Whether you're investing in a hedge fund or mutual fund, there are a few factors you should know about before you make your decision. These factors will help you to decide which type of investment will best meet your needs.
Dedicated short bias hedge funds are designed to capture the inverse of a market return. Typically, these funds maintain a net short position, or an inverse long position, and aim to profit during bear markets and reposition the position when the market recovers. They are typically highly leveraged and have a wide range of returns. They are ideal for tactical bets and hedging strategies. However, misuse of these funds has led to regulatory scrutiny. This study analyzes the performance of DSB hedge funds over an extended sample period. It utilizes an equally weighted dedicated short bias index to compare performance. The study finds that the alphas of short-biased funds deviate significantly from the market mean over time, and the volatility of the abnormal returns of individual funds is negatively affected by fundspecific and macro-based factors.
During the bull market, many dedicated short bias hedge funds underperformed. As the market recovered in 2009, some funds reloaded short positions, taking profits during the rally. In addition, many short-biased funds had lots of cash going into the crash, and some had no intention of risking it in the recovery.
In contrast, dedicated short bias hedge funds exhibited strong results during the recent market turmoil. They also outperformed many other hedge fund strategies. They are a good fit for hedging, tactical bets, and portfolio hedging. These funds typically have a large range of returns and are very risky. They are not suited for more conservative investors who are able to absorb losses easily. They are more prone to volatility than other hedge fund strategies.
The study found that short-biased hedge funds tend to be 30%-60% net short at all times. They also have the smallest maximum drawdowns and lowest standard deviation. During the January 2000 – July 2007 period, the average monthly return of these funds was 0.28 per cent. Compared to other hedge fund strategies, these funds display better security selection and market-timing abilities. The volatility of risk-adjusted returns decreases as the fund's assets under management increase. Inflation and higher interest rates are also negative influences on the performance of short-biased funds. This is because lower short-biased fund returns are correlated with higher broader market indices. The CITI six-month T-bill rate is a good example. The NYSE is also negatively correlated with alpha returns.
Some studies have found that onshore short-biased funds have higher volatility than offshore ones. This may be because short-biased managers have more accurate information than conventional long-only investors. They can identify firms that are under duress, and they have a tendency to spot unethical accounting practices. The availability of data has limited the number of studies that have been conducted. It is possible that future studies of short-biased hedge funds will have to be conducted on a larger sample size and use different methodologies.
Lack of transparency
Historically, the hedge fund industry has not been very transparent in terms of providing information to investors. However, with the advent of the International Financial Reporting Standards (IFRS), the hedge fund industry is now compelled to provide more information to its stakeholders. The FSOC has begun to require some funds to report in real time, but this could prove to be harmful.
For instance, a fixed income arbitrage fund with mortgage-backed securities investments would not tell most investors much about its risk level. In addition, many hedge funds are not subject to the same scrutiny as mutual funds, making it more difficult for investors to identify risky funds. In contrast, the transparency of ETFs is readily apparent. In this case, shares in listed funds are available for purchase by investors of all walks of life, from those with a modest savings to those who own super-wealth.
The disclosure of information about a fund's performance is the best way to ensure that investors are not duped into making bad investment decisions. Some managers may choose to bury their head in the sand, fearing that competitors will reverse engineer their proprietary trading models. Others have opted to use more innovative techniques to gain an edge over their rivals. For example, a hedge fund may use a neural network to generate signals on trades.
However, the most sophisticated of investors are capable of evaluating the risks and rewards of investing in a hedge fund. Aside from knowing how the manager makes his money, they also want to know what types of investments the manager is putting his hard-earned money into. This is not always as easy as it sounds, as the hedge fund industry has a reputation for being secretive.
Several areas of the industry are ripe for improved transparency. These include hedging instruments, the performance fee structure, and equalisation. While the latter is not a new concept, it is a good idea to see if a fund is taking the lead on the matter. In the meantime, it's worth noting that the FSOC has not yet finalized guidelines for hedge funds.
While the transparency of a hedge fund is not mandatory, a good number of funds are willing to go the extra mile and provide full disclosure to their investors. The Hedge Fund Working Group last reported to the FSOC in 2016, but the group has not formally recommended any changes to the underlying rules.
The most important thing to consider is what information a hedge fund should be able to provide its investors. For instance, an investor should be able to identify the hedging instruments and methods the manager uses, along with the hedging mechanism itself. A hedge fund can use a variety of alternative forms of investment, from currency futures to swaps.
Unlike mutual funds, which are regulated by the SEC, hedge funds are free to make decisions about their investments and can invest in a variety of sectors including real estate and art. They can also leverage their investment strategies to make gains. In short, the fees they charge are as inextricable from the industry as the leverage they use to increase their profits.
There are several reasons why hedge fund fees are more expensive than their mutual fund counterparts. While the majority of costs are necessary, there are some cost-cutting alternatives. Additionally, a few mutual funds could charge less. These fees are not always the most important consideration for most investors, though. The biggest fee the hedge fund industry charges is the performance fee. This is generally a percentage of incremental profit generated by the fund, and is a significant source of income. However, the performance fee is only charged if the fund exceeds a specific threshold. The usual threshold is between 8% and 20%, although some hedge funds are willing to pay up to 44%. The fee is not necessarily a bad thing, as it can act as a year-end bonus for the fund's employees.
Similarly, the management fee is a common expense. The expense ratio typically breaks out the management fee, 12b-1 distribution and other expenses. These fees can run as high as 0.25% for a front-end load fund, and 1% for a back-end load fund. This expense is often misconstrued as a broker's commission, but many investorright advocates believe it is actually a disguised commission.
The most basic distinction between hedge funds and mutual funds is that a hedge fund can go short in addition to going long. For example, a hedge fund manager can invest in foreign exchange, currency, real estate, or any other type of asset. The resulting gains are offset by losses from other investments. This is a much more tax efficient way to earn returns, and can be considered a form of “hedge” for a portfolio that is heavily invested in the market.
Another noteworthy aspect of hedge funds is their specialized investment strategies. In general, they are much more complex and expensive than mutual funds, and their investments are available only to accredited investors. Nonetheless, they have become more popular over the past few years as a result of their ability to generate high returns with lower volatility. They are also available to institutions and individuals with substantial amounts of capital.
The hedge fund industry has suffered a number of setbacks, including the recent GameStop short squeeze, and has been under pressure to slash fees in order to attract more investors. The recent education campaign launched by the MFA is aimed at promoting the merits of the hedge fund industry. The MFA argues that they are a necessary component of an investor's portfolio, and are a good way to protect and grow wealth.