Drawing on empirical evidence available in the literature, critically assess the ability of hedge funds in generating excess returns.
Hedge funds generate high returns as well as huge risks due to its unique and predominant characteristics such as flexible investment strategies, dominant sophisticated investors and its private financing. Hedge fund strategies vary enormously, each of them has its own risk and return characteristics. This article aims to critically analyze the effectiveness of hedge funds in generating excess returns and explore whether it is a perfect investment choice.
Hedge Funds, Long/Short Position, Risk and Return.
Investment in hedge funds has become increasingly popular in today's challenging global economic environment. Theoretically, hedge fund is a private investment pool that can be invested in large range of foreseeable opportunities. Compared to mutual funds, hedge funds only open to a limited range of institutional or wealthy investors and are not restricted by the Securities and Exchange Commission (SEC) regulations, thus it can pursue more speculative opportunities (Bodie, Kane and Marcus, 2008). Ackermann (1999) pointed out that the main aim of hedge funds is reducing systematic risk and pursuing high returns by using different investment styles and financial instruments. As the unconventional techniques that hedge funds based on and its high uncertainty, many people suspect its effectiveness in generating excess return (rate of return in excess of the risk-free rate). Investing in certain types of hedge fund is a really riskier proposition and can cause both anxiety and excitement.
The structure of this article is as follows. Part two briefly introduces the history of hedge funds. Part three explores the effectiveness of different hedge funds strategies (Event Driven, Relative Value, Directional, Global Macro) in generating excess returns. Finally, part four gives the conclusion and some implications from this study.
2. A Brief History of Hedge Funds
Hedge fund has a long history as it has existed for almost 50 years. According to Caldwell (1995), the first hedge fund was formed by Albert Wislow Jones in 1949. However, hedge funds were neglected by investors when they were firstly introduced to market. This situation did not change until 1986 when an article in Institutional Investor reported that Julian Robertson's Tiger Hedge Funds had annual net returns of 43% during its first six years. This news attracted attentions of all investors and increasing interests had been excited towards hedge funds. Moreover, the reduction in the threat of worldwide inflation as well as the growing maturity and diversification of financial instruments had brought more opportunities to hedge fund investments. From then on, hedge funds face a rapid development. It is indicated by Ackermann (1999) that, since the late 1980s, the number of hedge funds had increased by more than 25 percent per year. The amount invested globally in hedge funds rose to approximately $1 trillion by the end of 2005, which was about twenty times as much as the number in 1990 (Malkiel and Saha, 2005).
3. The Effectiveness of Hedge Funds in Producing Excess Returns
Hedge funds face some special risks that could greatly affect their abilities of generating returns. One critical factor is leverage risk, which means the loss will enlarge when wrong anticipation is taken. This situation occurs because hedge funds typically borrow large amount of money in addition to initial investment. Another risk comes from short-selling. As most hedge funds use short selling strategy, the investors will get high returns when their betting is correct, on the contrary, they will suffer huge losses if the market turns against their anticipation.
In order to comprehensively explore the abilities of hedge funds in yielding excess returns, it is significant to classify them according to their different investment styles. There are four main hedge fund strategy groups, which are Event Driven, Relative Value (also called Arbitrage or Market Neutral), Directional (also named as Equity Hedge) and Global Macro. Effectiveness of generating returns and risk characteristics vary enormously among those different hedge funds strategies.
3.1 Event Driven
Event driven hedge funds refer to funds that exploit pricing inefficiencies induced by anticipated particular corporate events (Fung and Hsieh, 1999). The two main principals of event-driven are merger arbitrage and distressed securities.
Fung and Hsieh (1999) indicated that funds that actively specialize in corporate bankruptcies and reorganizations mainly through bank debt and high yield corporate bonds are called ‘distressed securities' or ‘distressed debts'. Distressed securities are always thought to be undervalued because of risk-averse feature of investors, insufficiency of analysis knowledge as well as the restriction of regulations. It is expected that the value of those selected distressed securities will rise after purchasing them at a discount rate concerning their intrinsic values. If the prediction is correct, then excess return will be generated in the term of price differences. Nevertheless, practice of distressed securities is hard as it is a kind of professional investment that requires adequate expertise and ability to diversify and manage the portfolio.
Another well-known event-driven strategy is merger arbitrage which focuses on mergers and acquisitions activities. The strategy involves simultaneous taking long position of the targets equities and going short the equities of acquirers, and then profits from the spread between current market price and the offer price (Fung and Hsieh, 1999). The merger arbitrage strategy is quite successful in generating excess returns. According to Liang's (1999) study of three-year period (1994 to 1996), the highest return rate was found in the merger arbitrage fund group. However, this hedge fund investment sometimes fails and brings huge loss due to the risks it faces. The main risk factors for the merger arbitrage strategy include deal risk and portfolio risk. Deal risk refers to all factors that could prevent or delay the closing of the deal, such as government disposition, while portfolio risk means factors that may arise in the further assembly and management of the merger arbitrage portfolio (Demeter, 2007).
3.2 Relative Value (Arbitrage or Market Neutral)
Relative value also named as Arbitrage or Market Neutral, and it aims to exploit pricing inefficiencies between related assets that are mispriced. It has two popular types which are fixed income arbitrage and convertible arbitrage. In details, fixed income arbitrage does not bring obvious excess returns. It may perform well in calm market but behaves negatively when facing volatile markets. Turn to convertible arbitrage; Liang (1999) stated that convertible arbitrage works through purchasing chosen convertible bonds and then selling short the corresponding shares. Although this hedge fund can hedge a portion of the equity risk, it is still not risk-free as it cannot hedge the interest rates risk, credit risk and some other systematic risks.
3.3 Directional (Equity Hedge)
Long/short equity is the most common style in equity hedge funds. This strategy holds a long position in undervalued shares and a short position in overvalued shares to hedge assets risks. The average excess return of this strategy has greatly exceeded both the S&P 500 and the MSCI World Index during last one decade. However, Michaud (1993) argued that the long-short strategy is not perfect; increases in active return are generally accompanied by increases in active risk. The effectiveness of long/short equity in producing returns depends on the choices of less index-constrained portfolios that could increase the active return/risk ratio (Michaud, 1993).
3.4 Global Macro
Global Macro funds commonly use all market and instruments to take bets on the major risk factors, such as currencies, interest rates, stock indices and commodities. One case in point is the famous George Soros' Quantum Fund which once made US$1 billion returns by anticipating that the British Pound would drop out of the European Rate Mechanism (ERM) in September 1992 (Fung and Hsieh, 1999). Global Macro strategy had provided consistent returns with low volatility, but what makes it different from other hedge fund strategies is that global macro funds have a strong correlation with stock market indices. As a result, macro funds' ability of generating returns is strongly affected by the fluctuations in stock market.
Studies show that, in most cases, hedge funds work very well and can generate high returns to investors. Even during the period of world economy crisis in 2008, hedge funds performed substantially better than the average S&P 500. However, due to the nature of hedge funds, high returns generated are usually accompanied with high risk. Hedge funds may fail due to the wrong anticipation of market movements and thus can cause huge loss to investors' value. The sensational meltdown of Julian Robertson's Tiger Fund in March of 2000 is one example. Hedge funds have various strategies, each has their own risk and return characteristics. Given the above analysis, it is reasonable to conclude that investment in hedge funds must be rational as it is not an absolute perfect investment method.
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