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To learn more about Copies Direct watch this short online video. Need help? How do I find a book? Can I borrow this item? Can I get a copy? Can I view this online? Ask a librarian. Aboriginal, Torres Strait Islander and other First Nations people are advised that this catalogue contains names, recordings and images of deceased people and other content that may be culturally sensitive. When the upper or lower bands of that range are reached, a statistical arbitrage fund will bet on reversion to the mean. Unlike managed futures funds see below , which bet that a trend will continue, stat arb funds bet that it will stop.
Some of these profitable opportunities may last for only a fraction of a second. So, rather like gunslingers in the wild west, stat arb managers have to worry that there will always be someone faster than they are. There has been a kind of arms race to execute trades as quickly as possible, with trades now executed in a thousandth of a second.
Some even site their computers as close as possible to the stock exchange to minimise the time it takes their orders to travel down the wires. Stat arb managers also need markets to be liquid. Higgins says: There is clear evidence that they need very deep pockets to invest in research and development and to develop computer power. Because the models are so sophisticated, it is hard for managers to explain how they work indeed, it is not in their interest to give too much detail away.
The investor can only really be guided by their track record — not always a great predictor of future performance — and take their brilliance on trust. They benefited because many investors were trying to offload large positions on the market and there were not enough players with capital to take the other side of those positions; this gave the stat arb funds a chance to make a profit. One source of profit disappeared when Wall Street shifted from quoting share prices in fractions sixteenths, eighths to quoting in decimals. That allowed for much keener prices lower spreads and one-third of all marketmaking profits disappeared overnight.
Since then, stat arb funds 22 Hedge Funds. It is a tough business. Quant managers were hit particularly hard in the market turmoil of July and August , when their models appeared to break down and many including Renaissance suffered far greater losses than they had been expecting. The problem was that quant managers had become such a large part of the market that they were all holding similar positions; when they attempted to sell to reduce their leverage , it was rather like a crowd trying to leave a theatre via a narrow door.
The prices of the stocks they owned plunged because of an excess of sellers. Fixed income arbitrage The fixed income arbitrage sector carries the burden of Long-Term Capital Management ltcm ,2 the huge and hugely-geared hedge fund that collapsed in Thanks to their record and their contacts, they received a lot of backing, and had powerful people as investors it helped that two Nobel Prize winning economists advised them. Their essential idea was that some securities in the market were irrationally priced; for example, the Treasury bond market used to have the year issue as a benchmark.
Everyone would want to own that bond, hence a bond with only 29 years till maturity would trade at a discount. If this discount got too wide, it would eventually correct after all, the bonds were guaranteed by the American government and those who bought the year bond would make a profit. Because prices got only slightly out of line, it was necessary to use a lot of leverage to make money. You might have a system for beating the casino; for example, doubling up after every losing bet. This might work, but only if you have infinite capital.
If luck runs against you, you will be bankrupt before you succeed. This is what happened to ltcm. When 23 Hedge Funds. Spreads widened more than history suggested they would. But because of the leverage, ltcm ran out of money before that happened. In part, this was because extreme events occur more often in the financial markets than conventional models assume. This is particularly the case when markets are illiquid and one player such as ltcm has a large position.
There is an old story of an enthusiastic investor who piled into a penny stock a small company with a share price of a few pence or cents. As he bought, he was delighted to see the share price move higher, so he increased his position. It had to offload those positions at a fire sale price. There is no reason, in theory, why current fixed income arbitrage managers should run into the same problems. They have two main avenues for profit, the yield curve and credit spreads.
On the yield curve, as in the ltcm example above, they can bet on its shape. Traditionally, long-term bonds have yielded more than short-term bonds; if the shape does not conform to this pattern, they can bet on a return to the status quo. On credit, they can bet that wide spreads will narrow or that narrow spreads will widen.
However, it is easier for them to bet on narrowing than widening because of the way the trade works: narrowing involves buying a higher-yielding bond and shorting a lower-yielder. As a result, the trade has a positive carry it earns interest income. Betting on wider yields would mean losing money in the short term until the spread corrected.
The sector has been given a lot more flexibility by the development of credit derivatives, particularly credit default swaps cdss and collateralised debt obligations cdos. The former allow investors to insure their bonds against default, or alternatively to bet that default will occur; the 24 Hedge Funds. The result is that the corporate debt market is much more liquid. But the potential for risk-taking has increased sharply, as the problems facing hedge funds in the summer of illustrated. Directional funds Global macro managers Global macro managers dominated the industry in the early s but have since become much less significant.
As well as George Soros, the likes of Julian Robertson and Michael Steinhardt were renowned for making big plays on currencies, bonds and stockmarkets. But Steinhardt retired in and Robertson gave up the ghost in Each suffered problems towards the end, with Steinhardt making big losses in the bond market sell-off of and Robertson being caught out by the dotcom boom of the late s.
These are generally known as managed futures managers see next section. Global macro is hard to define. As Drobny writes in his book Inside the House of Money:3 Global Macro has no mandate, is not easily broken down into numbers or formulas, and style drift is built into the strategy as managers move in and out of various investing disciplines depending on market conditions. That makes the style a difficult sell now that the dominant investor class in hedge funds is institutional. The institutions, and the consultants who advise them, like to put hedge funds in a box so they can work out how much of their money is devoted to a particular asset class or risk approach.
They like predictability and dislike style drift. In contrast, 25 Hedge Funds. Trust me to navigate the markets. Some global macro managers have diversified into becoming multistrategy funds, a term that sounds more up-to-date but still, in essence, depends on the ability of one man or small group of men to allocate capital to asset classes based on his view of the world.
The key formal difference between multi-strategy and global macro is that the former allocates money to sub-managers as he sees fit and the latter is running all the money himself. In practice, the divide is not quite so sharp, since a big global macro manager will delegate certain asset classes to different trading teams. Managed futures or commodity trading advisers Technically speaking, this is not really a hedge fund sector at all.
Its name springs from its regulatory origins; these are funds that deal in the futures markets and, as a consequence, are overseen by the Commodity Futures Trading Commission in Chicago. They are required to disclose their activities, particularly the costs incurred in trading. Nevertheless, commodity trading advisers ctas are generally lumped in with the hedge fund industry, perhaps because they often take big risks and can earn outsized returns and perhaps because some of the big names of the hedge fund industry, such as Tudor Jones, started in this sector.
But they also attract a lot of suspicion, and some fund-of-fund investors will not include them in their portfolios. Recent performance has also been disappointing with single digit returns in each of , and , according to Hedge Fund Research. If a manager gives away how the model works, his business could be destroyed since another manager could copy it.
But that limits what they can tell clients. Here are the results. Trust us when we say this will also work in the future. According to Todd: Markets are not completely efficient. We believe such trends will exist whatever market you look at and over multiple timeframes.
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He says his firm attempts to exploit trends on a systematic basis, covering a wide range of markets 90 or so. The business started in the commodity markets hence the cta name and uses futures contracts, a cheap way of getting exposure to an asset class. Markets do indeed seem to show trends. They have long periods of rising prices bull markets interspersed with falling prices bear markets. Once a managed futures fund believes such a trend has set in, they will jump on the bandwagon. They are thus vulnerable to two things: a sudden break in the trend such as a crash , or a period of range-bound markets, where prices keep changing direction.
Like the stat arb funds, ctas suffered in the market turmoil of summer A further problem is that they are not the only ones looking for such trends. If it was obvious that a bull market was under way, lots of people would spot it and prices would rise quickly, before the managed futures fund had positioned itself. The half-life of any given systematic approach 27 Hedge Funds.
And it also means they have to be adaptable without changing tactics so often that clients start to wonder whether they are guessing. The need for new ideas is such that ctas often have a lot of mathematicians and academics on their staff. Winton has set up two academies, one in Hammersmith in west London and the other in Oxford, and the Man Group the parent company of ahl has sponsored the Oxford-Man Institute of Quantitative Finance. It all sounds a long way from Brideshead Revisited. Tim Wong, chief executive of ahl, says his firm spends a lot of time trying to improve on the execution of its ideas.
Some argue that managed futures funds offer a poor trade-off between risk and reward in technical terms, a low Sharpe ratio compared with other hedge funds. This is true. But Todd argues that funds with good Sharpe ratios tend to have short track records or are invested in illiquid assets, where the volatility is essentially hidden because prices move less frequently. Defenders of the sector argue that it does provide genuine diversification. Although managed futures funds do usually fall at market turning points because they have been following the trend , they quickly adjust to falling markets.
Event-driven Distressed debt Distressed debt managers invest in bonds or loans issued by companies that are in trouble. Traditionally, they hope to exploit the fact that investors generally panic when companies look in danger of default, and that drives the bond price down to depressed levels. The distressed debt manager may feel he has spotted something in the documentation that gives him greater rights than other people suspect. Or he may parlay his position into equity rights in a restructured company, hoping there will be substantial upside.
Ironically, thanks to their willingness to buy debt in troubled companies, they may prevent more companies from going into bankruptcy; in the old days, many companies would be in debt to banks, which would foreclose while they still had a good chance of reclaiming some value. Merger arbitrage Although this sector has an arbitrage label, it really is an event-driven approach. There is nothing that gets a stockmarket more excited than a big takeover.
Not only does the share price of the target company shoot up, but the shares of other potential targets tend to rise in sympathy. Since the initial offer is rarely successful, investors eagerly await details of the second, higher bid or a rival offer from an outside group. It is a situation that creates a lot of volatility, something that hedge funds love. And their interests tend to dominate when bids are announced. Twenty years ago, both predator and prey would have had to cultivate the big pension funds and insurance companies which were the long-term holders of the shares.
If there is money left on the table, merger arbitrage funds try to exploit it. But hedge funds would be attracted by that final dollar. With the use of leverage that can be turned into an attractive annualised return. As a result, shares in the predator generally fall when a bid is announced, while those in the prey rise.
So a simple merger arbitrage would be to go long of the shares in the prey and short of those of the predator. One academic study suggested that such a strategy would have delivered a return of 0. But this is another market that is highly competitive, since most hedge funds are following similar strategies. In the event, the funds are often betting on the bids going through, since if the deal fails, the shares in the prey will fall and those of the predator will rise causing the hedge funds to lose money on both legs. They thus have an interest in pushing the target company to accept an offer.
This may well lead to more takeovers occurring than happened in the past — a point that hedge fund critics who worry about short-term pressures on company executives are rapidly taking up. Activist funds The hedge fund group currently creating most of the headlines is activist funds. Their philosophy can best be summed up by a popular cartoon featuring two vultures. But within weeks, abn amro was on the receiving end of a friendly bid from Barclays Bank, and then a more hostile and ultimately successful bid from the Royal Bank of Scotland. The philosophy behind activist hedge fund investing is that company boards need to be pushed into action.
Ruddick says: 30 Hedge Funds. Activist funds are the catalyst. This can be an expensive process, since lawyers need to be used and other shareholders canvassed. One leading activist, William Ackman of Pershing Square Capital Management, says:7 Our preference is not to be activist if we can find a management team that is already doing the right thing. However, there are also advantages. With a small stake, activists can get a lot of leverage over executives, who may fear a shareholder revolt if they do not act.
Traditionally, activists were seen as a force in the American market, but they have been moving their attention to Europe. This helps explain why they have been the subject of controversy; in continental Europe, shareholders have traditionally been seen but not heard. However, Guy Wyser Pratte of Wyser Pratte Investments says Europe has some advantages for the activist:8 In Europe, the activist manager has a captive audience in terms of Anglo-Saxon fund managers who think the same way. Also in Europe, the company bears the cost of a proxy battle, whereas in the US it is the outside investor.
And in Europe, shareholder resolutions are legally binding; in the US, they are not. Finally, Wyser Pratte adds that in Europe, not many shareholders vote, making it easier for an activist resolution to be successful. An academic study9 looked at the record of activist hedge funds, 31 Hedge Funds. It found that activists typically targeted companies in the value stock category with low price to book or asset value and strong cashflows.
There was a definite bias against targeting the largest companies, probably because of the cost of acquiring the initial stake. On average, the campaigns resulted in improved returns for all shareholders. Other funds Hedge funds are ever inventive and there are some funds that do not fit plausibly into any of the above categories. Volatility arbitrage funds, for example, look at the fluctuations of different markets. If they expect volatility to rise, they might buy options that will rise in value.
If they expect volatility to fall or be low, they will sell options the equivalent of offering insurance. One example is film finance. Traditionally, movies have been financed by the big studios or by banks; returns have been patchy, with most films failing to break into a profit and a few blockbusters making up for the rest. The big money has been made by the likes of Tom Cruise and Julia Roberts.
Hedge funds have moved into this area, using various strategies: picking only low-budget films, or films in certain genres; or picking films that computer models suggest might be successful. In some ways, the more obscure the asset class, the better. If few investors follow it, the chances are that prices will be set inefficiently and excess returns can be achieved. Furthermore, obscure assets are unlikely to be correlated with stock or bond markets. Multi-strategy funds Multi-strategy is a term that covers two distinct trends. The first relates to the managers.
It makes sense for them to diversify their businesses, 32 Hedge Funds. As a group, they can thus be described as multi-strategy managers many of those described in Chapter 2 fit into this category. The second trend is for individual multi-strategy funds. For many of the strategies described earlier in this chapter there are periods when they are successful and periods when they struggle to earn decent returns. In an ideal world, investors would be able to anticipate those changes of fashion and would switch their funds accordingly. But even if they were blessed with perfect foresight, hedge fund investors would still find it difficult to transfer money because of notice and lock-up periods.
An asset allocator sits at the centre of the structure, deciding which strategies and which managers are likely to produce the best future returns. Because all the strategies are part of one group, the allocator does not have to worry about notice periods. It sounds good, in theory, and multi-strategy funds could be a powerful competitor to the funds-of-funds groups this issue is dealt with in Chapter 3.
But it depends on two key assumptions: that the allocator gives money to the right people; and that the underlying managers are worth giving money to. Will you really get a team of superstars with this structure or merely a bunch of mediocrities? After all, the managers may be cheesed off if the allocator pulls money away from them; they may even be tempted to set up on their own.
There may be a cost advantage to clients, at least on the performance-fee front. In a fund-of-funds, the clients will end up paying performance fees to successful managers, but will get no discount from the underperformers. If half the managers outperform and half the managers underperform, the client may end up paying performance fees for mediocre returns. In a multi-strategy fund, there is just one performance fee for the whole fund. Having said that, the annual fees charged by multi-strategy managers can be high. Whether or not they represent the best structure for clients, we may be heading for a world dominated by multi-strategy funds.
It is now easier for new hedge funds to launch if they have the brand name of a big hedge fund attached. Successful hedge fund managers will gradually attract other funds, as a planet attracts satellites. Sometimes these strategies will be run as a bunch of separate funds. But the group may be tempted to offer a fund that groups together these strategies, as a kind of instant diversification package.
Ruddick says being a multi-strategy fund is a much better business model for the hedge fund itself.
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Furthermore, managers are often expected by clients to invest in their own funds; so developing several strategies helps to diversify their own wealth. This is all part of the convergence between hedge funds and the financial sector, the subject of Chapter 6. But with the sole exception of George Soros, when it comes to hedge funds normal people will be stumped for a name.
Worse still, managers come and go with remarkable rapidity. So it is worth describing some of the more prominent names in the industry, as of mid Some hedge fund managers like publicity; others go to great lengths to keep out of the public eye. Since they do not market their wares to the general investor, even their websites can provide little information.
So, alas, it is not possible for this chapter to provide a comprehensive list; those not included have tried hard not to be so. And the length of the entries may well reflect the openness of the manager as much as the importance of the group. The funds follow long-short and market-neutral strategies across a range of assets including equities, fixed income, commodities and 35 Hedge Funds. The group has a heavily quantitativedriven approach, derived from the Goldman years. One of its hedge funds was hard hit by the market turmoil of August , losing Aspect Capital This London-based managed futures group emerged like Winton see below from ahl see the entry for Man on page The founders include Michael Adam and Martin Lueck, the a and l 0f ahl.
Its systems have a medium-term trend-following focus. The group is attempting to build long-term relationships with a few key institutional clients. Atticus Capital This activist hedge fund is run by Timothy Barakett, whose brother Brett also runs a hedge fund group. Atticus Capital, which makes big bets railway stocks were one prominent example in , had 36 Hedge Funds. That process can lead to discovering spurious statistical links. Instead, a market anomaly has to have a sound theoretical basis as well as a record of outperformance. The group is also a big player in the provision of —30 funds see page Brevan Howard This was the first single hedge fund to list on the London Stock Exchange with an offering of its bh Macro fund.
Brevan Howard was set up by Alan Howard, a former bond trader at Salomon Brothers and Credit Suisse First Boston, and has specialised in bond and currency trading, earning a reputation for solid returns with low volatility. Its master fund had an annualised return of A secretive man, Howard attracted some criticism for failing to take part in the roadshow for the Macro fund flotation. But the fund still has its admirers. Its website makes Bridgewater sound like rather an alarming place to work. Founder Ray Dalio writes: Substandard performance cannot be tolerated anywhere in the company because it would hurt everyone.
This is often perceived harsh or unkind, but it is ultimately best for everyone, including the person who is being cut. He ended up, along with several other industry luminaries, at the Commodities Corporation, now part of Goldman Sachs. Kovner is a well-known supporter of conservative causes, and is chairman of the board of trustees of the American Enterprise Institute, a right-wing think-tank. Its initial focus was on distressed debt junk bonds by another name. That led, fairly naturally, to an interest in investing in turnaround companies and thus into the private equity field.
The company has jumped into the public eye, first by recruiting luminaries such as former Treasury secretary John Snow and one-time vicepresident Dan Quayle. Then it got involved in a series of high-profile deals, buying grocery chain Albertsons, the lending arm of General Motors, gmac, and the car giant, Chrysler. Having bought the Japanese bank Aozora as well, Cerberus now has quite a diversified financial business. Founder Ken Griffin started an investment fund at Harvard and then received backing from a Chicago financier, Frank Meyer.
Citadel is seen as a highly flexible operator, swooping to buy a bankrupt mortgage lender during the early sub-prime crisis and making big profits in the energy market by picking up the energy positions of Amaranth, a struggling hedge fund, in The group is also a classic example of the convergence of the financial industry.
It has acted as a marketmaker in options, has a stock-lending operation useful for other hedge funds that want to go short and is planning to offer its back-office services to other hedge funds. Some people talk of Citadel as becoming the next Goldman Sachs. But the heart of the operation is a quant-driven investment fund that buys and sells frequently on the back of computer models. Griffin is gradually emerging as one of the more prominent 39 Hedge Funds.
CQS A London-based hedge fund group, cqs specialises in arbitrage, covering convertible bonds, credit, and equities. It was set up in by Michael Hintze, who had previously worked at Credit Suisse First Boston specialising in convertibles and equity derivatives. It managed to survive the problems that dogged the convertible sector in Hintze takes great pride in his risk management systems and in the experience of his team, with the 46 portfolio managers having an average of 15 years in the business.
Since then, it has added other hedge fund strategies, such as distressed debt and fixed income relative value. DE Shaw has been one of the most prominent hedge funds to move into the long-only arena, setting up a specialist subsidiary, DE Shaw Investment Management, in Shaw has recruited Larry Summers, former Harvard president and Treasury secretary. Lampert had previously worked for Goldman Sachs, leaving at just 25 to set up his own outfit. Like Buffett, Lampert has a value bent, looking for companies he thinks the market has undervalued.
Being kidnapped in January is part of the Lampert legend. After that experience, Lampert must find the odd bad day in the markets easy to cope with. It briefly hit the papers in a spat with American students, who accused it of an unethical investment policy in The deal delivered only small profits when Accredited was acquired by a private equity group in May that year.
Farallon invests in a number of different strategies, including distressed debt, real estate, event-driven company restructurings and spin-offs and merger arbitrage. Assets under management grew sharply. The group was yet another to be founded by Goldman Sachs refugees, Noam Gottesman, Pierre Lagrange and Jonathan Green, whose initials gave the company its name.
The most successful fund was called Market Neutral and was run by a star trader called Philippe Jabre. Jabre went on to start his own fund. But the group also runs hedge funds directly, such as the Global Alpha fund, and has a fund-of-funds operation to advise private and institutional clients. The group has a heavily quant-driven style.
However, was a difficult year, thanks to Global Alpha losing money and the fund-offunds operation having a holding in Amaranth. Leaving aside its own operations, Goldman Sachs seems to have given a start to half the hedge funds in this list. It is also one of the leading prime brokers. As a result, JP Morgan is perhaps one of the biggest manager of hedge fund assets in the world. However, the initial omens were not good. But the fund rebounded and added new strategies in areas such as statistical arbitrage. The duo initially specialised in the fund-of-funds market before establishing Highbridge as a separate group in Kynikos Associates Kynikos is one of the few successful short-selling groups.
Founder Jim Chanos made his name spotting such duds as Enron. As with all shortsellers, he regularly courts controversy because companies dislike his activities, especially when he publicises his views in the media. In , one of his targets was Macquarie Bank, an Australian investment bank involved in running and financing infrastructure projects around the world. It was founded in by Paul Ruddock, formerly of the Schroder fund management group, and Steven Heinz, who managed equities for Harvard University.
The group is highly respected and was awarded the title of management firm of the year, in respect of its performance. Long-Term Capital Management The hedge fund that almost wrecked the financial system, ltcm was founded by John Meriwether, a bond trader from Salomon Brothers, who has since gone on to found another hedge fund, JMW Partners. A full account of the ltcm saga was given in Chapter 1. Man , which among other things was the sole supplier of rum to the British navy. It moved into hedge funds in the s via the purchase of a stake in ahl, a cta or managed futures group.
The whole group was acquired in Since then the Man Group has acquired Glenwood and rmf, both funds-of-funds managers, the first focusing on the retail market, the second on the institutional sector. It has also added Man Global Strategies, which seeds makes initial investments in new hedge fund managers. It has also been innovative in launching new products, notably guaranteed funds such as the man ip This seems to have persuaded investors to venture into the world of hedge funds a field many intrinsically 45 Hedge Funds.
Man has gradually focused on its hedge fund activities, selling off its commodity side and, in , spinning off its futures brokerage business. The group has increased its public profile via its sponsorship of the annual Man Booker Prize for fiction it has recently added an international and an Asian prize to the stable. Marshall Wace London-based Marshall Wace has one of the more interesting business models. Marshall Wace did some analysis to see whether trades based on these recommendations would be successful; the answer was yes.
The development of the internet meant it was possible to systematically collect and analyse that information, and in Marshall Wace duly launched its Tops product. Tops is a long-short portfolio, which uses the best ideas generated by the salesmen who work at the banks and brokers. Salesmen talk every day to the analysts who follow individual stocks and sectors and then pass the best of those ideas on to clients the buy side that deal in the market. The salesmen have every incentive to come up with good ideas since they are paid on commission; the better those ideas perform, the more trading will be allocated their way.
It might seem that this model could be easily replicated. After all, the investment banks pass their ideas on to a whole range of clients, not just Marshall Wace. Some rival funds have indeed been launched. And with its market power as of March 46 Hedge Funds. In autumn , Marshall Wace floated one of its Tops funds on the Euronext stockmarket. The group has extensive operations in Asia as well as long-short funds, managed out of London, covering Asia, global equities and credit; the last-named was given the title European Credit Fund of the Year in The group also has a financial solutions division, which advises clients on complex financial products such as credit derivatives.
Och-Ziff Dan Och was a merger arbitrage specialist at Goldman Sachs who set up a hedge fund in , with the backing of the Ziff brothers, who had sold their publishing firm to a private equity group, Forstman Little. In a speech 47 Hedge Funds. Och-Ziff expanded from merger arbitrage to become a multi-strategy manager, running money in convertible arbitrage and event-driven sectors. It also runs private equity and real estate funds. Pershing Square Capital Management Pershing Square is an activist hedge fund spearheaded by William Ackman, who previously was a co-founder of Gotham Partners, a group that closed down amid a flurry of lawsuits.
Renaissance Technologies Renaissance is one of the most successful systematic trading funds, a style that uses computers to exploit small anomalies in the market. In a speech given to the International Association of Financial Engineers in May , Simons modestly said: There is no real substitute for common sense except for good luck, which is a perfect substitute for everything.
He started his trading career, making directional bets on commodities, 48 Hedge Funds. He bought sugar at 20 cents a pound and the price quickly reached 60 cents. The fund grew by a factor of ten within a year. Within five years, the fund was closed to new investors, the classic sign of success. Rather than the high-frequency trading that marked Medallion, the fund is looking at longer-term factors, including fundamentals such as company balance sheets.
Simons has used his wealth to encourage the development of maths teaching in America and has funded research to find the causes of autism, from which his daughter suffers. Cohen, who has followed perhaps the classic success story of a hedge fund manager. Originally from Long Island, Cohen became a junior trader on Wall Street after college and ended up running a trading group at his firm, Gruntal.
Like many traders before and after him, he set up on his own in the s, eventually expanding into running a multi-strategy operation. Among the strategies being followed are long-short equity, convertible arbitrage and statistical arbitrage. Soros Fund Management For a long time the biggest name in the industry, Hungarian-born George Soros has kept in the public eye, thanks to his political and philanthropic activities.
He is a keen enthusiast for open societies in eastern Europe and a strong opponent of the Bush administration in America. For a long time, his Quantum fund was seen as the template for hedge fund activities, making big bets on currencies and markets, notably gambling against the pound in September Soros has a market theory called reflexivity, which roughly states that perceptions shape the fundamentals. The other founders dropped out and the firm was renamed Steinhardt Partners in Steinhardt had an aggressive trading style, investing largely in equities but also in currencies and bonds which gave him a problem in the final years of his fund.
After a difficult , the fund was closed down in 50 Hedge Funds. Any investor who stuck with him to the end would have become exceedingly rich. This, he believes, was a true alignment of interest between investors and managers. It benefits from an automatic fee of 0. Hohn combines reticence about his personal life with an aggressive public approach, since tci is an activist hedge fund.
Before setting up tci, Hohn had followed an activist style at Perry Capital, an American hedge fund group. Third Point Capital This activist hedge fund group is run by Daniel Loeb, who is known for his aggressive letters complaining about the chief executives of companies he perceives as underperforming. He described one such executive as 51 Hedge Funds.
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He feels strongly about executive perks, such as limousines and expensive sports tickets. Its most prominent early success was calling the turn of the dollar in Ironically, one of its later mistakes was underestimating the strength of the dollar in the late s. Robertson also bet against the survival of the dotcom bubble.
Redemptions prompted him to close the fund in March , just as his bet against technology stocks was about to be proved right. Tudor Investment Corporation Paul Tudor Jones is from Memphis, centre of the American cotton industry, so perhaps it was no surprise that his first foray into financial markets was as a cotton trader. In , he became a local on the commodities market, trading on his own behalf.
He set up Tudor Investment Corporation in and was smart enough to predict and profit from the stockmarket crash. Indeed, he had lived up to the absolute return aim of the hedge fund industry, having never as of had a down year. Tudor Jones is not renowned for his willingness to talk to the press, but in a interview he said that the secret of a successful trader was to achieve an annual return two or three times the biggest drawdown fall in fund price.
He also said that he used a combination of technical analysis looking at charts and fundamental analysis to generate returns. He is also an enthusiastic supporter of wildlife conservation. Harding whose middle name is Winton left the group to set up his own firm in The company has set up research campuses in Oxford and Hammersmith, west London, to encourage work in statistics and actuarial science. But that is not the only problem for potential investors.
Most access the sector via a fund-of-funds manager, which charges a further layer of fees on top. That is a big hurdle to overcome. So why do investors bother? Such costs might easily equal the extra fees paid to a fund-of-funds manager, at least when an investor is in the process of setting up a hedge fund portfolio. At the very least, investors should expect the manager to spot the fraudsters. But for those managers who avoided Amaranth, the crisis was a godsend; it will have discouraged many institutional investors from trying to pick funds themselves. The danger of fraud means there is a need for funds-of-funds to be pretty well diversified.
Academic research suggests the optimal portfolio would consist of 10—15 hedge funds. But Dan Higgins of Fauchier Partners says that does not allow for the operational risk that a manager could blow up; if that happened in a portfolio of only 12 hedge funds, an entire 54 Hedge Funds. As a consequence, Fauchier aims for 20—25 funds. Few private investors have the capital to create a diversified portfolio of hedge funds on their own, even if they had the ability to do so. Few pension funds want to make their initial foray into the sector with a single fund, lest some bad numbers taint their whole experience.
So funds-offunds managers are an important force behind the expansion of the industry. It is an industry that is dominated by the Europeans. Apart from Permal, which is owned by Legg Mason, an American group, and the Chicago-based Grosvenor, the others in the top ten are all based in Switzerland or the European Union. As is usual in the hedge fund world, there are no definitive statistics. Hedge Fund Research says there were just 80 funds-of-funds in and 2, by the end of June In contrast, a study by Ibbotson Associates found that the number of funds-of-funds had risen from 98 in January to in October The Ibbotson study found that, up to a point, performance improved with size while volatility tended to decline.
Why might this be? The largest managers are probably well-established, have better research staff and will have access to the best fund managers — access that might not be available to the individual hedge fund client. This is one of the main selling points of the sector. However, the academic evidence that value is added by funds-of-funds is rather mixed. They co-authored a paper that showed the average fund-of-funds delivered no alpha after fees over the periods —98 and — The collapse of ltcm meant that risky assets were cheap and a lot of hedge fund managers made big profits by betting on a reversion to the mean.
In other words, you had a one-in chance of finding a manager with skill. But Fung and Naik reckon this is because such firms do not last long; investors quickly desert them and they go out of business. At the moment, few pension funds would feel happy about selecting a hedge fund manager directly, or indeed concentrating their exposure to the sector on just one or two managers. This is the underlying approach of many hedge fund clones see Chapter 6. Omar Kodmani of the fund-of-funds group Permal says: If you throw enough factors at something and use multiple 56 Hedge Funds.
Kodmani thinks that three or four factors explain the performance of most hedge funds. Permal was founded back in when, as Kodmani says, there were many fewer hedge funds to choose from. The group has more than doubled its assets under management over the past five years. Smith says: We have a bottom-up, labour-intensive research driven approach. We like to visit every single hedge fund and reach a level of detail which makes me feel comfortable.
We like to sit and ask exactly how the funds operate and come back every quarter to see if they are still operating that way. This drive for perfection has led Smith to develop his own statistics for the industry, surveying everyone he can think of for details of the funds in existence. In building a fund, Smith will establish its desired characteristics in terms of expected returns, volatility and correlation with the market.
The asset allocations to different types of funds flow from those characteristics. The key, he believes, is manager selection. This detail-driven approach makes Smith no respecter of reputations. He says: We analyse all our redemptions and we found that a third go out of business within 12 months, a third underperform and a third outperform. So we get about two-thirds right. A different approach is taken by Man Global Strategies mgs.
It looks for early-stage managers, starting their first hedge funds, with the hope of benefiting from their growth. The process is known as seeding. Of these, it did due diligence on 80 and then whittled that down to 15 for investment approval. The result of this process, says Lowe, is that after two years, the group will have a good idea of how the hedge funds work. Their funds will have been run on a managed account basis, enabling mgs to see the daily positions taken by the manager. Another company in the Man Group, rmf, starts from a different premise.
The individual managers are then rated on a series of criteria, such as operational risk, with only the best qualifying for consideration. It avoids funds with excessive leverage or black box funds, where the source of alpha is not clear. The outlook The danger for funds-of-funds may lie in excessive risk aversion. They will be desperate to avoid backing the next Amaranth or Bear Stearns, so they will go for stable hedge fund managers.
The result may be modest returns that, after fees, are unexciting. Someone who feels the industry has already gone down that route is Ken Kinsey-Quick of Thames River Capital:6 The returns have been bland because not enough risk has been taken, as the fiduciary responsibility has been paramount due to the institutionalisation of the industry. Thames River, which runs both individual hedge funds and funds-of-funds, is accordingly aiming for more innovative funds with higher returns. One way of avoiding the blandness problem is for fund-of-funds managers to slice up the industry, offering funds based on strategies distressed debt, equity long-short or geography.
In a way, they are following the tradition of the mutual fund industry, which developed to offer the Baskin-Robbins model of a variety of investment flavours, from emerging markets to corporate bonds. Funds-of-funds can be viewed in a mixed light by hedge fund managers themselves. They are, of course, a vital source of assets. But they can also be a lot more fickle than pension funds or individual investors. When they want to switch money out of a hedge fund, this can be a problem for a manager with a sophisticated strategy, even when that manager has a lock-up period. If the forced sale of assets adversely affects performance, other fund-of-funds managers may be tempted to pull out, resulting in a downward spiral that could eventually lead to the closure of the fund.
However, funds-of-funds face their own liquidity dilemma. Often, they 59 Hedge Funds. But they may be investing in hedge funds that have quarterly liquidity and a quarterly notice period and in start-up funds that have a lock-up period of a year or more. Then there are gating arrangements, clauses in hedge fund agreements that allow the managers to restrict the level of redemptions.
So what happens when investors in the fund-of-funds want to redeem their holdings? The temptation for the fund-of-funds manager will be to get rid of the most liquid of the underlying funds, regardless of their performance. Another possibility would be to borrow money to meet redemptions. But if redemptions are occurring in a skittish market, this might entail taking on risk at the worst possible moment; the remaining investors could be adversely affected.
This usually combines an investment in a hedge fund, or fund-of-funds, with a guarantee. The idea is to entice investors who might otherwise be nervous about the risks of fraud or otherwise of investing in the hedge fund sector. The guarantee will usually be provided by what is known as constant proportion portfolio insurance or cppi.
The rest of the portfolio is invested in hedge funds. The proportions are not set in stone but managed continuously; if the hedge funds perform well, they are allocated more capital; if they perform badly, more money will be invested in bonds. If you get just your 60 Hedge Funds.
You could then be sitting on dead money for several years. The fees involved can be huge. But the final point is more philosophical. Hedge funds are supposed to be about delivering absolute, not relative, returns, thus reducing risk. Funds-of-funds should reduce the loss of risk further.
The multiple strategies of hedge funds
So adding a guarantee on top of this structure is belt-and-braces, with Velcro as well. It seems an unnecessary encumbrance. Multi-strategy versus funds-of-funds The growth of the funds-of-funds sector shows no sign of slowing down. But there is a long-term potential threat to their position. Multi-strategy funds offer many of the same services as funds-of-funds groups, giving investors a diversified portfolio covering a range of different strategies.
Sometimes they have a star manager in charge that can attract investors. Perhaps they could replace funds-of-funds in the long run. As mentioned in Chapter 1, multi-strategy funds have one potential fee advantage over funds-of-funds, linked to the netting of performance fees. The net effect should be better for clients. However, while this effect sounds good in theory, in practice, multi-strategy funds are known for charging pretty high fees.
Furthermore, funds-of-funds feel obliged to offer reasonable liquidity terms to investors. Fred Siegrist, chief executive of rmf, says: The fund-of-funds business will develop into a two-tier market. On the one hand, many smaller boutique-type providers will continue to sell specific themed products and operate profitably in niches.
Hedge fund basics
In the middle, between the two models, asset managers will find it hard to survive. This is a perfectly plausible assessment, although it is also exactly the kind of forecast that commentators make about most industries: that only the giants and the niche players will survive. The bizarre thing about the fund management world is that struggling managers can be only one good year from success, while established managers can be just one bad year from disaster.
Rarely a year goes by without some kind of official report being issued on the sector. The world is split into two distinct camps on the issue. Let them alone, say regulators in free-market Britain and America. Tie them down, say politicians in continental Europe. The free-market camp has normally won the day, for the simple reason that hedge funds are globally mobile; unless all countries agree to restrict their activities, they will move to the region that gives them the greatest freedom. In May , Germany tried to push fellow finance ministers at a g8 meeting to agree a code of conduct for the industry, but faced resistance from the Anglo-American camp.
The Germans did have one good point. The speed of growth of the industry, its specialised nature and its peculiar client base few small, or retail, investors mean that regulation has turned out to be a bit of a mess. They recognise that low standards can keep potential investors away. Stanley Fink, deputy chairman of Man Group, says: We are generally very pro-regulation. It keeps the cowboys out of the industry and we much prefer a situation where the law is clear and rules can be followed.
Hedge fund managers have established themselves to escape from the paperwork that dogs their long-only counterparts. They want to keep their positions secret so that others cannot trade on the back of them. But this worries continental European politicians, who want markets to be as transparent as possible, so that hedge funds cannot build up large stakes in secret.
However, Callum McCarthy, chairman of the UK regulator, the Financial Services Authority fsa , said in December We do not seek, nor would we find it useful to have information about specific large positions of individual funds or their managers. What are regulators worried about? There are three main issues. The first is fraud — that investors may be ripped off. The second is that hedge funds, in their eagerness to earn performance fees, may break the rules by, for example, trading on inside information.
The third is that hedge funds, either by overreaching themselves borrowing too much or by all making the same bet, could destabilise the financial system and, by extension, the economy. In terms of fraud, the most common response has been to limit the kind of investors who can buy into hedge funds, on the grounds that more sophisticated investors can perform their own assessment or pay someone to do it for them.
In terms of market abuse, the same rules apply to hedge funds as to anyone else although the authorities are worried that hedge funds might gang up to force companies to accept a takeover; such collusion can be devilishly hard to prove. And on systemic risk, the main focus has been to look at the overall level of borrowing, to avoid a repetition of the ltcm saga. Approaches to supervision But there are a number of potential approaches to supervising the industry. Some countries impose restrictions on what hedge funds can do.
For example, in Portugal the use of derivatives is controlled, whereas in France there are limits on leverage. The most common approach, according to the iosco report, is to regulate the advisers, the people who manage the hedge funds. Observers say the fsa appeared to approach the industry in a sensible way.