Hedge Funds - There's No Free Lunch

The returns of such funds are negatively-skewed and fat-tailed, which means extreme occurrences are more common than traditional equity returns.

Hedge funds, the once surreptitious funds vilified as the villains which started the Asian currency crisis, are now hotly pursued by the wealthy in Asia.

They are sought after for their promise of attractive returns which are not strongly correlated to moves in the market in general. Based on the past performance of those which cared to share their results, hedge funds have indeed generally delivered on their promise. So whats the catch? But first, the basics.

What are hedge funds? A hedge fund is a privately organised, pooled investment vehicle which: 1) invests primarily in publicly-traded securities and derivatives based on publicly-traded securities; and 2) uses leverage. They are typically set up as limited partnerships with a lucrative incentive-fee structure. Hedge fund managers often have a

significant portion of their own capital invested in the partnerships. The first hedge fund on record was established by Alfred Winslow Jones in 1949. It invested in US stocks, taking both long and short positions, in an attempt to reduce market risk and focus on stock selection.

Jones generated very strong returns while managing to avoid significant attention from the general financial community until 1966, when an article in Fortune led to increased interest in hedge funds. Two years later in 1968, the US Securities Exchange Commission estimated about 140 hedge funds were in existence.

Brooks and Kats (2001) estimated that, as at April 2001, there were around 6,000 hedge funds with an estimated US$400 billion in capital under management and USS1 trillion in total assets.

Hedge funds are beginning to make their way here. Many familiar names like Merrill Lynch, Lazard, Morley, Societe Generale, HSBC and Crosby have introduced or launched hedge funds in Singapore.

Strategies used by hedge funds Hedge funds managers have significant flexibility in the way they manage their funds. They can short stocks, use derivatives and leverage up to the hilt. Such flexibility has expanded the opportunities hedge funds can tap and increased their potential returns.

Take for example a long-short portfolio. A long-short portfolio manager can use insights about good performers as well as poor performers to reap returns. He or she will buy, or long, expected good performers and short expected poor performers.

There are three sources of returns from long-short portfolios. Say the manager has $1 million and he has decided to be market neutral, ie he has decided not to take any bets on the market. With

the 81 million, he buys stock A, which he thinks will outperform its peers, and sells stock B in the same industry which he thinks will be a poor performer.

Assume the market came to agree with the manager's view three months down the road. By the end of six months, stock A has risen 15 per cent while stock B has declined by 5 per cent. So the portfolio would have earned 15 per cent on its long position and 5 per cent on its short position.

In addition, when the manager shorted stock B, he would have received proceeds from the sale of stock B. The proceeds can be invested in risk-free instruments to earn interest.

Even if both stocks rose, as long as stock A went up by a larger quantum than stock B, the portfolio would have made a positive return. Similarly in a down market, if stock B fell more than stock A, the portfolio would still make a positive return.