History and Overview of Hedge Funds

Hedge funds have in the recent past received a lot of media attention due to the complexities associated with them. It is imperative to note that, despite their popularity in the market, there exists no concurrence on a definition. However, hedge funds represent a pool of private investment portfolio, attracting affluent investors and large corporations. Investors hedge risks by diversifying their investment balances on stocks, bonds and other currency markets. Hedge funds also represent a collection of loosely regulated mutual funds attracting venture capitalist through investment in either cash or derivative markets. They represent an investment fund designed to circumvent security regulatory procedures. Additionally, the size of the hedge funds manager is estimated to amount to $1.4 trillion (Agarwal, 2004)

Alfred Jones pioneered the start of the first hedge fund in 1949. He used a strategy of selling short and leveraging. The presentation of his strategy had the effect of defining hedge funds as an investment portfolio earning unconventional returns. Alfred’s effectiveness in hedging risk seems to have provided for the coinage of that word. Returns on hedge funds were outdoing traditional mutual fund, and this lure of large returns saw the entry of prominent names in business, such as George Solos and Warren Buffet. Consequently, over 100 hedge funds were born in a short spun of time. Institutions were also quick in seizing this opportunity, hence a massive growth in size and popularity. Hedge funds have since then developed over time; the modern hedge funds seem un-hedged. Modern investors and hedge managers have been drifting from Alfred’s strategy into funds that purpose to secure absolute returns (Americanexpress, nd).

Despite the controversy surrounding hedge funds, they continue to lure and drive the investment banks’ agenda, attract regulators’ attention and dominate mainstream media. Their wide misunderstanding is due to the vague nature of strategies employed during their implementation, need for extremely smart managers or uncertain record of accomplishment in terms of success or failure. Attractiveness of hedge funds arises out of their approach to returns and risks in investments (Bloomberge Markets, 2011).

Traditional investors abide by the rules of the efficient-market hypothesis, which assume a perfect market with accurate information and price movements. Hedge funds, on the other hand, go against those rules and position themselves in a manner that aids them in exploiting market imperfections. Unlike outdated investment models that expect investors to move their trading bets in the direction of the market, hedge funds managers make returns, irrespective of a direction or cycle. It is worth remembering that hedge funds attain maximum flexibility in portfolio construction through private partnerships. Hedge funds enjoy a liberal field free from tight regulations and boast of unlimited field of reach. In contrast to mutual funds that have a limit of bonds and stocks, hedge funds cover extensive areas of investments. These include website domains, futures, and real estate, among others (Cima, nd)

Advantages of Hedge Funds

It is imperative to note that hedge funds’ returns are comparatively low not because of their ability to hedge, but rather due to the structural makeup of the funds per se. This has continued to provide hedge funds with a competitive edge over other investment portfolios, such as mutual funds.

Managerial Discretion and Incentives

Managerial incentives refer to various attractive packages offered to managers of hedge funds. Mostly, these incentives consist of a chance of co-ownership. On the other hand, managerial discretion is the degree of mangers freedom to decide key investment factors; this is normally enhances through lock-up to capital and restrictions on fund investors. In line with their advantageous structure, hedge funds employ a varying fee charge on a range of different investors. They are under skilled management like mutual funds, but unlike their counterparts who charge a management fee based on the total assets under management, hedge funds levy their fee as profits are generated. This approach resembles the commendation schemes created by companies to check the excesses of agency problem. The tying up of remuneration to returns generation creates congruence between the investor’s endeavor and manager’s conquests. Their goal of wealth maximization receives streamlining through harmonizing of their expected returns, i.e. pegging it on the managerial skill and effort. Empirical studies on the correlation between stronger discretion, choice and improved performance are receiving extensive focus. The findings point in the same direction, thus confirming that it is a factor. Most prominent feature deserving credit for this trend is the aspect of co-ownership and the long-term requirement of capital commitment. The two allow discretion to the fund managers and offer an attractive investment opportunity (Naik et al, nd).

Managerial Investment and Choice

Managers of hedge funds have a mandatory requirement of investing a sizable amount in the fund. As mentioned earlier, the extemporal performance of hedge funds receives its driving force from other areas not underlying market returns (denoted as beta) alone; rather, hedge funds performance has its basis on its manager’s wealth of skills. The structural aspect of allowing managers to invest their own funds together with the investors has been alluring the best and skilled managers into this industry. Studies do show that this industry is rich in managerial expertise; the Wall Street Journal called it the Major League. This is an advantage over all AIS, since they offer little or no such incentive (Fung, W & Hsieh, A , 2001).

Hedge fund managers and investors exhibit a principle-agent relationship. Normal company strategies to mitigate agency problem arising out of this relationship include commendation schemes, agency costs of auditing, regulation or market forces reliance. The hedge fund structure relies on the first aspect of incentive contract; it comes in a bonus or an asymmetric plan. Most managers have an entitlement to a 1% management fee and 14% of profits annually. However, the catch is that managers receive these bonuses subject to attainment of a particular return, which is higher than the projected level. This ensures recovery of past losses, as managers strive to qualify for this bonus, as well as a general culture of diligence to hard work. The character of managerial investment in the funds is unique due to offering a competitive motion. Studies show that hedge funds consistently outperform mutual funds. There is a common market trend in the US markets, whereby managers of hedge funds form part of general partners in the limited partnership of hedge funds. This, in accordance to the Stipulation of Partnership Act, makes partners liable to any claims arising under the hedge contract. Consequently, bankruptcy or dissolution claims have linkage with the mangers financial wellbeing. This character is the wisdom of hedge fund market, since it creates a unique bond between managers and investors, thus making them converge the same, yet different (Connor & Lesarte, nd).

Minimal Government Regulation

Hedge funds position themselves in a manner that assists them to exploit inefficiencies salient in the market structure as a strategy. The funds experience few regulatory bottlenecks and as such focus on this opportunity. Their managers, therefore, narrow down to the intricacies of these shortcomings and exploit them. The unregulated capital borrowing allows hedge funds to borrow funds and expose their presence. Hedge funds are an equivalent of a limited partnership in structural approach. This unique formation shields them from incorporation and subsequent subjection to the requirements of the Company’s Act. The United States also comprise many offshore hedge funds, which are outside the scope of the SEC regulation.  On the other hand, mutual funds experience tight regulation and deep scrutiny by SEC. Mutual funds have high disclosure requirements, which warns off investors against risky markets. Essentially, this limits mutual funds’ ability to use leverage, short selling or venture in the markets, as hedge funds do. However, this has a disadvantage to hedge funds, since it implies that they cause further inconvenience for investors, while mutual funds enjoy this privilege (Fung, W & Hsieh, A, 2001).

Diversification of Investment

One outstanding driving force behind investing in Alternative Investment Securities or hedge funds is a craving for diversification. Hedge funds are by far the investment option that offers the best range of diversifiable portfolio. They create risk adjustment to returns through this diversification and consequently lower investor and manager’s risk. Another prominent advantage of hedge funds is external advantages. They enjoy advantages peculiar to themselves due to their ability to supply the market with vast amounts of liquidity. Consequently, benefits, such as low rates, insider information and unhindered market access, accrue. The absence of obligation to the laws of the land within which they operate have granted them extreme flexibility in options. They are, therefore, able to use borrowing advantage, short selling, and investment with high concentration or derivatives (Dennis, 2001).

Strategies in Hedge Funds and the Risk Attached

Interest in hedge funds grows by the day. This is partly due to the urge to understand their true nature beyond their opaque presentation. However, mounting interest in hedge funds is attributable to a number of financial occurrences. Some of the notable market events that contribute to this include the 2008 Global Economic Meltdown and the 1998 Long-Term Capital Management brush with bankruptcy. Additionally, their unconventional play in the investment field is not only intriguing to academicians but also worrying. This has necessitated investigations into the risk associated with this liberal approach. The strategies employed in hedge funds are wide and diverse, changing in accordance to the managerial style and the demands of times, but each strategy has an associated return and risk. However, these strategies, despite their numbers, fall into three principal categories, such as: event-driven strategies, which develop and adapt to the changes within and without the hedge fund; global macroeconomic perspective, which shapes itself according to the prevailing macroeconomic variables; characteristics strategy, which is usually in pursuance of the unique conception of hedge funds ideology (Fell, 2009).

Event-Driven Strategy and its Risks

This strategy finds an investment opportunity in certain trading events, such as mergers, takeovers, consolidations, liquidation or bankruptcies. Through hedge funds, institutions enjoy unique advantages, such as access to sensitive insider information affecting companies within a given market. They use this knowledge for evaluating inconsistencies prior to or after such events to invest based on their prediction concerning the anticipated price of a security in question. The event-driven strategy concerns unique situations, such as company restructuring, this requires the hedge manager to be accurate in predicting forthcoming events. Another field of interest for this strategy is merger arbitrage, which means that hedge fund managers place themselves strategically to reap the fruits of such distressful occurrences. This includes investing in a company facing eminent bankruptcy, hence enjoying the benefits of rescuing it. The risks associated with this strategy are self-evident due to uncertainty and wrong prediction. Any erroneous analysis of facts results in irreversible burden of risk, such as investing in a company facing a lawsuit (Fox, 2012).

Risks Associated with Directional Strategy

This strategy is dependent on utilizing market movements and trends to make gains. The risk apparent in this strategy results from the use of computer programs as the major source of pattern prediction. This strategy also faces increasing risks, since it is extensively dependent on a how fast events take place. The extension of this strategy to investments in emerging markets creates more uncertainty and risks, since majority of emerging markets lack efficient pillars that ensure consistency. Computer models will, therefore give a considerable degree of inaccuracy (GAO, 2009).

Global Macroeconomic Strategy and Associated Risks

 A popular term in this strategy is the Big Picture strategy. Hedge funds managers make an analysis of macroeconomic variables and arrive at an investment portfolio that gives a risk-adjustable return. This directional strategy can be either discretionary or systematic. The discretionary aspect of the global strategy rests on the fund manager’s choice of investment fields. On the other hand, systematic approach relies on computer and mathematical softwares. There is a risk associated with this strategy because it involves limited human discretion beyond the stage of writing the software. The distance between investment decisions and the manager responsible for them is a potential opportunity for managers to distance themselves from decisions they ratify. This strategy has an advantage of a vast portfolio field, allowing for short and long selling, and thus letting the funds make gains in times of either recession or expansion (Giraud, 2004).

Neutral Market Strategy and Associated Risks

 This strategy, also known as relative value, is applicable when hedge fund managers detect price differences that offer a potential gain. The price differences may result from security mispricing. The discrepancy manifests itself upon a comparison of the security price of interest and its peers in the same platform, market or league. Since this strategy is not directional and is highly dependent on value judgment of managers, it poses risks. In the event that the security in question is not accurately estimated or presented at the wrong price on purpose, chances are that hedge fund managers will arrive at a decision devoid of pertinent facts, and hence erroneous (J P Morgan, 2012).

Symmetric Plan and Penalization

 A popular strategy in hedge funds management, as already discussed, is the application of penalties to managers upon failure to reach the projected performance. Notably, managers have to choose a resource amount and portfolio level of risk that lead to improvement of returns to attain the watermark. While this approach establishes an alignment of interest between managers and investors, it may lead to managers choosing investment levels that are below optimal. This will be evident in the manager’s attempts to reduce the performance level to a mark that is not too high, and hence reduce the risk of penalty. Research also links high incentives with reduction of the amount of risk the manager is willing to take. There is also an imbalanced level of relationship between bonus and symmetric plans. The later is superior to bonuses, while bonuses enable managers to select higher risks and invest less resource. As a result, hedge funds are at a risk of failing in a balance of the two, which would lead to imbalances of choice (Magnumfunds, 2012).

Information and Disclosure Risks

Perhaps the highest risk associated with hedge funds strategies is the absence of comprehensibility on the same. The scenario arises from the behavior of fund managers diversifying funds’ performance within a scope of different strategies. The performance so generated is, therefore, a function of different portfolio strategies. Since risk analysis is usually attendant upon the performance it affects, complications arise due to this dynamic allocation of funds across different strategies. Another information risk is the risk analysis methods employed in the computation of hedge funds’ risks. Popular linear-factor models for measuring risks use a standard asset benchmark. They are used very often, but these models fail to capture the non-linear returns character of hedge funds. The risk has been consistent with the erroneous conclusion that hedge funds contain no systematic risks (Fung, W & Hsieh, A, 2001).

Hedge funds are a part of structure of private partnerships whose chief investors are affluent individuals and institutions. These investors do their best to withhold the operations of their investments portfolio from public scrutiny. This, coupled with the non-mandatory requirement of disclosure, makes the situation more complex. However, scrutiny indicates that hedge funds do not outperform other funds based on market indices. There is evidence is that managerial strategy creates left-skewness of losses. Another strategic approach encouraging riskiness is the application of risk-free rate benchmarks. The continued managerial assumption of zero systematic risk continues to encourage this reckless approach (OptiRisk System, 2008).

Risks Associated with Management Strategy

The discretionary power in the hands of managers and their ability to draw the funds’ strategy direction render hedge funds predisposed to a management risk. This risk arises from a manager’s deviation from his/her field of expertise. This departure from the expertise area may lead to hedge funds facing valuation risks or concentration risks. The risks, particularly valuation ones, arise due to inaccurate measurement of net assets or security value. Employing the relative value strategy may mostly cause this risk. Additionally, concentration risk may also result from expertise drift;in this case, managers concentrate vast amounts of funds in one portfolio, and consequently, this predisposes hedge funds to all risks associated with that portfolio (Sun, 2011).