Mutual Funds, ETFs, and Hedge Funds
4.7 Hedge Fund Performance
Global macro is the hedge fund strategy used by star managers such as George Soros and Julian Robertson. Global macro hedge fund managers carry out trades that reflect global macroeconomic trends. They look for situations where markets have, for whatever reason, moved away from equilibrium and place large bets that they will move back into equilibrium.
Often the bets are on exchange rates and interest rates. A global macro strategy was used in 1992 when George Soros's Quantum Fund gained $1 billion by betting that the British pound would decrease in value. More recently, hedge funds have (with mixed results) placed bets that the huge U.S. balance of payments deficit would cause the value of the U.S. dollar to decline. The main problem for global macro funds is that they do not know when equilibrium will be restored. World markets can for various reasons be in disequilibrium for long periods of time.
4.6.9 Managed Futures
Hedge fund managers that use managed futures strategies attempt to predict future movements in commodity prices. Some rely on the manager's
judgment; others use computer programs to generate trades. Some
managers base their trading on technical analysis, which analyzes past price patterns to predict the future. Others use fundamental analysis, which
involves calculating a fair value for the commodity from economic, political, and other relevant factors.
When technical analysis is used, trading rules are usually first tested on historical data. This is known as back‐testing. If (as is often the case) a trading rule has come from an analysis of past data, trading rules should be tested out of sample (that is, on data that are different from the data used to generate the rules). Analysts should be aware of the perils of data mining.
Suppose thousands of different trading rules are generated and then tested on historical data. Just by chance a few of the trading rules will perform very well—but this does not mean that they will perform well in the future.
researchers, participation by hedge funds is voluntary. Small hedge funds and those with poor track records often do not report their returns and are therefore not included in the data set. When returns are reported by a hedge fund, the database is usually backfilled with the fund's previous returns.
This creates a bias in the returns that are in the data set because, as just mentioned, the hedge funds that decide to start providing data are likely to be the ones doing well. When this bias is removed, some researchers have argued, hedge fund returns have historically been no better than mutual fund returns, particularly when fees are taken into account.
Arguably, hedge funds can improve the risk‐return trade‐offs available to pension plans. This is because pension plans cannot (or choose not to) take short positions, obtain leverage, invest in derivatives, and engage in many of the complex trades that are favored by hedge funds. Investing in a hedge fund is a simple way in which a pension fund can (for a fee) expand the scope of its investing. This may improve its efficient frontier. (See Section 1.2 for a discussion of efficient frontiers.)
It is not uncommon for hedge funds to report good returns for a few years and then “blow up.” Long‐Term Capital Management reported returns (before fees) of 28%, 59%, 57%, and 17% in 1994, 1995, 1996, and 1997, respectively. In 1998, it lost virtually all its capital. Some people have argued that hedge fund returns are like the returns from writing out‐of‐the‐
money options. Most of the time, the options cost nothing, but every so often they are very expensive.
This may be unfair. Advocates of hedge funds would argue that hedge fund managers search for profitable opportunities that other investors do not have the resources or expertise to find. They would point out that the top hedge fund managers have been very successful at finding these
opportunities.
Prior to 2008, hedge funds performed quite well. In 2008, hedge funds on average lost money but provided a better performance than the S&P 500.
During the years 2009 to 2016, the S&P 500 provided a much better return than the average hedge fund.9 The Barclays hedge fund index is the
arithmetic average return (net after fees) of all hedge funds (excluding funds of funds) in the Barclays database. (Potentially, it has some of the
biases mentioned earlier.) Table 4.5 compares returns given by the index with total returns from the S&P 500.
Table 4.5 Performance of Hedge Funds
Barclays Hedge Fund S&P 500 Return Year Index Net Return (%) Including Dividends (%)
2008 −21.63 −37.00
2009 23.74 26.46
2010 10.88 15.06
2011 −5.48 2.11
2012 8.25 16.00
2013 11.12 32.39
2014 2.88 13.39
2015 0.04 1.38
2016 6.10 11.96
Summary
Mutual funds and ETFs offer a way small investors can capture the benefits of diversification. Overall, the evidence is that actively managed funds do not outperform the market and this has led many investors to choose funds that are designed to track a market index such as the S&P 500.
Most mutual funds are open‐end funds, so that the number of shares in the fund increases (decreases) as investors contribute (withdraw) funds. An open‐end mutual fund calculates the net asset value of shares in the fund at 4 P.M. each business day and this is the price used for all buy and sell orders
placed in the previous 24 hours. A closed‐end fund has a fixed number of shares that trade in the same way as the shares of any other corporation.
Exchange‐traded funds (ETFs) are proving to be popular alternatives to open‐ and closed‐end mutual funds. The shares held by the fund are known at any given time. Large institutional investors can exchange shares in the fund at any time for the assets underlying the shares, and vice versa. This ensures that the shares in the ETF (unlike shares in a closed‐end fund) trade at a price very close to the fund's net asset value. Shares in an ETF can be traded at any time (not just at 4 P.M.) and shares in an ETF (unlike shares in an open‐end mutual fund) can be shorted.
Hedge funds cater to the needs of large investors. Compared to mutual
funds, they are subject to very few regulations and restrictions. Hedge funds charge investors much higher fees than mutual funds. The fee for a typical fund is “2 plus 20%.” This means that the fund charges a management fee of 2% per year and receives 20% of the profit after management fees have been paid generated by the fund if this is positive. Hedge fund managers have a call option on the assets of the fund and, as a result, may have an incentive to take high risks.
Among the strategies followed by hedge funds are long/short equity, dedicated short, distressed securities, merger arbitrage, convertible arbitrage, fixed‐income arbitrage, emerging markets, global macro, and managed futures. The jury is still out on whether hedge funds provide better risk‐return trade‐offs than index funds after fees. There is an unfortunate tendency for hedge funds to provide excellent returns for a number of years and then report a disastrous loss.
Further Reading
Jensen, M. C. “Risk, the Pricing of Capital Assets, and the Evaluation of Investment Portfolios.” Journal of Business 42, no. 2 (April 1969): 167–
247.
Khorana, A., H. Servaes, and P. Tufano. “Mutual Fund Fees Around the World.” Review of Financial Studies 22 (March 2009): 1279–1310.
Lhabitant, F.‐S. Handbook of Hedge Funds. Chichester, UK: John Wiley &
Sons, 2006.
Ross, S. “Neoclassical Finance, Alternative Finance and the Closed End Fund Puzzle.” European Financial Management 8 (2002): 129–137.
Practice Questions and Problems (Answers at End of Book)
1. What is the difference between an open‐end and closed‐end mutual fund?
2. How is the NAV of an open‐end mutual fund calculated? When is it calculated?
3. An investor buys 100 shares in a mutual fund on January 1, 2018, for
$30 each. The fund makes capital gains in 2018 and 2019 of $3 per share and $1 per share, respectively, and earns no dividends. The
investor sells the shares in the fund during 2020 for $32 per share. What capital gains or losses is the investor deemed to have made in 2018, 2019, and 2020?
4. What is an index fund? How is it created?
5. What is a mutual fund's (a) front‐end load and (b) back‐end load?
6. Explain how an exchange‐traded fund that tracks an index works. What are the advantages of an exchange‐traded fund over (a) an open‐end mutual fund and (b) a closed‐end mutual fund?
7. What is the difference between the geometric mean and the arithmetic mean of a set of numbers? Why is the difference relevant to the
reporting of mutual fund returns?
8. Explain the meaning of (a) late trading, (b) market timing, (c) front running, and (d) directed brokerage.
9. Give three examples of the rules that apply to mutual funds, but not to hedge funds.
10. “If 70% of convertible bond trading is by hedge funds, I would expect the profitability of that strategy to decline.” Discuss this viewpoint.
11. Explain the meanings of the terms hurdle rate, high–water mark clause, and clawback clause when used in connection with the incentive fees of
hedge funds.
12. A hedge fund charges 2 plus 20%. Investors want a return after fees of 20%. How much does the hedge fund have to earn, before fees, to
provide investors with this return? Assume that the incentive fee is paid on the net return after management fees have been subtracted.
13. “It is important for a hedge fund to be right in the long term. Short‐term gains and losses do not matter.” Discuss this statement.
14. “The risks that hedge funds take are regulated by their prime brokers.”
Discuss this statement.
Further Questions
15. An investor buys 100 shares in a mutual fund on January 1, 2018, for
$50 each. The fund earns dividends of $2 and $3 per share during 2018 and 2019. These are reinvested in the fund. The fund's realized capital gains in 2018 and 2019 are $5 per share and $3 per share, respectively.
The investor sells the shares in the fund during 2020 for $59 per share.
Explain how the investor is taxed.
16. Good years are followed by equally bad years for a mutual fund. It earns +8%, –8%, +12%, –12% in successive years. What is the investor's overall return for the four years?
17. A fund of funds divides its money between five hedge funds that earn – 5%, 1%, 10%, 15%, and 20% before fees in a particular year. The fund of funds charges 1 plus 10% and the hedge funds charge 2 plus 20%.
The hedge funds' incentive fees are calculated on the return after management fees. The fund of funds incentive fee is calculated on the net (after management and incentive fees) average return of the hedge funds in which it invests and after its own management fee has been subtracted. What is the overall return on the investments? How is it divided between the fund of funds, the hedge funds, and investors in the fund of funds?
18. A hedge fund charges 2 plus 20%. A pension fund invests in the hedge fund. Plot the return to the pension fund as a function of the return to the hedge fund.
Notes
1 Stable value funds are a popular alternative to money market funds. They typically invest in bonds and similar instruments with lives of up to five years. Banks and other companies provide (for a price) insurance
guaranteeing that the return will not be negative.
2 The root mean square error of the difference (square root of the average of the squared differences) is a better measure. The trouble with standard deviation is that it is low when the error is large but fairly constant.
3 See A. Khorana, H. Servaes, and P. Tufano, “Mutual Fund Fees Around the World,” Review of Financial Studies 22 (March 2009): 1279–1310.
4 See S. Ross, “Neoclassical Finance, Alternative Finance and the Closed End Fund Puzzle,” European Financial Management 8 (2002): 129–137.
5 See M. C. Jensen, “Risk, the Pricing of Capital Assets and the Evaluation of Investment Portfolios,” Journal of Business 42 (April 1969): 167–
247.
6 The famous investor Warren Buffett can also be considered a hedge fund pioneer. In 1956, he started Buffett Partnership LP with seven limited partners and $100,100. Buffett charged his partners 25% of profits above a hurdle rate of 25%. He searched for unique situations, merger
arbitrage, spin‐offs, and distressed debt opportunities and earned an average of 29.5% per year. The partnership was disbanded in 1969, and Berkshire Hathaway (a holding company, not a hedge fund) was formed.
7 Although a bank is taking some risks when it lends to a hedge fund, it is also true that a hedge fund is taking some risks when it chooses a prime broker. Many hedge funds that chose Lehman Brothers as their prime broker found that they could not access assets, which they had placed with Lehman Brothers as collateral, when the company went bankrupt in 2008.
8 The Michael Douglas character of Gordon Gekko in the award‐winning movie Wall Street was based on Ivan Boesky.
9 It should be pointed out that hedge funds often have a beta less than one (for example, long/short equity funds are often designed to have a beta close to zero), so a return less than the S&P 500 during periods when the market does very well does not necessarily indicate a negative alpha.