Investment Strategies: Mutual Funds vs. Hedge Funds

Mutual Funds

• Strictly regulated and transparent, required to disclose portfolio holdings.
• Restricted investment strategies: no leverage, derivatives, short selling, small-cap, or micro-cap stocks.
• Invest primarily in traditional assets (bonds, stocks).
• Charge a flat management fee.
• Highly liquid; easily traded.

Hedge Funds

• Actively managed; aim for superior returns through manager skill.
• Utilize diverse strategies: leverage, derivatives, short selling, arbitrage.
• Not publicly traded; structured as private placements.
• Some actively influence company operations and capital structure.
• Offer access to alternative return streams and diversification benefits beyond traditional asset classes.

Hedge Fund Investing Rationale

• Access to unique return streams unavailable in traditional markets.
• Leverage the specialized investment skills of general partners (managers).
• Managers exploit market inefficiencies, such as identifying and shorting overvalued stocks—a strategy less common among traditional investors.

Adding Hedge Funds to a Portfolio

• Reduces portfolio volatility if hedge fund returns have low correlation with other portfolio assets.

Hedge Fund Risk

• Higher acceptance of complexity, illiquidity, and event risk compared to long-only investments.
• Often rewarded for managing complex securities.

Hedge Fund Characteristics

• High barriers to entry (significant capital requirements).
• Relatively anonymous; less transparent regarding information disclosure.
• High incentive fees based on performance.
• Illiquid; limited access to funds.
• Low correlation with traditional assets.
• Flexible investment strategies (short positions, derivatives, etc.).
• Fewer investment restrictions than mutual funds.

Hedge Fund Liquidity

• Less liquid than mutual funds due to infrequent pricing and trading.
• Often involve lock-up periods restricting withdrawals.
• Require advance notice for redemptions to allow managers time to liquidate positions without market impact.
• Liquidity varies depending on fund strategy.

Hedge Fund Fees

• Management fee: Typically 1-2% of assets under management (AUM), regardless of performance.
• Incentive fee: Typically 10-20% of profits exceeding a hurdle rate. Common fee structures are "1 and 10" or "2 and 20," referring to the management and incentive fees, respectively.
• Fee schedules can vary by investor, often favoring larger investors or those accepting less liquidity with lower fees.

Hurdle Rates

• Incentive fees are paid only after exceeding a predetermined return threshold (hurdle rate).
• Hard hurdle: Only profits above the hurdle are used to calculate incentive fees.
• Soft hurdle: All profits above the hurdle are used to calculate incentive fees.

High-Water Marks

• Incentive fees are calculated using a high-water mark (HWM), the highest previous net asset value (NAV).
• Incentive fees are earned only on returns exceeding the HWM. If the closing NAV is below the HWM, no incentive fee is paid.

Moral Hazard

• Asymmetrical incentive structure: Managers benefit disproportionately from profits, while investors bear the brunt of losses.
• This creates potential for excessive risk-taking due to option-like payoff structure.
• Risk-averse behavior may emerge after strong performance, encouraging managers to lock in gains.
• Conversely, large drawdowns might incentivize increased risk-taking to recoup losses and earn significant incentive fees.

Mutual Fund vs. Hedge Fund Fees

• Mutual funds: Flat management fees; no incentive fees.
• Hedge funds: Charge both management and incentive fees. This difference raises risk-taking concerns.

Hedge Fund Biases

• Information asymmetry: Limited transparency hinders objective performance evaluation.
• Selection bias: Only successful funds tend to report their performance.
• End-of-life bias: Funds ceasing operations stop reporting.
• Back-fill bias: Ignoring poor past performance in favor of recent positive results.
• Survivor bias: Databases may overrepresent successful funds that haven't failed. This leads to overestimation of returns and underestimation of risk when evaluating hedge fund returns.

Hedge Fund Strategies

• Macro strategies: Bet on macroeconomic trends (currencies, interest rates, commodities) using leverage and derivatives. High liquidity allows for quick reactions to market changes.
• Event-driven strategies: Profit from inefficiencies surrounding corporate events (mergers, acquisitions, bankruptcies).
• Relative value strategies: Exploit price discrepancies between related securities (e.g., convertible arbitrage). Convergence strategies profit from price alignment between similar assets. High leverage amplifies both profits and losses.
• Equity hedge strategies: Employ long and/or short positions in equities.
  • Long-short funds: Maintain a net long position.
  • Market-neutral funds: Aim for zero beta by hedging against market movements.
  • Short-selling funds: Focus on short positions.

Hedge Fund Return & Risk: Alpha and Beta

• CAPM (Capital Asset Pricing Model): E(Ri) = Rf + β(Rm - Rf) or Y = Alpha + β(x + E)
• Beta (β): Measures sensitivity to market movements. Positive beta indicates positive correlation with market returns, negative beta indicates negative correlation.
• Alpha (α): Represents manager skill; the portion of return not explained by market factors. Positive alpha signifies outperformance. Investors prioritize alpha as an indicator of a fund manager's skill.

Hedge Fund Investment Considerations

• Diversify across multiple funds and strategies.
• Conduct thorough due diligence: operational (risk controls, conflicts of interest) and investment (manager skill, strategy viability).

Funds of Funds (FoFs)

• Offer individual investors access to hedge funds with lower minimum investments.
• FoFs pool investor capital and invest across various hedge funds.
• Investors pay management fees to both the FoF and individual hedge fund managers.
• Incentive fees are typically paid to both levels as well, resulting in a "double layer" of fees.

FoFs: Advantages and Disadvantages

• Advantages: Access to multiple managers and strategies, professional selection and due diligence; potential negotiation for lower fees.
• Disadvantages: Higher overall fees due to multiple layers of charges, which may often lead to underperformance compared to direct hedge fund investments.

Conclusion

• Hedge funds diversify strategies beyond just investing in stocks or bonds.
• They can offer attractive risk-adjusted returns but at a considerable cost in fees and illiquidity.

Hedge Fund Beta and Market Performance

• Hedge funds with positive betas generally outperform the market during market upturns.
• Hedge funds with negative betas can generate positive returns during market downturns due to inverse correlation.
• Example: A hedge fund with a beta of -0.05 would see a 5% return when the market drops 10%.

Hedge Fund Strategies

Macro Strategies

• Identify and capitalize on broad market trends (currencies, interest rates, commodities).
• Employ long/short positions across global markets using derivatives.
• Historically, macro funds perform well during market crises.
• Investors should consider liquidity and crisis performance when allocating funds.
• Managers often have macroeconomic expertise and analyze central bank actions.
• Example: Long position in equities and short position in bonds anticipating interest rate increases.

Event-Driven Strategies

• Capitalize on price inefficiencies surrounding corporate events (mergers, restructurings).
• Target substantial price changes following these events.
• Analysis involves assessing sensitivity to equity, credit markets, and company-specific factors.
• High profit potential but also significant downside risk.
• Example: Long position in Company K and short position in Company D during a merger announcement.

Relative Valuation Strategies

• Exploit price differentials between related securities (stocks and bonds of the same company).
• Focus on price convergence of similar instruments.
• Generally perform well during stable market conditions with low volatility.
• High leverage exposes funds to substantial losses during market turbulence.
• Example: Convertible arbitrage – long position in underpriced convertible bonds, short position in the underlying stock.

Equity Hedge Strategies

• Involve long and short positions in equities or equity derivatives.
• Fundamental managers select stocks based on in-depth research; quantitative managers focus on factor exposures.
• Example: Long position in promising technology stocks and short position in underperforming ones.

Fund of Funds (FOFs)

• Allow smaller investments and access to diverse hedge fund managers.
• Charge management fees and two layers of incentive fees (one to underlying managers and one to FOF managers).
• This structure increases costs compared to direct hedge fund investing.
• Potential to negotiate lower fees exists.
• Provide access to a diversified portfolio for investors with limited time, knowledge, or capital.

Commodity Futures Market Participants

• Commodity producers and users primarily hedge risk by using futures contracts.
• Speculators (including hedge funds) trade for profit and provide market liquidity.

Collectibles Investment Market and Auction Houses

• Auction houses play a vital role, acting as agents and sometimes guaranteeing minimum prices.
• They offer transparency in pricing, significant market exposure, and liquidity for future sales.
• Buyers gain an edge by monitoring exhibits, establishing industry relationships, and analyzing undervalued items.
• Buying through auction houses are preferred over buying from collectors due to transparency, information, liquidity and market exposure.

Mutual Funds

• Strictly regulated and transparent, disclosing portfolio performance.
• Restricted investment strategies: no leverage, derivatives, short selling, or small-cap/micro-cap stocks.
• Focus on diversification across traditional assets (bonds, stocks).
• Charge management fees and offer high liquidity.

Hedge Funds

• Actively managed to generate returns through manager skill.
• Employ diverse strategies: derivatives, short positions, high leverage, arbitrage.
• Offer high return potential and diversification benefits.
• Privately placed, not publicly listed.
• Some act as active investors, influencing company operations for value creation.

Rationale for Hedge Fund Investing

• Access to alternative return streams beyond traditional assets.
• Leveraging specialized investment skills of fund managers.
• Exploiting market inefficiencies less common to other investors (e.g., shorting overvalued stocks).

Adding Hedge Funds to a Portfolio

• Can reduce overall portfolio volatility if their returns are uncorrelated with other investments.

Hedge Fund Risk

• Higher tolerance for complexity, illiquidity, and event risk compared to traditional long-only investors.
• Often rewarded for expertise in complex securities.

Hedge Fund Characteristics

• High barriers to entry.
• Relatively opaque information disclosure.
• High incentive fees.
• Low liquidity.
• Low correlation to traditional assets.
• Flexible investment strategies.

Hedge Fund Liquidity

• Lower liquidity than mutual funds due to infrequent pricing and trading.
• Lock-up periods and advanced notice for withdrawals are common.
• Liquidity varies depending on fund strategies.

Hedge Fund Fees

• Management fees: typically 1-2% of assets under management (AUM).
• Incentive fees: usually 10-20% of profits exceeding a hurdle rate.
• Common fee structures: "1 and 10" or "2 and 20".
• Fee schedules may vary based on investor size and liquidity conditions.

Hedge Fund Hurdle Rates and High-Water Marks

• Hurdle rate: Minimum return before incentive fees are applied.
  • Hard hurdle: Incentive fees calculated only on returns above the hurdle.
  • Soft hurdle: Incentive fees calculated on all returns exceeding the hurdle.
• High-water mark: Highest previous net asset value (NAV); incentive fees are only paid on returns exceeding the high-water mark, preventing double-counting of profits.

Moral Hazard in Hedge Funds

• Asymmetric incentive structure: Managers benefit significantly from profits but bear minimal losses. This creates potential for excessive risk-taking.

Key Differences: Mutual Funds vs. Hedge Funds

• Mutual Funds: Flat management fees, no incentive fees.
• Hedge Funds: Management and incentive fees.

Concerns with Hedge Fund Fee Structures

• Risk-taking behavior: Asymmetric incentives can lead to excessive risk-taking during drawdowns or overly conservative behavior after strong returns.
• Conflicts of interest: Misaligned incentives between fund managers (large personal investment) and clients (small percentage of portfolio) can impact risk management.

Hedge Fund Biases

• Information asymmetry: Limited transparency makes evaluating hedge fund performance difficult.
• Selection bias: Only successful funds tend to report their performance.
• End-of-life bias: Funds ceasing operations stop reporting performance data.
• Back-fill bias: Reporting only positive returns while omitting past losses.
• Survivor bias: Databases focusing solely on currently existing funds, omitting failed ones.

Consequences of Hedge Fund Biases

• Potential for overestimating returns and underestimating risk when evaluating hedge fund performance from databases.

Hedge Fund Strategies

• Macro strategies: Betting on macroeconomic trends (currencies, interest rates, commodities) across multiple asset classes using derivatives and leverage. Tend to perform well during crises.
• Event-driven strategies: Exploiting price inefficiencies around corporate events (mergers, bankruptcies). Highly sensitive to event outcomes.
• Relative value strategies: Profiting from price discrepancies between related securities (e.g., convertible arbitrage). Vulnerable to market turbulence.
• Equity hedge strategies: Long and/or short positions in equities, based on fundamental or quantitative analysis. Includes long-short, market-neutral, and short-selling funds.

Equity Hedge Strategy Types

• Long-short funds: Maintain a net long position, aiming for lower volatility than the market.
• Market-neutral funds: Fully hedged against market movements, relying solely on stock selection skill.
• Short-selling funds: Primarily net short positions, performing well in declining markets.

Risk in Hedge Fund Strategies

• Each strategy carries specific risks. Many hedge funds fail each year despite manager experience and past success.

CAPM and Hedge Fund Performance

• CAPM (Capital Asset Pricing Model): E(Ri) = Rf + β(Rm - Rf). Y = Alpha + β(x + E)
• Alpha: Excess return beyond market expectations (β). Indicates manager skill.
• Beta: Sensitivity of fund returns to market movements.

Hedge Fund Investment Considerations:

• Diversification among multiple managers and strategies is crucial for investors with significant wealth. Thorough due diligence (operational and investment) is essential.

Due Diligence

• Operational Due Diligence (ODD): Assessing risk controls, conflict of interest, and operational efficiency.
• Investment Due Diligence: Evaluating manager skills, performance, and investment strategy.

Fund of Funds (FoFs)

• Allow smaller investors to access hedge funds.
• FoF managers select and monitor underlying hedge funds.
• Investors pay management fees and incentive fees at two layers (FoF and underlying hedge funds).

FoF Structure and Fees

• Two layers of fees: FoF management fee + incentive fee; also fees from underlying hedge funds.

Benefits of FoFs

• Simplified access to hedge fund strategies.
• Professional manager selection and monitoring.
• Potential for fee negotiation.
• Lower minimum investment requirements.

Disadvantages of FoFs

• Higher overall fees than direct hedge fund investments. Often underperform direct investments due to double-layered fees.

Conclusion

• Hedge funds are not a distinct asset class but use diverse strategies to generate returns.
• While they offer high risk-adjusted returns, substantial fees and illiquidity are inherent.

Alpha vs. Beta: Selection Criteria for Hedge Funds

• Alpha: Measures manager skill independent of market movements; positive alpha is desirable.
• Beta: Measures market sensitivity; can be positive or negative depending on strategy. Positive beta funds are better in bull markets, while negative beta funds offer downside protection.

Hedge Fund Beta and Market Performance

• Hedge funds with positive betas generally outperform the market during market gains.
• Hedge funds with negative betas can yield positive returns even during market downturns due to inverse correlation with market performance.
• Example: A hedge fund with a beta of -0.05 would see a 5% return if the market drops 10%.

Macro Strategies

• Focus on identifying and capitalizing on broad market trends (currencies, interest rates, commodities).
• Employ long or short positions across global markets using derivatives.
• Often outperform during crises due to anticipatory analysis of market conditions.
• Managers typically possess strong macroeconomic backgrounds, enabling analysis of central bank actions and their impact on markets.
• Example: Long position in equities and short position in bonds if interest rates are expected to rise.

Event-Driven Strategies

• Profit from price inefficiencies surrounding significant corporate events (mergers, restructurings, etc.).
• Employ fundamental analysis, considering equity, credit, and company-specific factors.
• Potential for substantial profits but also significant losses depending on the success or failure of the events.
• Example: Long position in a target company and short position in an acquiring company during a merger.

Relative Valuation Strategies

• Exploit price discrepancies between related financial instruments.
• Focus on convergence in prices of similar securities.
• Perform well in stable markets with low volatility.
• High leverage can lead to significant losses in turbulent times.

Equity Hedge Strategies

• Involve long and short positions in equity or equity derivative strategies.
• Stock selection relies on deep company research (fundamental analysis) or quantitative factor exposures.
• Fund managers may employ concentrated (fundamental) or diversified (quantitative) portfolios.

Fund of Funds (FOFs)

• Allow smaller investments in hedge funds through a collective fund structure.
• Charge management fees and two layers of incentive fees (one to underlying hedge fund managers, one to the FOF manager).
• Offer diversification across multiple hedge fund managers but with higher overall fees compared to direct hedge fund investment. - This higher fee structure is a potential disadvantage but fees may be able to be negotiated.
• Provide access to small investors due to reduced minimum investment requirements.

Commodity Futures Market Participants

• Commodity producers and users utilize futures contracts primarily for hedging.
• Speculators and arbitrageurs (including hedge funds) trade for profit and provide liquidity to the market.

Auction Houses in Collectibles Investment

• Auction houses act as agents, providing transparency, market exposure, and liquidity to the art market.
• They provide market information and price ranges, reducing information asymmetry for buyers.
• Choosing to buy through renowned auction houses (e.g., Sotheby's, Christie's) mitigates these inherent risks in the high-value art sector.