BACK TOB ASICS Demystifying Funds Angel Ubide

edge funds may have an aura of exoticism even if the fund declined in value, so long as it did not decline and modernism, but their goals are as old as as much as the benchmark index. the art of investing itself. They seek a positive In contrast, managers focus on risk-adjusted annual return (the higher the better), limited absolute returns—that is, their objective is to maximize the Hswings in value, and, above all else, capital preservation. increase in investment value per year rather than to simply They do so by using the best of what modern financial sci- ence can provide—rapid price discovery; massive math- ematical and statistical processing; risk measurement and Box 1 control techniques; and leverage and active trading in corporate equities, bonds, foreign exchange, futures, op- It all began with olives tions, swaps, forwards, and other derivatives. The first recorded hedge fund–style investment was a “call Because of their nature, hedge funds are restricted to large- ” trade and appears to have occurred about 2,500 scale investors. Historically, they have attracted high-net- years ago. Aristotle told the story of a poor philosopher, worth individuals and institutional investors, and the array of Thales, who proved to doubters that he had developed a the latter has widened significantly in recent years to include “financial device, which involves a principle of universal application,” by making a profit from negotiating with pension funds, charities, universities, endowments, and foun- owners of olive presses for the exclusive rights to use their dations. Funds of funds are starting to introduce hedge funds equipment in the upcoming harvest. Olive press owners to retail markets, but on a rather limited scale. Currently, there were happy to pass on the risks of future olive prices and are about 8,500 hedge funds operating worldwide, managing to accept payment now as a hedge against a bad harvest over $1 trillion in assets. Quite a leap from the 2,800 hedge later. As it turns out, Thales correctly predicted a bounti- funds, managing $2.8 billion in assets in 1995, not to men- ful harvest, and the demand for olive presses rose. He sold tion the amounts involved in the earliest hedge fund–type his rights to use the presses and made a profit. Thales’s investments in the days of Aristotle (see Box 1). “” risked only his down payment. Although he did not invest in fields, workers, or olive presses, he par- What is hedging? ticipated actively in olive production by taking on a kind A few key features distinguish hedge funds from other of risk olive growers and press owners were unable or investment vehicles: the focus on absolute returns, and the unwilling to take—in the process enabling them to con- use of hedging, , and leverage. centrate on growing and processing olives. They made a Absolute versus relative returns. Over very long periods, profit from their work, and he made a profit from his. buy-and-hold strategies almost always do well. The problem Modern hedge fund history began with Alfred Winslow is the length of time and starting point: it can matter enor- Jones, a sociologist and journalist who wrote about mar- mously when you buy. For example, over hundreds of years, ket behavior in the 1930s and 1940s and founded one of stocks returns have averaged about 8 percent a year, but the first hedge funds in 1949. Jones’s fund used leverage there can be several decades when stock prices don’t increase and selling to “hedge” its stock portfolio against in value at all. The Standard & Poor’s (S&P) index, which fell drops in stock prices. There was little widespread interest sharply after reaching a peak in 1968, failed to return to its until 1966, when an article in Fortune magazine generated 1968 level in inflation-adjusted terms until 1992! Back in the considerable interest by pointing out that Jones was earn- ing 44 percent higher returns than the best-performing 1970s, these swings in value prompted investment managers equity asset fund—even though he charged a fee equaling to focus on returns relative to benchmarks, such as the S&P 20 percent of the fund’s gain. By 1968, there were about 500 stock index. That way, good performance was expressed 200 hedge funds, although many failed in the 1969–70 in terms of asset managers’ performance relative to standard and 1973–74 market downturns. Hedge fund business asset-class indices, and the better the relative performance, really picked up in the 1990s, fueled mainly by new wealth the more investors were attracted. In other words, manag- generated during the 1990s equity bull market. ers attracted more investors—and were paid more money—

Finance & Development June 2006 41 ©International Monetary Fund. Not for Redistribution perform better than the average. Consequently, most hedge price in all markets at the same time, a way to capture a low- fund managers are paid based on how much they increase risk profit is to sell the higher-priced asset in one market (sell investors’ wealth—a percent of the return—not on how well it short) and buy the lower-priced asset (buy it long) in the they do relative to a benchmark, thus focusing their perfor- other market. When the prices converge, an arbitrage profit mance exclusively on positive returns. Although managers can be captured by selling the formerly low-priced asset and are also paid a 1 or 2 percent commission a year for assets buying back the formerly high-priced asset. A typical example under management, most of their compensation depends of potential arbitrage opportunities is company bonds that are on delivering a positive . In addition, manag- convertible into equity shares of the company. ers typically invest significant amounts of their own capital A hedge fund manager focuses on achieving absolute in the fund, which aligns their interests with the investors returns by finding as many profit opportunities as pos- and discourages reckless risk taking. And, when used, a sible that are immune to market gyrations—in industry “high-water mark”—whereby capital losses have to be made lingo, generating (returns uncorrelated to market up before a performance fee is paid—introduces a strong performance) rather than . Because these opportuni- incentive toward capital preservation. In this context, mini- ties often involve small trading margins, the use of lever- mizing swings in value and immunizing the hedge fund’s age and prudent risk management seeks to achieve good portfolio from general swings in market values, through returns with lower . The key performance variable hedging, become key to long-term return maximization. is risk-adjusted returns. The most widely used measure is Hedging, arbitrage, and leverage. What is hedging? It is the Sharpe ratio—the rate of the mean of the return to its a technique aimed at protecting a portfolio against sharp standard deviation. Higher values mean the risk-adjusted movements in market values. It essentially implies buying return is higher, given a particular measure of risk. and holding assets that have good long-term prospects while The bottom line is that hedge fund profits arise not from simultaneously selling assets that have doubtful prospects. accurately predicting the direction of prices but from being The latter technique, short selling, involves borrowing some- able to identify transient pricing opportunities. To believe one else’s shares of stock and selling them, with the intent to in the ability of hedge funds to be successful, one must dis- buy the shares back at a lower price and return them to the believe, or at least relax, the well-known efficient markets original lender. The difference between what the shares are hypothesis, which says that on average no model projecting sold for and what needs to be paid to buy them back is the directional movements in asset prices will be significantly profit. The development of market-traded stock and stock superior to tossing a coin. In fact, however, the operations index futures, options, and related derivatives over the past of hedge funds may be viewed as promoting efficient mar- half-century has created a near-infinite number of ways to kets: by actively seeking to eliminate market mispricing, engage in short selling and hedging (see Box 2). hedge funds contribute to a faster and more efficient con- The technique of arbitrage tries to profit from the fact that vergence of prices toward a market equilibrium, diminish sometimes an asset trades at a different price in different mar- market pricing errors, reduce price extremes, and can help kets at the same time. Because an asset should have the same to stabilize markets, “buying low and selling high.”

Box 2 . A strategy in which managers employ “top down” global approaches and may invest in any markets Basic hedge fund arbitrage strategies using any instruments to profit from inaccurately priced . A strategy in which managers pur- market movements resulting from shifts in world econo- chase a portfolio of securities that are convertible into mies, geopolitical conditions, global supply and demand other kinds of securities. For example, corporate bonds are balances, or other large-scale changes. often convertible into equity shares of the issuing compa- Long/short. Strategies in which managers take long posi- nies. Normally, the prices of the bonds and shares trade tions in securities expected to rise in value and short posi- in a close relationship. Sometimes bond and tions in securities expected to fall in value in an effort to conditions cause the prices to get out of line. Hedge funds insulate the portfolio from market volatility. One example buy and sell the bonds and stocks simultaneously, push- of this strategy is to build a portfolio made up of long posi- ing the prices back into line and profiting from market tions in the strongest companies in an industry and corre- mispricing. sponding short positions in the weakest companies. . A strategy in which managers use . A category of long/short strategies in borrowed funds to invest in the debt and equity of compa- which managers invest the same amount of capital in off- nies that are currently or recently in bankruptcy reorgani- setting long and short positions, maintaining a portfolio zation, or may declare bankruptcy in the near future. with zero or near-zero net market exposure. Event-driven/merger. A strategy in which managers invest Volatility arbitrage. A strategy in which managers sell in opportunities created by significant transactional events, short-term call and put options to profit from option pre- such as spin-offs, mergers and acquisitions, bankruptcy mium decay and volatility mean-reverting tendencies using reorganizations, recapitalizations, and share buybacks. index options and/or options on futures contracts.

42 Finance & Development June 2006 ©International Monetary Fund. Not for Redistribution Debunking hedge fund myths ing to take the risk of buying some of the assets that had In recent years, there has been a lot of debate and hand already fallen significantly in price, contributed to lim- wringing about hedge funds, their effects on global finan- iting the downfall during the Asian crisis and advancing cial stability—especially since a major U.S. hedge fund had the recovery. to be bailed out in 1998 (see Box 3)—and the degree of The reality is that hedge fund activity makes financial regulation or supervision to which they are subject. The markets more efficient and, in many cases, more liquid, reality is that these worries are overblown. Take two of the as has been widely recognized by the U.S. Federal Reserve, biggest myths. the SEC, and the IMF. Not only do hedge funds contribute Myth 1: Hedge funds can move financial markets for to the adjustments of markets when they overshoot, they their own gain or cause market turmoil. After exhaustive also help banks and other creditors unbundle risks related analysis, the U.S. Securities and Exchange Commission to real economic activity by actively participating in the (SEC) recently determined that there is little evidence market of securitized financial instruments. And because that hedge funds can move markets, and several research hedge fund returns in many cases are less correlated with studies have found no evidence that hedge funds were a broader debt and equity markets, hedge funds offer more cause of the Asian crisis or other world economic turmoil traditional investment institutions a way to reduce risk by (Eichengreen and others, 1998). The unwinding of “carry providing portfolio diversification. trades” (borrowing at a low interest rate and lending at Myth 2: Hedge funds are unregulated and unsuper- a higher one) did contribute to Europe’s 1993 exchange vised. The fact is that hedge funds in the United States rate mechanism crisis, the 1994–95 peso crisis, and the are regulated and supervised directly or indirectly by 1997–98 Asian crisis. But the key problem underlying seven U.S. government agencies (the Federal Reserve, the these events was the misalignment of exchange rates with Department of Treasury, the SEC, the Commodity Futures respect to their fundamentals—not the intervention of Trading Commission, the National Futures Association, financial market participants. In fact, the IMF study led the Comptroller of the Currency, and the Federal Deposit by Eichengreen found that hedge funds, by being will- Corporation) and by numerous international agencies.

Box 3 Here to stay In sum, hedge funds are called hedge funds because they The LTCM debacle use a full array of hedging techniques to reduce portfolio In all markets there are failures, and hedge funds are not volatility. They are becoming increasingly popular, as pri- immune to them. The most famous case is that of Long- vate ownership of capital expands worldwide and large- Term Capital Management (LTCM), a well-known hedge scale capital owners seek to preserve their wealth in volatile fund that lost all its capital in the fall of 1998. A sudden markets. In an effort to soothe worries about transparency spike in market volatility in the summer of 1998 led to a very rapid increase in LTCM’s losses, forcing its liquida- and supervision, public authorities are trying to develop tion. In addition to the doubtful soundness of some of its new approaches to meet the public’s need for financial strategies, LTCM’s failure happened for two main reasons: system stability and investor protection while enabling risk management systems in LTCM and its banks were investors to enjoy the benefits that hedge funds bring to weak; and LTCM’s investment positions had become too financial markets. n large relative to the total market volume in those assets. When prices turned against it, LTCM could not sell its Angel Ubide is Director of Global Economics, Tudor Invest- holdings quickly enough. And as it engaged in fire-selling ment Corporation. to adjust its portfolio, its losses snowballed. Because its positions were so large and were linked to so many other References: financial institutions, LTCM became a potential systemic Eichengreen, Barry J., and others, 1998, Hedge Funds and Financial risk, convincing the authorities to intervene. Market Dynamics, IMF Occasional Paper No. 166 (Washington: As a result of a thorough review of the hedge fund International Monetary Fund). business following the LTCM failure, companies that Financial Stability Forum, 2002, “The FSF Recommendations interact with hedge funds have tightened counterparty and Concerns Raised by Highly Leveraged Institutions (HLIs): An risk management. And national and foreign financial Assessment” (Basel). regulatory institutions have upgraded their supervi- International Monetary Fund, 2004, Global Financial Stability sory oversight of hedge funds. But perhaps even more Report: Market Developments and Issues, September 2004, World important, there has been a rethinking within the hedge Economic and Financial Surveys (Washington). fund industry itself, with leading hedge fund companies ———, 2005, Global Financial Stability Report: Market establishing best practice guidelines for the industry. And Developments and Issues, April 2005, World Economic and Financial follow-up evaluations, such as the one by the Financial Stability Forum in 2002, show that risk management dis- Surveys (Washington). cipline has increased and leverage has fallen. Managed Funds Association, 2003, “2003 Sound Practices for Hedge Fund Managers” (Washington).

Finance & Development June 2006 43 ©International Monetary Fund. Not for Redistribution