Factors to Consider When Investingin Hedge Fund Funds
Hedge fund funds are a type of investment strategy that allows investors to buy and sell stocks and other financial assets in the markets. However, there are certain factors that should be considered when investing in hedge fund funds. These factors include: location, leverage, trading strategy, and the rules of the market.
Most hedge fund indices have experienced big declines in performance during market downturns, raising questions regarding diversification. However, there have been some exceptions, including the event driven strategies, which were more sensitive to the 2008 financial crisis.
Hedge fund indices are constructed in an attempt to provide a broad picture of the hedge fund industry and to offer potential investors a benchmark against which to compare their own portfolios. These indices may be based on absolute returns, risk adjusted performance, or both. Typically, the returns are reported in U.S. dollars and are net of fees. Some indices are designed to capture the performance of a single hedge fund, while others are designed to include multiple funds, in order to enhance diversification.
Several studies have investigated hedge fund indices. Many of these have found that hedge fund indices are highly leptokurtic. That is, their return distributions tend to be more symmetric than those of traditional market indices. In particular, the left tails of these returns tend to be longer than the right tails.
A recent study by Bali, Brown, and Caglayan (2011) looked at the performance of several hedge fund indices and compared them with traditional market indices. They found that the global macro index outperformed all other indices, with the exception of the emerging markets index.
An alternative method of comparing indices is to examine their performance relative to non-hedge fund indices. Non-hedge fund indices are constructed in much the same manner as investable indices. However, these indices do not have the smoothness of investable indices and therefore have inferior risk-adjusted performances.
In addition to comparing hedge fund indices to traditional market indices, this study also examined the effect of various strategies on these indices. Of the indices studied, the most successful was the global macro index, followed by the distressed restructuring index.
Trading strategy factors
Hedge fund strategies can be positioned to protect or increase returns. They can also be positioned to profit from market uptrends. However, hedge funds do not necessarily perform well in down trending markets.
The benefit of selecting a common set of factors to replicate a hedge fund's returns is that it can be done at a low cost. However, this approach has limited performance, as it fails to mimic the holdings of a hedge fund. Consequently, investors are beginning to question the value of hedge fund fees.
Traditional hedge fund replication analysis focuses on factor exposures related to each individual fund strategy. For example, an event-driven hedge fund is positioned to take advantage of short-term opportunities, while a managed futures fund is positioned to capitalize on long-term trends. Using a factor model, an investor can choose between funds with higher average returns, or funds with higher Sharpe ratios.
For most categories, clones constructed using general factors have better performance than clones built using factors specifically selected for a specific category. Clones constructed using a rolling window model, for example, performed better than clones built from a fixed weight set. Similarly, clones created from the top 50% of funds with the highest Sharpe ratios provide an excellent option because of their balanced risk reward properties.
In a quantitative hedge fund trading environment, most strategies fall into two groups. Those that focus on relative value, such as distressed debt or high-yield bonds, are typically shorter-term in nature and are less exposed to the stock market.
Conversely, systematic traders are positioned to capitalize on long-term trends and can generate spectacular returns. But this type of strategy is risky and can be volatile. Therefore, a multi-linear asset factor model has been developed to estimate daily VaR for a hedge fund portfolio. It has shown good results for long/short strategies, but it did not perform as well for equity market-neutral and event-driven strategies.
Leverage factors
The use of leverage in hedge funds can have a number of advantages. One benefit is that it increases the overall return of the portfolio. However, it can also increase the risk of failure. Furthermore, it can magnify the volatility of market prices and distributions. This is especially true when leverage is applied to derivatives, which tend to have asymmetric risk.
Another benefit is that leverage can help to reallocate financial risk. For example, it can allow a fund to buy more securities. Similarly, it can allow a fund to sell more securities short. But it can also cause the fund to be vulnerable to liquidity shocks. It is also important to note that leverage is not universal. Each type of leverage is well suited to different market conditions. In some cases, regulatory capital requirements limit the amount that a firm can leverage. At other times, a firm may choose to use multiple types of leverage.
A common type of leverage is borrowing on margin. This allows a hedge fund to purchase more securities than they have the cash for. Alternatively, a firm can borrow on a revolving line of credit. Typically, revolving lines of credit are not used for leverage.
A few other types of leverage include repurchase agreements (RPAs) and derivatives. These are often used to enhance the returns of a fund, but can also lead to a higher degree of risk.
Hedge funds are a growing segment of the asset management industry. They differ from traditional investment vehicles, such as mutual funds and equities, because they typically charge a fee based on performance. Although they have been around for decades, their popularity has recently increased.
Hedge fund rules have changed
Hedge fund rules have changed over the last few years. This is due to the global financial crisis and subsequent regulatory reforms. These changes have reduced the hedge fund industry's competitive advantage over other investors. They have also led to greater investment flexibility and oversight.
Some of the major reforms include the Jumpstart Our Business Startup Act (JOBS Act) and Dodd-Frank Wall Street Reform and Consumer Protection Act. The bills also require periodic stress tests for funds.
In addition, hedge funds have to report large foreign exchange transactions to enforce capital controls. Funds must also report their total borrowings. Rule 506(c) allows certain types of funds to solicit investments from accredited investors. However, the SEC is considering tightening the rule. It also has the authority to adjust the net worth standard.
Most investment advisers must register with the SEC. A number of bills have been proposed to change the regime governing hedge fund managers and investment advisers.
The Managed Funds Association and the Hedge Fund Association are two of the industry's most influential trade groups. While the associations differ on specific issues, they agree on a few key aspects.
They both support the SEC's efforts to increase the minimum net worth of an “accredited investor” to $1,000,000. But they disagree on the SEC's rules on issuer advertising.
Hedge funds must file Schedule 13-D with the SEC. It currently requires funds to disclose their investment activity within ten days. Many critics of the rule say that the deadline is too strict.
The Securities and Exchange Commission recently closed its comment period on proposed regulations for the hedge fund industry. Chairman John Arnold said the agency is examining the proposal, which could result in a tighter rule for hedge funds
Olga Steiner
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