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Hedging your bets in an uncertain market Back  
John Garvey takes a historical look at the hedge fund and discovers the appeal, despite Irish investors’ seeming reluctance to embrace this intricate instrument.
On September 28th 1998 the Federal Reserve Committee in the U.S. headed by Alan Greenspan appointed six men to save the global financial system from possible meltdown. The world’s most prestigious hedge fund, Long Term Capital Management had failed.

The near collapse of this hedge fund was a fascinating but not unique example of the dangerous use of innovative financial techniques in the pursuit of money. Over the last ten years there have been notable examples of where hedge fund managers have been pushed into the limelight. The case of LTCM in 1998 is the most obvious. In 1992 the activities of George Soros’ Macro Hedge Fund were blamed for forcing the British Government to devalue sterling and leave the exchange rate mechanism.

Hedge funds have taken the blame for many of the travails of the financial markets over the past number of years. From exacerbating volatility on stock markets through their sizable leveraged trades to infecting the banking system with instability and risk and causing the downfall of emerging economies through currency plays.

It is now almost five years since the LTCM crisis, yet the global hedge fund industry has assets under management estimated at almost $1 trillion and is growing rapidly. Since 2000 the level of risk in the financial markets seems to have increased if anything. Surely, the sensible investor will avoid the more exotic investment options and seek out the comfort of conservative assets whose behaviour can be understood with relative ease and their performance tracked more easily.

The motivation for investing in alternative asset classes is to diversify against poor performance in traditional asset classes, particularly equities. Hedge fund returns derived from past performance figures show a low correlation with traditional asset classes. However, the majority of studies of hedge funds rely on data from only the past decade and do not take account of up and down stock markets. Conclusions therefore are based largely on an environment of rising stock markets. Understanding and analysing hedge fund performance and style is not simple. The term hedge fund covers a broad number of investment strategies.

The concept of hedge funds has been in existence for more than 50 years. In the 1940s Alfred Winslow Jones, a journalist for Fortune magazine, hit on a way to neutralise or hedge market risk. At the time expert knowledge on Wall Street told him it was impossible to forecast the direction of the market. He devised an investment technique that would not require a call on the market direction to generate profit. His strategy was to take a long position in an undervalued stock and a short position in an overvalued stock. Short selling is selling securities one doesn’t own. The short seller borrows the stock in the hope of buying it back at a lower price to return to the lender, while pocketing the profit. Stocks that are sold short are the ‘hedge’ against a drop in the market. Jones never took large bets on the market moving up or down, hence the term ‘hedge fund’.

In 1966 Jones’ strategy was made public. His fund had outperformed the next best performing mutual fund by a margin of 87 per cent over ten years, even after deducting a 20 per cent incentive fee. It didn’t take long before the management industry was awash with imitators and their funds. Agarwal and Naik describe them broadly as ‘private investment vehicles where the manager has a significant personal stake and enjoys high level of flexibility to employ a broad spectrum of strategies involving the use of derivatives, short selling and leverage in order to enhance returns and better manage risk.’

The majority of modern hedge funds no longer ‘hedge’. However, they have the important feature of having a low correlation with traditional market instruments. The equity bear market is now moving towards the end of its third year. For both the private and institutional investor there has been an increased awareness of the risks inherent in the stock market. Traditional investment vehicles have performed poorly and there is clearly a very high correlation between returns on all standard equity-based funds. An investment fund with a low correlation with the equity market and low volatility would provide welcome diversification for investors. Hedge funds have the ability to introduce those qualities to a portfolio.

How do hedge fund managers achieve these results? Management strategies are the key. The level of complexity has increased over time as each manager tries to get an edge over his competitors. Standard & Poor’s define three broad styles in their Hedge Fund Index: Event-Driven, Arbitrage, and Directional/Tactical. Event-Driven, for example, has an investment theme dominated by events that are seen as special situations or opportunities to capitalise on price fluctuations such as distressed securities where a firm may be near bankruptcy or risk arbitrage which can be employed when a merger may be announced. The investment strategy is to go long in the company being acquired and short the stock of the firm that is initiating the deal.

From an investor’s point of view hedge funds seem to have delivered. They have become even more attractive from a risk and return point of view in light of the strong downturn in equity markets because of their previously mentioned ability to diversify the traditional investment portfolio. The difficulty is acquiring accurate risk-adjusted performance figures for these funds.

Hedge funds have yet to gain much popularity with the investing public in Ireland. An important issue from a marketing point of view is that fund investment is based primarily on expected performance. In order to determine expected hedge fund returns, theoretical or empirically based return expectation models are required. These models can provide the answer to which factors are pervasive in explaining historical returns.

There already exists single-factor and multi-factor theoretical models and empirical tests of return for stock and bond funds. Sharpe (1992) used over 15 global stock and bond indices to explain the return structure of U.S. equity funds. Elton, Gruber, and Blake (1995) used fundamental economic variables to describe the cross-sectional returns of U.S. bond funds. For ease of acceptance among the investing public in Ireland and Europe, return expectation models for hedge funds are necessary and should be presented in a form similar to those of return expectation for stock and bonds.

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