Q UANTITATIVE S TRATEGIES MORGAN STANLEY DEAN WITTER WHY HEDGE FUNDS MAKE SENSE FEATURE OVERVIEW NOVEMBER 2000 The hedge fund industry has experienced enormous growth in the last decade, growing by some estimates from as few as 300 funds in 1990 to more than 3000 today. They have become highly vis- ible and are thought to command up to $400 billion in capital before leverage. In this article, we analyze the performance and risk characteristics of hedge funds. We evaluate the reasons why hedge funds have produced high levels of risk-adjusted return and alpha, and show how portfolios of hedge funds can enhance strategic asset allocation for both pension funds and endowments. We conclude that hedge funds will increasingly challenge conventional investment management. • Over the past ten years, the typical individual hedge fund has produced risk adjusted returns that are quite similar to the typical mutual fund manager. However, individual hedge funds have realized a much wider range of performance compared with mutual funds. • Indexes of hedge funds have displayed risk-adjusted performance superior to traditional active managers and passive benchmarks over the past ten years. – Volatility of hedge fund indexes is typically much lower than that of mutual fund indexes and equity benchmarks. We believe that this is due to the low correlation among individual hedge funds. • The performance of hedge fund indexes can be closely approximated with a portfolio of as few as 20 hedge funds, suggesting a pooled fund-of-funds approach as a viable alternative investment strategy. • Hedge fund portfolios also exhibit a low correlation with traditional asset classes, suggest- ing that hedge funds should play an important role in strategic asset allocation. – We illustrate the efficacy of hedge funds for typical pension and endowment funds using MSDW’s asset-liability modeling framework. • Evidence points to continued success for hedge fund managers. – Historical performance of hedge funds appears to be based on the exploitation of market inefficiencies. Due to the expected growth in the supply of these inefficiencies, the advan- tages of hedge fund investments are not likely to diminish soon. MICHAEL W. PESKIN MICHAEL S. URIAS SATISH I. ANJILVEL BRYAN E. BOUDREAU (1-212) 761-6525 (1-212) 762-4788 (1-212) 762-4785 (1-212) 762-4875 [email protected] [email protected] [email protected] [email protected] This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities or instruments or to participate in any particular trading strategy mentioned. Please refer to the notes at the end of this report. Global Equity and Derivative Markets November 2000 | Page 1 Q UANTITATIVE S TRATEGIES MORGAN STANLEY DEAN WITTER WHY HEDGE FUNDS MAKE SENSE MICHAEL W. PESKIN MICHAEL S. URIAS* SATISH I. ANJILVEL BRYAN E. BOUDREAU he hedge fund industry has experi- database covering the last ten years. We that when structured as portfolios, hedge enced enormous growth in the last evaluate trends in the capital markets that funds can provide a meaningful improve- T decade, growing by some estimates support a favorable outlook for hedge funds ment in the risk-reward tradeoff for an from as few as 300 funds in 1990 to more going forward, and show how hedge funds investor. can enhance Broadly speaking, hedge funds can be Hedge fund portfolios can provide a meaningful strategic asset defined as unregulated investment pools, improvement in the risk-reward tradeoff for an investor. allocation for generally with fewer than 100 investors, both pension that may invest in any asset class as well as than 3000 today.1 They have become funds and endowments. Our work shows derivative securities and use long and short highly visible in markets and the press, and are thought to 1 command up to $400 billion 1 A TAXONOMY OF HEDGE FUND STRATEGIES in capital before leverage. 2 Hedge funds, like # of Distinct other established alternative Strategy Description Sub-Strategies Fund Histories1 investments including real DIRECTIONAL Directional trading strategies are based upon Discretionary 408 estate, commodities, venture TRADING speculation of market direction in multiple asset Trading, Macro capital, and private equity, classes. Both model-based systems and Trading, Systems Trading are thought to provide access subjective judgment are used to make trading decisions. to returns that are uncorre- lated with traditional invest- RELATIVE Relative value strategies focus on spread Convergence 348 ments, and superior risk- VALUE relationships between pricing components of Arbitrage, Merger adjusted returns as well. financial assets. Market risk is kept to a minimum. Arbitrage, Statistical Many managers use leverage to enhance returns. Arbitrage There is a trend among fund management compa- SPECIALIST Specialist credit strategies are based around Distressed 80 nies to introduce hedge fund- CREDIT lending to credit sensitive issuers. Funds in this Securities, Positive like products, and large asset strategy conduct a high level of due diligence in Carry, Private order to identify relatively inexpensive securities. Placements owners have begun to make strategic allocations to hedge STOCK Stock selection strategies combine long and short Long Bias, No Bias, 547 funds (more on this later). SELECTION positions, primarily in equities, in order to exploit Short Bias, Variable In this article we ana- under and overvalued securities. Market exposure Bias lyze the performance and can vary substantially. risk characteristics of hedge 1. Since 1990. funds using a comprehensive 1. See Barry Riley, “Hedge Funds Come in From the Cold,” Financial Times, June 12, 2000. 2. Hedge funds are private funds that are available only to certain institutional and individual investors who meet specified legal and investment criteria. * We are grateful for the significant contributions of Joan K. Tse and Bradford J. Johmann to this article. We also thank Peter Fanelli for his comments and input. This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities or instruments or to participate in any particular trading strategy mentioned. Please refer to the notes at the end of this report. Page 2 | November 2000 Global Equity and Derivative Markets Q UANTITATIVE S TRATEGIES MORGAN STANLEY DEAN WITTER WHY HEDGE FUNDS MAKE SENSE positions, as well as leverage. A distin- guishing feature of hedge funds is their rou- 2 MEDIAN INDIVIDUAL HEDGE FUND PERFORMANCE AND RISK CHARACTERISTICS tine use of long or short positions to offset “market” risks and isolate arbitrage oppor- 20% Directional Trading tunities, although these opportunities are 16% Relative Value not without their own specific risks. Hedge Specialist Credit funds are generally more nimble and 12% dynamic in their trading strategies than tra- Stock Selection ditional active funds. 8% Lipper Large Cap Core To establish the historical facts about 4% Lipper Large Cap Grow th Geometric Return hedge fund performance and risk, we study Lipper Large Cap Value a comprehensive database maintained by 0% Financial Risk Management, Limited 0% 5% 10% 15% 20% 25% (FRM). The Appendix describes the con- Volatility tents of the FRM database. Also, since Note: Performance is annualized from monthly total return data, covering 1990 through June 2000. hedge fund performance data is susceptible to biases, we will adjust our figures where appropriate, with details on the methodol- return/risk profile of the typical Directional distribution of hedge fund managers is their ogy given in the Appendix. Trading or Stock Selection hedge fund man- much greater performance dispersion rela- Exhibit 1 briefly summarizes the data- ager is not demonstrably different from that tive to the Lipper large cap managers. base according to a classification system of the typical active manager. Exhibit 3 provides details on individual recently adopted by FRM and Morgan Stanley Capital Inter- The return/risk profile of the typical Stock Selection and Directional Trading national, Inc. (MSCI)1 , Given the wide range and hedge fund managers is similar to that of the typical active manager, but the idiosyncratic nature of hedge variation in performance across managers is wider for hedge funds. fund specialties, any classifi- cation system will not completely character- Focusing on the period since 1990, hedge fund manager performance and risk ize some managers, but we believe this one Exhibit 2 plots the annualized geometric for the four broad strategies and their sub- to be a reasonable description of the uni- return and standard deviation of the median strategies, as well as the three Lipper large verse. individual hedge fund in each of the four cap categories, for various subperiods from strategy categories, as well as the median in 1990. Looking at the percentiles of individ- THE FACTS ABOUT HEDGE three categories of Lipper large cap U.S. ual manager return and risk, hedge funds in 2 FUNDS mutual funds. The median number gives a particular category are much less similar an indication of the experience for a typical to one another, no matter how narrow the THE PROPERTIES OF INDIVIDUAL HEDGE manager. The median Relative Value and category is. Of course, the benchmark- FUNDS Specialist Credit managers have been less driven approach of the Lipper managers To begin our analysis of hedge fund perfor- volatile than the median Lipper large cap suggests such an outcome, but the actual mance and risk, we look at the distribution manager, while the median returns of the difference is striking. of individual hedge fund total returns, net of four hedge fund strategy managers have Compare, for example, the Stock fees, and compare it to that of traditional been in the same ballpark as the median Selection hedge fund managers and the Lip- active managers as well as individual Lipper managers.