PQ510-0269G-PFM[i-xi].qxd 6/30/03 8:41 PM Page iii Quark04 Quark04:BOOKS:PQ510-Philips:FINAL FILES: Hedge Funds Definitive Strategies and Techniques Edited by KENNETH S. PHILLIPS and RONALD J. SURZ, CIMA John Wiley & Sons, Inc. PQ510-0269G-PFM[i-xi].qxd 6/30/03 8:41 PM Page xii Quark04 Quark04:BOOKS:PQ510-Philips:FINAL FILES: PQ510-0269G-PFM[i-xi].qxd 6/30/03 8:41 PM Page i Quark04 Quark04:BOOKS:PQ510-Philips:FINAL FILES: Hedge Funds PQ510-0269G-PFM[i-xi].qxd 6/30/03 8:41 PM Page ii Quark04 Quark04:BOOKS:PQ510-Philips:FINAL FILES: Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Aus- tralia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding. 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HG4530.P47 2003 332.64Ј5—dc21 2003006622 Printed in the United States of America 10987654321 PQ510-0269G-PFM[i-xi].qxd 6/30/03 8:41 PM Page v Quark04 Quark04:BOOKS:PQ510-Philips:FINAL FILES: Contents PREFACE VII ACKNOWLEDGMENTS XI CHAPTER 1 Hedge Funds: Overview and Regulatory Landscape 1 The Managed Fund Association CHAPTER 2 Alpha-Generating Strategies 10 Thomas Schneeweis and Richard Spurgin CHAPTER 3 Funds of Hedge Funds: Definitive Overview of Strategies and Techniques 25 Thomas Zucosky CHAPTER 4 Investing in Hedged Equity Funds 49 Brian A. Wolf, CFA CHAPTER 5 Arbitrage 65 Alfredo M. Viegas CHAPTER 6 Global Macro Funds 82 Gary Hirst CHAPTER 7 Managed Futures 94 Frank Pusateri v PQ510-0269G-PFM[i-xi].qxd 6/30/03 8:41 PM Page vi Quark04 Quark04:BOOKS:PQ510-Philips:FINAL FILES: vi CONTENTS CHAPTER 8 Manager Searches and Performance Measurement 112 Meredith A. Jones and Milton Baehr CHAPTER 9 Risk Management for Hedge Funds and Funds of Funds 139 Leslie Rahl CHAPTER 10 Structured Products—Then and Now 159 John Kelly and Kirt Strawn, CFA, CIMA APPENDIX A The Hedge Fund Difference 176 Todd Goldman APPENDIX B Some Helpful Links 180 APPENDIX C Value at Risk and Probability of Loss 181 RESOURCES 183 GLOSSARY OF TERMS 192 CONTRIBUTORS 195 INDEX 205 PQ510-0269G-PFM[i-xi].qxd 6/30/03 8:41 PM Page vii Quark04 Quark04:BOOKS:PQ510-Philips:FINAL FILES: Preface ince the downturn in the U.S. and global equity markets in 2000, S investors and their advisors have begun seriously questioning many of the asset allocation and portfolio diversification assumptions that had influ- enced their policies and decisions. Several theories that had previously been considered unquestionable, and which had served as the cornerstones of their asset diversification strategies, were increasingly being challenged. As a result, investment policy and strategy saw significant shifts, both at the institutional and high-net-worth investor levels. A broader segment of insti- tutional and private investors began embracing alternative investment strategies, private equity, venture capital, and a range of sophisticated hedge fund strategies. To be sure, many investors had already embraced the notion of alter- native investment strategies during the 1990s, while equity and fixed- income returns were experiencing historic bull market appreciation. But the majority of investors, experiencing substantial investment success, showed little interest in changing their strategic investment policies. Infact, many investors abandoned all sense of discipline, expecting equity returns to sim- ply continue to rise. Times are changing and the returns of the global capital markets over the 5 years ending December 2002 have encouraged investors to question many of their most basic investment theories. Beginning with the “efficient market” theory, investors learned that although markets may prove efficient over the long term, there may be incredibly large short-term inefficiencies, and tactical and strategic asset diversification strategies should be managed accordingly. Investors that had shifted from value equities to growth equi- ties in the latter part of the 1990s as a result of the poor relative perform- ance of value managers, for example, found their decision to be one of the worst they could have made. Similarly, the more recent “flight to quality” from equities to fixed-income investments during the tandem decline in equity valuations and interest rates could potentially result in similar investor losses should the U.S. economy recover and experience a rapid or sustained rise in interest rates. On a similar note, investors have begun ques- tioning the notion that stocks always outperform fixed-income invest- ments—the notion of risk-premium-related return expectations. Over the short term, this theory is as threatened as the efficient market theory, from vii PQ510-0269G-PFM[i-xi].qxd 6/30/03 8:41 PM Page viii Quark04 Quark04:BOOKS:PQ510-Philips:FINAL FILES: viii PREFACE which it was initially derived. As recent times have demonstrated, markets are not efficient over short-term periods, stocks don’t necessarily always outperform bonds, and prices don’t always rise! Unfortunately, during this difficult period many investors also learned that their portfolio mangers were poorly equipped to protect them from declining markets. Traditional equity strategies—and their managers— whose prior selection had been based upon their relative performance ver- sus unmanaged indices and/or peer groups with similar strategies, experi- enced significant absolute losses. When compared on a relative basis these absolute losses appeared understandable and perhaps acceptable. However, on an absolute basis, these losses were dramatic and significant for most. Fortunately for some, while most investors were experiencing substantial losses, a growing group had already begun embracing a completely differ- ent paradigm of investing—a paradigm of absolute returns. The term “absolute return” refers to a broad range of investment strategies that seek to profit from all market conditions. Rather than employ investment strategies that are closely correlated to the performance of the broad equity and fixed-income markets, managers of absolute-return strategies attempt to employ noncorrelated, skill-based strategies with the intention of delivering consistent, positive returns in all market conditions. These managers, in general, don’t measure or compare their returns on a relative basis against passively managed indices—such as the S&P 500— although such comparisons are often useful. Instead, these managers are held to a different standard—the standard of generating positive returns irrespective of the direction of the markets or the behavior of the rest of the world. The funds (and managers) that operate in this world are often referred to as hedge funds, largely because their strategies attempt to hedge various investment risks.