Stock Market Investment
1.0 Abstract
The investment conduits that proliferated the hedge funds as a major investment alternative has taken the stock market with the boomerang. Traditional models of investments such as equities, corporate bonds have been out run by the hedge funds. Lhabitant, F.S (2003). There worst market performance is a result of alternative trading stint that has incorporated various diversified modes of doing business. The experienced high return with low risk has promulgated hedge funds, funds of funds and commodity trading advisors (CTA funds) as the reliable economic renaissance.
These have stimulated a colossal entrance of small investors into funds of funds that grants authentic acquisition of shares in the hedge funds. Research findings conducted by the Hedge Fund Research Incorporation indicate that by the year 2004 assets managed by the hedge funds had been approximated at £ 3.5 trillions. Assets managed by CTA were estimated at around US$ 100 billion. Carhart, M.M., (1997).
What makes these funds to mushroom on considerable scales is the fact that legal frameworks don’t regulate the funds and also the exposition of data has been made available thus empowering monitoring of the indices on the market. Virtually hedge funds have a diversified benefit without a large reduction in expected returns. Hedges therefore are playing a multifaceted asset allocation role hinging on clear objectives into realizing equity profits with diversified benefits. Peskin, M.et al (2000)
1.1 Executive Summary:
The central dynamism about the research finding is to establish the magnanimity that elevates the hedge funds as an alternative investments benchmark on the global economy. A myriad of strategies is being employed to enhance these alternative investment conduits into offering competitive terms in a sandwich market. Portfolio optimization and construction have been discussed broadly as impeccable options geared towards a modified risk adjusted hedging phenomenal.
Emerging issues have shown that the popularity of hedging opportunities have circumvented on opulent entities with long term objectives. This research is therefore inclined to the school of thought rooted to emancipating the investment lot from the anathemas that bedevil asset allocation. Various models have been ingrained into this thesis, to elaborate how these funds have been sleek in trying to grasp lengthy uncertainties ratings hence boosting high preferences for colossal investment at favorable times.
This thesis also upholds the fact that two decades evidently record that private investment chariots including hedging and the private equity and venture capital have evolved so tremendously. Hedge funds have been embraced as the corner stone of investment through the allocation of assets. Owing to the diverse attribute exhibited by the hedge funds; market variations under particular circumstances offers the funds a patronage value and the ability to leverage and consequent short selling. Fung, W, and D. Hsieh (1997)
Most corporate organizations are convinced with the hedging strategies owing to its better returns and consistency on the market. By the year 2020 asset management under hedge funds is approximated at $ 900 billion while institutions will account for more than 70% of the collective flow of the funds. However timing is an important element the needs to be put into consideration if hedge funds are to scale great heights of performance? Fung and Hsieh (2001) mooted the resemblance that co-exists between timing and the global performance of the hedging styles.
1.2 Introduction
The global market economy has undergone tremendous revolutions that have necessitated the contemporary society into embracing modern stratagems of doing business. With the promising historical records of investment styles on the stock exchange, hedge funds performance has registered tremendous returns on the Wall Street business cycle in past few decades.
Research findings indicate that reduced market uncertainties and vibrant equity performance has been obtained. Franchois-Serge Lhabitant (2004). Hedge funds performance and strategic investment ideals propagated by its managers have given it a new face that is now a mainstream kind of investment. By the year 2001 hedge funds tremendously outran both the public and private equity markets in the United States. What makes hedge fund investment style more agreeable with most investors is the reason that related risks disappears when funds are re-clustered as funds of funds.
Nevertheless, the free-for-all nature of hedge funds that enhances investments without analysis is a potential risk on the Wall Street market. Unlike mutual funds, hedge funds conceal their assets and the end result is that quantification of invested holdings become multifarious. Consequently, based on a derivative model embraced by hedge funds; investment Implies that, with diminutive and tangible money invested they have the audacity to create large dangles in the market.
As a result an assumption to the highly escalated oil prices in July of 2006 for instance has pointed an accusing finger to the hedge funds. Some of the top performing hedge funds with at least $100 million under management as by September this year include Balestra Capital Partners with a global macro of 70.66% and at the second position is Oinhan China Fund with 56.67% in the emerging markets.
The fundamental investors in hedge funds are wealthy individuals and institutions with a great deal of funds to invest, and can also weather imperative downturns in their portfolio in their request for higher returns. In the United States hedge funds are open to accredited investors only. The centrality of these research findings is to determine how the integration of hedge funds in to the US economy and how it has influenced the Wall Street stock market. Peskin, M.et al (2000).
Objective
It is a complex venture to try to offer a collective definition of hedge of funds. The original concept of a hedge fund was to offer plays against the markets, using short selling, futures, and other derivative products. Today, funds using the hedge fund appellation follow all kinds of strategies and cannot be considered a homogeneous asset class. Some funds are highly leveraged; others are not. Some engage in hedging activities, and others do not.
Some are centered on making macroeconomic bets on commodities, currencies, interest rates, and so on. Some are mostly technical funds trying to take advantage of the mispricing of some securities within their market. Futures funds belong to the world of hedge funds. In fact, the common denominator of hedge funds is not their investment strategy but the search for absolute returns. Black, Fischer (1972)
Money management has progressively moved toward a focus on performance relative to reassigned benchmarks. An institutional money manager’s performance is generally evaluated relative to some market index that is assigned as mandate. In turn, these benchmarks guide the money manager’s investment policy. The risk of deviating from the performance of the benchmark has become huge, given all of the publicity surrounding relative performance in a very competitive money management industry.
The development of hedge funds can be seen as a reaction against this trend, with the search for absolute return in all directions. In practice, this means that hedge funds might have more appropriately been termed isolation funds. They generally try to isolate specific bets for the purpose of generating alpha. One can infer the particular bet from each hedge fund position. Hedge fund managers seek freedom to achieve high absolute returns and wish to be rewarded for their performance. These objectives are apparent in the legal organization and the fee structure of hedge funds.
1.5 Historical Perspective
The emergence of the hedge fund on the global market was the precept of Alfred .W. Jones the year 1949. With almost six decades since it was hedge fund was first inaugurated, the industry is catapulted with myriad issues that have been threatening its existence; non-transparency and higher minimum investments. Lhabitant, F.S (2003).Hedge fund have been performing with considerably profit returns as early as in the 80s where hedge fund capital grew in the quantities of billions of dollars that earned the market substantial returns that increased the funds of hedge from 16% to 21% annual risk adjusted basis where relative returns underperformed four times less than absolute returns.
The endangered crop of managers was the antidote to this movement since it championed monopoly through non-transparency, who out rightly embraced subversive ness in their prolific successes. By early 90s so many scandals were still befalling hedging styles. Corruption and sheer market phobia dominated the funds and the integral structuring of investment chariots with well documented vision Granite CTA (1993), LCTM (1998), Manhattan (2000), Bayou Capital (2005) and Amaranth (2006).
Initially the hedge funds were strictly a classical venture that target elite in society, but over time it had to be streamlined to cater for small investors. With a diversified approach funds of hedge were clustered into small ratios known as funds of funds, whence hammering a stunning currency approximated at around $ 50 billion of assets under management by the 2000 and by the end of 2006 the allocation of assets was valued at $ 1 trillion. Brooks, C., Kat, H. (2001)
The rationale is that the construction of diversity reinvigorated the hedge fund prolific investment that increased the hedging viability in containing particular risks and also minimizing anomalies associated with selection criteria and the minimum value facing investors. This has amalgamated myriad investors awarding the managers the ability to professionally patronize the market trends and hence advocating for transparency. Carhart, M.M., (1997),
1.3 Strategies:
Some of the strategies employed by hedge funds include global macro investing; this one seeks out for assets that have deviated from some anticipated relationship; although this strategy under certain condition it does not involve hedging at all. Arbitrage is also a strategy used in hedge funds; this model seeks for mis-priced assets relative to global conduits of investment. Merger arbitrage is also embraced; this is a public company’s are acquired with a target public company. Convertible arbitrage, fixed income arbitrage; between related bonds. Risk arbitrage; between related securities whose prices appear to imply different probabilities for an event. Equity market neutral among others.
Since hedge funds don’t belong is a homogenous category, under a certain circumstances an investor of hedge fund can absolutely prevaricate the risks of an investment and therefore getting hold of unadulterated profit. For instance, it is feasible for substitute traders to buy shares of say, Compaq on one exchange and concurrently sell them on another exchange, parting with clean returns. Competitive markets have however, percolated away such turnovers, divulging hedge fund managers with trades that are virtually prevaricated, at best.
1.4 Why Hedge Funds are Successful
From research findings it has been indicated that about 20 hedge fund managers earned in excess of $100 in compensation last year while Eifuku master Fund in Japan lost $300million portfolio in seven trading days. These disparities conjurer’s up the notions of how the hedge funds have been premeditated in taking home bigger returns than other investment conduits. Perhaps to help ponder this question a few propositions can help in combating the arising queries.
One panorama of the nature of the hedge funds industry is that this funds are virtual not synchronized, as a consequence they exhibit huge collections of evenhandedness capital, deliberate elasticity, and incredible liquidity; all this attributes enhance to trade swiftly to incarcerate value than its primary competitors. One the other hand gigantic, exceedingly, synchronized and somewhat dull mutual fund industry, speculation capital and private equity industries are demented by the mere fact that they focus on long term investments which engage in running of the companies instead of being purely investor oriented.
In a different light, while private equity money is imprisoned for 5 to 7 years in individual firms, and mutual funds is pre-commited to single strategies like emerging markets equity. With this scenario hedge funds are able to restructure models that are instantaneous and with minimal cost to shift money to where proceeds are excellent.
Hedge funds have the knack to generate significance through the so called ‘event driven’ investments. This strategy engrosses active involvement by funds in capture skirmishes, mergers, and calculated repositioning at firms. Hedge funds are a capacity attraction for the best brightest Wall Street where elegant investment has augured advanced returns.
While hedge funds are practically a small segment of the value of equity and debt markets, the funds are more vigorous traders. On any given day, hedge funds can account for 50% or more of the quantities traded on key exchanges. Since most investor employ the buying and holding stratagem as emphasized by the modern portfolio theory, hedge fund consequently buys and sells generating profits however minimal and thus making it the most strategic investment model.
1.5 How mortgage crisis affected the hedge funds.
The underperforming tendencies of housing in United States impaired the mortgage market which greatly hampered the banking system. Since hedge funds are not as tightly regulated as funds of funds it is predictable therefore that most of hedge’s unquantified funds invested in the mortgage industry were lost due to the a sharp decline in home prices.
As a result home owners could not pay the mortgage nor sell the home for a profit and consequently failed to pay. Because hedge funds employ sophisticated derivatives, the impact of the depression was gravely magnified owing to the fact that derivatives allow hedge funds to fundamentally have access to money in form of loan to make investments, creating most advantageous profits in a good market and greater losses in a bad one.
Many banks, mortgage lenders, real estate investment trusts (REIT), and hedge fund importantly endured losses as a result of mortgage payment evasions asset devaluation. As of November 21, 2007 banks had registered sub prime-associated assets over and above U.S. $30 billion, with an augmented $8-$11billion anticipated from Citibank.
Sub prime lending is essentially a collective term that refers to the practice of making loans to borrowers who do not meet the criteria for market interest in esteem to anomalies with their credit background or capability to prove that they have adequate earnings to support the monthly recompense on the loan for which they are applying.
2.1 Paradigm shift from traditional to Hedge funds
Wilton, Conn.- Endowments and foundations increased their allocations to hedge funds in the year ended June 30, a common fund report shows. Among those that altered their asset allocations during the year, hedge fund exposure rose to 35% of the average alternatives portfolio from 22%. Increased use of hedge funds helped boost alternative investments to 15% of total assets as of June 30, from 11% a year earlier among the funds that changed their asset allocations. Brooks, C., Kat, H. (2001)
Of the 97 endowments and foundations surveyed, 29% reported changes in the asset allocation in the previous year. The $ 197 million University of Connecticut foundation in Storrs is among those hiking hedge fund exposures. The found doubled its hedge fund allocation to 10% of total assets following an asset allocation study by Wilshire et al (2000) of the institutions that made changes, the average allocation to domestic equities dropped one point to 10%. John Griswold, executive director of common fund institute, said while he’s pleased endowments and foundation as largely stick to their guns on asset allocation, he expects more shifts soon
Hunter
A couple of years ago, when he was just 31, Calgary's Brian Hunter, a tall, unassuming University of Alberta math-geek-turned-über-successful natural gas trader,
Brian Hunter the manager and advisor for Amaranth hedge funds made a stunning profit of about $ 1billion profit. This monumental leap in the stock market was realised in 2005 bonus hit of an industry trade magazine.
One year down the road, Hunter lost Amaranth’s $ 6.50 billion, where $560 million of this amount was lost in September last year as a result of gambling on the weather. This has been recorded as the biggest fund loss in the history of the hedge fund. Gas prices were overblown creating stumpy shocks in the market.
Continued Below
His new hedge fund, Solengo Capital, is reportedly seeking to amass $800 million while requiring investors to lock their money in for two years. More than just an echo of Amaranth, Solengo is something of a redux: former Amaranth colleagues Karl Koster, Shane Lee and Matthew Calhoun are also involved. The gambit unfolds even as Hunter, who refused to comment for this story, is haunted by Amaranth: a legal action launched last week by the San Diego County Employees Retirement Association names Hunter and other Amaranth types in what is likely the first in a flurry of lawsuits.
Meanwhile, Solengo has moved on litigation of its own, suing one online site for copyright infringement after it would not remove a posting of its "confidential" promotional literature. The six-month respite from such Amaranthentine antics isn't much of a moratorium, leading to complaints Hunter is contributing to increasingly bad optics surrounding hedge funds. But when you've demonstrated to Wall Street your ability to win -- even in a remote past (just two years ago) before you became an indelible loser -- Wall Street will always afford you another shot.
Hedge funds have for the last 10 years completed a commendable job of navigating the treacherous and increasingly-shifting financial landscape. Progenitors, their corresponding mutual funds have failed keeping pace with the major equity indexes and are currently mire in one of the worst scandals in the history of the monetary business industry.
The real differences between the performance of these two investment vehicles may not, as many believe, come down to the types of fees charged, but rather the amount of personal capital the managers have committed to the products they captain.
The mutual fund business conventionally levy a predetermined administration fee, most firms take sides citing that most firms capitalises on this assets to hike assets even though it may affect performance. Consequently, hedge funds levy both a management and a performance-based fee, this offers a strong incentive for outperfomance.
The concluding observation is hypothetically supported by utility theory, the implicit symbolizes the rational that investors endeavour tirelessly to maximize on the earnings while curtailing on the losses. Besides, a modest study established minor differences in manager behavior flanked by functional-remunerated along with asset-orient-rewarded Endurance Circumstances.
Shifting threats in addition to hedge fund performance managers as well as CTA, Asset management disputes various long-held beliefs connected to incentives fees by Stephen Brown of NYU’s Stern School of Business, William Goetzmann of Yale, and James Park of Paradigm Asset Management challenges several long-held beliefs associated with incentive fees.
On the contrary, anticipations of the hedge funds, viewed beneath the benchmark took no supplementary dangers sequentially in face-painting underperformances of the charge.
Hedge funds that performed well in the first half of the year generally reduced their portfolio volatility for the remainder of the year. Even more noteworthy was how similarly managers behave regardless of whether they are compensated by a traditional asset fee or a combination of a management fee and incentive fee.
Categorically forecasted characteristics by usefulness presumption-dawdled funds give the impression extra disturbed with their positions relative to their peers. They come into view much more concerned with the prospect of termination that the potential of earning greater profits. In other words, increasing their portfolio variance to gain a performance fee is not enough of motivational factor to risk going out of business.
According to the study, the incentive portion of the fee structure is similar to a call option. Out-of-the-money managers, or those below their high-water marks, are therefore rationally expected to increase the risk in their portfolio to make up for losses. In-the-money funds are most likely to lower their variance (i.e., take less risk).
Regardless of fee structure, ranking among peers plays an important role in manager behavior, often more important than performance. This is a curious inconsistency in an industry that is seen as a source of absolute returns. It also raises the issue of whether a hedge fund would incur greater risks to catch up to the group than to surpass a high-water mark if the fund was comfortably ensconced in the middle of the pack.
Decision-creation recompense apprehension issues aside there are some important differences between mutual funds and hedge funds. Besides the opportunity to hedge long positions (hedge funds can, mutual funds generally cannot), one of the biggest ways the two vehicles differ is the tendency for hedge fund managers to invest heavily in their own funds. This is virtually unheard of in mutual fund circles.
Even though relationships flanked by proprietary resources plus performance up till now to be officially premeditated, my take is that investing one’s own money in one’s artefact arrange in a line with patron and executive concentrations superior than any other explanations.
2.1.2 Legal Structure
Hedge funds are typically set up as limited partnership, as a limited liability corporation (in the united stat, or as an offshore corporation. These legal structures allow the fund manager to take short and long positions in any asset, to use all kinds of derivatives, and to leverage the fund without restrictions. Hedge funds based in the United states most often take the form of a limited partnership organized under section 3 (c ) (1) of the investment Company Act, thereby gaining exemption from most U.S. Securities and exchange Commission (SEC) regulations.
The fund is limited to no more than 100 partners, who must be accredited investors Fama, Eugene F., and Merton H. Miller (1972) and is prohibited from advertising. Some U.S hedge funds are organized under section 3 (c) (7) of the investment company Act, and are also exempt from most SEC regulations. In this case, the fund is limited to no more than investors, who must be qualified purchasers Edwards, F.R., and J.Liew, (1999) and is prohibited from advertising. Given the small number of partners, a minimum investment is typically more than $200,000.
Institutional investors can become partners. U.S. hedge funds are typically incorporated in a fund friendly state, such as Delaware. Offshore funds have also proved to be attractive legal structure. These are incorporated in locations such as the British Virgin Islands, of view.
A hedge fund might consider using ‘feeders’(vehicle that have ownership interest in the hedge fund) that enable the hedge fund to solicit funds from investors; another for tax-free pensions; another for Japanese who want their profits hedged in yen; still another for European institution’s, which invest only in shares that are listed on an exchange. The feeders don’t keep money but they are used as paper conduits that channel the money to a central fund, typically a Cayman Islands partnership.
2.2 Classification
Hedge funds have become quite global, as evidenced by the wide array of global investments used by these hedge funds and the international diversity of their client base. Some classification of hedge funds by investment strategy is provided in the media and by hedge funds databases. These classifications are somewhat arbitrary, exhibit a large degree of overlap, and differ extensively across sources: Long/short funds are the traditional type of hedge funds, taking short and long bets in common stocks. Black, Fischer (1972)
They vary their short and long exposures according to forecasts, use leverage, and now operate on numerous markets throughout the world. These funds often maintain net positive or negative market exposures; so they are not necessarily market-neutral. In fact, a subgroup within this category is funds that have a systematic short bias, known as dedicated short funds, or short-seller funds.
Long/short funds represent a large amount of hedge fund assets. Elton, Edwin J.., and Martin J. Gruber (1995). Market-neutral funds are a form of long/short funds that attempt to be hedged against a general market movement. They take bets on valuation differences of individual securities within some market segment. This could involve simultaneous long and short positions in closely related securities with a zero net exposure to the market itself.
A market-neutral long short equals the total value of the positions sold short (dollar neutrality) and so that the total sensitivity of the long positions equals and offsets the total sensitivity of the short positions (beta neutrality).
The long position would be in stocks considered undervalued, and the short position would be in stocks considered overvalued. Leveraged is generally used, so that the investment in the long position (or the short position) is a multiple of hedge market risk. For example a manager could buy some bond futures or other fixed-income derivatives. This type of fund is sometimes called fixed-income derivatives.
This type of fund is sometimes called a fixed-income arbitrage fund. Other types of arbitrage make use of complex securities with option-like clauses, such as convertibles, warrants, or collateralized mortgage obligations (CMOs). Among the various techniques used by market-neutral funds are.
2.7 Unique Risks for Hedge Funds
In addition to market and trading risks in different markets, hedge funds face the following unique risks;
2.7.1 Liquidity risks:
The liquidity risk is common to all investors who trade in illiquid or thin markets. However, the lack of liquidity under extreme market conditions can use irreversible damage to hedge funds whose strategies rely on the presence of liquidity in specific markets. For example, the demise of LTCM was attributed to the unexpected absence of normal liquidity.
2.7.2 Pricing Risk:
Hedge funds often invest in complex securities traded over-the counter. Pricing securities that trade infrequently in a difficult task, especially in periods of high volatility. Broker-dealers tend to adopt an extremely conservative pricing policy to protect themselves in periods of high volatility. The marking-to-market (margin call) of positions based on these prices can create severe cash needs for hedge funds, even if the funds do not try to liquidate their positions.
For example, it is widely believed that the cash drain of marking-to-market positions based brokers’ conservative pricing of derivatives compounded the problems of LTCM. A similar problem arose for Askin Capital’s market-neutral funds. Farrel, James L., Jr.. (1997)
2.7.3 Contemporary credit risk:
Because hedge funds deal with broker-dealers in most transactions- from buying securities on margin to mortgage trading-counterparty credit risk can arise from many source. Thus, hedge funds face significant counterparty risk.
2.7.4 Settlement risk:
Settlements risk refers to the failure to deliver the specified security or money by one of the parties to the transaction on the settlement day.
2.7.5 Short squeeze risk:
A short squeeze arises when short sellers must buy in their positions at rising prices, for example because owners of the borrowed stock demand their shares back. Because some hedge fund strategies require short selling (e.g., long/short strategies), this risk can affect fund performance significantly. Farrel, James L., Jr... (1997)
2.7. 6 Financing squeeze:
If a hedge fund has reached or is near its borrowings capacity, its ability to borrow cash is contained. Margin calls and marking position to market might result in a cash need for the fund. This risk puts the hedge fund in a vulnerable position when it is forced to reduce the leveraged positions, say, in an illiquid market at substantial losses, in order to stop the leverage from rising. If the hedge fund were able to borrow more cash, these substantial losses could be avoided.
However, the study of performance and risk of all of these hedge funds indexes yields a strong case for investing in hedge funds. Hedge funds end to have a net return (after fees) that is higher than equity markets and bond markets. For example, Exhibit 75-2 reports the average U.S hedge fund net returns for various indexes over the period January 1996 to September 2002, as calculated by CIDM. The mean annual return for U.S hedge is 10.92 percent based on the HFR Fund Weighted Composite Index, compared with 5.86 percent for the S&P500, and 7.24 percent for the Lehman Brothers government/corporate bond index.
Hedge funds tend to have lower risk (measured by the volatility of return or standard deviation) than equity investments. Their investments strategies appear to provide more stable return than traditional equity investments as shown in the table below. Campbell, John Y., and John Ammer (1993)
Conclusion
The central dynamism about the research finding is to establish the magnanimity that elevates the hedge funds as alternative investments that has transformed United States as a benchmark on the global economy. The investment conduits that proliferated the hedge funds as a major investment alternative has taken the stock market with the boomerang. Traditional models of investments such as equities, corporate bonds have been out run by the hedge funds. Lhabitant, F.S (2003).
References:
Lhabitant, F.S (2003). Hedge Funds: EDHEC Business School.pg 330-349
Fung, W, and D. Hsieh (1997). The Journal of Portfolio Management; Investment Style in the Returns of CTAs; the Information Content of Perfomance Track Records: pg 121-134
Peskin, M.et al (2000). Global Equity and Derivative Markets; Quantitative strategies, why Hedge Funds Make Sense. Pg 23-35.
