The Hedge Fund Boom: The Unıversıty of Edınburgh

THE UNıVERSıTY OF EDıNBURGH
The Hedge Fund Boom

Do hedge funds represent a new
paradigm in asset management?
by
Christian Jakobsons
Dissertation presented for Honours Degree in Commerce
(2001/2002)
Dissertation Supervisor:
Dr. Peter Moles

Matriculation No. 9810572 Exam No. 1057262
ABSTRACT
The hedge fund industry is currently attracting a truly booming inflow of
capital. Concerns are now being raised in the asset management industry, which is
questioning whether hedge funds may become the next bubble. The intention of this
paper is to put forward a resolute clarification of this tentative situation in asset
management. This paper investigates the hypothesis that hedge funds produce
abnormal risk-adjusted returns, and should therefore be inherent part of a portfolio
of investments, thus designating a new paradigm in asset management. The
analysis employed reviews the relationship between existing performance evidence
and actual market conditions. This evaluates if fundamentals reflect the current
pattern of investments into hedge funds.
This paper presents tangible evidence of hedge funds being a new paradigm
in asset management. They consistently produce superior risk adjusted returns
compared to other investment classes, and yield significant value when incorporated
into a portfolio. There are no indications of these value-adding performance
characteristics disappearing in short-term. Furthermore, the notion of the hedge
fund bubble is fallacious. Capital allocated into hedge funds far undermines what is
anticipated by fundamentals. Consequently, investments in hedge funds reflect
economic logic.
2
ACKNOWLEDGEMENTS
This dissertation would not have been possible without the help, support and inspiration from
various people and institutions to whom I wish to express my gratitude:
• The greatest of thanks and gratitude to my parents, who have provided me
with unconditional support throughout.
• I wish to express my sincere thanks to Colin McLean and Michael Nicol,
Scottish Value Management, for introducing me to hedge funds, and
providing me with the opportunity to work with them.
• I would like to thank my close friend Nadine Vohrer for her accomplished
efforts in proof reading and correcting the dissertation.
• I express my sincere thanks to my supervisor Dr. Peter Moles for academic
guidance.
• Furthermore, I would like to thank Mag. Thomas Klatzer and Mag. Roland
Klemm, Merrill Lynch Private Banking, for the opportunity to work for their
team and gain resourceful experience. Euromoney Conferences very
considerately gave me complementary admittance to a hedge fund
conference, for which I am grateful and express my thanks.
3
TABLE OF CONTENTS
List of figures .................................................................................................. V

List of tables ................................................................................................... V
1. Introduction .......................................................................................... 6
1.1 Objectives and structure of the dissertation..............................................8

1.2 Research collection and methodology .......................................................9
1.3 Limitations of the study .........................................................................10
2. Hedge Funds.........................................................................................11
2.1 Origin of hedge funds.............................................................................11

2.2 Definitions and characteristics of hedge funds ........................................12
2.3 Hedge funds in the investment universe .................................................16
2.4 Hedge fund investment strategies ...........................................................17
3. Performance .........................................................................................22
3.1 Databases, measurement, and research methodologies...........................22

3.2 Literature review ....................................................................................24
3.2.1 Evidence of out-performance ..................................................................25
3.2.2 Biases in hedge fund databases..............................................................28
3.2.3 Sources of out-performance ...................................................................30
3.3 Future out-performance .........................................................................33
4. Investing in Hedge Funds ....................................................................36
4.1 Hedge funds in a portfolio ......................................................................36

4.2 Alternatives to hedge funds ....................................................................39
4.3 Risk management and selection .............................................................41
5. The Evolution of the Hedge Fund Industry .........................................44
5.1 Asset volumes........................................................................................44

5.2 The European marketplace ....................................................................46
5.3 Key developments ..................................................................................50
5.4 Future evolution of the hedge funds .......................................................53
6. Conclusion ...........................................................................................56
References ......................................................................................................58
Appendix A – Strategy classification ................................................................63

Appendix B – Regulatory issues ......................................................................65
4
LıST OF FıGURES
2.1 Universe of investment opportunities......................................................16
3.1 Performance measurements ...................................................................23
3.2 Performance comparison: fund of fund, individual strategies, bonds,

equities, and mutual funds ....................................................................26
5.1 Growth of the global hedge fund universe ...............................................44
5.2 Total number of funds in the industry ....................................................45
5.3 Growth of the European hedge fund market ...........................................47
5.4 Percentage of European institutions currently investing or

considering investing in hedge funds ......................................................48
5.5 European asset management industry rating of the relative importance

of hedge funds to profitability now and in three years .............................48
5.6 Main problems cited by European institutions regarding hedge funds .....49
LıST OF TABLES
2.1 Definitions and statements.....................................................................13
2.2 US and European definitions..................................................................15
3.1 Performance comparison hedge funds/S&P 500 .....................................25
4.1 Hedge funds in a portfolio ......................................................................37
4.2 Process of due diligence/qualitative analysis of hedge fund

investment vehicles................................................................................42
A.1 Classification by industry professionals ..................................................63
A.2 Classification by academics....................................................................64
B.1 Degree of regulation of hedge funds in certain countries .........................65
5
1. ıNTRODUCTıON
Hedge funds as a type of investment vehicle date back to 1949. They can be
categorised as an alternative, non-traditional investment. Contrary to asset class-
based long-biased traditional investment funds, focus is on investment strategies.
Although grouped under the name “hedge funds”, the investment funds are an
assortment of very heterogeneous types of alternative investment funds. Compared
to traditional funds, hedge funds operate in a liberalised and loosely regulated
framework, which sanctions the diversity. The investment strategies employed differ
greatly and the managers can utilize the full spectrum of financial instruments,
including leverage.
Academics have only recently begun to pay attention to hedge funds. Hedge
funds address new challenges to financial theory; they systematically beat markets
and traditional funds from a return-volatility criterion, but academics are perplexed
by how and why. This is commonly referred to as the “hedge fund puzzle”. Hedge
funds fascinate by having superior risk-return yields, but frighten by their lack of
transparency. Professional expertise on hedge funds is poor, and public knowledge
is still extremely limited. Thus, hedge funds are often misunderstood, and numerous
misconceptions about their nature persist, although significant investments are now
placed in them.
Hedge funds remained a marginal investment vehicle until the beginning of
the 1990s. The 1990s observed a real boom in assets allocated into hedge fund was
observed, especially in the US. In the late 1990s and post millennium this trend
became more prevalent in Europe, whilst still continuing and escalating in the
international investment management market. Hedge funds have existed for over
half a century but have only recently attracted significant capital. Dramatic capital
inflows have been registered with investment houses and managers. Hedge fund
start-ups are now even commonly closing their funds to new investors prior to the
launch due to excessive demand.
6
The analysis will present core drivers behind the evolution, and evaluate if
the growth is natural or bubble-theory based. Furthermore, the core drivers are
examined for their role in promoting further growth. Performance is key in
investment management studies. The evaluation of performance/fundamentals is
one of two main elements in the analysis. The other main element is an examination
into the evolution of the hedge fund industry. When under combined scrutiny, they
will answer if the current boom is a bubble.
The current hedge fund boom could be a short-lived trend, but can also be a
new paradigm in investment management, where hedge funds become a natural
part of certain investment portfolios. An answer to this question could be of great
assistance to the many asset managers currently considering allocating assets into
hedge funds. In the European market-place institutional investors are still sceptical
towards hedge funds; although most of them are increasingly considering investing
in hedge funds in the future1. Only 17 % of institutional investors currently invest in
hedge funds, and the majority opt to delay their hedge fund investments because of
uncertainty and lack of credible information.
A growing number of market observers consider the increasing allocation of
capital into hedge funds to be a bubble. Authors, experts and analyst predict with
rising confidence that the bubble will burst in the near future2. An examination of
the current hedge fund boom and the underlying reasons, will answer if the
prevailing scepticism towards hedge funds is justified. An outline of the objectives
and structure of the dissertation, followed by a description of the research
methodology employed, presents the means in which this will be achieved.
1
From presentation by Bruce Weatherill, Price Waterhouse Coopers, “Examining the findings of the
2000/2001 Private Banking Survey: Private Banking and its Changing Approach to Alternative
Investments”, 2nd Annual Euromoney European Hedge Funds Conference 2001.
2
Examples: “Hedge Funds – The latest bubble?”, The Economist, September 1st, 2001, “SEC’s Paul
Royce Issues a warning About a Hedge Fund Craze”, Bloomberg News, July 23rd, 2001, “The $500
Billion Hedge Fund Folly”, Forbes, June 8th, 2001, “The Hedge Fund Bubble”, Financial Times, 9th
July, 2001, “Hedge Funds May become the Next Investment Bubble” , Bloomberg News, May 30th,
2001. Drawn from INEICHEN, Alexander M, “Hedge Funds: Bubble or New Paradigm? The Asset
Management Industry is Leaning Towards Absolute Return Objectives and Risk Management”, UBS
Warburg, London, 2001.
7
1.1 OBJECTıVES AND STRUCTURE OF THE DıSSERTATıON
The overall objective of the dissertation is to evaluate hedge funds’ position in
investment management and portfolios, and to assist professional money managers
in current and future asset allocation into this type of investment.
1. The first objective is to introduce the nature of hedge fund, their
characteristics, and their use in investment portfolios. This includes a review
of definitions and descriptions of hedge funds found in literature, and an
outline of the complex investment strategies they employ.
2. The second objective is to critically evaluate the academic literature on the
performance of hedge funds. This will examine if hedge funds are providing
superior risk-adjusted returns, and hence, contest the notion that active
management does not yield rewards. An investigation into the sources of the
returns, and the future perseverance of these sources, will look at whether
performance will persist in other than the current market conditions.
3. The third objective is to examine how to invest in hedge funds and make
efficient use of them in a portfolio of investments. Alternatives to hedge funds
will be considered and evaluated on performance. Fund selection and risk-
management are highlighted due to their paramount importance in the
investment process.
4. The fourth objective is to present an overview of the hedge fund industry,
focusing particularly on the European market. Asset volumes and industry
trends, market demand and interest, and key developments will be
comprehensively considered in order to evaluate the future outlook for hedge
funds.
5. The fifth objective is to assess if hedge funds have the ability to provide
added value to investors, and their ability to do so in the future. This gauges
the probability of the current boom becoming a bubble, and gives insight into
the future role of hedge funds in investment management.
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1.2 RESEARCH COLLECTıON AND METHODOLOGY
This dissertation draws on different sources to gather information on the
hedge fund universe. The research methods included: collecting information from
articles, journals, books and the Internet. The author also attended a recognized
hedge fund conference. Informal interviewing of people involved in the industry
contributed to the research process, and provided inspiration for the analysis.
Furthermore, the author used practical experience gained from working for Scottish
Value Management, an investment house running a hedge fund, and working for the
private banking division of Merrill Lynch, a major international investment bank.
Finding information on the subject proved to be very complicated. Firstly
there is a very limited base of recognised literature on hedge funds. Secondly, this
literature is very difficult to obtain. Few articles on hedge funds feature in the
popular financial press, and in many instances they can be misleading. Some
specialist press exists, but is priced for the corporate clientele. Papers on hedge
funds are published in journals that are difficult to access for undergraduate
students, as they are specialist journals few universities subscribe to. Books on
hedge funds are extremely hard to come by in university and national library
collections. Only a very limited number exist, and normally they have to be retrieved
through international online book merchants.
Nevertheless, the Internet is a good source of information. There are a
number of sites dedicated to hedge funds, but most are password protected and
require individuals to apply for access. Some sites are restricted to investment
professionals, but the majority also permit academic access. Conferences are still
exotic in the context of hedge funds: there are few, and they are exclusive and
expensive. The author did however gain a complementary place, and the information
distributed was valuable to the research.
Notwithstanding the inherent difficulties, ample information required to
comprehensively examine the questions set out in this dissertation, was collected
through a lengthy period of rigorous research.
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1.3 LıMıTATıONS OF THE STUDY
Hedge funds can still be considered mysterious and closed natured. There is
a general lack of transparency, which causes misunderstanding, and prevents
public knowledge and academic efforts in the field. The inherent limitation of the
study is the difficulty in acquiring information. The gathering of information on
hedge funds is a formidable task in itself. The information can often be of a
misleading and ambiguous nature, and therefore has to be closely scrutinised.
There are an infinite number of factors that influence the development of the
hedge fund industry, and certain factors must be highlighted. Other developments
in the investment management sector, and in the global markets, might influence
the evolution of hedge funds. These developments are not taken into consideration
with the same detail and comprehensiveness as hedge funds, but are given
reasonable attention.
The conclusions set out in the paper are general, and seek to assist the
average institutional and private investor, bearing in mind that all investment
portfolios are unique, and individual investors have different needs to consider.
Thus, capital allocation into hedge funds should be judged with respect of the
individual portfolio. Investments in individual hedge funds will have very different
risk/return patterns from investments in a portfolio of hedge funds, which is the
context in which this paper considers hedge fund investments. The conclusions
therefore only partially apply to investments into individual hedge funds.
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2. HEDGE FUNDS
The objective of this section is to, firstly gain a brief insight into the history of
hedge funds and how they have evolved. Secondly, to understand what hedge funds
are and what characterises them, and appreciate the complexity of their nature.
2.1 THE ORıGıN OF HEDGE FUNDS
The first hedge fund was set up in 1949 by Alfred W. Jones. By short-selling
stocks in addition to holding long positions, Jones hoped to eliminate part of the
market risk. In doing this he shifted most of his exposure from market timing to
stock picking. Largely through his own common sense, he realised that the risk of
investing in the market was distinct and separate from the risk inherent in investing
in a stock, and could be identified and substantially reduced, even more or less
eliminated by appropriate hedging. This pioneering insight took academic financial
economists several more years to identify and explain3.
The fund was the first to use short sales, leverage and incentive fees in
combination. Compared to many of today’s hedge funds, and in sharp contrast to
the aggressive strategies employed by well-known global macro funds in the past
three decades4, the fund employed a conservative strategy. The investment vehicles
used were long and short equities, leverage was limited, and central to its
investment strategy was the hedging of market risk, hence the name “hedge fund”.
An article published in 1966 shocked the investment community. Having
operated largely in secrecy until then, the article described Jones’ fund and its
superior performance. The fund had outperformed all the US mutual funds of its
time. This sparked a rush into hedge funds, which eventually was offset by the bust
years following the booming late 1960s. Prominent “survivors”, like George Soros
and Michael Steinhart, lead the way in the aftermath. In 1986 another article
reported on Julian Robertson’s exceptional performance as a hedge fund manager, it
3
TEMPLE, Peter, “Hedge Funds: the courtesans of capitalism”, John Wiley & Sons, Chichester,
2001.
4
E.g. LTCM (Long-term capital management), Quantum, Tiger, etc.
11
lead to a renewed interest in hedge funds. In the following years the hedge fund
industry entered a more mature stage, but nonetheless saw an exceptional rise in
asset volumes throughout the 1990s.
2.2 DEFıNıTıON AND CHARACTERıSTıCS OF HEDGE FUNDS
In literature hedge funds are often defined by an enumeration of typical
characteristics rather than a defining, clear and differentiating statement. These
characteristics are generally determined and evaluated in discord to mutual funds5.
A general, albeit all-encompassing definition employed frequently by the industry is:
“All forms of investment funds, companies and private partnerships that
1. use derivatives for directional investing

2. and/or are allowed to go short
3. and/or use significant leverage through borrowing”
(Source: Cottier, 2000)
Although this is perhaps the best definition of a hedge fund, the nature of
hedge funds is infinitely more complicated. There are great variations in the market
for hedge funds, and perceptions of hedge funds are unclear and mixed.
Nevertheless, the definition is a starting point in understanding what hedge funds
are and how they operate.
In contrast to unit trusts, hedge funds are less regulated and constrained in
business activities and investing. This is the core of what distinguishes hedge funds
from traditional investment funds, and is also the main reason they are difficult to
define, clearly understand and monitor. Since hedge funds are private investment
companies or partnerships that are formed by a limited number of investors and
primarily are located offshore, they are often not required to register with market
securities agencies. Circumventing aspects of local investment regulations, hedge
5
WARWICK, Ben, “Searching for Alpha – The Quest for Exceptional Investment Performance”, John
Wiley and Sons, New York, 2000.
12
funds are by definition not restricted to one asset class or one financial instrument.
Hence, they can go short, use derivatives, currencies and employ leverage.
Table 2.1 Definitions and Statements
The term “hedge fund” typically refers to “ any pooled investment vehicle that is
privately organised, administered by professional investment managers, and not
widely available to the public.
(Source: Report of the US President’s Working Group on Financial Markets, 1999, used by IMF in;
“Background Note on the Hedge Fund Industry”, Financial Stability Forum, 2000)
A hedge fund is an investment structure for managing a private, loosely regulated

investment pool that can invest in both cash (physical securities) and derivative
markets on a leveraged basis.
(SCHNEEWIES, Thomas & SPURGIN Richard, “Hedge Funds: Portfolio Diversifiers, Return Enhancers
or Both? Isenberg School of Management & University of Massachusetts, 2000)
Hedge fund – An absolute return investment fund designed to invest in a wide range
of instruments in order to achieve a high return for a given level of risk. It is usually
based offshore and the manager is reimbursed through an incentive fee.
(Source: CHANDLER, Beverly, “Investing with the Hedge Fund Giants”, 2nd Edition, Prentice Hall
London, 2002.)
Hedge funds are considered “alternative” investments since they employ an

investment strategy that differs from conventional, long only, money management
…It encompasses a greater variety of investment instruments (options and futures)
and a greater variety of investment techniques (short selling, hedging, arbitrage,
etc.) than conventional money management.
(Source: DUNMIRE, Michael E, “Assessing the risks of hedge fund investing, in COTTIER, Philipp,
“Hedge Funds and Managed Futures”, 3rd Edition, Verlag Paul Haupt, Bern, 2000.)
Hedge funds – usually structured as private placements, encompasses a wide variety

of skill-based investment strategies such as fixed income arbitrage, risk arbitrage,
hedged equity, directional equity, convertible bond arbitrage, event-driven, global
macro, and emerging markets. While most hedge funds primarily invest in the debt
and equities markets, some may also take significant positions in the currency and
commodities markets. Common to most hedge funds is the use of leverage and both
long and short positions. Because hedge funds are able to take short positions, they
have the potential to profit in any market, including one characterised by sharply
declining market.
(Source: Merrill Lynch, MLIM Alternative Investment Group, 2001.)
Traditionally, hedge funds are run as small financial boutiques and have
therefore enjoyed less internal corporate constraints in investing. Many hedge funds
have exploited this by using a free choice of asset classes, international markets and
trading styles, adapting to current market conditions and using the freedom to their
advantage. They are mostly sold on a private basis and are free from the obligation
to release even the most basic data, e.g. monthly performance, asset size or
13
investment policy. These data are often disclosed exclusively to existing investors
and therefore poses severe limits to transparency, not only for the individual fund,
but also for the industry as a whole, complicating studies of the hedge fund
universe.
For regulatory and administrative reasons the minimum investment required
is often high, and infrequent subscription and redemption possibilities with long
notification periods have become an industry norm. Investors in hedge funds are
primarily high net worth individuals, but institutional investors are increasingly
allocating assets in hedge fund. To promote the funds credibility the manager
usually also allocates a high proportion of his own capital into the hedge fund.
Two other features are also very important characteristics of hedge funds,
distinguishing them from traditional funds. Firstly, a performance oriented incentive
fee is commonly charged in addition to a flat administration fee6. A high watermark
is often applied to this incentive fee, and it can be benchmarked to an index such as
the UK or US treasury rate, e.g. hurdle rate7. Secondly, hedge funds are marketed as
being oriented towards absolute performance, alpha, rather than performance
related to a benchmark or reference index. Hedge fund indices have now been
created, but are still not seen as a benchmark for individual fund performance since
managers cannot easily replicate them with a passive strategy.
The hedge fund industry has constantly recruited arguably some of the best
and most talented investment managers in the business8. They are drawn by the
substantial rewards hedge funds can offer through performance incentive fees and
could certainly be a factor in explaining why another characteristic of hedge funds
are superior risk related returns compared with unit trusts and equity indexes.
6
Commonly management fee rates are between 1% and 1.5%, and 15-25 % for the performance fee.
According to the TASS database, 64 % of single manager hedge funds charge performance fee of 20%
or more. Multi manager fund of funds usually charge less, and 51% of the multi manager funds in the
same database charge 10% or less.
7
According to Van Hedge Fund Advisors, 64 % of hedge funds have a high water mark and 17% have
a hurdle rate.
8
2001.
14
Hedge funds originated in the US, and have existed in the European market
since the 1970s. European market professionals do however employ the term hedge
fund slightly differently than their US counterparts, including a broader category of
alternative investments.
Table 2.2 US and European definitions
US Definition
In the US hedge funds include any funds that are not conventional
funds and which use a strategy or a set of strategies other than investing
long in bonds, equities and money markets. In its most rigorous
definition, a hedge fund would involve the services of a prime broker
which would typically provide trading and custody services to the fund,
and would also retain the right to utilize or re-hypothecate the assets of
the fund for its own trading purposes.
European Definition
European market professionals consider that a hedge fund is any fund

which adopts an alternative investment strategy seeking to generate
high absolute rate of returns. Any collective investment scheme
employing asset management strategies which can benefit from rising
as well declining market price, could be qualified as a hedge fund.
Unlike the US, there are many hedge funds which do not involve a
relationship with a prime broker, but which are considered “hedge
funds” as a result of the trading strategies adopted and the financial
strategies dealt with by the fund
(Source: Andersen, publication: Basis Point, No. 9, 2001)
The definition as outlined by Andersen does however ignore recent industry
developments. In Europe it is now the norm for new hedge fund start-ups to employ
a prime broker9. The increased presence of US investment banks in Europe is one of
the driving forces behind this development. The hedge fund industry is international
by nature, and it is very difficult to clearly distinguish any general differences
between European and US hedge funds, and the rapid reforms currently observed in
the European markets further complicate this matter. Academics rarely emphasize
the cross-Atlantic operational differences, but do concentrate on intra European
differences in marketing and regulatory environment. It is nevertheless apparent
that the European market is at an early stage of development compared to the US.
15
2.3 HEDGE FUNDS ıN THE ıNVESTMENT UNıVERSE
Hedge funds are an alternative investment vehicle. Today, an increasing
number of investors are turning to alternative investments to diversify traditionally
structured portfolios because of the non-correlation characteristics and potential
above-average returns. Other alternative investments have also received an
increasing share of assets, but hedge funds have arguably seen a more dramatic
development in recent years10.
Figure 2.1 The Universe of Investment Opportunities
Investment
Universe
Alternative/Non Traditional Investments Traditional Investments
PRIVATE
EQUITY/DEBT
-VENTURE COMMODITIES HEDGE STOCKS BONDS
CAPITAL FUNDS
-REAL ESTATE
Alternative investment strategies are characterised by their absolute return
objectives. Absolute return strategies charge high fees and performance is, in theory
and to some extent in practice, determined by manager skill. At the other extreme
are index funds, where margins are low and performance is attributed to the
market11.
Incorporating alternative investments in a traditional portfolio might reduce
the overall volatility as well as offer opportunities for capital appreciation. Hedge
9
“What do you want from a prime broker?”, Cover Story, Hedge Funds Review, January 2001.
10
RAMA, Rao & SZILAGYI, Jerry G, “The Coming Evolution of the Hedge Fund Industry: The Case
for Growth and Restructuring”, RR Capital Management and KPMG, New York, 1998.
11
INEICHEN, Alexander M, “Hedge Funds: Bubble or New Paradigm? The Asset Management
Industry is Leaning Towards Absolute Return Objectives and Risk Management”, UBS Warburg,
London, 2001.
16
funds generally have a low correlation with traditional investments, like stocks and
bonds12. Studies on the performance of hedge funds have also shown that hedge
funds produce above average returns, alpha13. Hence, hedge funds can diversify a
traditional portfolio, reduce risk and enhance returns.
Professional investment advisors do however usually discourage an
allocation in excess of 10-15% of a clients’ net worth into alternative investments14.
The recent high volatility and decreasing returns in traditional investments have
further fuelled the interest for alternative investments. Yet investment management
industry remains conservative in the volumes of capital placed in alternative
investments, and there is a degree of scepticism towards hedge funds. Many
participants in the industry still seem to be misinformed about the most basic facts
on hedge funds, and there is a general lack of knowledge and understanding of the
investment strategies they employ15.
2.4 HEDGE FUND ıNVESTMENT STRATEGıES
There is no accepted norm in classifying the different hedge fund strategies.
Data providers, industry professionals and academics categorise and divide
strategies into their own classifications. This predicament is further exemplified in
Appendix A. An analysis of how one might distinguish the strategies will best explain
the rationale behind classification, and provide reasoning for the classification
employed in this paper.
A wide variety of hedge fund strategies exists. Classification of these
strategies is not only of importance when conducting performance monitoring and
quantitative research, but is used by hedge funds in marketing. The investment
strategy is the primarily characteristic which distinguishes a hedge fund, and is an
12
ZASK, Erza, “Hedge Funds: “An Industry Overview”, Journal of Alternative Investments, Winter
2000.
13
LIANG, Bing, “On the Performance of Hedge Funds”, Weatherhead School of Management, 1999.
14
Merrill Lynch International Private Banking/Euromoney, 2nd Annual European Hedge Funds
Conference 2001.
15
COTTIER, Philipp, “Hedge Funds and Managed Futures”, 3rd Edition, Verlag Paul Haupt, Bern,
2000.
17
essential issue in the asset allocation process. The four dimensions of hedge fund
classification according to the TASS model are; 1) Asset Class, 2) Investment Bias, 3)
Trading Style, 4) Geographical Focus. These features are key factors in describing a
hedge fund strategy, and hence, can be used in classification.
Furthermore, it is possible to divide strategies into non-directional and
directional strategies (Burki, 2000). Non-directional strategies are also known as
market neutral strategies. Their trademark is low correlation with markets. By
exploiting arbitrage opportunities and structural discrepancies through identifying
miss-pricing and market inefficiencies, the manager seeks to capitalise gains while
keeping a minimum of market exposure. Directional strategies can also be called
market-timing strategies. Typically, these strategies are more strongly correlated
with markets, and involve the manager timing the market and betting on
movements.
However, classifying a strategy as directional or non-directional would be far
too simple. Strategies also vary considerably within these boundaries and a
particular strategy can also be played differently to deliver varied levels of market
correlation. In spite of this most investors and hedge fund practitioners would argue
that hedge funds have their place in a portfolio to provide returns that have a low
correlation with traditional investment, and hence, improve the risk/return
relationship in a portfolio context. Hedge funds in general yield returns that have a
low correlation with the market, but non-directional strategies can be perceived as
less aggressive, and hence, more prudent strategies. Returns are normally more
stable and have a very low correlation to the market. Directional strategies are of a
more opportunistic nature; returns are more varied and can be sensational. To
illustrate the differences, directional strategies are characterised by being more
aggressive, but this may not be the true in individual cases.
Since there are no industry standards in defining different strategies, it is
better to define broader categories, which are employed in this paper. Hedge fund
managers will often use their own interpretations, subdividing strategies further
18
than is presented in this paper. The analysis is partially based on Deutsche Bank’s
interpretation of the hedge fund universe (Fothergill, 2000), but will also include
contributions from academics and other industry professionals presented in
Appendix A.
Equity Hedge – the strategy employs bottom-up research and seeks to take
advantage of undervalued and overvalued securities by taking up long and
short positions. Managers can be net long or short, value or growth, small or
large cap and focus on different regions and sectors. The most common
strategy name is Long/Short Equity, it also covers a multitude of sub
strategies which mainly are divided up by their net exposure and
geographical focus e.g. from Domestic Long Equity to Emerging Markets.
Managers commonly use leverage, and levels of opportunism vary
considerable. Long/short equity should not be confused with market neutral,
in essence the strategies are very similar but short positions are taken more
to avoid specific risk or to benefit from opportunities, rather than solely
focusing on eliminating market risk.
Market Neutral – Being the prime non-directional strategy, this strategy is
also called relative value. The manager tries to generate excess returns while
eliminating systematic risk. There are a number of different specifications of
this general strategy. The most widely used is Equity Market Neutral. These
funds take simultaneously long and short positions for the same amount
making their net market exposure zero. In a simple form the strategy would
involve a long position and a short position in two companies in the same
sector within the same region, shorting the equity less likely perform. The
manager seeks to benefit from both alphas created while remaining beta
neutral. The strategies can become much more complicated and
sophisticated than exemplified here and may be based on “black box”
mathematical systems. This is particularly present in similar market neutral
19
strategies based on arbitrage, namely; Convertible Arbitrage, Fixed Income
Arbitrage, Capital Structure Arbitrage, Derivatives Arbitrage and Equity
Index Arbitrage.
Global Macro – This flexible strategy employs an opportunistic and
speculative top-down approach to investing, and takes advantage of market
movements through long and short positions. The investment process is
based on macroeconomic analysis and forecasts in global interest rates,
currency and equities markets, and policy changes. A variety of financial
instruments, markets, sectors and trading styles are used, and the funds are
often highly leveraged. Being the most directional of strategies, it can also be
one of the riskiest, but returns are not necessarily strongly correlated with
the market. Global Macro funds were made famous by high profile investors
with extraordinary returns, most notably George Soros.
Event Driven – This strategy focuses on companies that are involved in
special situations, including M&A, corporate restructuring and bankruptcy.
Managers invest in companies that are involved in these situations, and
typically would take a long position in the target and simultaneously short
the acquirer in an M&A deal. This strategy is called Merger Arbitrage, and
constitutes that the principle risk factor becomes the deal rather than the
market. The Distressed Securities strategy is more directional due to the
financially unstable nature of the underlying financial instruments
employed. Other sub-strategies include Risk Arbitrage and Multi-Event.
Short Selling – Investment funds that mostly or exclusively use short
positions in equity and put derivatives products employ the short selling
strategy. They always have a short bias greater than zero, and seek to benefit
from overvalued individual companies and bearish markets. Throughout the
20
1990s bull market the short sellers almost disappeared, but have lately once
again emerged as an alternative strategy.
Fund of Funds – This approach involves a hedge fund investing in external
hedge funds. Managers create a diversified portfolio of managers, single or
multi-strategy, to produce consistent returns with a minimum risk. Fund of
funds provides better access to experienced management, enhanced liquidity
and less risk of default. However, due diligence, transparency and easier
access comes at a cost, and additional layers of fees increase the cost of
investing.
This overview provides an introduction to the many different investment
strategies employed by hedge fund managers. In sharp contrast to index investing
and traditional active management16, the strategies are complex and can be difficult
to understand. The performance characteristics of the different strategies are
presented in figure 3.217. Reports concerning the capital allocation into the various
strategies provide inconsistent evidence, but equity hedge being the broadest of
strategies, is assumed to receive around 50% of capital. In the European
marketplace varieties of Long/Short Equity investments have attracted the bulk of
assets. Fund of funds have also developed into a popular way of investing into the
hedge fund universe.
16
Index investments are investments in funds that try to replicate the market portfolio. This technique
is based on the theory of efficient markets, stating that no investors can beat the market without access
to superior information. Consequently, indexing should provide the best risk adjusted return.
Replicating an index is a fairly simple investment task, and professionals use the index as a benchmark
of performance. Research has shown that it is virtually impossible to beat the market on a consistent
basis, arguably the majority of traditional fund managers that claim to carry out active management
therefore employ indexing to a certain extent, hence “closet indexing” (Colin McLean, MD, SVM)
17
See part 3.2.1.
21
3. PERFORMANCE
Empirical research on hedge funds concentrates on the evaluation of
performance. Performance is an assessment of the risk/return relationship. Both
elements possess considerably complex characteristics in the context of hedge
funds. This section reviews the current literature on the performance of hedge
funds, with the underlying objective of examining if the current booming inflow of
assets into hedge funds can be justified by out-performance. Consideration of hedge
funds place in a portfolio of investment is also essential in assessing this
relationship and will be examined further in Part 4.
3.1 DATABASES, MEASUREMENT, AND RESEARCH METHODOLOGıES
With the industry in some respects still in its infancy and under no
obligation to disclose results, gathering hedge fund performance characteristics is
no simple task. Fortunately, many funds release monthly data to attract new
investors and accommodate existing ones. The most respected databases are HFR
(1400 funds)18, TASS (2200 funds)19, and MAR/Hedge (1500 funds)20. These
databases are not comprehensive and may contain a number of biases.
Nevertheless, they replicate the hedge fund universe to the extent that they can be
the basis for empirical studies on performance, and are used to calculate hedge fund
indices21.
The performance of hedge funds is measured against traditional benchmarks
like the S&P and FTSE, and more innovative benchmarks; mutual fund performance
and managed futures investments. Performance depends to a large extent on risk,
and both risk and return must be examined when comparing the performance of
hedge funds and other investment vehicles. The Sharpe ratio: (Return-risk free
18
Hedge Fund Research currently monitors approx. 4000 funds, the database available by subscription
covers only 1400.
19
TASS/Tremont database in co-operation with Credit Suisse First Boston.
20
MAR/Hedge sold database operations to Zurich Capital Markets on March 22, 2001.
21
AMIN, Gaurav S & KAT, Harry M, “Hedge Fund Performance 1990-2000: Do the Money
Machines Really Add Value?”, University of Reading, 2001.
22
rate)/Standard Deviation, is the most commonly used measure for this relationship,
and is essential in the valuation of hedge fund performance since no uniform
benchmark exists. Investors in hedge funds do nevertheless employ a number of
measurements in evaluating return and risk, and figure 3.1 presents the most
commonly employed.
Figure 3.1 Performance Measurements
Frequently used return measures Frequently used risk measures
• Average rate of return • Standard Deviation
• Median rate of return • Shortfall probability
• Rolling 12-month rate of • Median absolute deviation and semi

return deviation
• Alpha coefficient • Market beta
• Percentile Rank • Maximum draw-down
• Ratio of negative V. profitable

months
• Leverage
• Net exposure
• Coefficient of correlation
Risk-Adjusted Performance Measures
Sharpe Ratio (P.a. historic return – risk free rate) / p.a. standard deviation
Semi Sharpe Ratio (P.a. historic return – risk free rate) / p.a. semi deviation
Sterling Ratio 3 year average annual performance / (average of the maximum

drawdown experienced in each year + 10 %)
MAR Ratio Geometric annual average/largest drawdown
(Source: Cottier, P., 2000)
Other, less frequently used risk-adjusted ratios include the Sortino ratio,
Treynor measure, differential return, and Jensen differential performance22.
22
CHANDLER, Beverly, “Investing with the Hedge Fund Giants”, 2nd Edition, Prentice Hall London,
2002.
23
Nonetheless, the asset management industry still has difficulties with finding
adequate risk adjusted performance measures. The Sharpe ratio should theoretically
be comparable to any traditional or non-traditional investment since it is risk
adjusted, but the ratio is based on assumptions; normal distribution of returns and
historic standard deviation indicating future risk. The non-traditional universe of
investment incorporates specific risk that is not necessarily expressed by the
volatility of past returns. These risks are very difficult to measure and include; gap
and liquidity risk, market-to-market risk, human risk, change of strategy risk, and
size risk. Traditional investments may be exposed to some of these risks, but they
may be amplified in the context of hedge funds.
Empirical studies on hedge funds often examine investment strategies
individually to gain further insight into the characteristics of hedge fund
performance. Industry professionals classify their investment strategy when
supplying information data to the databases, but hedge funds employ dynamic
strategies. However, academics and investors consider this detailed research
valuable, especially in the context of practical investing and portfolio construction23.
3.2 LıTERATURE REVıEW
A review of the literature covering the performance of hedge funds is a
complex task. Much of the information required to gain a accomplished
understanding remains unavailable, and current literature is often plagued by
ambiguity. Studies on hedge funds are consequently ground-breaking and
informative at this early stage. Researchers have not yet completely clarified many
issues: What drives hedge fund returns? (e.g. What are their risk exposures?) Are
these exposures stable over time? How do we measure hedge fund performance? Is
there a reliable benchmark model? Do hedge fund managers have skills that are
greatly superior to other investment managers? Is performance persistent over time?
23
Ineichen, Alexander, Head of Derivatives Research, UBS Warburg. From presentation: “New
developments in Hedge Fund Research”, given at Euromoney 2nd Annual Hedge Fund Conference,
London, October, 2001.
24
How can biases in databases be accounted for? Nonetheless, a comprehensive
investigation into these issues is beyond the scope of this paper.
Current literature does give some indications to the answers of these
questions, but further research remains a necessity for a more accomplished
understanding. In their quest to answer the “hedge fund puzzle” of abnormal
returns academics are arguing towards conclusions that are wide ranging and
pioneering in the field of finance. Nevertheless, the empirical evidence currently
available is ample to answer the queries raised in this paper.
3.2.1 EVıDENCE OF OUT-PERFORMANCE
The outright performance of hedge funds has been under great scrutiny by
academics. Empirical research has resolutely concluded that hedge funds do provide
superior risk-adjusted returns to the S&P and FTSE indices24. Table 3.1 presents a
performance comparison of the “average” hedge fund, represented by a Marhedge
fund of funds median, and the S&P 500 index.
Table 3.1 Performance Comparison Hedge Funds/S&P 500
Marhedge Fund of
Performance Comparison S&P 500
Funds Median
Total Return 246.50% 221.80%
Compound Annualised Return 11.41% 10.70%
Annualised Standard Deviation 14.27% 4.61%
Sharpe Ratio 0.45 1.24
Reward to Risk Ratio 0.48 1.52
Profit Factor 1.70 5.79
Average Monthly Return 0.99% 0.86%
Best Month 11.16% 4.50%
% of (+) Months 64.59% 81.88%
Average (+) Months 3.38% 1.28%
Average (-) Months -3.36% -1.03%
Annualised Standard Deviation 9.56% 4.58%
Maximum Drawdown (Peak to Valley) 23.55% 7.04%
Average 3 Largest Drawdowns -18.32% -4.79%
(For period 1990 – June 2001. Data sources: Bloomberg and Zurich Capital Markets, 2001,
reproduced from www.marhedge.com)
24
for Growth and Restructuring”, RR Capital Management and KPMG, New York, 1998. Studies
included: Hennesee (1994), Brown and Goetzman (1995), Fung and Hsieh (1997), Van (1996), and
Scholl (1996)
25
A recognised study by Cottier25 found that single manager hedge funds
posted returns of 17.86% p.a. with a volatility of 9.81%. Hedge funds outperformed
managed futures on a risk-adjusted basis, and outperformed both mutual funds
and traditional investments on both return and risk adjusted performance during
the sample period. The study further showed that infrequent redemption
possibilities and high incentive fees have a positive effect on performance26.
Figure 3.2 shows how the performance of a fund of funds index, and the
performance of different hedge fund strategies, compares to equity, bond, and
mutual fund returns. Hedge funds clearly produce superior risk-adjusted returns.
This is amplified in a fund of funds context, which have bond levels of risk, whist
still yielding 15% p.a.
Figure 3.2 Performance Comparison: Fund of funds, Individual Strategies,
Bonds, Equities, and Mutual Funds.
25
EACM HF index
20
Relative Value
15 Event Driven
Returns %
Equity Hedge
10 Global Macro
Short Sellers
5 Bonds
S&P Composite
0
Mutual Funds
0 5 10 15 20 25
-5
Volatility (%/Std. Dev.)
(Source: From data presented in; FOTHERGILL, Martin & COKE, Carolyn, “Funds of Hedge
Funds: An Introduction to Multi-manager Funds”, Deutsche Bank, London, 2000. EACM 100
index is a arbitrary constructed index compromising different strategies to resemble a fund of
funds.)
25
2000.
26
Liang’s27 study finds abnormal returns for 7 out of 16 hedge fund strategies
with out-performance ranging from 7.68% to 15.12% p.a. Whilst he does not find
significant out-performance for the remaining strategies, the average hedge fund
offers higher Sharpe ratios and better manager skills than mutual funds, and
consequently out-performs. The study furthermore notes that fund size and lockup
periods are positively related to performance, and that fund age is negatively
correlated to performance. Moreover, funds with high watermark incentive
structures significantly outperformed those without.
He also concludes that hedge funds have relatively low correlation with
traditional asset classes, arguing that hedge funds follow dynamic trading strategies
rather than buy-hold strategies, conforming to the pioneering work by Fung and
Hsieh28 that concluded that dynamic trading creates option like return payoffs
which differ from traditional investments. This is further supported by a study by
Agarwal and Naik29. Liang concludes that the abnormal performance by hedge funds
cannot be explained by survivorship bias30.
Agarwal and Naik31 find significant positive alphas for 10 out of 10 different
hedge fund strategy indices, ranging from 6.36% to 15% p.a. In a subsequent paper
they find abnormal returns for 7 of 10 strategies32. These studies were not corrected
for any biases, but they examined multi period persistence of returns. The first
study found some degree of persistence, but argues that this is rather due to losers
remaining losers more than winners remaining winners. The second study further
examined this relationship, and found that persistence exists in the short term, but
26
There was no convincing evidence that high manager investment in own fund, offshore domicile,
high minimum investment, nor size or age of fund, had any positive effect on performance.
27
LIANG, Bing, “On the Performance of Hedge Funds”, Weatherhead School of Management, 1999.
Financial Analysts Journal, 1999, Vol. 55, No. 4.
28
FUNG, William & HSIEH, David A., “Empirical Characteristics of Dynamic Trading Strategies;
The Case for Hedge Funds”, The Review of Financial Studies, 1997a, Vol. 10, No. 2.
29
AGERWAL, Vikas & NAIK, Narayan Y, “Performance Evaluation of Hedge Funds with Option-
based and Buy-and Hold Strategies”, Working Paper, August 2000.
30
See section 3.2.2 for explanation of the survivorship bias.
31
AGERWAL, Vikas & NAIK, Narayan Y, “On taking the Alternative Route: Risk, Reward, Style and
Performance Persistence of Hedge Funds”, Journal of Alternative Investments, 2000a, Vol. 2, No. 4.
32
AGERWAL, Vikas & NAIK, Narayan Y, “Multi Period Performance Persistence of Hedge Funds”,
Journal of Financial and Quantitative Analysis, 2000b, Vol. 35, No. 3.
27
decreases in the long term. It does not seem to be related to hedge fund strategies,
and was less evident in a multi period framework.
Caglayan and Edwards33 found average out-performance ranging from
12.96% to 28.56% p.a. for a selection of investment strategies. The study corrected
for survivorship bias and instant history bias, but questions that it may subsist a
selection bias in the performance measure. In addition, they examine whether
manager skill can be explained by fundamental fund characteristics such as
incentive fees, management fees, size or age of fund. They find that only high
incentive fees have a positive relation to performance. In another study they examine
hedge fund and commodity fund performance in bull and bear markets34. They find
that commodity funds are less correlated to the market than the average hedge
fund. Moreover, hedge funds are found not to be negatively correlated in bear
markets, but do significantly beat the market. In bull markets, hedge funds are less
correlated, and returns far exceed the market and the performance of commodity
funds.
There are no recognised studies that do not find hedge funds to significantly
out-performs traditional investments and commodity funds/managed futures on a
risk-adjusted basis. However, due to the ambiguity of the data employed, some
academics have questioned the studies. The widely acknowledged conclusion is that
hedge funds do generate alpha by achieving superior returns without being exposed
to higher levels risk, employing all common measures of risk.
3.2.2 BıASES ıN HEDGE FUND DATABASES
Biases are a central issue in hedge fund research. Databases are not
representative of the whole hedge fund population, and therefore biases can exist.
33
CAGLAYAN, Mustafa O & EDWARDS, Franklin R, “Hedge Fund Performance and Manager
Skill”, Working Paper, JPMorgan Chase Securities & Colombia University, May 2001.
34
CAGLAYAN, Mustafa O & EDWARDS, Franklin R, “Hedge Fund and commodity Fund
Investment Styles in Bull and Bear Markets”, Working Paper, City University of New York &
Colombia University, 2000.
28
Fund and Hsieh35 show that the construction of hedge fund indices or portfolios
may face four potential sources of biases; survivorship bias, instant history bias,
selection bias, and multi-sampling bias. They provide estimations for these using
the TASS database.
Survivorship bias. The databases only provide information on funds that are
currently operational. The exclusion of dead funds when computing the returns of a
portfolio or index of funds biases upward performance measurement. The return an
investor who would have invested in all of the funds available at the beginning of the
period will therefore not reflect the true return. Fung and Hsieh estimate
survivorship bias to be 3% p.a. for hedge funds. Liang36 estimates the bias to be 2%,
noting that poor performance is the main reason for a funds disappearance. Some
performance studies have incorporated this bias, and future studies should
certainly take it into consideration.
Selection bias. As explained above, not all hedge funds report data to the
vendors, and it remains the manager’s choice to do so. Consequently, the database
is not representative of the whole population. On the one side it is expected that
hedge fund managers with good performance would want to be in the database,
whilst on the other hand they might have reached their critical size37 and do not
need to attract new investors. Fung and Hsieh estimate that these two opposite
effects may result in a negligible bias38.
Instant history basis (or back filling bias). Before reporting to a vendor a fund
manager undergoes an incubation period in which they trade with their own money,
in order to back-fill the database with historical returns. Managers find it easier to
market themselves with good performance and may be induced to cheat by reporting
better performance during the incubation period. Estimates of this bias by Fung and
35
FUNG, William & HSIEH, David A., “Performance Characteristics of Hedge Fund and CTA
Funds: Natural Versus Spurious Biases”, Journal of Financial and Quantitative Analysis, 2000, Vol.
10, No. 3.
36
LIANG, Bing, “Hedge Funds: The Living and the Dead”, Weatherhead School of Management,
Forthcoming Journal of Financial and Quantitative Analysis, Current Version 2000.
37
Hedge funds normally close for new investors at a certain asset volume under management.
29
Hsieh were calculated by computing the difference between returns, excluding and
including incubation period. The bias was found to be 1.4% p.a. for hedge funds.
This bias might be related to the superior performance of younger funds argued by
Howell39.
Multi period sampling bias. A study of hedge fund performance over the long-
term, might discard the shorter time-series hedge fund returns commonly have, and
introduce possible biases. Fung and Hsieh estimate that this bias is very small, if it
exists. It does however point out that empirical long-term performance studies on
hedge funds are difficult to conduct.
Although these biases exist, performance studies on hedge funds can not be
disregarded; they show abnormal returns for hedge funds even when
accommodating for biases. There are ambiguity issues related to the individual
studies, but the general assumption is clear. Academics have now largely moved on
to examining the sources of out-performance. This remains a puzzle for academics,
and might induce academics to rethink the notion of risk, market player rationality
and other key assumptions in financial theory40.
3.2.3 SOURCES OF OUT-PERFORMANCE
Academics have been unsuccessful in developing a financial model that can
reliably explain the risk/return relationship seen in hedge funds, but it has been
argued that hedge funds have return patterns that are more option like than
traditional investments. There has been considerably less research dedicated to the
sources of out-performance than performance itself. The key to the hedge fund
puzzle might be that in comparison to traditional investments these sources do not
necessarily increase the risk, hence, hedge funds inherently generate risk-adjusted
38
FUNG, William & HSIEH, David A., “Performance Characteristics of Hedge Fund and CTA
Funds: Natural Versus Spurious Biases”, Journal of Financial and Quantitative Analysis, 2000, Vol.
10, No. 3.
39
HOWELL, Michael, “The Young Ones”, AIMA newsletter, June 2001. (Managing Director,
Crossborder Capital Ltd.)
40
BURKI, Valentin & LARQUE Rudolphe, “Hedge Fund Returns and their Drivers”, Ecole des HCE,
University of Lausanne 2001.
30
alpha41. This would challenge well-established theories of finance. In the absence of
financial modelling there is a need to approach this analysis on a qualitative basis.
Cottier argues that hedge funds have specific characteristics that can
account for superior performance. These include; low liquidity, incentive fees,
offshore domicile, or high minimum investments. He finds empirical evidence linking
high incentive fees and infrequent redemption to superior performance.
Furthermore, he points out that high fees, premiums, transaction costs and sales
commissions can work against high returns.
Conversely Cottier argues that the enormous flexibility regarding asset
classes, markets, trading styles, instruments, and investment bias, probably is the
predominant factor in explaining the abnormal returns. To exploit these flexible
investment criteria, hedge fund managers have to be outstanding in their
professional expertise. It is widely agreed in the professional investment community
that hedge fund managers are superior, and it is a well known fact that investment
banks are loosing their best traders and fund managers to the hedge fund
industry42.
Liang attributes the superior performance to effective incentive schemes,
dynamic and flexible trading schemes, and the various financial instruments
employed by hedge funds. He does not emphasise manager skill as a driver, and
academia is divided on this issue. However, the flexibility gained by the hedge fund
structure must be managed, and certainly in the context of risk management. The
hedge fund manger’s role as risk managers is amplified and skill is an important
element of success43. Thus, superior management skills in hedge funds should
therefore not be ignored as an important source of performance.
41
SCHNEEWIES, Thomas, “Alpha, Alpha, Whose got the Alpha?”, Working Paper, Isenberg School
of Management & University of Massachusetts, 1999. He argues that the term alpha is used in two
circumstances by industry professionals; 1) As the return over a specified index benchmark, 2) As the
risk adjusted out-performance.
42
2000.
43
London, 2001.
31
A study by Tremont and its subsidiary, TASS investment research presented
a comprehensive outline of “why hedge funds make money”, e.g. their source of
superior performance44. While the hedge fund structure is relatively new, the
investment activities conducted within hedge funds are not. Historically, large
financial institutions were the only organisations with the infrastructure to carry out
the strategies, and the proprietary desk was very much at the top of the career
ladder for a trader. These operations in investment banks can be highly profitable,
but also very risky. Hedge funds are drawing the top talent from proprietary desks,
and the banks are developing more towards being providers of instruments and
leverage, itself a profitable activity and less risky than proprietary trading.
There has been a tendency to outsourcing of proprietary trading, transferring
this profitable activity to hedge funds. Some of the most talented individuals have
left the investment banks to started their own funds. Financial institutions have for
decades been granted “unfair” trading advantage that arguably give inherent return
in proprietary trading. These include; first call on breaking news, reduced
transaction costs, superior market access, as well as structural and statutory
benefits. They now represent a component of the inherent return in hedge funds.
Hedge funds mainly invest in highly specialised areas which require expertise
and substantial research infrastructure. The higher fees in comparison to a
traditional actively managed fund, which may charge 60 to 100 basis points, make it
economically possible for the funds to develop some type of investment edge45. This
specialist edge can be exploited, but this does not mean that all specialists are
profitable. Nevertheless, specialist knowledge combined with the trading advantages
outlined above can be an influential criterion for out-performance46. The relative size
of the fund can be an advantage as well. Hedge funds dynamically change
investment strategies to adapt to change, thereby exploiting their size, whether
44
TREMONT PARTNERS & TASS INVESTMENT RESEARCH, “The Case for Hedge Funds”,
London & New York, 2000.
45
HARMSTONE, Andrew R, “Alpha transfer: Optimising the Benefit of Active Management”,
Lehman Brothers Inc, London, 2000.
46
2000.
32
small or large; e.g. a small fund is able to capture small market movements in a
specialist market, whereas a large fund may get exceptionally low transaction costs
in the macroeconomic market.
Hedge funds are among investment banks’ most profitable clients, and
therefore usually benefit from superior service to other clients. The study further
argues that hedge funds make money in areas where “money is left on the table”,
when other participants can’t or chose not to trade, or must be on the other side of
the transaction. The inherent return has been transferred from investment banks to
hedge funds, while investment banks more often chose to be the providers rather
than the players.
Empirical studies have found high incentive fees to been related to
performance. For the hedge fund industry as a whole, performance based
compensation arguably creates positive manager selection. Only managers with
established industry pedigrees have the credibility to raise initial assets and only
managers who continue to deliver compelling net returns will keep or receive more
capital. Managers are more personally involved in the business, both on a financial
and emotional scale, creating a positive agency effect. This further amplifies the
“Darwinian model”, making it stronger in hedge funds than in the financial
institutions that their trading strategies emerged from47.
3.3 FUTURE PERFORMANCE
Most sources of out-performance expected to remain static. The regulatory
network is not predicted to change in any way that will infringe on hedge funds’
ability to trade freely48. However, there is some concern that the performance of
hedge funds might suffer in the light of increased asset allocation. Most industry
professionals argue that proprietary trading and hedge fund management requires
special skills, and point out that there are a limited number of people in the
47
48
33
business with adequate skills to succeed in this competitive environment49. If this
proves to be correct it might damage overall performance and increase the risk in
investing.
However, positive manager selection should cancel out this effect. The
financial rewards of hedge fund management are substantial and might induce more
hedge fund start-ups than needed, but solid industry credibility is a requirement by
investors and hedge funds will continue to recruit only the best and brightest. There
is also an increased understanding of hedge funds and their strategies in the
investment community, and aspiring industry entrants have improved opportunities
to educate themselves in hedge fund management.
Hedge fund managers profit on market imperfections. With more capital
chasing this source of revenue, performance may decline. Studies on performance
from different time periods throughout the expansion of the hedge fund industry
have thus far not shown declining profits, and out-performance is still very much
prevalent. It is obvious that there is not an infinite capacity for hedge funds in the
financial system though, probably leading to a decline in profits at some stage.
Currently, and in the near future, there should be profit-making
opportunities aplenty to support the higher fees charged by hedge funds because
there is limited arbitrage in financial markets50. MSDW predicts a future growth in
the supply of these inefficiencies51. Unilever’s successful case against Merrill Lynch
asset management has sent shock waves through the investment management
community, and most actively managed funds will now be required to follow the
index more stringently than before52. Thus, creating further market inefficiencies
hedge funds can exploit in their investment strategies.
49
2000.
50
MITCHELL, Mark & PULVINO, Todd & STAFFORD, Erik, “Limited Arbitrage in Equity
Markets”, Harvard University and Northwestern University, Forthcoming Journal of Finance April
2002.
51
MORGAN STANLEY DEAN WITTER, “Why Hedge Funds Make Sense”, New York, 2000.
52
Actively managed institutional investment funds are often bound by contract to perform better or
equal to the index, this means they rather than truly actively managing their funds have to employ
“closet-indexing”.
34
Should there be a future decline in the profitability of hedge funds it will not
be a dramatic event. Hedge funds continue to produce superior risk-adjusted
returns and do have generous leeway in comparison to traditional investments.
Uncertainties concerning the future performance of hedge funds should therefore
not be an impediment to further investments.
Part 4 examines hedge funds in portfolio context, and evaluates possible
alternatives to hedge funds. It will provide further evidence on the performance
efficiency of hedge fund investments, and will also review some of the important
practical issues in hedge fund investment. Essentially, the analysis will stipulate
how an investor can best capture the performance advantages of hedge funds
established in part 3.
35
4. ıNVESTıNG ıN HEDGE FUNDS
When investing, an investor constructs a portfolio of investments. Hedge
funds are rarely used as a stand-alone investment. Moving on from the previous
chapter, this chapter examines how hedge funds can best be used in a portfolio.
Some academic research on the efficient level of hedge fund investment has been
published. This will be used in companion with industry research and opinions, to
evaluate how to best utilize and capture the performance patterns shown by hedge
funds. Alternatives to hedge funds in a portfolio will be examined, and this will be of
further assistance when evaluating the future of the hedge fund industry.
4.1. HEDGE FUNDS ıN A PORTFOLıO
Drawing on modern portfolio theory, a stand-alone investment in a hedge
fund would most certainly not be efficient. Even a portfolio of hedge funds would
probably not be the optimal investment, unless it was mixed with other types of
investment. Although it makes an interesting prospect to be fully invested in a
diversified portfolio of hedge funds from an absolute return perspective, it is not
advisable in practice. As a result, the real risk and return benefits of a particular
hedge fund has less to do with its own stand-alone performance than how it
performs relative to an investor’s existing portfolio.
An integral factor in the continued dominance of high net worth investors in
the hedge fund industry is their willingness to bear the higher risks associated with
investing in individual hedge funds, in exchange for higher returns. Investing in a
portfolio of hedge funds would, in theory, be the best exposure to hedge funds, and
academics and professional asset managers consent in this matter. This requires
the investor to carry out thorough and costly due diligence, and the capital
committed would have to be substantial due to minimum investment requirements.
In practice the preferred vehicle to gain this exposure is a fund of funds.
Asset managers have found that a portfolio of no more than 20 funds can replicate a
36
hedge fund index53. Fung and Hsieh54 even argue that fund of funds should be used
for measuring hedge fund performance. This does however add another layer of fees
on the investor, and Amin and Kat55 find an efficiency loss of 5.17% p.a. in
comparison with hedge fund indices. The costly due-diligence process an individual
investor would have to undertake would probably cancel out this loss.
Adding hedge funds to a portfolio of investments remains the most effective
use of the investment vehicle for most investors. Hedge funds can function
simultaneously as return enhancers and risk diversifiers when combined in a
portfolio. Academics and investment managers are in widespread agreement on in
this matter, and studies suggest that the inclusion of hedge funds has a positive
effect on performance. Table 4.1 presents the result of a study by TASS/Tremont
where hedge fund index performance was included in a typical pension fund index
portfolio.
Table 4.1. Hedge Funds in a Portfolio
Hedge Fund Pension

5% 10% 15% 20%
allocation/performance56 Fund
Average Annual Return
13.1 13.2 13.3 13.4 13.5
(%)
Drawdown (%) 9.41 8.90 8.28 7.99 7.86
Standard
8.96 8.66 8.27 7.98 7.71
Deviation (annualised)
Semi Deviation
6.92 6.52 6.12 5.74 5.54
(annualised)
Sharpe Ratio
0.90 0.95 1.00 1.05 1.10
(annualised)
(Source: Tass/Tremont, 2000)
There is a clear pattern of increased performance with the incorporation of
hedge funds in a portfolio. Other studies support these findings57. The broad range
53
From evidence presented in: MORGAN STANLEY DEAN WITTER, “Why Hedge Funds Make
Sense”, New York, 2000. & FOTHERGILL, Martin & COKE, Carolyn, “Funds of Hedge Funds: An
Introduction to Multi-manager Funds”, Deutsche Bank, London, 2000.
54
FUNG, William & HSIEH, David A., “Benchmarks of Hedge Fund performance: Information
Content & Measurement Biases”, Working Paper, Fuqua School of Business, Duke University, 2000.
55
Machines Really Add Value?”, Working Paper, University of Reading, 2001.
56
The table indicates the effect on performance measurements when a standard pension fund chooses
to re-invest 5, 10, 15, and 20% of its capital from its standard portfolio into hedge funds.
57
JEAGER, Lars, “The significance of Transparency and Liquidity for Multi-Manager Portfolios of
alternative investment strategies”, SAIS Group AG, Switzerland, 2001.
37
of investment strategies and sectors covered by a portfolio of hedge funds
demonstrate very attractive risk/reward characteristics in combination with a
traditional portfolio, and can dramatically improve the efficient frontier, by
producing significantly higher returns and substantially reducing risk58.
Efficient frontier analysis has found the optimal level of hedge fund
investment to be between 10 and 20% of capital available for a portfolio59. Research
carried out by Rzenpceynski, Nenbauer and Henry supports that this level of hedge
fund investment would suit and enhance portfolios of both risk-averse and risk-
tolerant investors60. They further argue that hedge funds can sculpt the risk/return
profile desired by an investor in ways international diversification historically has
been unable to do, and that the addition of hedge funds in a portfolio is a prudent
investment strategy.
Schneeweis and Spurgin61 argue that each hedge fund strategy must be
judged on its own unique relationship with an investor’s portfolio. They classify
hedge funds on the impact they have on an individual portfolio; return enhancer,
risk reducers and total diversifier. In doing so they emphasise that individual hedge
fund strategies might have different impacts on an investor’s portfolio, and that they
can be employed by investors to create a desired end-effect. Fund of funds or
portfolios of hedge funds can, in turn, be heavily weighted in some strategies to suit
the requirements of different investors.
Hedge funds’ main attraction for investors is the weak relationship between
hedge fund returns and other asset classes. This is a relatively new perspective in
the context of hedge funds. For many years high-net-worth individuals primarily
58
JEAGER, Lars, “The significance of Transparency and Liquidity for Multi-Manager Portfolios of
alternative investment strategies”, SAIS Group AG, Switzerland, 2001.
59
AMIN, Gaurav S & KAT, Harry M, “Hedge Fund Performance 1990-2000: Do the Money Machines
Really Add Value?”, Working Paper, University of Reading, 2001., FOTHERGILL, Martin & COKE,
Carolyn, “Funds of Hedge Funds: An Introduction to Multi-manager Funds”, Deutsche Bank, London,
2000., & MORGAN STANLEY DEAN WITTER, “Why Hedge Funds Make Sense”, New York, 2000.
60
RZENPCEYNSKI, Mark S & NENBAUER, Franklin & HENRY, John W & Co, “Adding hedge
funds to a traditional asset portfolio: what can we learn?”, AIMA Newsletter, London, 2001.
61
SCHNEEWIES, Thomas & SPURGIN Richard, “Hedge Funds: Portfolio Diversifiers, Return
Enhancers or Both?, Working Paper, Isenberg School of Management & University of Massachusetts,
2000.
38
used hedge funds as opportunistic investment vehicles, sometimes employing them
in a manner resembling gambling. Currently institutional investors are rethinking
their approach to hedge funds and discovering them as a very useful and effective
investment vehicle, with especially good correlation characteristics. Hedge funds
gain these uncorrelated returns by not explicitly tracking a particular index, but
rather emphasising on maximising long-term absolute returns. As presented above,
they are a valuable addition to portfolios, especially institutional portfolios.
4.2 ALTERNATıVES TO HEDGE FUNDS
Other investments used for the same purpose include all other alternative
investments, and specially constructed traditional investments. Mutual funds are
the obvious alternative. These funds have also experienced an enormous increase in
popularity, but are under-performers in most respects compared to hedge funds.
Amin and Kat find that they exhibit a stronger correlation with the traditional
portfolio, produce lesser returns, and provide poorer downside protection62. The
investment process into mutual funds is often simpler, with a lower minimum
investment, shorter lock-up periods, and easier and more frequent redemption.
These features make them more accessible, but the performance lags far behind that
of hedge funds. Cottier’s and other academic research conforms with this63.
Funds with specific asset allocation and geographical focus can be viewed as
alternatives to hedge funds, but would not display the same characteristics as a
hedge fund portfolio. Moreover, they are very likely to under-perform in
comparison64. Private Equity can also be an investment vehicle designed to diversify
and enhance returns. This may include venture capital, growth capital,
turnaround/reorganisation capital, and leveraged buy-outs or re-capitalisations.
Nevertheless, these strategies can also be employed by hedge funds, which have
62
Machines Really Add Value?”, Working Paper, University of Reading, 2001.
63
2000.
64
MARTIN, George, “Making Sense of Hedge Fund Returns: What matters and what doesn’t”,
Forthcoming in Derivatives Strategies, University of Massachusetts, 2000.
39
greater trading flexibility. A hedge fund portfolio would probably be less exposed to
risk and be a more effective way of diversifying, but private equity is a viable
alternative and this investment approach has also attracted an enormous inflow of
capital.
Managed futures are closely related to hedge funds, and exhibit similar risk
and return patterns. Cottier65 examined both hedge funds and managed futures. He
found that single manager futures funds had higher returns than hedge funds, but
that overall, hedge funds out-performed managed futures on a risk-adjusted basis.
Multi manager funds were less volatile than single manager funds for both
investment vehicles, multi manager futures funds clearly under-performed
compared to single manager funds though. Multi manager hedge funds exhibited
similar returns to single manager funds.
Caglayan and Edwards66 also found that overall hedge funds out-performed
managed futures on a risk-adjusted basis. Commodity funds yield better returns in
bear markets and they conclude that, on average, commodity funds may provide
better downside protection, but four hedge fund styles; market-neutral, event
driven, global macro, and short selling, also perform well in bear markets. These
strategies, except from short selling, are also top performers in bull markets. They
continue to argue that the primary reason to invest in alternative investments is
diversification and downside protection, and that only certain hedge fund strategies
can provide this effectively, but that the strategies mentioned above possess a
superior risk/return relationship while still providing good downside protection.
Structured products67 are specialist investment vehicles that can be used to
diversify investors portfolios that have a significant proportion of their wealth tied up
in few investments. They can be used to create a hedge against stocks, offer
65
2000.
66
CAGLAYAN, Mustafa O & EDWARDS, Franklin R, “Hedge Fund and commodity Fund
Investment Styles in Bull and Bear Markets”, Working Paper, City University of New York &
Colombia University, 2000.
67
Includes hedging strategies for single stocks, principal protected notes, income generating notes, and
index trackers.
40
protection with access to volatile markets with a pre-defined risk, and also help to
reduce an investor’s tax burden. As an alternative to hedge funds they offer very
different return patterns, but hedge funds can also be incorporated into structured
products. This is especially popular in countries where tax regulation prevent
efficient investing in hedge funds. Structured products are more individually
tailored, and are a minor investment vehicle compared to hedge funds68.
4.3 RıSK MANAGEMENT AND SELECTıON
The problem with transparency throughout the hedge fund industry becomes
even clearer in the context of the individual fund. Hedge fund investment strategies
are proprietary by nature, and the fund managers often resent disclosing
information, even to existing investors. Nevertheless, this policy is in change
throughout the industry. The near collapse of Long Term Capital Management in
1998 arguably worked as a catalyst for increased disclosure, which in turn has
contributed to the industry’s recent success69. This will be further examined in part
5.
Investing in hedge funds, and to a certain extent fund of funds, remains very
different from investing in traditional investments. By investing blindly an investor
can be exposed to great risk, and the selection process is not an easy task.
Therefore, many investors hire hedge fund consultants or invest through multi-
manager fund vehicles. In any case, the selection of a hedge fund investment vehicle
is an imperative element of risk management in the investment process.
The selection of individual funds and programs is usually based on a
thorough quantitative and qualitative analysis. Quantitative analysis uses figures
produced in past periods, which are used in performance measurement methods
presented in part 3.2. Qualitative analysis, or due diligence, is extremely important
in hedge funds due to their private structure, and the enormous flexibility in
68
MERRILL LYNCH/CAP GEMINI ERNST & YOUNG, “World Wealth Report 2001”, published
2001 by Merrill Lynch Group International and Cap Gemini Ernst & Young International.
69
McKENZIE, Mark-Anthony, “Growth in the Global Hedge Fund Industry and Due Diligence of
Offshore Hedge Funds”, Cayman Islands Monetary Authority, 2001.
41
investment strategies and trading. An outline of the elements of this process that
should be considered is presented in Table 4.2.
Table 4.2 Process of Due diligence/Qualitative Analysis of Hedge Fund

Investment Vehicles
Business information on management company:

Name, address, phone number of management company; contact persons; structure of organisation;
major shareholders; affiliations, memberships, and registrations; number and turnover of employees;
different funds and programs traded; total assets under management.
General information on specific fund/program:
Date of inception; domicile; current assets under management and growth of these assets; typical
investors; brokers used; custodian; administrator; auditor.
Conditions:
Fee structure; sales commissions and kick-backs; round turn brokerage fees; subscription and
redemption frequency and notification periods; minimum investment amount required; possibility of
customisation to special investor needs.
Information on key principals and traders:
Biographical background, previous employers; trading experience; reputation and life style; legal
actions against one of the principals of the fund in the past; personal assets invested in then fund;
remuneration and incentive style.
Strategy:
Investment philosophy; trading style, investment bias, markets and instruments used; strengths and
weaknesses of strategy; success of strategy dependent on which market conditions; competitors;
competitive edge and adaptability of traders; main investment decision process; investments based on
what signals; possibility of overriding these signals; size of positions; diversification; average holding
periods; speed of entering and pulling out of positions; types of orders; investments based on what kind
of data; research; consistency of strategy; changes occurred during the course of the track record; how
are/were investors informed; size of niche and impact of large money additions; acceptance of new
money once capacity is reached.
Risk management:
Hedging methods; position, loss, and leverage limits; value-at-risk in specific time periods; back office
infrastructure and systems used; 24 hour monitoring of positions and limits; independent risk control;
counter parties used; credit limits with brokers; marking-to-market of illiquid positions; any changes in
risk management during the course of the track record; reasons for largest draw-downs and upturns;
how did risk management work or not work; how did risk management function in function in special
market conditions; rising correlations to markets or to other funds/managers in special market
conditions.
Performance data:
Monthly return figures since inception; copies of audited performance tables and official tax
statements; copies of recent broker statements in order to duplicate individual trades and positions;
sample of reports sent out to clients; frequency of communication with investors; reporting to database
providers.
(Source: based on COTTIER, Philipp, “Hedge Funds and Managed Futures”, 3rd Edition, Verlag
Paul Haupt, Bern, 2000.)
An investment analysis of a fund should not only take into consideration the
likelihood of decline or loss of capital due to human and corporate aspects, but
importantly, should assist in the evaluation of the hedge fund’s/fund of funds’
relationship with the investors existing portfolio. This provides insight into the
42
optimum level of diversification that can be achieved by including hedge funds.
Clearly, continuous monitoring is crucial in hedge fund investing, and should be
rigorously employed.
The underlying flexible corporate structures and the dynamic investment
strategies employed create an environment where important changes occur more
frequently and quicker than in other investment funds. Monitoring is important for
every investor, but has been re-introduced with more vigour by institutional
investors in the hedge fund industry.
Proactive buy-side risk management can help minimise losses, and this in
turn maximises the returns gained from money-making efforts. These are
interlinked factors in investment, but the asset management industry is leaning
towards employing more rigorous risk management processes because of a
newfound respect for the value generating effect they yield70. In hedge fund
investment its importance in amplified, and a thorough implementation can
generate vastly improved risk/adjusted returns71.
To summarise, selection and risk management in the hedge fund investment
processes is arguably closely linked to performance. Yet, it remains a practical task,
and although academic research can present good guidelines, it has an inherent
limited ability to assist the investor in separate investment decisions.
Part 5 examines hedge funds in a wider context. This supplements previous
parts by reviewing related factors other than fundamentals/performance centred
aspects. The review of the evolution of the hedge fund industry, and associated
issues of interest, represents the second element required to evaluate if the current
hedge fund boom has bubble theory characteristics.
70
GIBSON, Lang, “Proactive Buy-Side Risk Management”, Mr. Gibson is a member of Global
Association of Risk Professionals, the paper was published on the Hedgeworld database, 2001.
71
LO, Andrew, W., “Risk Management for Hedge Funds: Introduction and Overview”, Working
Paper, MIT Sloan School of Management & AlphaSimplex Group, US, June 2001.
43
5. THE EVOLUTıON OF THE HEDGE FUND ıNDUSTRY
The hedge fund industry has experienced a dramatic rise in capital under
management in the 1990s. Since 1998, significant developments have been taking
place in the hedge fund industry, attracting further growth in investments. This
section examines the scale of the evolution in the hedge fund industry, the main
drivers and key developments, and outlines future developments that will shape the
industry and influence the role of hedge funds in asset management. This
complements parts 3 and 4, presenting hedge funds in a wider perspective,
identifying other factors that might influence an investment decision. The European
marketplace is of particular interest due to an arguably young and untapped hedge
fund sector.
5.1 ASSET VOLUMES
Because of the private nature of hedge funds and regulatory disclosure
requirements, definitive data on the size of the market and number of hedge funds is
not readily available. Hedge fund databases provide estimates though, and by
comparing these, a reasonably accurate picture of the hedge fund industry can be
presented.
Figure 5.1 Growth of the Global Hedge Fund Universe
600
500
400
$ bn
300
200
100
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Mondohedge Hedge Fund Research Van Hedge Fund Advisors
(Source: Mondohedge, Hedge Fund Research and Van Hedge Fund Advisors)
44
In 2002, capital currently under management by hedge funds is estimated to
be between $ 600 and $ 700 billion72. One industry prediction expects these figures
to grow to approximately 1.7 trillion by 200573. The growth in hedge fund capital has
far surpassed the growth in equity markets and assets under investment
management74. The number of funds has increased proportionately, and
TASS/Tremont estimates the total number of hedge funds to exceed 6000 in 200175,
with about 2000 funds created in the year 2000 alone. Hedge Fund Research
presents an overview of the developments in the total number of hedge funds, their
findings largely conform with other industry estimates76.
Figure 5.2 Total Number of Funds in the Industry
4500
4000
3500
Number of Funds
3000
2500
2000
1500
1000
500
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
(Source: Hedge Fund Research)
An astounding number of funds have been created to meet the increased
demand for hedge fund products in the asset management industry. Beyond
investment demand though, there are other factors driving the increasing numbers
of new hedge funds; 1) There are few regulatory requirements and low start-up
72
www.hedegworld.com, April 10, 2002.
73
2000.
74
75
76
Tass/Tremont, Marhedge, MondoHedge & Deutsche Bank.
45
costs, making barriers to entry trivial. 2) Investment professionals are attracted by
the financially rewarding compensation structure common to hedge funds77. 3) The
freedom to manage assets without constraints imposed by clients, benchmarks, and
guidelines, is very attractive to competent managers78.
Nevertheless, the capital allocated to hedge funds still pales in comparison to
the amounts of capital allocated to traditional strategies79. Institutions currently
allocate less than 1% of assets into hedge funds80, and high/ultra high net worth
investors allocate approximately 4% of their capital into hedge funds81. When viewed
in the light of the findings in parts 3 and 4, which clearly establishes the
performance efficiency of hedge fund investment allocation in portfolios, there is
certainly an untapped market.
5.2 THE EUROPEAN MARKETPLACE
Since the financial crisis of the late 1990s, there has been a significant
expansion in the hedge fund industry, particularly in Europe. Research has shown
that the European hedge funds are at the leading edge of the industry’s growth82.
The European market is still negligible compared to the US market, which has
evolved more rapidly. Sources vary83, but currently the European market is
estimated to constitute only around 5 % of the total hedge fund universe. Earlier
growth in the European market can largely be attributed to fund of funds. The first
fund of funds came from Europe in 1969. In the latter half of the 1990s substantial
77
Hedge fund management yields earnings that are vastly superior to traditional active fund
management; a fund charging 1% of capital committed plus 20% of gross profits p.a., assuming a 5%
trading profit, would earn more than 5 times the fees for traditional active equity products. From:
BARRA ROGERS CASEY, “An Introduction to Hedge Funds”, BARRA Inc., 2001.
78
CHANDLER, Beverly, “Investing with the Hedge Fund Giants”, 2nd Edition, Prentice Hall London,
2002.
79
ARTHUR ANDERSEN, “The Global Hedge Fund Industry: Moving into the New Millennium”, by
Market Practices Group, Financial Markets Practice, Arthur Andersen, November 2001.
80
FOTHERGILL, Martin & COKE, Carolyn, “Funds of Hedge Funds: An Introduction to Multi-
manager Funds”, Deutsche Bank, London, 2000.
81
MERRILL LYNCH/CAP GEMINI ERNST & YOUNG, “World Wealth Report 2001”, published
2001 by Merrill Lynch Group International and Cap Gemini Ernst & Young International.
82
William Dombrowski, Arthur Andersen, 1999, in: FOTHERGILL, Martin & COKE, Carolyn,
“Funds of Hedge Funds: An Introduction to Multi-manager Funds”, Deutsche Bank, London, 2000.
83
Tass/Tremont, MarHedge, Hedge Fund Research.
46
amounts of European capital was invested in single manager start-ups and existing
funds84.
Figure 5.3 Growth of the European Hedge Fund Market ($ billion)
35
30
25
20
15
10
0
1994 1995 1996 1997 1998 1999 2000 2001
(Source: Fothergill and Coke, Deutsche Bank, 2000)
Growth in the European hedge fund market has been inhibited by the
complex regulatory environment, which varies between countries. This is further
examined in Appendix B. Different currencies and smaller individual asset
management markets are further reasons behind the low levels of hedge fund
investments85. The breakdown of corporate barriers in Europe and the introduction
of the Euro, are important elements in the increased growth prospects for hedge
funds in European markets.
Institutional investors are expected to be the strongest driving force of growth
in the European marketplace. A recent survey revealed that 56% of European
institutional investors are either currently investing in hedge funds or intend to do
so in the future86. This will be produce a considerable boost to the European hedge
fund industry, and capital under management is consequently expected to soar.
84
FOTHERGILL, Martin & COKE, Carolyn, “Funds of Hedge Funds: An Introduction to Multi-
manager Funds”, Deutsche Bank, London, 2000.
85
2000.
86
Ludgate Communications survey of 100 of the leading European Institutions that collectively control
60% of assets under management in Europe, Euro 5,300 billion, 2000.
47
Figure 5.4 Percentage of European Institutions Currently Investing or
Considering Investing in Hedge Funds
80
70
60
50
%
40
30
20
10
0
a
s
nd
ly
al
ce
K
nd
vi
an
Ita
t
To
an
la
na
rla
m
er
Fr
di
er
he
itz
an
G
Sw
et
Sc
N
Currently Investing Considering Investing
(Source: Ludgate Communications, 2000)
This considerable institutional interest in hedge funds is to due the
increased realisation of the performance enhancing capabilities of hedge funds in a
portfolio context. Institutional interest in hedge funds will not only increase the
number of investors in hedge funds, but also raise levels of total assets committed.
Figure 5.5 European Asset Management Industry rating of the relative
importance of hedge fund products to profitability now and in three years.
Low Not Relevant

Low 10% 14%
Medium
Medium
Not Relevant High
High 40%
36%
(Source: From presentation by Bruce Weatherill, Price Waterhouse Coopers, “Examining the
findings of the 2000/2001 Private Banking Survey: Private Banking and its Changing Approach to
Alternative Investments”, 2nd Annual Euromoney European Hedge Funds Conference 2001)
48
Institutional investors’ current reluctance to invest in hedge funds is
peculiar, and an examination of the underlying factors is necessary to understand
the future evolution of the hedge fund sector.
Figure 5.6 Main Problems Cited by European Institutions Regarding Hedge

Fund Investing
40
35
30
25
%
20
15
10
5
0
e
cy
d
es
l
n
e
ity
tro
dg
an
io
ag
en
id
Fe
at
on
le
em
Im
qu
ar
ul
ow
h
C
Li
eg
sp
ig
D
or
k
Kn
H
Po
is
an
of
R
of
Tr
of
ck
La
ck
ck
of
La
La
ck
La
(Source: Ludgate Communications, 2000)
Developments in these problem areas are key to an increased acceptance of
hedge funds in the European market, and ultimately an increase in capital invested.
Since 1998 the hedge fund industry has greatly improved measures for
transparency and risk control, and although this has contributed to growth, it
remains an area of controversy. Fund of funds assist in bypassing the stated
problems, and financial advisors commonly view them as the best way of investing
in hedge funds87. The industry is however working towards accommodating the
particular demands placed by institutional investors, which is in the interest of both
parties.
An additional underlying factor that may contribute to the continued growth
of the European hedge fund sector is the predicted dramatic rise of the European
pensions and long-term savings market. This market controls a dominant
87
ROSENBAUM, Robert I., “Fund of Funds: The Right Choice for Your Clients’ Allocation to Hedge
Funds”, Investment Management Consultants Association, IMCA, September/October 2000.
49
proportion of capital under management, and represents a very important market
for the hedge fund industry. A report by PWC predicts an increased annual inflow
into EU savings of 200-300 billion euros88. It further argues that this will greatly
affect the investment management sector, attracting many new entrants, including
those from outside the traditional financial services industry.
In summary, the European hedge fund sector is at an early stage of
development. There are large growth prospects driven by solid underlying factors, in
a relatively untapped market.
5.3 KEY DEVELOPMENTS
This section outlines the key developments in the hedge fund and investment
management industries that have driven the increased interest and growth in hedge
fund investments. An understanding of the evolutionary factors is important when
evaluating the future role of hedge funds in portfolio management. This also gives
insight into whether hedge funds will have continued success irrespective of market
conditions. Not only have hedge funds developed in the last few years, but the asset
management industry as a whole is also undergoing reform. Many of the factors are
interlinked and it is difficult to distinguish their individual importance. However,
other than the obvious performance argument, certain trends have shaped the
evolution of the hedge fund industry.
The fundamental tools of successful hedge fund management have improved.
The investment technology hedge fund managers use has vastly improved and
become more attainable. Advanced computer systems and software are available at
lower costs, when before they were reserved for large corporate structures.
Competitive trading advantage enjoyed by investment banks has therefore been
channelled into hedge funds, and the playing field has consequently been levelled89.
88
PRICE WATERHOUSE COOPERS, “The European Pensions and Savings Revolution – Our Vision
of the Future”, by John Hawksworth, Nicholas Vause, David Pettitt, Jenny Lee, and Travis Baker,
PWC, 2000.
89
50
The essential prime brokerage services are now well developed and offered by most
investment banks.
Hedge funds have increasingly attracted talent and expertise by recruiting
the cream of asset managers and traders from the financial services sector. This is
arguably an important factor contributing to the attractive performance generated
by hedge funds. These individuals also bring more credibility to the industry, and
channel their previous traditional clients into hedge funds90.
Academic research is considered to have been a great contribution to the
asset management industry’s increased realisation of the performance
characteristics of hedge funds. Hedge fund managers have generated very attractive
risk-adjusted returns for a long time91, and the industry perception of hedge fund
returns has been clarified. Hedge funds are now viewed to be an increasingly
important alternative source of returns. By displaying low correlation to traditional
asset classes they are a valuable addition to investment portfolios. This also yields a
risk management opportunity, contrary to the popular view of hedge funds being very
risky investments.
Increased knowledge on hedge funds in the investment community has
certainly been a contributor to growth. The mythical perception of hedge funds,
which existed for over half a century, has only recently been removed92.
Misconceptions of hedge funds are still prevalent but there is an increased
understanding of the risk and return opportunities hedge funds offer, and clichés
that have hindered the industry from expanding have been unravelled.
The near collapse of LTCM was a defining moment for hedge funds, which
induced the sector to facilitate for increasingly risk-concerned investors93. This only
caused a temporary outflow of capital from hedge funds, but inevitably brought
more attention to the transparency problem in hedge funds. Increased transparency
90
2001.
91
Performance of hedge funds is comprehensively outlined in Part 3.
92
SCHNEEWIES, Thomas, “Dealing with the Myths of Hedge Fund Investments”, Journal of
Alternative Investments, Winter 1998.
51
not only makes for more efficient use of hedge funds in investment portfolios, but is
also an essential criterion for attracting more of the gigantic institutional investment
market. Although there have been developments in transparency, the industry still
has a long way to go. Fund of funds can bypass some of the problems related to
transparency, and are proving increasingly popular.
Current market conditions have made investors realise that the phenomenal
returns seen in the last two decades cannot continue due to decreasing inflation94.
Nevertheless, with a lot of volatility in individual share prices, the hedge fund
approach is also suited to these market conditions. The asset management industry
is therefore leaning towards absolute return objectives to partly eliminate market
risk95. Hedge funds are now perceived to be a more powerful tool in generating
alpha, and alpha is becoming more important to investors as market-based
investment returns are decreasing96.
In conjunction with the increased interest in absolute return strategies, the
institutional investment management industry has arguably changed its perception
of risk. There has been a shift in focus from expected return to risk, causing
portfolio management to mutate into risk management, e.g. long held methodologies
and investment styles are gradually being replaced by more scientific approaches
and tools to manage money, assets and risk97. Hedge funds partly replicate this
progressive view of portfolio management by searching for alpha while managing
risk, and would therefore be a natural addition to any portfolio pursuing it. Recent
hedge fund start-ups are increasingly employing investment strategies that are more
93
JORION, Philippe, “Risk Management Lessons from Long-Term Capital Management”, European
Financial Management Journal, September 2000.
94
FREEMAN & Co LLC, “Asset Management Industry: Changing Tides”, New York, 2001.
95
London, 2001.
96
97
London, 2001.
52
suited to this, i.e. more conservative strategies embracing risk management;
moderately leveraged market neutral and equity long/short funds98.
Marketing of hedge funds has traditionally been, and remains, complicated.
But with an institutional investment industry partly in agreement that hedge funds
make sense, the channelling and distribution process of hedge funds has become
more straightforward. Larger institutions and financial advisors now offer hedge
fund products to their clients, whilst previously the investor had to actively search
for hedge funds99. The institutionalisation of hedge funds is another step in this
process; traditional asset management firms are now buying up hedge funds and
larger alternative investment/hedge fund groups are forming, although the boutique
structure is still the most prevalent100.
5.4 FUTURE EVOLUTıON OF HEDGE FUNDS
There is widespread consent that the hedge fund industry will attract more
capital in the future. How dramatic this development will be is difficult to gauge, but
predictions suggest that the inflow of capital, especially from institutional investors,
will be substantial. The hedge fund industry is very dynamic and changing
constantly, and should be able to accommodate for increased capital. More precise
forecasts, other than that the industry will continue to grow, are difficult to make.
There are major trends that will have an impact on the industry though, which in
turn could influence investment decisions, and the long-term outlook for hedge
funds.
Increasing competition within the sector is a certainty, although the current
climate with investors racing to allocate capital into hedge funds suggests otherwise.
Competition will be intensified when the industry grows and matures. This could
lead to declining fees and profits, but current profit margins for hedge funds are very
98
INEICHEN, Alexander M, “Who’s Long? Market Neutral Versus Long/Short Equity”, UBS
Warburg, London, 2001.
99
CULLIN, Iain, “SPECIAL REPORT: Marketing Hedge Funds”, AIMA, London, 1999.
100
ARTHUR ANDERSEN, “The Global Hedge Fund Industry: Moving into the New Millennium”, by
Market Practices Group, Financial Markets Practice, Arthur Andersen, November 2001.
53
generous. A growing hedge fund sector will also arguably find it difficult to maintain
vastly superior returns, due to the increased capital exploiting the same niches of
market inefficiency. There are also concerns related to the industry’s ability to
recruit enough talented managers to cater for increased capacity, but this is a rather
unconvincing proposition. Declining returns may be a reality in the long term, but
the implied risks should also decrease through improved risk management
techniques, and correlation to traditional assets classes will remain low.
A tougher competitive environment will evolve new investment strategies and
increase product innovation. Institutional investors will require more customisation,
and the hedge fund sector will continue to structure more sophisticated products.
This could lead to an increased polarisation between niche specialists and multi-
manager structures; e.g. a division of labour with specialists focusing on trading and
fund funds focusing on selection and marketing. Hedge fund consultants and
intermediaries101 with expertise will play an increasingly important role in the
distribution of hedge funds.
Industry consolidation will occur to some extent, but will fall short of evolving
into a concentrated group of global providers, as is argued by some experts102. The
private “boutique” structures of hedge funds are not only favourable for proprietary
investment strategies, but are also cherished by the industry’s leading
professionals103. Large progressive asset management groups are establishing their
own funds or offering fund of funds, through which they are capturing an increasing
market share, but there is arguably a limit to economies of scale in the hedge fund
industry, where diseconomies of scale can be a greater concern.
Increased transparency, as emphasised in part 5.3 is still in demand and is
key to future development. At some point transparency could endanger the
proprietary nature of the investment strategies though. As hedge funds grow and
gain acceptance, regulation might be adapted to better facilitate for investments.
101
Financial advisors, private banks, asset managers etc.
102
54
This could lead to stricter supervision of hedge funds, and hence increased
transparency, but it is ambiguous how welcome this development will be. The first
step could be the establishment of a specific independent regulatory body to make
disclosure practices less obscure, but currently this is a long way ahead.
In summary, the future evolution of the hedge fund industry should not
hamper the industry’s ability to produce superior risk-adjusted returns to the extent
that it should have a deterring influence on an investor’s decision to invest in hedge
funds at the present time.
103
LATHAM, Mark, Investment Director, Odey Asset Management. From presentation: “Established
Firms Vs. Boutique Firms”, Euromoney 2nd Annual Hedge Fund Conference, London, October, 2001.
55
CONCLUSıONS
The hypothesis presented in this paper is that hedge funds do represent a
new paradigm in asset management. This stipulates that theoretically hedge funds
should be included in a portfolio of investments, but also refers to the notion of the
hedge fund puzzle of abnormal risk-adjusted returns being genuine. A clarification
of this hypothesis should be of credible assistance for the overwhelming number of
investors currently considering investing in hedge funds, and provide reassurance
for investors who have capital allocated in hedge funds.
The contrary hypothesis would be that the hedge fund boom is a bubble. A
bubble exists when investors reach a consensus view of increased expected returns
and de-emphasise sound research, due diligence and logical economic reasoning,
causing expectations to slowly diverge from fundamentals. A bubble will eventually
burst when expectations converge with reality. The apparent hedge fund boom has
been under suspicion of being such an overvalued bubble.
To evaluate whether such a bubble exists, the paper has examined the
relationship between performance-oriented evidence, and the actual state of the
hedge fund industry and the wider investment management industry. The findings
are that the current boom does not display the characteristics of a bubble, but
rather the opposite. Capital allocation into hedge funds falls well short of what
fundamentals suggest, with the current boom reflecting economic rationale.
This paper has provided solid evidence in favour of the rationale of hedge
fund investment. Hedge funds do add value, and there is significant evidence of out-
performance. The risk/return characteristics of hedge funds are unique, and there
are no alternatives that can offer similarly rewarding risk-adjusted returns. In
contrast to the traditional view that active management does not yield better
performance, hedge funds produce abnormal returns, hence the hedge fund puzzle.
The risk exposures faced by hedge funds are not comprehensively understood, but
this does not discard the notion of abnormal returns.
56
Significant non-correlation to traditional investments further enhances their
value in a portfolio context, and partial capital allocation into hedge funds is a
prudent investment approach. Fund selection and risk management are of great
importance, and the risks associated with holding just one or two funds can be
extreme. Hedge fund investments should be considered in the context of a broadly
diversified portfolio of funds. Hedge fund consultants and fund funds are
intermediaries that provide this service effectively.
There is evidence that fund of funds is a highly efficient vehicle for capturing
hedge fund performance. They can reduce risks to bond levels and while still
maintaining steady returns of 10 to 15% p.a. These performance characteristics are
especially valuable in current market conditions, and could become even more
valuable in the event of the predicted further market slowdown occurring. But there
is also evidence that hedge funds were value-adding investments during the strong
bull markets of the 1990s. The current boom is therefore not only a product of
current market conditions, but represents a newly understood paradigm in
investment management.
Although there has been a dramatic inflow of capital into hedge funds, they
still control only a minute amount of the capital available. Evidence of the efficient
levels of hedge fund investments lying between 10 and 20%, contrasts with
institutional investors currently allocating less than 1 %. The growth prospects are
enormous. This raises the issue of capacity problems, which eventually might have a
deterring effect on hedge fund returns. This issue remains ambiguous, but hedge
fund performance has been persistent throughout the dramatic expansion seen in
the last decade.
Nevertheless, hedge funds do significantly out-perform traditional
investments. Moreover, they have such strong performance characteristics that it is
certain that their ability to provide value-added will not fade away in the short term.
It is questionable whether this could even occur in the longer term. At this point in
time, investors should therefore disregard bubble theory and follow fundamentals.
57
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ıNTERNET RESOURCES
http://altinvest.org
http://www.aima.org
http://www.e-hedge.com
http://www.hedgefund411.com
http://www.hedgefundcenter.com
http://www.hedgefundcity.com
http://www.hedgefunddynamics.com
http://www.hedgefundnews.com
http://www.hedgeinfo.com
http://www.hedgeworld.com
http://www.hfr.com
http://www.iijai.com
http://www.irr.org
http://www.magnum.com
http://www.mondohedge.com
http://www.parkplace.net
http://www.planethedgefund.com
http://www.plusfunds.com
http://www.tassman.com
http://www.turnkeyhedgefunds.com
http://www.vanhedge.com
http://www.village.albourne.com
62
APPENDıX A – STRATEGY CLASSıFıCATıON
To illustrate the diversity in hedge fund strategy classification, an overview
with examples of different hedge fund classifications is presented here. Included are
guides from recognised hedge fund advisories, investment companies and
academics. There is a confusing array of strategies, but the overview serves to
further build an understanding of investment approaches hedge fund managers can
employ, and portrays the complexity and sophistication of the hedge fund universe.
Table A.1 Classification by Industry Professionals
Financial Risk RR Capital/KPMG TASS/Tremont Van Hedge Fund

Management Ltd. Advisors Inc.
Market speculating Long/short equity Market neutral Aggressive growth
- Discretionary
trading Convertible arbitrage Convertible arbitrage Distressed securities
- Systems trading
Event driven Global macro Emerging markets
Market hedged
- Equity hedge Equity market neutral Growth Funds of funds
- Fixed income
hedge Equity trading Value Income
Market independent Global macro Sector Macro

- Distressed
securities Fixed income arbitrage Distressed securities Market neutral
- Merger arbitrage - arbitrage
Dedicated short bias Emerging markets - securities hedging
Market neutral
- Long/short equity Emerging markets Opportunistic Market timing
- Convertible bond
arbitrage Managed futures Leveraged Bonds Opportunistic
- Mortgage backed
securities Fund of funds Short Only Several strategies
- Fixed income
arbitrage Short selling
- Capital structure
arbitrage Special situations
- Equity index
arbitrage Value
- Derivatives
arbitrage
- Index
Enhancement
63
Table A.2 Classification by Academics
Phillip Cottier Thomas Schneeweis Vikas Agerval & William Fung &
& Richard Spurgin Narayan Y. Naik David A. Hsien
Leveraged long equity Relative value Non-directional Convertible arbitrage
- Equity market Strategies
Short-only equity neutral Distressed securities
- Convertible hedge - Fixed income
Long/short US equity - Bond hedge arbitrage Emerging markets
- Event driven
Long/short European Event - Equity hedge Equity hedge
equity - Merger arbitrage - Restructuring
- Bankruptcy - Event arbitrage Equity market neutral
Long/short global - Multi-strategy - Capital structure
equity arbitrage Equity non-hedge
Equity hedge
Leveraged bond and - Domestic long Directional Strategies Event driven
fixed income arbitrage - Hedged equity
- Global / - Macro Fixed income
Mortgage-backed international - Long
securities arbitrage - Hedge (long bias) Macro
Global - Short
Convertible bond - Discretionary Market timing
- Systematic
Distressed securities - Short Merger arbitrage
Emerging markets Relative value arbitrage
Macro Sector
Currency Short Selling
Multi-strategy Statistical Arbitrage
Multi-manager
A universal classification of hedge fund strategies is far from existing. It is
questionable if there will ever be one considering; 1) The complexity of the strategies,
2) Managers ability to change and drift between strategies, 3) The lack of
transparency, 4) The lack of a leading hedge fund index. These factors combine to
make academic work and performance monitoring difficult, but such is the nature of
the industry.
64
APPENDıX B – REGULATORY ıSSUES
The European hedge fund industry has been limited in development due to
complicated and inflexible regulation. This is very much an international business
though, and other countries are represented in this short description of the
regulatory environment in important markets. Presented here is an overview of the
degrees of regulation in selected countries. The regulatory environment for the hedge
fund industry is very complex and varies greatly from country to country. However,
a detailed description of the legal and marketing aspects for the selected countries is
beyond the scope of this paper.
Table B.1 Degree of regulation of hedge funds in selected countries
General Hedge fund Public offering of Private offering

flexibility of incorporation non-traditional of domestic and
regulation funds offshore non-
traditional funds
EC Very low No No Not specified
Austria, Very low No No Existing clients
Germany only, up to 30 in
Germany
Japan Low No No If registered to
qualified
institutional
investors or up to
50 private
investors
France Low No No To existing clients
U.K Medium Very limited Authorised unit By authorised
trusts only persons to
professionals and
existing clients
Switzerland Medium Yes If registered as a Yes, if not on a
mutual fund or as commercial basis
a participation
company
Luxembourg Medium Yes, but limited Yes Yes
Channel Islands, Medium Yes, but limited - -
Isle of Man
U.S. High Yes No (except public Not more than 99
futures funds) sophisticated
investors of which
65% must be
accredited
Ireland High Yes, including Professional Unlimited for
offshore funds investor funds professional
only investor funds
Bermuda High Yes if local - -
management and
sufficient
disclosure
65
Cayman Islands, Very High Yes if very high - -
Bahamas, investment
Netherlands
Antilles
British Virgin Very High No restrictions - -
Islands
(Source: The overview is based on findings in: COTTIER, Philipp, “Hedge Funds and Managed
Futures”, 3rd Edition, Verlag Paul Haupt, Bern, 2000.)
66

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THE UNıVERSıTY OF EDıNBURGH

The Hedge Fund Boom

Dissertation presented for Honours Degree in Commerce

Dr. Peter Moles

The hedge fund industry is currently attracting a truly booming inflow of

paper is to put forward a resolute clarification of this tentative situation in asset

abnormal risk-adjusted returns, and should therefore be inherent part of a portfolio

of investments, thus designating a new paradigm in asset management. The

analysis employed reviews the relationship between existing performance evidence

pattern of investments into hedge funds.

in asset management. They consistently produce superior risk adjusted returns

into a portfolio. There are no indications of these value-adding performance

characteristics disappearing in short-term. Furthermore, the notion of the hedge

anticipated by fundamentals. Consequently, investments in hedge funds reflect

various people and institutions to whom I wish to express my gratitude:

• The greatest of thanks and gratitude to my parents, who have provided me

with unconditional support throughout.

• I wish to express my sincere thanks to Colin McLean and Michael Nicol,

Scottish Value Management, for introducing me to hedge funds, and

providing me with the opportunity to work with them.

efforts in proof reading and correcting the dissertation.

• I express my sincere thanks to my supervisor Dr. Peter Moles for academic

team and gain resourceful experience. Euromoney Conferences very

considerately gave me complementary admittance to a hedge fund

conference, for which I am grateful and express my thanks.

List of figures .................................................................................................. V

1.1 Objectives and structure of the dissertation..............................................8

2.1 Origin of hedge funds.............................................................................11

3.1 Databases, measurement, and research methodologies...........................22

4. Investing in Hedge Funds ....................................................................36

4.1 Hedge funds in a portfolio ......................................................................36

5. The Evolution of the Hedge Fund Industry .........................................44

5.1 Asset volumes........................................................................................44

Appendix A – Strategy classification ................................................................63

3.1 Performance measurements ...................................................................23

3.2 Performance comparison: fund of fund, individual strategies, bonds,

5.1 Growth of the global hedge fund universe ...............................................44

5.2 Total number of funds in the industry ....................................................45

5.3 Growth of the European hedge fund market ...........................................47

5.4 Percentage of European institutions currently investing or

5.5 European asset management industry rating of the relative importance

2.2 US and European definitions..................................................................15

3.1 Performance comparison hedge funds/S&P 500 .....................................25

4.1 Hedge funds in a portfolio ......................................................................37

4.2 Process of due diligence/qualitative analysis of hedge fund

A.1 Classification by industry professionals ..................................................63

A.2 Classification by academics....................................................................64

B.1 Degree of regulation of hedge funds in certain countries .........................65

categorised as an alternative, non-traditional investment. Contrary to asset class-

based long-biased traditional investment funds, focus is on investment strategies.

assortment of very heterogeneous types of alternative investment funds. Compared

to traditional funds, hedge funds operate in a liberalised and loosely regulated

transparency. Professional expertise on hedge funds is poor, and public knowledge

Hedge funds remained a marginal investment vehicle until the beginning of

launch due to excessive demand.

examined for their role in promoting further growth. Performance is key in

investment management studies. The evaluation of performance/fundamentals is

will answer if the current boom is a bubble.

new paradigm in investment management, where hedge funds become a natural

part of certain investment portfolios. An answer to this question could be of great

in hedge funds in the future1. Only 17 % of institutional investors currently invest in

uncertainty and lack of credible information.