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Hedge Funds: Past, Present, and Future
Rene´ M. Stulz
H
edge funds often make headlines because of spectacular losses or spec- tacular gains. In September 2006, a large hedge fund, Amaranth, re- ported losses of more than $6 billion apparently incurred in only one month, representing a negative return over that month of roughly 66 percent. Earlier in the year, newspapers focused on the $1.4 billion compensation in 2005 of hedge fund manager Boone Pickens and the 650 percent return that year of his BP Capital Commodity Fund (Anderson, 2006b). The importance of hedge funds in the daily life of financial markets does not make the same headlines, but hedge funds now account for close to half the trading on the New York and London stock exchanges (Anderson, 2006a). Chances are that you personally cannot invest in a hedge fund. Most U.S. investors cannot. Hedge funds are mostly unregulated. These funds can only issue securities privately. Their investors have to be individuals or institutions who meet requirements set out by the Securities and Exchange Commission, ensuring that the investors are knowledgeable and can bear a significant loss. Most likely, how- ever, you personally can invest in mutual funds, which are heavily regulated in how they can invest their funds, how their managers can be paid, how they are governed, how they can charge investors for their services, and so on. The typical mutual fund cannot make the investments that provide the performance of Amaranth or the BP Capital Commodity Fund. The economic function of a hedge fund is exactly the same as the function of a mutual fund. In both cases, fund managers are entrusted with money from
y Rene´ M. Stulz is the Everett D. Reese Chair of Banking and Monetary Economics, The Ohio
State University, Columbus, Ohio. He is also a Research Associate of the National Bureau of Economic Research, Cambridge, Massachusetts, and a Fellow of the European Corporate Governance Institute, Brussels, Belgium. His e-mail address is Stulz@cob.osu.edu .
Journal of Economic Perspectives—Volume 21, Number 2—Spring 2007—Pages 175–
investors who hope that they will receive back their initial investment, plus a healthy return. Mutual funds are divided into two types. Some funds are indexed funds (also known as “passive” funds). With these funds, the managers attempt to pro- duce a return which tracks the return of a benchmark index, like the Standard & Poor’s 500. However, most mutual funds and all hedge funds are active funds. Investors in such funds hope that the manager has skills that will deliver a return substantially better than passive funds. Hedge funds have existed for a long time. It is generally believed that Alfred W. Jones, who was a writer for Forbes and had a Ph.D. in sociology, started the first hedge fund in 1949, which he ran into the early 1970s. He raised $60,000 and invested $40,000 of his own money to pursue a strategy of investing in common stocks and hedging the positions with short sales.^1 From these modest beginnings, especially since the turn of the century, the assets under management of hedge funds have exploded. At the end of 1993, assets under management of hedge funds were less than 4 percent of the assets managed by mutual funds; by 2005, this percentage had grown to more than 10 percent. In 1990, less than $50 billion was invested in hedge funds; in 2006, more than $1 trillion was invested in hedge funds.^2 Since hedge funds and mutual funds essentially perform the same economic function, why do they coexist? Hedge funds exist because mutual funds do not deliver complex investment strategies. Part of the reason mutual funds do not is that they are regulated. In addition, mutual funds and other institutional investors can gather a lot of funds from investors by promoting simple strategies. Mass selling of hedge fund strategies is much harder because hedge fund strategies are too complex for the typical mutual fund investor to understand. It is therefore not surprising that the largest mutual funds dwarf in size the largest hedge funds. At the end of 2006, the largest mutual fund, the Growth Fund of America from American Funds, had assets under management of $161 billion and the largest mutual fund companies managed more than $1 trillion. In contrast, with a few exceptions, the largest hedge funds managed less than $10 billion. Goldman Sachs managed close to $30 billion in hedge funds and was apparently the largest hedge fund manager. Can hedge funds and mutual funds coexist in the long-run? Will regulators or market forces make these two vehicles more similar? I will argue that the bulk of the hedge fund industry will experience some convergence towards the traditional mutual fund model. First, the prospects for greater regulation of hedge funds,
(^1) A hedge is a position designed to reduce a risk one is exposed to. To sell a stock short, an investor borrows the stock and sells it. The investor closes the short sale when he buys the stock back and returns it to the lender. The investor profits from the short sale if the stock falls in value. If stocks fall in value and an investor has a hedge of short stock positions, the short positions are expected to gain in value and to some extent offset the loss of the stocks held in the portfolio. (^2) A well-established data provider on hedge funds, Hedge Fund Research (HFR), estimates assets under management at $973 billion at the end of 2004 and reported strong increases in assets under manage- ment subsequently. However, larger estimates exist— up to the estimate of $2.17 trillion of assets under management for 2005 from a survey by Hedgefundmanager and Advent.
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does not have to register with the SEC under the traditional interpretation of “clients.” In 2005, the SEC attempted to change this interpretation by making the hedge fund investors the “clients” of the management company, so that hedge fund management companies would have had to register with the SEC. The courts struck down this interpretation. Many management companies register anyway, perhaps because they believe that registration gives them credibility. Further, hedge funds in which U.S. pension funds invest must have registered management companies. The incentives of hedge fund managers differ sharply from those of mutual fund managers. The compensation contract for mutual fund advisers is restricted by regulation so that the incentive compensation, if there is any, has to be sym- metric— essentially, a dollar of gain has to have the opposite impact on compen- sation as a dollar of loss. As a result, relatively few mutual fund advisers have an incentive compensation clause in their contracts, and the compensation of mutual fund managers depends mostly on the amount of assets under management (Elton, Gruber, and Blake, 2003). One of the most famous mutual funds is Fidelity’s Magellan fund. The compensation to Fidelity for managing the fund is a fixed fee (0.57 percent for the year ending March 2006) plus an adjustment depending on how the fund performs relative to the Standard & Poor’s 500 of up to minus or plus 0.20 percent of assets under management. In contrast, almost all hedge fund managers have an asymmetric compensation contract that specifies that they receive a substantial fraction of the profits they generate (Ackermann, McEnally, and Ravenscraft, 1999). Alfred Jones reorganized his fund in 1952 as a limited partnership and instituted the rule that the general or managing partner would keep 20 percent of the profits generated by the fund. Typically, hedge fund managers receive a fixed compensation corresponding to 1–2 percent of the net asset value of the fund (or of the limited partners’ equity) and 15–25 percent of the return of the fund above a hurdle rate (which can be the risk-free rate). The typical compensation contract of a hedge fund manager makes extremely high compensation possible if the investors experience large returns. In 2005, at least two managers had compensation in excess of $1 billion: James Simons of Renaissance Technologies earned $1.5 billion and Boone Pickens, as mentioned earlier, earned $1.4 billion (Schurr, 2006). The 2005 Hedge Fund Compensation Report states that “the average take-home pay of the top 25 hedge fund earners in 2004 was over $250 million.” Generally, the compensation of hedge fund managers has a so-called “high water” mark—if the managers make a loss in one period, they can get the perfor- mance fee only after they have recovered that loss. The high water mark limits the risk taking of the fund. Without it, the manager gets all the upside from big bets but suffers little from the downside. With a high water mark, though, the manager may just close the fund if it makes a big loss. As long as the fund manager does not have a large investment in the fund, it is not always easy to resist the temptation to take large risks. As an example, the trader apparently responsible for the large losses at Amaranth in 2006 is reported to have earned between $80 million and $100 million
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there in 2005. As long as no illegal actions took place, the trader will not have to return his past compensation to the fund—in fact, he is planning to start a hedge fund of his own. Investors in mutual funds typically can withdraw funds daily. Thus, mutual funds must have some low-earning cash on hand. It is risky for mutual funds to invest in strategies that may take time to prove profitable, because adverse devel- opments in the short run may lead investors to withdraw their money. Hedge funds have rules that restrict the ability of investors to withdraw funds; for instance, a hedge fund might allow investors to withdraw at the end of a quarter provided that they give a 30-day notice. Depending on the fund, an investor may not be allowed to withdraw an initial investment before a period of several years. Eton Park Capital, a fund launched in 2004 by a star Goldman Sachs trader, Eric Mindich, raised $3 billion even though investors had to commit to keep their money in the fund for at least three years. Mutual funds have to disclose a lot of information to investors. They have to report their holdings to the Securities and Exchanges Commission (SEC) and must have audited statements.^3 Hedge funds may agree contractually to disclose some types of information and to provide audited financial statements, if they decide that it helps them to recruit investors, but they are not required to do so. For instance, referring to the Long Term Capital Fund (often referred to as LTCM, which stands for Long-Term Capital Management, the company which managed the fund), Lowenstein (2001, p. 32) states: “Long Term even refused to give examples of trades, so potential investors had little idea of what they were doing.” The Long Term Capital Fund, founded in 1994, was spectacularly successful until the middle of 1998 (in 1995–1997, the fund’s average yearly return net of fees was 33.4 percent). Its managing partners were star traders and academics. It had capital of $4.8 billion and assets of $120 billion at the beginning of 1998. In the aftermath of the Russian crisis in August 1998, the fund lost almost all its capital in one month. Secrecy does help hedge fund managers protect their strategies from potential imitators; on the other hand, secrecy makes it harder to assess the risk of a fund. In the past, investors typically invested in individual hedge funds. Investors who want to invest in a hedge fund usually have to commit a large amount of money— often at least $1 million ($5 million in the case of the Eton Park fund mentioned earlier). Since individual hedge funds can be highly risky, diversification can reduce risk, but diversification across hedge funds for a single investor requires a very large amount of investable wealth. Further, because hedge funds are unregu- lated, an investor has to investigate a hedge fund thoroughly before investing in it. It is quite expensive for funds that are not well-established—$50,000 is a frequently
(^3) Since 1978, all institutions with over $100 million must report stock holdings in excess of $200,000 or holdings of more than 10,000 shares. Hedge funds are not exempt from this requirement. The requirement does not apply to derivatives and short positions. Further, institutions can ask that their positions be kept confidential for one year and hedge funds have been known to do so aggressively.
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and they must redeem shares on short notice. In contrast, derivatives and short positions are critical in most hedge fund strategies and enable hedge funds to reduce mispricings more forcefully than mutual funds. For instance, if a mutual fund manager concludes that firm A is valued too richly compared to firm B which is in the same business, that manager will typically buy more of firm B and less of firm A. In contrast, a hedge fund manager would react to a belief that firm A is overvalued compared to firm B by buying firm B and selling firm A short. With this strategy, the hedge fund portfolio will not be affected by changes in the market as a whole— or even in the industry. If the stock market drops sharply, the mutual fund would lose, but the hedge fund would not. Until 1997, the tax code made short sales extremely expensive for mutual funds, but it no longer does. As a result, the binding short-sale restriction for mutual funds is a restriction that funds put on themselves—in 2000, two-thirds of reporting mutual funds prohibited short sales (Almazan, Brown, Carlson, and Chapman, 2004). With their focus on arbitrage opportunities, hedge funds in principle pursue absolute returns rather than returns in excess of a benchmark, such as an index of the stock or bond markets. In principle, this approach tends to make hedge funds market-neutral over time: that is, hedge funds are expected to have average performance whether equity markets have extremely good or bad performance. It is therefore not surprising that hedge funds performed well when U.S. equity markets registered sharp losses in the wake of the collapse of Internet stocks. Many investors tend to extrapolate from past returns (see Barberis and Shleifer, 2003, for possible reasons and implications), so it is not surprising that investors were attracted to hedge funds when they performed so well compared to stocks. Also, hedge funds appear an attractive diversification vehicle for investors who hold stocks. However, correlations of hedge funds with the broad markets have in- creased, so that evaluating the diversification benefits of hedge funds has become trickier (Garbaravicius and Dierick, 2005). Some hedge funds may have effectively become mutual funds; that is, an investor in such a fund is paying hedge fund fees for mutual fund risks and returns. Investment in a hedge fund is a bet on the skills of the manager to identify profit opportunities. A managers’ strategy may be complex and difficult to com- municate. In addition, the manager has incentives not to communicate too much— otherwise investors might not need the manager. Further, it is possible for a strategy to make losses before it eventually pays off. Viewed from this perspective, it is easier for professional investors than for others to evaluate hedge fund strategies and the skill of managers. Such investors are less likely to misinterpret short-term losses as evidence of poor skills on the part of the manager. When investors do not understand these strategies, they may withdraw their funds when they make losses and force managers to liquidate their positions at a loss (Shleifer and Vishny, 1997). Therefore, hedge funds will seek both restrictions on redemptions and investors who are knowledgeable. It is not unusual for a hedge fund to reject potential investors, which would be unheard of for a mutual fund. Hedge fund investment strategies are classified into style categories. One way
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to measure the popularity of the styles is to measure the funds under management for a style relative to the sum of the funds under management. According to the Tremont Asset Flows Report (Second Quarter, 2005), the four most popular styles and their strategies are: long–short equity (31 percent of total); event-driven (20 percent); macro (10 percent); and fixed-income arbitrage (8 percent). A long–short equity hedge fund takes both long and short positions in stocks. The fund started by Alfred Jones was a long–short fund. These funds tend to hedge their positions against market risks. For example, a hedge fund of this type might have only long positions in stocks but use options and futures contracts so that fund returns will be unaffected by changes in the market as a whole. A typical strategy is to identify undervalued and overvalued stocks. Event-driven hedge fund strategies attempt to take advantage of opportunities created by significant transactional events, such as spin-offs, mergers and acquisi- tions, reorganizations, bankruptcies, and other extraordinary corporate transac- tions. Event-driven trading attempts to predict the outcome of a particular trans- action as well as the optimal time at which to commit capital to it. Macro hedge fund strategies attempt to identify mispriced valuations in stock markets, interest rates, foreign exchange rates, and physical commodities and make leveraged bets on the anticipated price movements in these markets. To identify mispricing, managers tend to use a top-down global approach that concentrates on forecasting how global macroeconomic and political events affect the valuations of financial instruments. Fixed-income arbitrage hedge funds attempt to find arbitrage opportunities in the fixed-income markets. Another 13 percent of the amount invested in hedge funds is invested in multi-strategy funds. Other strategies involve emerging markets funds, funds that trade futures contracts, and convertible arbitrage funds (convertible debt is debt convertible into stock and these funds exploit mispricings in the debt relative to the stock). The arbitrage opportunities identified by hedge funds are often small. As a partner of Long-Term Capital Management put it before the fund collapsed, their strategies amounted to vacuuming pennies—though others have described hedge fund strategies as picking up pennies in front of a steamroller. Many hedge funds use leverage, both to take advantage of more investment opportunities and to increase the return on the funds invested. To illustrate, if a hedge fund starts with equity of $100 million invested in a strategy that earns $5 million, its return on equity is 5 percent. However, if the fund borrows an additional $300 million to take advantage of three similar strategies and the cost of borrowing is $2 million per $100 million, its return on equity becomes 14 percent on the original $100 million invested (the income becomes $14 million, or $5 million 3 x $3 million). The LTCM fund had an extremely high degree of leverage—more than $20 of assets were supported by a dollar of equity capital. The typical hedge fund has much lower leverage—a dollar of equity supports two or three dollars of assets. Mutual funds do not have the same ability to use leverage without restrictions.
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until 2000 and then outperformed it. The spectacular growth of the hedge fund industry took place mostly after 2000. At the end of 2000, $218 billion was invested in hedge funds (Tremont Asset Flows Report, Second Quarter, 2005). By June 2005, assets under management were $735 billion. Other industry reports have the assets under management exceeding $1 trillion in 2005. During that period of time, mutual fund assets grew much less—from close to $7 trillion at the end of 2000 to about $8.5 trillion at the end of 2005 (Investment Company Institute, 2005). However, investing in a hedge fund index from 1994 to 2006 would have been very difficult. Index funds of the hedge fund universe do not exist. Investors can only put their money in individual hedge funds or in funds-of-funds. Investing in a portfolio that replicates the Standard & Poor’s 500 over that period would have been straightforward; for instance, Vanguard has offered an S&P 500 index fund since 1976. Since investors cannot invest in an index of the hedge fund universe, it is critical to focus on the performance of individual funds. Do individual hedge funds beat the market? Do they outperform mutual funds? The academic literature on hedge funds is young: the first paper, Fung and Hsieh (1997), was published only ten years ago. After reviewing the four main reasons why it has proven difficult to answer these questions, I will offer a conclusion. First, reports of hedge fund performance are based on biased samples. Since hedge funds are not regulated, they need not disclose their performance. Data- bases only report the performance of hedge funds that voluntarily send their returns to the sponsoring organizations. A hedge fund might not report its perfor- mance for a number of reasons: It might be closed to investors, so that it would not benefit from advertising its performance. It might have forgotten to send in the form. Or its performance might have been poor. Indeed, for a number of years, some databases dropped the returns of liquidated funds, so that funds with poor performance disappeared from the database. The range of estimates of these biases is wide, from less than 100 basis points (1 percent) per year (Ackerman, McEnally, and Ravenscraft, 1999) to more than 400 basis points (4 percent) at the high end (Malkiel and Saha, 2005). Second, a fair estimate of hedge fund returns will need to adjust performance for market exposure. Suppose you found that a hedge fund’s performance mimics the performance of the Standard & Poor’s 500 index in both returns and volatility. In this case, the hedge fund manager did not add value, because you could have achieved a better net return by investing in an indexed fund which has dramatically lower fees than a hedge fund. Because hedge funds can go long and short, can use derivatives, and can borrow, their exposure to market risks can vary tremendously over a short period of time, which makes it difficult to assess these exposures based on a limited sample of monthly returns. In addition, techniques that work well to assess risk exposures for mutual funds do not work so well when applied to hedge funds. An equity mutual fund’s return is typically best viewed as the return of a basket of stocks, plus some component that is unique to the fund. A hedge fund’s return, in contrast, is best viewed as a basket of derivatives—and often rather exotic
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derivatives with nonlinear payoffs (for discussion and references, see Fung, Hsieh, Naik, and Ramadorai, 2007). For instance, a fund might not be exposed to interest rates when they are low but might be when they are high. A third difficulty in assessing hedge fund returns is that the past performance of a particular hedge fund may give a very selective view of its risk. Hedge funds may have strategies that yield payoffs similar to those of a company selling earthquake insur- ance ; that is, most of the time the insurance company makes no payouts and has a nice profit, but from time to time disaster strikes and the insurance company makes large losses that may exceed its cumulative profits from good times. Investors who usually focus on volatility may conclude that the fund has low risk because they look at returns before a disaster occurs. The example shows why volatility is a poor measure of individual hedge fund risk: the hedge fund would appear to have low volatility compared to a mutual fund, but it also has a much higher probability of losing all its assets. The fourth difficulty in calculating hedge fund returns involves problems of valuation. A mutual fund invested in U.S. stocks can compute the daily value of its portfolio by using the closing prices of the stocks. In contrast, hedge funds often hold securities that are not traded on exchanges. For instance, many derivatives are traded over-the-counter. For securities not traded on an exchange, no closing price exists. A hedge fund may need to rely on theoretical models to estimate the value of some securities, or rely on quoted prices rather than actual transaction prices. In an efficient market, one would not expect the return of a fund during one month to have information for the return of the fund over the next month. In general, mutual fund returns are not serially correlated— but hedge fund returns are. There can be valid reasons for hedge fund returns to be serially correlated, but one reason that such serial correlation can arise is when hedge fund managers use the flexibility that they have in valuing the securities to massage returns and present a picture of low risk and consistent performance (Getmansky, Lo, and Makarov, 2004). It is also somewhat disturbing that Santa Claus is so kind to hedge funds— the average monthly return of hedge funds in December is more than twice what it is for the rest of the year (Agarwal, Daniel, and Naik, 2006). With these four problems, the performance of hedge fund managers is sure to be controversial. A common way to evaluate hedge fund investment strategies is to estimate the “alpha” of the strategy, which is the performance of the strategy that cannot be explained by beta risk. Beta risk is the risk arising from exposure to common market movements—in other words, beta risk is a measure of market risk exposure. The skill of a hedge fund manager is required to produce alpha returns, but not to take beta risk. For instance, a fund that moves on average one for one with the stock market has a beta of one with respect to the stock market. It should compensate investors for risk by earning at least the same return as the stock market. If a fund has an annualized alpha of 5 percent, this means that the fund earns 5 percent more than the risk-free rate after taking into account the compen- sation earned through the fund for taking beta risk. Another way to see this is the following. Suppose that a fund invests all its money in the Standard & Poor’s 500.
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their positive and significant alpha; the other managers do not have a positive, significant alpha. We now turn to the issue of whether the performance of hedge fund managers persists. Jagannathan, Malakhov, and Novikov (2006) use a large database of hedge funds and account carefully for the various problems in estimating hedge fund performance. The study concludes that about half of the performance of hedge funds over a three-year period spills over to the next three-year period. Thus, if a fund has an alpha of 2 percent during a three-year period, it can be expected to have an alpha of 1 percent during the next three-year period. This paper therefore suggests that investing in high alpha funds is profitable. The academic bottom line on hedge fund performance is captured well by these studies. If one picks randomly a hedge fund, it should be expected to have a positive but statistically insignificant alpha after fees. Such performance appears better than the performance of a randomly selected mutual fund. Being able to pick good hedge funds can therefore be highly rewarding. Some evidence suggests that past history helps to pick good hedge funds. However, remember that it is much harder to evaluate the performance of hedge funds than to evaluate the performance of mutual funds. A hedge fund that implements a strategy akin to selling earthquake insurance and whose risk is not captured well by commonly used risk factors will have a significant positive alpha— until the quake hits. Mutual funds are rarely closed to investors. However, an investor may not be able to invest in a winning hedge fund because the manager rejects the investor. One very successful hedge fund manager told me that he did not want individuals as investors because they require too much hand-holding when things go poorly.
Do Hedge Funds Pose Significant Risks for the Economy?
Many hedge funds appear at first glance to have low return volatility compared to an investment in the stock market. For instance, from February 1994 to August 2004, the average annualized standard deviation of the monthly returns of fixed- income arbitrage hedge funds was 7.76 percent, or slightly more than half the standard deviation of the Standard & Poor’s 500 return over the 1994 –2005 period (Chan, Getmansky, Haas, and Lo, 2006). However, even funds with a history of low volatility can end up losing most of their money, an outcome that is almost inconceivable for a mutual fund. The Long Term Capital Fund had lower volatility than the S&P 500 for almost all its existence, but this low volatility did not prevent it from losing most of its capital in the span of a month. Regulators are concerned about the risks of hedge funds for at least four reasons: investor protection, risks to financial institutions, liquidity risks, and excess volatility risks. We review and evaluate these reasons in turn. The Securities and Exchange Commission wanted to force registration of hedge fund managers because hedge fund collapses had generated large losses for their investors, arguably indicating a need for greater investor protection. Each year,
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roughly 10 percent of hedge funds die. A fund might die because the investors withdraw funds following significant losses. Some funds disappear because fraud or misreporting becomes apparent. However, aggregate losses from hedge fund fraud seem relatively small. The SEC brought 51 hedge fund fraud cases from 2000 to
- The U.S. Securities and Exchange Commission (2003) estimates the damages in these cases to amount to $1.1 billion. Banking regulators are concerned that hedge funds may create risks to financial institutions. Hedge funds create credit exposures for financial institutions in several ways: they borrow, they make securities transactions, and they are often counter- parties in derivatives trades. Because of leverage, a hedge fund might get in trouble if its assets experience a sharp drop and the market for these assets lacks liquidity so that the fund cannot exit its positions. The collapse of a hedge fund could have far-reaching implications if the fund is large enough. When the Long Term Capital Fund lost more than $4 billion in August and September 1998, the Federal Reserve Bank of New York organized a rescue by private banks to avoid possible widespread damage from a possible disorderly liquidation or bankruptcy of the fund. However, the debacle at the hedge fund Amaranth in late 2006 had only a trivial impact on the markets. Nonetheless, the Amaranth losses led to calls for regulation of hedge funds. For instance, the New York Times (2006) published an editorial stating that “regulators need to act now to translate their various calls for hedge-fund oversight into enforceable rules and, in some instances, into concrete proposals for Congress to enact.” Hedge funds rely on their ability to move out of trades quickly when prices turn against them, which raises an issue of liquidity risk. If too many funds have set up the same trades, they may not all be able to exit their positions at the same time. In that case, two adverse developments can ensue: prices may have to overreact and liquidity may fall sharply. With low liquidity, hedge funds that rely on trading quickly to control their risks cannot do so. Hence, such hedge funds become more risky, which increases threats to financial institutions and can lead to further overreaction in prices as financial institutions have to reduce their positions as well. Further, when hedge funds use leverage, they cannot just ride out a serious adverse shock; instead, they must reduce their exposures to satisfy the banks from which they borrowed. As a result, adverse shocks could lead hedge funds to dump securities and cash out precisely when things are going poorly, which could make matters worse. Finally, hedge funds could lead prices to overreact by making trades that push prices away from fundamental values and lead to excess volatility risks. Though hedge funds have certainly been accused of creating volatility, the case that they have done so is far from ironclad. For example, hedge funds were net buyers during the stock market crash of 1987, so that they helped stabilize markets at that time (Presidential Task Force on Market Mechanisms, 1998). During the Asian currency crisis of 1997, the prime minister of Malaysia attacked George Soros for causing the crisis. However, an IMF study concluded that hedge fund positions were too small to have much of an impact on emerging markets (Eichengreen et al., 1998). Earlier, the
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cally from fundamentals, one cannot count on hedge funds to bring them back to fundamentals.
The Future of Hedge Funds
Over recent years, the hedge fund industry has grown sharply and regulatory concerns about the industry have increased. In this section, we examine the implications of these developments for the industry. We expect: 1) the hedge fund industry as a whole will perform less well over the next ten years than over the last ten; 2) the hedge fund industry will become more institutionalized; and 3) the hedge fund industry will become more regulated. These changes will reduce the gap between mutual funds and hedge funds, but not for all hedge funds. Some hedge funds will choose their investors and how they organize themselves so that they will be less affected by the increasing institutionalization and regulation of the industry.
How Will the Hedge Fund Industry Perform Over the Next Ten Years? As discussed earlier, Ibbotson and Chen (2005) estimate the average alpha of the hedge fund industry to be above 3 percent per year. Large funds seem to have performed somewhat better. As a rough estimate, suppose that the value-weighted alpha for hedge funds is 4 percent, net of fees. During their sample period, the yearly average size of the hedge fund industry is $262 billion according to one consulting firm. Thus, the skills of hedge fund managers were contributing on average $10 billion a year to investors. The industry is now at least three times as large. For the performance of hedge funds to generate 4 percent net of fees for investors, the skills of hedge fund managers have to produce an additional $20 billion of alpha. However, as more money enters the hedge fund industry, it either funds existing strategies, new strategies that typically cannot be as good as the ones already implemented, or new managers. More hedge funds chasing the same price discrepancies means that these discrepancies get eliminated faster, leading to smaller profits for the funds. Hence, additional money entering hedge funds in the future will typically not find average returns as high as in the past. A clear example of this problem is the recent performance of convertible arbitrage funds. The typical trade for a convertible arbitrage fund is to buy convertible bonds issued by a firm and to hedge the purchase with short sales of the stock of the firm. As more funds buy convertible bonds, the strategy becomes less profitable because the funds push the price up, so that the performance of this strategy falls. Not surprisingly, the increase in convertible arbitrage funds, from 26 in 1994 to 145 in 2003 according to one database, eventually led to poor perfor- mance and a drop in the number of such funds.
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How Will the Organization of Hedge Funds and Mutual Funds Change? Twenty years ago, most of the money invested in hedge funds came from individuals, who would largely give the manager a free hand. In 2003, roughly 40 percent of the money invested in hedge funds came from individuals (U.S. Securities and Exchange Commission, 2003). This percentage has fallen since. As a larger fraction of the assets under management of the hedge fund industry comes from institutional investors—from pensions and endowments directly or from funds-of-funds—the rules of the game change. Investors with fiduciary duties cannot give managers a completely free hand. Institutional investors have to be able to justify their investments and explain the outcomes. They fear large losses in individual funds, because they could be criti- cized for having such funds in their portfolio. As a result, hedge funds have to provide more information to investors if they want investors with fiduciary duties to invest in them. Some funds-of-funds require and are able to obtain full transpar- ency from the funds they invest in, therefore they know the securities positions of those funds, sometimes daily. Providing more information is costly, both because it requires a larger administrative staff and because the information could be used against the fund. Hedge funds have to make sure that their largest “drawdown” (the loss a hedge fund makes before the loss is recovered through performance) is palatable to their investors. Institutions can even pull money because large current gains make them worried about future risk— one large institutional investor re- portedly pulled funds after Amaranth reported large gains early in 2006. Individual investors often seek returns that are high in absolute terms; insti- tutional investors are more likely to measure performance relative to benchmarks such as hedge fund indices. As benchmarks become more important, it becomes less advantageous for a hedge fund manager to take risks that could lead to a performance that greatly exceeds the benchmark if doing so entails a substantial risk of falling short of the benchmark. As hedge funds are held to a similar standard of performance, performance will become more similar across funds. As institu- tional investors become more important, the manager’s skills will matter less compared to the other services provided to investors—reporting, risk management, transparency, liquidity, and ability to absorb large new investments. Moreover, many of these services can be obtained by institutions without paying a large performance fee to a hedge fund. Perhaps most strikingly, there is increasing evidence that the performance of hedge fund indices can largely be replicated by machines (Kat and Palaro, 2006), so that investors who want to achieve a hedge fund benchmark may have an inexpensive alternative to high-cost hedge fund managers. As a hedge fund succeeds, it faces pressure to become essentially a diversified financial institution. To understand this pressure, consider a successful hedge fund manager who specialized in one strategy. The manager’s net worth is largely invested in the fund. The manager runs an organization with substantial fixed costs that has access to large-scale investors and that provides services to these investors.
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Conclusion
We still have much to learn about hedge funds. We are not very good yet at assessing the risk-adjusted returns and the absolute returns of individual hedge funds. We have yet to understand fully the risks that hedge funds pose to financial institutions and to financial markets. Though we know that hedge funds can make markets more efficient, no analysis has yet reliably quantified the social costs and benefits of hedge funds. This being said, hedge funds on average have performed well over the last 15 years compared to mutual funds or to the stock market as whole. Indeed, the hedge fund industry may have played more of a role in creating liquidity and making markets efficient than the mutual fund industry. The hedge fund industry could do so because it was generally not regulated, so that funds were free to take whatever positions they wanted and to make full use of financial innovations. As the hedge fund industry grows, regulation becomes more likely, and large hedge funds are likely to become more similar to financial institutions. However, regulation should leave alone financial innovators who dream of new strategies and find savvy and well-funded investors to bet on them. Without such financial innovators, capital markets will be less efficient.
y I am grateful for comments from Joe Chen, Harry DeAngelo, David Hsieh, Ravi Jagan-
nathan, Andrei Shleifer, Jeremy Stein, Timothy Taylor, and Michael Waldma and for scientific assistance from Je´roˆme Taillard.
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