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Saturday October 20 2018
 
Dealing With Myths of Hedge Fund Investment

The Journal of Alternative Investments Winter 1998

by Thomas Schneeweis

 

THOMAS SCHNEEWEIS is a professor at the School of Management of the University of Massachusetts at Amherst.

 

Recent events in financial markets have focused interest on the existence and operations of a relatively new form of investment entity, the hedge fund. While many definitions for hedge funds exist, they are basically "loosely regulated private pooled investment vehicles that can invest in both cash and derivative markets on a leveraged basis for the benefits of its investors." Unfortunately, there are a number of myths surrounding hedge funds and the risk and return opportunities that hedge funds offer. In a short comment one cannot cover in detail all of the misconceptions about the performance of hedge funds or other alternative investments. In fact, journals such as The Journal of Alternative Investments exist to permit a better long term understanding of many of the new alternative investment forms. However, despite a wide range of research conducted on hedge funds and their performance, the following are a number of popular misconceptions.

 

MYTH: HEDGE FUNDS ARE AN INVESTMENT PRODUCT OF THE 1990s

 

While the number and size of hedge funds have grown in recent years, hedge funds have existed since the 1940s. It was not until the 1980s that they experienced rapid growth. This growth was due in part to the increase in the number of new financial vehicles as well as changes in technology that permitted sophisticated investment strategies to be designed and implemented without the infrastructure of a large investment house.

 

MYTH: HEDGE FUNDS ARE UNIQUE IN THEIR INVESTMENT STRATEGIES

 

Hedge funds call be viewed as the privatization of the trading floor of investment banks. New technology has permitted investment professionals to leave investment banks and trade externally what for years was conducted only internally. The strategies are not new. Insurance companies, endowments, and other institutional investors have invested in alternative investments such as private debt, private equity and derivative strategies for years. What is new is that when these large, diversified investors took losses in a particular product, it often was hidden by their gains in other areas. For a single hedge fluid, the lack of product diversification heightens its risk, but does not necessarily increase the risk of its investors, who should be well diversified across a number of hedge funds and a number of asset classes.

 

MYTH: THE FAILURE OF A SINGLE HEDGE FUND IS CAUSE FOR CONCERN

 

Many hedge funds failed before Long Term Capital, and many will fall in the future. Some failed quietly, returning some investor capital after liquidating positions. Others, like LTCM, failed in a more spectacular fashion. The failure of a single firm or investment product is always of concern to the investors as well as those who invest in similar ventures. However, modern investment theory points out that no person should have a sizeable portion of their wealth invested in any one investment product. In short, unless one has a perfect forecast of the future, diversify, diversify, diversify. The stock market has survived the bankruptcy of many companies. This does not mean that stocks are bad investments. It does not even mean that the investors in a company that loses money ex post, initially made the wrong choice. The most notable aspect of the LTCM is not in its near collapse, but in the fact that many highly sophisticated investors held a single large portion of their personal wealth in the single fund which is completely contrary to modern investment principals.

 

MYTH: ALL HEDGE FUNDS ARE RISKY BECAUSE THEY USE DERIVATIVES

 

Not all hedge funds use derivatives. Hedge funds employ a wide array of investment strategies including arbitrage strategies which may use derivatives as well as strategies such as distressed debt, merger arbitrage, emerging market debt and equity that may not. In fact, in the recent market environment, many of those hedge fund strategies that rely heavily on derivatives had superior performance to traditional asset markets, and some of the worst performing hedge funds (e.g., emerging market hedge funds), generally do not use derivatives at all.

 

MYTH: HEDGE FUNDS ARE HIGHLY LEVERAGED, RISKY INVESTMENTS

 

The risk and return attributes of hedge funds are determined solely by their investment strategy. Some hedge funds which invest primarily in long only cash positions may employ little leverage when the underlying asset itself has a high return to risk tradeoff. Other hedge funds invest in low-risk strategies such as security arbitrage. These funds use leverage positions in order to offer a reasonable expectation of return. The fact is that during the first half of the 1990s, the typical hedge fund's returns have been less volatile than the typical stock or stock mutual fund.

 

MYTH: ALL LEVERAGE IS BAD

 

One must remember that leverage itself is not something to be avoided. Banks, for example, are levered about 20 to 1 (about 5% of assets are equity capital, 95% are loans and deposits). Residential real estate is typically levered 5 to 1 (a 20% down payment is common, with 80% borrowed). However, the more highly levered an instrument is, the more care one must take to insure that the payment flow is more predictable or large losses are possible.

 

MYTH: HEDGE FUNDS OFFER NO ECONOMIC VALUE

 

Hedge funds invest in a wide variety of investment arenas including private equity, private debt, merger and acquisitions, emerging markets. Without their participation, many worthwhile projects could not find the necessary financing. In addition, hedge funds trade in financial products, offering liquidity to other investors in these assets. The primary use of derivative products is to offer a mechanism for firms to reduce or manage their own risk. Financial innovations such as mortgage-backed bonds provided a means for individuals and institutions to raise capital more efficiently. Recent innovations are much more exotic but have the same objective-allow one to effectively raise capital and manage risk. In many cases, hedge funds are a primary purchaser of these new securities, both in the primary market and the secondary market. Without hedge funds, financial markets could have fewer risk management choices and, for some projects, a higher cost of capital.

 

MYTH: THE RESCUE OF LONG TERM CAPITAL WAS ILL-ADVISED

 

It is possible, in hindsight, to question whether the partners and employees of LTCM got too much or too little in the bailout. It is also fair to question whether the Fed should have played the role of policemen in the deal rather than let the banks and other creditors fight it out on their own. It is likely that the banks or some investment house would have reached some settlement with LTCM without the Fed's intervention. There was simply too much at stake, as the banks had to realize that a mass liquidation of LTCM would have had a disastrous effect on their own balance sheets as well as on the markets as a whole. Most of the credit, if one wishes to use that word, for putting the bailout together, along with the blame for lax credit controls, belongs to the associated banks and investment houses albeit with the support and encouragement from the Fed.

 

MYTH: HEDGE FUNDS CAUSE WORLDWIDE PANICS

 

Numerous academic studies have shown that hedge funds were not the cause of the Asian crisis or other major world economic collapses. It is true that in today's financial markets, capital reacts quickly to information. As a result, when countries or firms fall to live up to their promises- overbuild, over-buy, over-monetize-- funds flee and the market reacts quickly. While such capital fight may have its own associated problems, the alternative to free flows is almost always worse. If investors are afraid of an inability to retrieve capital, it simply will never go there in the first place.

 

MYTH: HEDGE FUNDS ARE TOO RISKY TO BE INCLUDED IN AN INVESTOR'S PORTFOLIO

 

Academic research [Schneeweis and Spurgin, 1998] has shown that hedge funds offer an attractive opportunity to diversify an investor's portfolio of stocks and bonds. This is true even if the returns earned by hedge funds in the future are merely on par with that of stocks and of bonds. We do not need to see risk-adjusted returns as high as they have been in order to justify diversifying into hedge funds.

 

MYTH: HEDGE FUNDS DON'T INVEST, THEY JUST TRADE

 

Academic research [Ackerman, 1998] has shown that one of the principal economic benefits provided by hedge funds is their ability to provide capital to relatively illiquid investment markets. Investment in liquid assets can be accomplished easily through mutual funds, which are highly regulated and offer the ability to redeem assets instantly. Hedge funds can require investors to lock up capital for many years, which allows them to make investments that are highly illiquid. It is surprising and perhaps ironic that many of the same people who have been critical of short-term trading and favor long-term investing are now critical of hedge funds, which exist primarily to invest in less liquid, long-term investments or to permit other investors, such as banks, to redeem themselves out of investment positions they no longer wish to hold.

 

MYTH: THE LESSON OF LTCM IS NOT TO INVEST IN HEDGE FUNDS

 

There are many lessons to be learned from LTCM; 1) diversify, 2) high return investments are also potential low return investments, and 3) trading in illiquid secondary markets is potentially disastrous in extreme market conditions. These are, of course, lessons that are true for all investments, and have nothing to do with the fact that LTCM was a hedge fund.

 

MYTH: THE FAILURE OF LTCM WAS THE FAILURE OF THE MARKET

 

Financial markets are not people. LTCM was a combination of many human failures. Most of the reasons behind the failure may be laid directly on the traders at LTCM who took highly leveraged positions while failing to divulge to creditors the extent of this leverage. But the credit officers at the banks are equally culpable for their willingness to extend even more credit without adequate information about the potential risks. A future problem to be solved is how to manage the individual human appetite (however unattainable) for return without risk combined with banks desire for return with limited risk and with societies need for risk capital which requires the existence of financial institutions and traders as financial intermediaries.

 

MYTH: WE CAN AND MUST CONTROL THE FINANCIAL MARKETPLACE

 

It is always possible, in hindsight, to see the mistakes that compound on mistakes that lead eventually to collapse. It is often easy, ex post, to see where a simple rule or regulation may have prevented a catastrophe. Improved credit analysis and risk analysis is always a goal, but one can never and should never prevent all possible losses. If we never extend credit to a firm or investment strategy that may fall, a large number of worthwhile project or products would go unfunded. Growth requires investment in risky ventures. Risky ventures imply the possibility of loss. In the long run, a diversified portfolio will offer a return commensurate with the risk. All of us must learn to live with that reality.

 

MYTH: THERE IS NOTHING "'SCARY" ABOUT LTCM'S NEAR-COLLAPSE

 

An investment that can earn 40% in a year may also be posed to lose 40% just as easily in an opposite economic environment. There's nothing scary about that. What is scary is the number of investors bankers, and investment managers who forgot this simple truth and thought LTCM had figured out a way to beat the market consistently without the potential for loss. It wouldn't have taken much for LTCM to survive intact. Russia maintains fiscal discipline. Japan takes action to solve its banking crisis. Malaysia keeps its markets open to foreign investment. Any of these events could have turned LTCM's losses into gains and continued praise for LTCM while waiting for the shoe to drop on some future date.

 

WHAT'S NEXT FOR HEDGE FUNDS....

 

While the hedge fund community will almost certainly survive, the landscape has certainly changed as a result of Long Term Capital.

 

1. Many more funds will probably close. The rumor going around that there are more spectacular failures and bailouts waiting in the wings seems unlikely. However, many funds that have annual redemption policies are going to have a difficult time surviving into 1999. Many supposedly market-neutral funds have been exposed as being anything but neutral. Their investors will be redeeming their shares and many funds will simply shut down as a result.

 

2. The funds that survive are going to reduce their leverage. There will be backlash from bank credit departments against the surviving funds. Hedge funds will need to post more collateral and the banks will be more conservative in their pricing of the collateral. This will result in lower returns posted by the hedge fund community but also commensurately lower risk. Investors used to 25% annual returns from hedge funds will probably have to get used to 15% for at least the next few years.

 

3. Investors will diversify their holdings across many hedge funds. One of the most surprising things about investors in hedge funds is that many currently hold relatively few funds. Investors will look at the impact of a 100% loss in one of their funds and realize that the best way to invest in hedge funds is to take small stakes in a large number of funds.

 

REFERENCES

 

Ackerman, C. "The impact of Regulatory Restrictions on Fund Performance: A Comparative Study of Hedge Funds and Mutual Funds," FMA Presentation, October 1998.

 

Fung, W., and D.A. Hsieh. "Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds." The Review of Financial Studies, 10 (1977), pp. 275-302.

 

Henker, T., and G. Martin. "Naive and Optimal Diversification For Managed Futures." The Journal of AlternativeInvestments, Fall (1998), pp. 25-39.

 

Henker, T. "Naive Diversification for Hedge Funds," The Journal of Alternative Investments, Winter (1998), pp. 33-38.

 

Jaffer, S. (Ed.), Alternative Investment Strategies. Euromoney, 1998.

 

McCarthy, D., T. Schneeweis, and R. Spurgin. "Investment in CTAs: An Alternative Managed Futures Investment. " Journal of Derivatives, Summer (1996), pp. 36-47.

 

McCarthy, D. and R. Spurgin. "A Review of Hedge Fund Performance Benchmarks." The Journal of Alternative Investments, Summer (1998), pp. 18-28.

 

Schneeweis, T. The Benefits of Managed Futures. AIMA, 1996.

 

Dealing with Myths of Managed Futures." The Journal of Alternative Investments, Summer (1998), pp. 9-17.

 

Schneeweis, T., R. Spurgin, and D. McCarthy. "Survivor Bias in Commodity Trading Advisor Performance." Journal of Futures Markets, October (1996), pp. 757-772.

 

Schneeweis, T., R. Spurgin, and M. Potter. "Managed Futures and Hedge Fund Investment for Downside Equity Risk Management." Derivatives Quarterly, Fall (1996), pp. 62-72.

 

Schneeweis, T., and R. Spurgin. "Comparisons of Commodity and Managed Futures Benchmark Indices." journal of Derivatives, Summer (1997), pp. 33-50.

 

"Alternative Investments in the Institutional Portfolio." AIMA, 1998.

 

"Multifactor Analysis of Hedge Fund, Managed Futures, and Mutual Fund Return and Risk Characteristics." The Journal of Alternative Investments, Fall (1998), pp. 1-24.


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