LO 71.10: Explain the impact of institutional investors on the hedge fund industry

LO 71.10: Explain the impact of institutional investors on the hedge fund industry and assess reasons for the growing concentration of assets under management (AUM) in the industry.
As mentioned earlier, beginning in 2000, institutional investor funds flowed into hedge funds, and assets under management in the hedge fund industry grew from $ 197 billion at 1999 year-end to $1.39 trillion by 2007 year-end. Institutional investors were rewarded for allocating capital to a much higher fee environment. Three hedge fund performance databases, DJCSI, HFRI, and HFRFOFI, respectively, reported cumulative performance of 72.64%, 69.82%, and 38.18% from the 2002 to 2010 time period, compared to the S&P 300 index return of 13.3%. The S&P 500 index had a 16% standard deviation during that period, versus annualized standard deviations of return of 5.84%, 6.47%, and 5.51%, for the respective hedge fund indices.
With the increase of institutional investment came greater demands on hedge fund management for operational integrity and governance. Some institutional investors were seeking absolute performance, while others were seeking alternative sources of return beyond equities. There is some concern that there is no identifiable alpha associated with hedge fund investing, so it is increasingly important that hedge fund managers differentiate themselves from their peers.
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Topic 71 Cross Reference to GARP Assigned Reading – Constantinides, Harris, and Stulz, Chapter 17
Ke y Co n c e pt s
LO 71.1 Hedge funds are private investments and have very little financial regulation. They tend to be highly leveraged, and managers make large bets. On the other hand, mutual funds are regulated and more structured.
LO 71.2 There are some hedge funds that do not participate in commercial databases, which impacts aggregate hedge fund performance. Thus, there is selection bias contained in hedge fund databases.
LO 71.3 There have been major events affecting the hedge fund industry, including large losses following a change in Fed policy in 1994, the LTCM collapse in 1998, and the dot-com collapse in 2001.
LO 71.4 >From 1999 to 2007, investors in hedge funds shifted from exclusively private wealth to institutions, including foundations, endowments, pension funds, and insurance companies.
LO 71.5 Alpha is the return in excess of the compensation for risk. Beta is a measure of the systematic risk of the security or portfolio relative to the market as a whole. Firms may independently manage alpha and beta. This is known as separating alpha and beta. Managers can use investment tools to pursue alpha while sustaining a target beta for the portfolio.
LO 71.6 Managed futures funds focus on investments in bond, equity, commodity futures, and currency markets around the world. The payoff function of this strategy is similar to a lookback straddle.
Global macro managers make large bets on directional movements in interest rates, exchange rates, commodities, and stock indices, and do better during extreme moves in the currency markets.
Merger arbitrage funds bet on spreads related to proposed merger and acquisition transactions, and perform poorly during major market declines.
Distressed hedge funds invest across the capital structure of firms that are under financial or operational distress, or are in the middle of bankruptcy. The strategy tends to have a
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Topic 71 Cross Reference to GARP Assigned Reading – Constantinides, Harris, and Stulz, Chapter 17
long-bias. These hedge fund managers try to profit from an issuers ability to improve its operation, or come out of a bankruptcy successfully.
Fixed income arbitrage funds try to obtain profits by exploiting inefficiencies and price anomalies between related fixed income securities. Their performance is correlated to changes in the convertible bond default spread.
Convertible arbitrage funds attempt to profit from the purchase of convertible securities and the shorting of corresponding stock.
Long/short equity funds take both long and short positions in the equity markets, diversifying or hedging across sectors, regions, or market capitalizations, and have directional exposure to the overall market and also have exposure to long small-cap/short large-cap positions.
Dedicated short bias funds tend to take net short positions in equities, and their returns are negatively correlated with equities.
Emerging market funds invest in currencies, debt, equities, and other instruments in countries with emerging or developing markets.
Equity market neutral funds attempt to achieve zero beta(s) against a broad set of equity indices.
LO 71.7 The top 50 hedge funds demonstrated statistically significant alpha relative to the DJCSI and HFRI hedge fund indices. The strategy of buying large hedge funds appears to deliver superior performance compared to just investing in hedge fund indices. Hedge fund managers are still delivering alpha relative to peers, and also have low exposure to the U.S. equity market.
LO 71.8 Diversification among hedge fund strategies may not always be effective due to the convergence of risk during times of extreme market stress. There is significant credit-driven tail risk in a hedge fund portfolio. The use of managed futures may be a partial solutionit has been a strategy with a convex performance profile relative to other hedge fund strategies. Hedge fund investors need to consider portfolio risks associated with dramatic market events.
LO 71.9 In the hedge fund industry, risk sharing asymmetry between the principal (investor) and the agent (fund manager) is a concern due to variable compensation schemes.
LO 71.10 Institutional investors flocked to hedge funds beginning in 2000. With the increase of institutional investment came greater demands on hedge fund management for operational integrity and governance.
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Topic 71 Cross Reference to GARP Assigned Reading – Constantinides, Harris, and Stulz, Chapter 17
Co n c e pt Ch e c k e r s
1.
2.
3.
4.
3.
What critical shift occurred in the hedge fund industry following the collapse of Long-Term Capital Management (LTCM) in 1998 and the dot-com bubble burst in 2001? A. There was a significant drop in assets under management in the hedge fund
B. There was a large influx of institutional investors investing in hedge funds. C. Reporting within the hedge fund industry became more regulated than mutual
industry.
funds.
D. There was a significant increase in hedge fund failures.
Which of the following hedge fund strategies would be characterized as an asset allocation strategy that performs best during extreme moves in the currency markets? A. Global macro. B. Risk arbitrage. C. Dedicated short bias. D. Long/short equity.
Comparing hedge fund performance during the time period 2002-2010 to earlier time periods, how would monthly alpha compare, if looking at large hedge funds? A. Alpha was higher in the 2002-2010 time period. B. Alpha remained constant over both time periods. C. A foresight-assisted portfolio did not have a statistically significant alpha
during the 2002-2010 time period.
D. There was a decline in alpha in the 2002-2010 time period.
Jamie Chen, FRM, is considering investing a client into distressed hedge funds. Which of the following investments would serve as the best proxy for the types of returns to expect? A. Convertible bonds. B. Small-cap equities. C. Managed futures. D. High-yield bonds.
What would be an ideal approach for a hedge fund investor who is concerned about the problem of risk sharing asymmetry between principals and agents within the hedge fund industry? A. Focus on investing in funds for which the fund managers have a good portion of
their own wealth invested.
B. Focus on diversifying among the various niche hedge fund strategies. C. Focus on funds with improved operational efficiency and transparent corporate
governance.
D. Focus on large funds from the foresight-assisted group.
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Topic 71 Cross Reference to GARP Assigned Reading – Constantinides, Harris, and Stulz, Chapter 17
Co n c e pt Ch e c k e r An s w e r s
1. B During the time period following the dot-com collapse, hedge funds outperformed the
S&P 500 with a lower standard deviation, which attracted institutional investment.
2. A A global macro fund does better if there are extreme moves in the currency markets.
Along with managed futures, global macro is an asset allocation strategy. Managers take opportunistic bets in different markets. The strategy has a low correlation to equities.
3. D Comparing the two different time periods, there was a decline in alpha due to more
competition in the hedge fund industry.
4. D Distressed hedge funds have long exposure to credit risk of corporations with low credit
ratings. Publicly traded high-yield bonds are a good proxy for the returns to expect.
5. A The incentive fee structure within the hedge fund industry has not really changed over the years, and there is incentive for managers to take undue risks in order to earn fees. Thus, there should be a focus on investing in funds for which the fund managers have a good portion of their own wealth invested.
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The following is a review of the Risk Management and Investment Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
Pe r f o r m i n g D u e D i l i g e n c e o n Spe c i f i c M a n a g e r s a n d Fu n d s
Ex a m Fo c u s
This topic emphasizes the reasons investors should perform due diligence on potential investments. It provides a thorough list of items to consider in the due diligence process. For the exam, understand in detail the steps involved in evaluating a manager, a funds risk management process, and a funds operational environment.
Topic 72
Pa s t Fu n d Fa il u r e s