The data below, supplied by Financial Risk Management, the hedge fund specialist, tracks the performance of every type of hedge fund conceivable. The figures on the opposite page are FRM estimates of how the industry has grown in the past seven years and more specifically, which of the four classes of hedge funds have flourished the most. The two separate bar charts are useful for comparison with one and other. With returns some years running at 30%, it makes it more difficult to ascertain the relative size of the industry. What the more detailed bar chart on the opposite page shows is the net flow of new funds allocated to each asset class, something that John Capaldi, senior vice president at FRM, says is key to differentiate from compounded growth.
Strategies associated with hedge funds vary considerably and for ease of presentation, the data below tries to place the myriad approaches into similar categories. As the name suggests, directional trading comprises strategies that speculate on the direction of the prices of currencies, commodities, equities and bonds in the futures and cash markets. Investment horizons vary considerably but managers are able to change their positions as a situation unfolds. Of an estimated $616bn (e 678bn) market, this class of funds makes up $138bn making it the second largest.
Under the relative value or arbitrage approach come strategies that try to find and exploit spreads between the prices of financial assets or commodities. These strategies incur no intentional market risk although the spread risk may be significant. This approach is firmly in the arena of the number crunchers- often statistical and mathematical techniques are used to identify and exploit opportunities, particularly where the hedging strategy requires frequent trading in order to maintain neutrality. Opportunities that the strategies try to exploit tend to be both low risk and low return so the managers will typically have significant leverage. This category accounts for $110bn in assets.
Long/short equity strategies are the most popular and most easily recognised type of hedge fund. Managers mix both long and short positions to varying degrees in an attempt to increase investment specific sources of return while reducing systematic risk. Key to this strategy is gauging which stocks are under and overvalued and buying and selling short accordingly until the market realises the mispricing and readjusts. Market exposure within the various approached varies considerably and so therefore do the risk and return profiles. According to FRM figures, equity long/short accounts for more than half of the hedge fund business or more than $338bn.
Specialist credit is on the fringes of the hedge fund world in that it provides credit in one form or another and as such is similar to private equity investment. Specialist credit strategies are based around lending to credit sensitive issuers, normally below investment grade. The credit manager typically carries out high due diligence and purchases those securities he feels are inexpensive. Returns come from capital appreciation, positive carry or both but the key to any specialist credit investment is the level of due diligence, the timing of the investments and the assumption of credit risk. Credit sensitivity may enable the manager to negotiate extremely favourable terms. This class is relatively niche and represents $27bn in assets.
The table at the bottom of the page shows how the geometric returns, standard and downside deviation and largest drawdown vary across the strategies and how they measure up to similar data for the S&P 500 and the Lehman aggregate. There are also Sharpe ratios for the various strategies. What this represents is the unit of return per unit of risk. The mathematical formula for standard deviation does not distinguish between positive and negative deviations about the mean. Downside deviation only uses observations below Libor and if it therefore exceeds the standard deviation, the volatility has historically been on the downside; if it is smaller, vice versa.
As the figures suggest only long/short outperformed the S&P 500 between 1994 and 2001. However, volatility for the hedge fund strategies was significantly lower and their Sharpe ratios, or unit of return per unit of risk, are considerably higher. As for the graph immediately above it, this is probably the most relevant for any pension fund or institute interested in investing in hedge funds. The graph shows the annualised geometric return between January 1994 and June of this year and the annualised standard deviation over the same period.
The two lines and their corresponding points compare the risk return profiles of the four hedge fund strategies with a few more traditional indices. If the graph is to be taken at face value then the notion of investing in hedge funds appears absolutely failsafe. But this representation can be misleading and is no exception to the old adage of there being lies, damned lies and statistics. Take the MSCI World index which, on average, has produced returns of 9.3% in the past five years at an average standard deviation of 13.8%. The risk return profiles for the four hedge fund strategies are in the north west quadrant relative to the MSCI coordinate. In other words, they suggest higher returns for less volatility. Compare also the average return of directional trading and the S&P 500- on the basis of the graph, the two produce roughly the same average return but the volatility of the directional strategy is half the S&P 500. The chart, often used to support hedge fund investing, is somewhat misleading as the points only refer to the average hedge fund manager. Nowhere in the graph is there any reference to the distribution of potential returns. No one doubts that if you pick a top performing hedge fund manager then the returns can be spectacular. Pick a dud though and the returns can be equally disastrous. Due to short positions and the leverage common to some of the strategies, it is possible to lose all the initial investment.
The charts above left demonstrate the growth in the overall hedge fund market. In absolute terms, the value of the total assets in the class has risen to $616bn at the end of June from $161bn in 1994. The purpose of the lower left chart is to show the funds that have been allocated to and withdrawn from each strategy. For although the top left is useful for illustrating the size of the market, returns of over 30% per year in some categories distort real and net growth. FRM’s Capaldi says that the majority of this though is simply compounding. New inflows for the last two and a half years is roughly $65-70bn, during 1998, new money flow was about zero, whereas 1996 and 1997 were roughly 20bn per annum.
Talk of a hedge fund craze and a hedge fund bubble is rife and misplaced; these figures need putting in perspective. Capaldi says that the amount of capital that has left the investment bank proprietary trading world over the same period probably exceeds the 60-70bn growth over the same period. In fact it’s not unrealistic to see the growth in hedge funds as coming directly from the investment banks. According to Capaldi, hedge funds say that one of the reasons they are able to make money is because market making desks at investment banks nowadays have a far lower risk appetite. Instead they are much more prepared to field out large positions to hedge funds who are able to warehouse the position.
“In the old days, if a big client came and gave you a position as a market maker the big investment banks would be rubbing their hands thinking this was a good chance to make five basis points whereas nowadays they are happy to dump the position and make one and a half points. The appetite for risk in investment banking now at the market making level and at the proprietary capital level appears to be much lower.”
Many of the individuals at the hedge funds were those previously doing much the same at the investment banks. Taking this interpretation, the growth in the hedge fund world is in practice a transfer of both human and investment capital. In the greater scheme of things the $20bn-$30bn in new money per year is relatively insignificant according to Capaldi.
Those sceptical about hedge funds would perhaps highlight leverage as being a more representative figure and certainly it is more revealing than overall assets. The relative value and arbitrage strategies are the only ones with any significant leverage at the moment. According to FRM, with the markets as difficult as they are at the moment, the amount of leverage in fixed income arbitrage strategies is currently running at between 15-20 times balance sheet making it the most leveraged strategy.
Convertible bond arbitrage is probably running at around 3-5 while the rest of the arbitrage strategies are using between two and three times leverage. A ball park figure for leverage in the arbitrage sector as a whole is probably somewhere between three and four times taking positions in balance sheet exposure to somewhere between $300bn-$400bn. “Compared to global market capitalisation, this is not a massive exposure,” says Capaldi.
In the other three strategies, the amount of leverage being used is very small. Long short strategies are roughly unleveraged at the moment whereas during 1999 these strategies were typically running at one and a half to two times. In the US, hedge funds set up under Regulation T are unable to exceed two times leverage and Capaldi estimates that the entire industry is probably running at about this level, representing exposures of roughly $1.2trn. Again, in the greater scheme, this is not that substantial.
Growth in the industry has recently been driven by the long/short equity and arbitrage strategies. New money coming to hedge funds in the last three years has been dominated by these two primarily because of new markets opening up. In Europe there has been very strong growth in the number of new equity funds. “A lot of these are growing up out of traditional asset management companies eager to maintain staff, and eager to provide their investors with an alternative solution to long only investing,” says Capaldi.
There has also been significant growth in the number of long short managers in the US, home of the hedge fund. Critics of hedge fund investing are quick to suggest that if this growth continues then the number of arbitrage opportunities will dwindle. This is apparently a non sequitur though. Says Capaldi “the reason the equity long short managers are able to make better risk-adjusted returns is that they are more flexible and are able to move in an out of positions quicker. The average long short fund has around $300m-$700m and can therefore move assets to adjust its balance sheet relatively quickly. Traditional long only managers, often with hundreds of billions, do not have the luxury being able to adjust their exposures so quickly.”
Going back to the various returns, long/short equity strategies during the bull market (1994-March 2000 for argument’s sake) have on average slightly outperformed indices and done so about with around half the volatility (see table) In the 18 months since march 2000 when equity markets began to correct, the same managers have outperformed indices significantly.
Capaldi says that since March 2000, returns from the long/short equity funds have been relatively flat. This is quite something considering the Dow is down 12%, Nasdaq 68% and the S&P 22%. In addition the associated volatility and in particular the downside volatility is below half that of the indices. However, the dispersion of returns from managers vary enormously. Some managers have produced returns of 30% or so while some have registered similar losses. “The range of performance in this period has been huge so selecting the right manager is very important” says Capaldi.
In terms of the arbitrage approach it is merger arbitrage strategies that have had the roughest ride. Returns of 18% were not unusual during 1999 and 2000 but this year has been more difficult and returns are consequently nearer 2-5%. This is due to fewer opportunities thanks to less corporate activity coupled with a strong inflow of capital into merger arbitrage between 1999-2000 when returns were easier to achieve. More importantly though, the dispersion of returns in some of the arbitrage and value strategies has also widened. There are some fixed income arbitrage managers that have found 2001 very rewarding, others have found it far more difficult.
Capaldi says another sector of interest is that of convertible bond arbitrage, which posted very strong returns during 1999 and 2000. Unlike merger arbitrage though, convertible bond managers have maintained performance in 2001. “This is mainly due to managers being creative in the way they hedge their credit risk because convertible bond arbitrage is an amalgam of fixed income, equity volatility and credit spread risk. The thing that has been difficult this year has been credit spread risk. By using credit derivatives and other hedging techniques, many convertible bond managers have managed to avoid the losses associated with credit spreads widening while continuing to make gains from the volatility in equity markets.”
Directional trading managers have not had a particularly good year until this September when many of the systematic traders made very strong returns mainly through positions in interest rate markets. Overall systematic traders have done pretty well with the gains concentrated in September. Returns on other directional strategies have been more mixed.
In specialist credit, very much the niche sector of hedge funds, average returns have been around 7.25% for the year to date opposed to an average of around 13% per year between 1994 and 2001. Distressed debt is an area where some managers have been able to make some very good returns. According to Capaldi this sector has been somewhat depressed for two or three years due to an excess supply of distressed assets. It now appears that more money is flowing into distressed markets and some of the other high yield markets now that the spreads have widened. “There’s slightly better supply/demand balance in the industry which is allowing people to make some positive returns.” But again the dispersion for these strategies is very large.
Another issued discussed frequently is that of capacity. In many of the arbitrage and value strategies the issue of capacity tends to felt most acutely is very cyclical. “What you find is that when an arbitrage strategy has a year or two of good steady returns, a lot of people try to jump on the strategy- you’ve seen this happen with merger arbitrage. Sooner or later that individual strategy gets clogged up with too much capital which then tends to move elsewhere. There is a definite cyclicality to the returns of most arbitrage strategies. There are periods when people move capital away, opportunities appear and the capital reappears. There’s quite a lot of fast money that revolves around arbitrage strategies, some of it coming from the investment banking world.”
In these strategies, some are therefore oversubscribed, others undersubscribed. “The trick is to interview as many managers as possible to find out what the opportunities are in each of the strategies.” In the other three sectors Capaldi believes there is not a problem. Collectively the assets held by equity long short managers are probably less than those held a very big long only manager.
“This is where I think the logic sometimes gets confused. There’s a belief think that if more and more people go into long short equity then the opportunities will disappear. But the opportunities are driven by the size of long only money relative to the volume of money in long short. It the nimbleness and agility that really makes the difference. It’s not that a hedge fund is quicker to spot that stock A is undervalued with respect to stock B. Long only managers do this as well but it’s just that they cannot move the positions as quickly, nor are they generally able to go short.”
So despite the flurry of new funds being launched in Europe, Japan and Asia, the size of the market is still, relatively speaking, insignificant in its own right. As such, the future for the industry remains promising according to Capaldi. “I don’t believe there is a capacity constraint at this stage nor in the foreseeable future as this universe of managers is so small with respect to global equity market capitalisation and trading volume.”

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