Bond Index hedged to USD (total return). Equity
hedge: HFRI Equity Hedge (Total) Index. Event driven: HFRI Event Driven (Total) Index. Global macro: HFRI
Macro (Total) Index. Managed futures: Barclays BTOP 50 Index. Relative value: HFRI Relative Value (Total)
Index. Date range: 1 January 1994 to 29 February 2012.
access to the scarce capacity of the most
talented hedge fund managers. These are
Advantages of funds of hedge funds
two of the major reasons why investors With one single transaction, funds of hedge funds can provide:
should consider fund of hedge funds
rather than making direct allocations to • Professional portfolio construction
• Optimal diversification
• Ongoing due diligence and
• Superior risk management
• Access to ‘closed’ funds
• Enhanced liquidity
• Low minimum investments
Alpha The component of investment return that can be attributed to the skill of the fund manager(s).
Beta The component of investment return provided by (positive or negative) market movements
(alpha +/- beta = total return).
Correlation A measure of the interdependence or strength of the relationship between two investments.
A correlation of 1 means that the two investments are perfectly synchronised, while a
correlation of -1 implies that they move in symmetrically opposite directions.
Derivative A financial instrument that offers synthetic access to the properties of an underlying asset,
typically a commodity, bond, equity or currency. Examples of derivatives include futures and
options. Derivatives can be used to manage the risk associated with the underlying security,
to protect against fluctuations in value, or to profit from periods of inactivity or decline.
Drawdown A term used to describe the extent of a decline in asset value from peak to trough in any given
cycle. The worst or maximum drawdown constitutes the greatest peak to trough fall since
inception of the fund. In this context, the worst drawdown for any comparison index relates to
the period being analysed rather than the full history of the index.
Leverage A term used to describe the degree to which an investor utilises borrowed money or
speculative derivative positions to enhance investment returns.
Liquidity A relative term describing the speed at which an asset or assets can be converted into cash
(liquidated) and vice versa.
Lock-up period Indicates how liquid a hedge fund is through the specification of a notice period which
investors must provide prior to making a withdrawal. This is typically 30 days although certain
hedge fund styles such as event driven and relative value may be less liquid to enable the
manager to avoid having to sell assets cheaply to fund redemptions.
Risk-adjusted Describes the investment return achieved for each unit of risk absorbed, typically measured
performance using the Sharpe ratio.
Sharpe ratio The original measure of risk-adjusted performance. It is calculated by dividing the sum of the
return on an investment less a risk-free (cash) rate by the annualised volatility of the
investment. If one investment is similar to another in composition but has a higher Sharpe
ratio, it can be considered to offer greater efficiency.
Short selling A trading technique whereby an investment manager arranges to borrow stock
from a stock lender with a view to selling it and buying it back at a lower price in
Transparency A term that relates to the level of disclosure that a hedge fund manager is willing to provide.
Hedge funds have traditionally been seen as opaque but levels of transparency have improved
in the aftermath of 2008. Fund of hedge fund managers are usually able to negotiate
enhanced transparency terms in return for a guarantee of confidentiality, which enables them
to provide superior risk management.
Volatility A measure of the relative rate at which the price of an investment moves up and down.
Volatility is found by calculating the annualised standard deviation of daily change in price. If
the price changes rapidly over short time periods, it has high volatility and is therefore riskier
than investments with lower volatility. (Please note that volatility is an absolute measure of the
total range of prices and does not convey any information about price direction).
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