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2014 Curriculum CFA Program Level II Alternative Investments

Alpha and the Capacity for Hedge Funds to Increase Assets

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Introduction

Although the media and many investors perceive hedge funds to be uniformly risky, the facts are that little about the hedge fund universe is homogenous.  Some hedge funds hedge, whereas others take directional market risks. As a result of the private and opaque nature of hedge fund investing, a multitude of data challenges exist because hedge funds are not required to report their returns to regulators or any single database. Much of the literature describes adjustments and caveats to working with as- reported hedge fund returns and risk data. “Hedge fund” is a term used to describe a wide variety of investment strategies. As a general rule, these strategies are less regulated and more opaque than long- only funds offered by traditional investment managers. Rather than taking a long- only exposure to a single asset class, many hedge fund strategies involve the use of leverage, derivative products, multiple asset classes, and short selling. The net market exposure of hedge funds can vary over time, which makes it more difficult to analyze performance, man-age risk, and decide on the proper allocation of hedge funds in investor portfolios. Stulz (2007) draws several contrasts between mutual funds and hedge funds. Hedge fund assets have grown explosively to more than $1 trillion, which is now more than 10 percent of the size of the mutual fund industry. In the United States, mutual funds are required to report to the U.S. Securities and Exchange Commission (SEC). This requirement includes filing a prospectus, full disclosure of portfolio holdings on a semiannual basis, and the daily dissemination of a net asset value (NAV). Mutual funds are also subject to limits on leverage.  In exchange for this regulation, mutual fund providers are allowed to market their products to a wide variety of investors, ask for low minimum investments, and offer universal availability to investors. Hedge funds may earn exemptions from many of these regulatory requirements. By choosing to not market their investments to the public and restricting fund investments to certain types of high- net- worth investors, hedge funds are exempt from disclosure requirements. The unregulated nature of hedge funds, then, simply refers to the ability to provide less disclosure to investors and little or no disclosure to noninvestors. The opaque nature of hedge funds makes it difficult to calculate exact statistics on the size and performance of hedge funds because even their existence may not be disclosed. Although exempt from disclosure requirements, hedge funds are not entirely unregulated. Hedge fund managers must still follow other laws determined by securities regulators. Hedge funds may not misrepresent performance, steal client funds, or engage in insider trading, manipulative trading, or front running. In contrast to the low minimum investment and daily liquidity of mutual fund shares, investments in hedge funds are much less liquid. Most hedge funds report a NAV at the end of each month or calendar quarter. Many hedge funds also have lockup periods that restrict withdrawals from the hedge fund for some period of time. Popular lockups at hedge funds are one and two years, ad three- year lockups are becoming more common. A “hard lockup” states that no provisions exist for the redemption of hedge fund investments for the stated period of time. A “soft lockup” period suggests a minimum investment period, but investors have the ability to sell their shares before the expiration of the lockup period by paying a redemption fee, which is often in the range of 1–3 percent. As a result of regulatory requirements that limit the number of investors in each fund, hedge funds typically have high minimum investment requirements, generally ranging from $500,000 to $10 million per investor.

Learning Outcomes

The candidate should be able to:

a. distinguish between hedge funds and mutual funds in terms of leverage, use of derivatives, disclosure requirements and practices, lockup periods, and fee structures;

b. describe hedge fund strategies;

c. explain possible biases in reported hedge fund performance;

d. describe factor models for hedge fund returns;

e. describe sources of non- normality in hedge fund returns and implications for performance appraisal;

f. describe motivations for hedge fund replication strategies;

g. explain difficulties in applying traditional portfolio analysis to hedge funds;

h. compare funds of funds to single manager hedge funds.

0.5 CE

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Hedge Funds

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