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Chapter 20 - Hedge Funds
CHAPTER TWENTY
HEDGE FUNDS
CHAPTER OVERVIEW
While mutual funds are still the dominant type of investment fund, hedge funds enjoyed much
faster growth until the financial crisis of 2008. In 1997 assets under management were about
$200 billion; this number peaked at about $2 trillion before the downturn in 2008 reduced the
number to $1.6 trillion. Hedge funds are organized as private partnerships and are not subject to
SEC disclosure requirements. Hence many people have only a limited understanding of what
these funds do and particularly have little idea about their risk adjusted performance. The chapter
provides an overview of different hedge fund strategies before turning to evaluating hedge fund
performance. Hedge fund alphas and Sharpe ratios are presented and problems with interpreting
these measures are presented. The chapter covers hedge fund fees and their effect on
performance, particularly for funds of funds. The chapter concludes with a brief discussion of the
Madoff scandal.
LEARNING OBJECTIVES
After studying this chapter students should be able to differentiate between directional and non-
directional strategies and state several of each. Students should understand a pure play strategy
such as alpha capture while hedging out fundamental risk. Readers should have knowledge about
some of the problems involved in evaluating hedge fund performance and should understand the
value and effects of incentive fees. After completing the chapter students will be far more familiar
with this industry and will be able to sort out the myths and the facts about hedge funds.
CHAPTER OUTLINE
1. Hedge Funds versus Mutual Funds
PPT 20-2 through PPT 20-3
Mutual funds are regulated under the SEC Act 1933 and the Investment Company Act of 1940
and they must invest according to the stated goals in the prospectus. They are adjured to avoid
‘style drift.’
Characteristic Mutual Funds Hedge Funds
Transparency Public info on portfolio
composition
Info provided only to
investors
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Strategies
limited short selling &
leverage, limited
derivatives usage
No limitations
Liquidity Redeem shares on demand Multiple year lock up
typically 0.5% to 2%
gains above threshold
return
Notes to the table:
Some mutual funds can engage in short selling, but not to the extent that hedge funds can. The
lock up period employed by some hedge funds allows the funds to invest in less liquid assets and
2. Hedge Fund Strategies
PPT 20-4 through PPT 20-7
Text Table 20.1 provides a comprehensive list of hedge fund strategies. Hedge funds employ both
directional strategies and non-directional strategies. A directional strategy is a position that
benefits if one sector of the market outperforms another, an unhedged bet on a price movement.
capture the increase in price of the corporate bonds as their yield falls when the spread narrows
and you capture the price drop on the Treasuries that occurs when their yield rise. The offsetting
long and short positions limit risk from interest rate moves. This position is said to be market
neutral with respect to overall interest rates. Directional strategies are riskier, but neither is
riskless. The strategy described above is termed an intermarket spread strategy or a convergence
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Chapter 20 - Hedge Funds
Convertible bond arbitrage is a type of risky arbitrage strategy. If the fund thinks the convertible
is underpriced it would buy the convertible and short the stock and then wait for the mispricing to
strategy requires fast trading and low transactions costs. An example of this is so called “Pairs
Trading” where the fund attempts to find two ‘twin’ stocks and then shorts the high priced one
and buys the low priced one. The fund places small bets on large numbers of pairs hoping to rely
on the law of large numbers.
3. Portable Alpha
PPT 20-8 through PPT 20-12
Suppose a fund finds a positive alpha stock but the fund expects the overall market to fall. This is
called fundamental risk. The solution is to buy the stock and sell stock index futures to drive the
The example assumes the hedge termination date is the futures contract expiration date. That is
why we get convergence. The two terms with rM cancel out and we effectively have a zero beta
position.
Step 3: Verify that the return captures the alpha of 2% (plus the risk free return of 1%).
4. Style Analysis for Hedge Funds
20-4
Chapter 20 - Hedge Funds
5. Performance Measurement for Hedge Funds
PPT 20-14 through PPT 20-26
Hasanhodzic and Lo (2007) find that style adjusted alphas and Sharpe ratios are significantly
greater than these measures for the S&P500 for a large sample of hedge funds. Does this mean
that hedge funds are earning abnormal returns? The answer is maybe, but probably not. On the
of hedge fund shares.
Prices in illiquid markets tend to exhibit serial correlation. This is because in illiquid markets the
funds themselves estimate values for their investments to calculate the fund’s share values and
rates of return to quote to investors. This brings up the possibility that funds estimate prices
optimistically and/or mark to market slowly instead of all at once if the positions are generating
additional evidence of manipulation of position values by hedge fund managers.
\ Other Problems in Hedge Fund Performance Evaluation
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Chapter 20 - Hedge Funds
Most performance measures assume constant risk levels and many hedge funds have variable risk
levels. This implies that the positive alphas may simply be due to measurement error. Moreover,
many funds hold options or perform like options. Option positions make performance
measurement more challenging because options result in nonlinear performance, but most
performance measures assume or fit a straight line to return data. Text Figures 20.4,
market betas, although not all hedge funds exhibited this pattern.
Figure 20.6 Panel B Returns on Income Arb Funds vs S&P500
Figure 20.6 Panel C Returns on Event Driven Funds vs S&P500
Hedge fund performance lines in Panel B and Panel C are roughly analogous to writing a put
option. This may well be an explanation of the supposed positive alphas. Many hedge funds
likely to appear as strong and they may suffer large losses.
6. Fee Structure in Hedge Funds
PPT 20-27 through PPT 20-28
Typical hedge fund fees includes a fixed management fee between 1% and 2% of assets plus an
incentive fee usually equal to 20% or more of investment profits above a benchmark performance
return. Incentive fees are analogous to call options on the portfolio with a strike price equal to the
The fund has a net asset value of $100 per share and the annual risk free rate is 5%.
The implicit exercise price of the incentive fee is $100 x 1.05 = $105
The Black-Scholes value of a call option with S0 = $100,
X = $105, =30%, T = 1 year, & rf = LN 1.05 = 4.88% is $11.92. The Black-Scholes
inputs are as follows:
20-6
incentive fee = 20% x $11.92 = $2.38 per share or 2.38% of the $100 net asset value.
Combining this with the 2% management fee yields total fees of 4.38%. This is much
larger than most mutual funds.
Mutual funds as a group suffered large losses during the subprime fallout and the related financial
crisis. However according to the Economist Magazine in 2009, hedge fund customers were
so called “High Water Mark.” This complicates estimating the value of the incentive and it gives
managers an incentive to close the fund and start over when large losses occur. This is probably
one of the reasons for the large amount of turnover in the industry.
Funds of Funds
Funds of funds invest in one or more other hedge funds and serve as ‘feeder funds’ to the ultimate
investors in Bernard Madoff’s $50 billion Ponzi scheme (see below for more on the scandal).
Suppose a fund of funds has $1 million invested in each of three hedge funds. For simplicity
assume the hurdle rate to earn incentive fees is a zero rate of return (no losses) and the normal
fixed asset management fee is zero. The following text table illustrates the effect of the fees on
this fund of funds:
Chapter 20 - Hedge Funds
End of year (M$) $1.20 $1.40 $0.25 $2.85
Gross rate of return 20% 40% -75% -5%
Incentive fee (M$) $0.04 $0.08 $0 $0.12
End of year value, net of fee $1.16 $1.32 $0.25 $2.73
Bernard Madoff pleaded guilty to operating a $50 billion Ponzi scheme. In a Ponzi scheme the
con artist (Madoff) promises and initially pays high returns to investors. The large returns are
generated by paying out to old clients some of the money paid in by new clients. The con artist
also skims some of the money for his or her own use. The scheme can work for some time until
the fund stops growing. When growth stops the fraud will become apparent. Madoff apparently
Partners and Access International Advisors. Their due diligence must have been poorly done.
In 2008 redemptions began as more clients needed money and the scheme unwound. The lack of
reporting requirements in this industry made the fraud possible but there were several warning
signs including:
Returns were too stable for too long. His firm was Bernard L. Madoff Investment
The fund fee structure was too generous by far in comparison to competing funds. There
were no incentive fees and apparently no management fees. Madoff claimed the
commissions on trades provided sufficient income for his firm.
All assets were kept in house rather than with a custodian. This made the fraud possible
since no one could check on the actual fund assets.
apparently ignored the letter.
20-8
