1.1-Introduction:
Hedge funds are actively managed portfolios that hold positions in publicly traded securities. Gaurav S. Amin and Harry M. Kat (2000) stated on their report that "A hedge fund is typically defined as a pooled investment vehicle that is privately organized, administrated by professional investment managers, and not widely available to the public". It charges both a performance fee and a management fee. It allows a flexible investment for a small number of large investors (usually the minimum investment is $1 million) can use high risk techniques. 1Now days it is very clear that in the matter of alternative investment mutual fund is not performing well. As a high absolute returns and typically have features such as hurdle rates and incentive fees with high watermark provision hedge fund gives a better align to the interests of managers and investors. 2Moreover mutual funds typically use a long-only buy-and-hold type strategy on standard asset classes, which help to capture risk premia associate with equity risk, interest rate risk, default risk etc. However, they are not very helpful in capturing risk premia associate with dynamic trading strategies. That is why hedge fund comes into the picture.
In the year of 2009, this takes the greatest history of the world in the following century. In the year of 2008 the world saw the greatest fall down of the world economy. Lots of people missing their jobs, lots of company were stopped. The world economy faced the highest losses in the history. These all factors are showing only one way to makeover from that greatest downfall that is hedging. 3The last couple of decades have witnessed a rapidly growing in the hedge funds. Relative to traditional investment portfolios hedge funds exhibit some unique characteristics; they are flexible with respect to the types of securities they hold and the type of the position they take.
1 Agarwal, V. and Naik, N. (2000). "Multi-period performance persistence analysis of hedge fund s". The journal of financial and quantitative analysis. Vol. 35, No,3. PP-327.
2 Agarwal, V. and Naik, N. (2004). "Risks and portfolio decisions involving hedge funds". The review of financial studies, Vol. 17, No.1. PP-64.
3 Journal of banking and finance 32(2008) 741-753- "Hedge Fund Pricing and Model Uncertainty" by Spyridan D. Vrontos, Ioannis D. Vrontos, Daniel Giomouridies.
Since the early 1990s, hedge funds have become an increasingly popular asset class. The amount invested globally in hedge funds rose from approximately $50 billion in 1990 to approximately $1 trillion by the end of 2004. And because these funds characteristically use stantial leverage, they play a far more important role in the global securities markets than the size of their net assets indicates. Moreover, investments in hedge funds have become an important part of the asset mix of institutions and ever wealthy individual investors (Malkiel, B. and Saha, A. (2005).
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4The number of FOHFs increase by 40% between 2001 and 2003, and now comprised almost two third of the $650 billion invested in the USA's hedge fund market. Due to its nature it is difficult to estimate the current size of hedge fund industry. 5Van Hedge Fund Advisors estimates that by the end of 1998 there were 5380 hedge fund managing $311 in capital, with between $800 billion and $1 trillion in total assets, which indicates the higher number of recent new entries. So far, hedge fund is based on American phenomena. About 90% hedge fund managers are based in the US, 9% in Europe and 1% in Asia and elsewhere. Now a day's around 5883 hedge funds are trading around the world. (*Barclay Hedge database).
Chart 1: Assets of Hedge fund industry from 1997 to 2009.
Source: http://www.barclayhedge.com/research/indices/ghs/mum/Hedge_Fund.html
According to the Barclay hedge database the asset of hedge fund industry is $1205.6 billion dollar.
4 Financial times, 29th October, 2003.
www.vanhedge.com
http://www.barclayhedge.com/products/hedge-fund-directory.html
1.2-Research questions:
Specifically in this paper, I want to address two main questions. First one is what is the performance of hedge fund and FTSE100 over the period of 2001 to 2008? To evaluate the performance I use three traditional risk adjusted performance measurement model. To give a better idea and matter of easily understand I use the Sharp ratio, the Treynor ratio, and the Capital Asset Pricing Model (CAPM). However, the equity market index is not necessarily the right benchmark for hedge funds, therefore, market betas and abnormal returns may not be the appropriate measures for risks and profits. To mitigate this problem, I calculate sharp ratios, which are defined as the ratio of the average excess fund returns over the standard deviation.
Second question is does hedge funds gives better return from UK equity market (FTSE100)? To make this comparison I use regression analysis where the correlation will show how the hedge funds act against the FTSE 100.
1.3-Objective of the study:
The main objective of this study is to find out the performance of Hedge fund relatively with the UK equity market FTSE 100. In addition, I address in this paper four major hedge funds performance correlation with FTSE100. As a result an individual investor can easily understand which portfolio will give better return at their investment perspective. This study focuses on UK investor's perspective only.
In the past several years, lots of studies had been done on this area like Park and Staum (1998), Brown et al. (1999), Agarwal and Naik (2000), Herzberg and Mozes (2003), Capocci and Hubner (2004), and Malkiel and Saha (2005) analysis the hedge fund performance. Most of the statistical methodology is on the regression with equity markets and rest of all are in the cross product ratio. Above all they tried to find out the return of different types of hedge fund depending on the market risk and market return.
So finally, the purpose of this paper is clearly established, that is to understand hedge fund performance over the UK equity market (FTSE100).
1.5-Overview of the methodology:
In this section I would like to describe an overview of my methodology. To find out the hedge fund performance and the FTSE100 market's performance I use three traditional risk-adjusted performance measurement models. First one is the Sharpe ratio, secondly, the Treynor ratio and finally, the Capital Asset Pricing Model (CAPM). I address the Sharpe ratio and the Treynor ratio because these two gives better easy view for an investor to evaluate the hedge fund performance by themselves. However, the Sharpe ratio and the Treyneo ratio measure the excess return of per unit of risk for an investment asset. These two are used to understand how well the return of an asset compensates the investor for the risk taken. When comparing two assets each with the expected return of fund against the same benchmark with risk free return, the asset with the higher Sharpe ratio gives more return for the same risk. As a result investor can easily understand where to invest.
In this paper I use total 287 funds including different types of hedge funds like- Event driven (31), Hedge fund (54), Global macro (37) and Market neutral (165). As a benchmark I use FTSE100 and for the risk free rate I use UK 10 year Treasury bond. All data were collected from the DataStream which is run by Thomson Reuters the world's leading source of intelligent information for businesses and professionals (http://thomsonreuters.com/).
1.6-Definition of the key terms:
Hedge fund:
In the early study by Francis C.C. Koh, Winston T.H. Koh , David K.C. Lee, Kok Fai Phoon (2004) stated in their report that "Hedge Funds are innovative investment structures that were first created more than 50 years ago by Alfred Winslow Jones. He established a fund with the following features:
(a) He set up "hedges" by investing in securities that he determined as undervalued and funding these positions partly by taking short positions in overvalued securities, creating a "market neutral" position;
(b) He also designed an incentive fee compensation arrangement in which he was paid a percentage of the profits realized from his clients' assets; and
(c) He invested his own investment capital in the fund, ensuring that his incentives and those of his investors were aligned and forming an investment "partnership". Most modern hedge funds possess the above listed features, and are set up as limited partnerships with a lucrative incentive-fee structure. In most hedge funds, managers also often have a significant portion of their own capital invested in the partnerships. The term "hedge fund" has been generalized to describe investment strategies that range from the original "market-neutral" style of Jones to many other strategies and opportunistic situations, including global/macro investing."
On the other report by Liang, B. (1999) stated on his report that there are two major types of hedge funds, one is inshore and another is offshore. Onshore funds are limited partnerships of no more than 500 investors. Offshore funds are limited liability corporations or partnerships established in the tax neutral jurisdictions that allow investors an opportunity to invest outside their own country and minimize their tax liabilities.
Due to the large variety of hedge fund investing strategies, there is no standard method to classify hedge funds smartly. There are at least 8 major databases set up by data vendors and fund advisors. I follow the classification used by Eichengreen and Mathieson (1998), which relied on the MAR/Hedge database. Under this classification, there are 8 categories of hedge funds with 7 differentiated styles and a fund-of-funds category. For my paper I chose three different categories, which are as follows:
(a) Event driven funds. These are funds that take positions on corporate events, such as taking an arbitraged position when companies are undergoing re-structuring or mergers. For example, hedge funds would purchase bank debt or high yield corporate bonds of companies undergoing re-organization (often referred to as 'distressed securities'). Another event-driven strategy is merger arbitrage. These funds seize the opportunity to invest just after a takeover has been announced. They purchase the shares of the target companies and short the shares of the acquiring companies.
(c) Global/Macro funds refer to funds that rely on macroeconomic analysis to take bets on major risk factors, such as currencies, interest rates, stock indices and commodities. Opportunistic trading manager that makes profits from changes in global economies typically based in major interest rate shifts. To make profits managers uses leverage and derivatives.
(d) Market neutral funds refer to funds that bet on relative price movements utilizing strategies such as long-short equity, stock index arbitrage, convertible bond arbitrage and fixed income arbitrage. Long-short equity funds use the strategy of Jones by taking long positions in selective stocks and going short on other stocks to limit their exposure to the stock market. Stock index arbitrage funds trade on the spread between index futures contracts and the underlying basket of equities. Convertible bond arbitrage funds typically capitalize on the embedded option in these bonds by purchasing them and shorting the equities. Fixed income arbitrage bet on the convergence of prices of bonds from the same issuer but with different maturities over time. This is the second largest grouping of hedge funds after the Global category.
Source Eichengreen and Mathieson (1998).
2.1.2-Current scenario of hedge funds:
