Speeches

Lecture by Professor Maria Vassalou, Columbia University, on "Hedge Funds and their Prospects" at the Bank of Greece.

22/06/2005 - Speeches

It is a great pleasure and honor to speak in front of such a distinguished audience on the important topic of "Hedge Funds and their Prospects" and I would like to take this opportunity to thank the Bank of Greece, and in particular Mr Thomopoulos and Mr Kyriakopoulos for the invitation.

Hedge funds are largely unregulated investment vehicles that maybe invested in any continent, asset class, or type of security. There are two main differences between hedge funds and the familiar to all mutual funds. First, hedge funds can employ leverage, that is, they can borrow and invest many times their capital. Second, they can short sell, that is, they can borrow an asset they do not have and sell it. These two features are the source of the differences in the risk/return characteristics of hedge funds and mutual funds, as well as the reason for the fact that their returns are largely uncorrelated with those of mutual funds. Of course, both features are the result of the different regulatory status of mutual funds and hedge funds. We will discuss regulatory issues later during this talk.

The hedge fund industry has experienced a spectacular growth in assets under management over the past eight years. This is despite the very public near-collapse of Long-Term Capital Management, which almost brought the world financial system to its knees. It is worth noting that the industry as a whole managed around $150bn in 1997 and this amount has grown to over $1trillion by the first quarter of 2005. The growth of the industry was not halted by the LTCM incident in the fall of 1998 and the Asia crisis. Nor was its rate of growth decreased by the prolonged recession/slowdown of the US economy in 2001-2003. The spectacular growth in assets under management was accompanied by an equally dramatic increase in the number of hedge funds. Whereas In 1997 there were about 3,000 hedge funds operating, today this number has grown to over 8000. Where does all this money come from? It is estimated that about 44% of the assets under management come from high net wealth individuals, 24% from Funds of Hedge Funds, 15% from institutions, 9% from pensions, and 8% from endowments and foundations. Therefore, despite their high rate of growth, hedge funds remain a very rich man' s investment vehicle.

There are good reasons for that. First of all, the barriers to invest in hedge funds are quite high. Most hedge funds require a minimum investment of $1m, and for some this threshold is higher. Hedge funds invest in risky instruments, and employ high leverage. These characteristics make them inaccessible and unsuitable to small and medium-size investors.

What is the distribution of assets across strategies used by hedge funds? Although there is a broad range of strategies employed, the industry tends to classify them in the categories shown in Table 1. I have seen over time various articles in the Greek press about the definitions of the strategies listed in the table. For that reason, I will not waste your time going over them now, but I would be happy to answer questions related to them during the Q&A session. It is worthwhile to note, however, that the bulk of the money managed is invested in equity strategies, which account for about 70% of the assets under management. This is despite the fact that the market capitalization of the world' s bonds markets is larger than that of the world equity markets, and the fixed income market is typically more liquid than the equity market. The main reason for the concentration of funds in the equity asset class has to do with the generally higher return opportunities that exist in the equity markets. Recall that fixed income assets can be priced through replication, which allows the arbitrage forces to come into play. This is not feasible in equities. We cannot replicate the riskiness and cash flows of one equity with others. The results is that there are may be more inefficiencies, or perceived inefficiencies, in the equities markets, but also more sources of return, since investors will require a risk premium to assume risks they cannot hedge through replication techniques.

While I defer for later potential questions related to the specifics of the strategies listed in Table 1, I would like to spend some time discussing the philosophies behind the strategies employed. What are the common characteristics among the strategies followed by hedge fund managers?

Essentially, we can identify two types of strategies. Those that seek to capture a risk premium associated with an exposure to a particular risk factor, and those that aim to exploit some type of market inefficiency. In both cases, it is typically the case that the position will be " hedged" . And by that I mean that the strategy will include both a long and a short position. This investment approach allows the manager to isolate the effect of the market inefficiency or risk premium in the strategy, exploit its potential returns, while neutralizing the effects of exposures to the market as a whole, or other specific factors. As you can see from Table 1, equity long-only strategies account for less than 2% of the assets under management.

Most of us, and certainly previous generations, were taught finance theory that used as its cornerstone the Capital Asset Pricing Model (CAPM). This is the model on the basis of which most finance textbooks are written. In the world of CAPM, risky assets earn returns that are proportional to their covariance with the return of the market portfolio. In such an environment, a strategy whereby we would buy some stocks and we would simultaneously sell some other stocks would lead to an average return over time equal to zero. The reason is that the market beta of the portfolio of stocks we buy (long position) will quickly approach one, as the number of stocks in our long position exceeds a handful. The same would happen with the market beta of the stocks we sell (short position). The net effect would be a portfolio with a zero beta with respect to the aggregate market factor. If the CAPM is the model that explains the workings of our financial markets, then the return of such a portfolio would be zero, and after transaction costs are taken into account, it would be negative. No sane investor would persistently invest in such a strategy.

How can then so many hedge funds survive and flourish when they trade strategies that are market neutral, i.e., they have a zero beta with the market portfolio? The reason is simple. The CAPM cannot explain the returns of risky assets. The discovery of this fact was a big shock to the academic community, but also a big blow to many theories we teach our students. Nowadays, however, we have come to grips with the fact that we live in a multifactor world. Investment opportunities vary over time, and there are many risk factors, beyond the market, that help explain the returns of risky assets. In fact, the market factor as used in the CAPM cannot even explain returns. At best, it can describe them, to paraphrase Professor John Cochrane' s argument. The reason is that in order for the market factor to explain returns, we first have to explain what explains the returns of the market portfolio. Obviously, we need something more fundamental than the return of the broad market index to achieve that.

What is therefore the rationale behind many of the strategies that fall in the first category I identified? As mentioned, by having both a long and a short position constructed so that the market beta of the overall portfolio is zero, they make their strategy " market neutral" . This means, that the performance of the strategy is independent of the performance of the market. This is particularly attractive when the market performs poorly. During those periods, the hedge fund strategies still have a good chance to perform well. However, what is crucial in these strategies is the composition of the long and short positions. Typically, a strategy " bets" on a specific risk factor. In other words, it seeks to have an exposure to that particular risk factor, with the hope that it will earn a risk premium. In other words, the return of the strategy is primarily driven by the risk premium attached to the risk factor. Recall that risk averse investors require a risk premium to hold an asset that has a positive exposure to a particular factor that they deem risky. For the purpose of clarity, let us call the risk factor " default risk" . Whereas default risk is one factor that affects asset returns, there are also many others. It should be obvious, however, that if a stock for instance, has a higher probability to go bankrupt than another stock, a risk averse investor will require a higher return to hold the stock with the higher probability of default. The reason is that if the stock defaults, the stockholder, being a residual claimant, could lose as much as 100% of his investment. Stocks do default sometimes, and therefore this risk is real and increases during contractions of the business cycle. Since default risk varies over time, typically with the business cycle, the risk premium attached to it will also vary. If a hedge fund manager feels that he has a comparative advantage in measuring the risk of default of firms and the variation of this risk over time, he can exploit his expertise by formulating a strategy around this concept.

Analogous strategies are followed in the fixed income area. A classic risk factor targeted in this case is liquidity. You may have noticed that yield curves are often not exactly smooth. They exhibit what the market calls bumps and dings. Fixed income managers will analyze the source of those bumps and dings. Often they are formed because of differences in the supply and demand for bonds of different maturities. If that is the underlying reason for their appearance, they may decide to act as liquidity providers. In other words, they will sell bonds at the maturity where the yield curve exhibits a bump, and buy the bonds at the maturity where the yield curve exhibits a ding. To the extent that they were right in their assessment, their trade will be profitable. But at the same time, the more money they put in this trade, the more likely it is that the yield curve will become smooth at the targeted maturities. Once this happens, they need to search for other profitable opportunities along the yield curve.

Besides offering, on average, handsome returns, these strategies also improve risk sharing in the financial markets, which is a desirable byproduct of their existence with important social benefits.

What about the strategies that aim to exploit some type of market inefficiency? An inefficiency is defined as a situation where two assets with the same riskiness, same cash flows, and same maturity sell for different prices. If that is the case, one can sell the expensive asset and buy the cheap one. This is called riskless arbitrage. In a well functioning and developed financial market there are limited opportunities for riskless arbitrage strategies. It is more common to perform what is termed as " risky arbitrage" . Two assets are not exactly the same in terms of their riskiness, cash flows, and maturity. One or more of those characteristics differ. Hedge funds have proprietary models that tell them what the spread in the prices of these two assets should be. If the spread observed in the market is substantially different, they may decide to take a position, betting that the spread will converge to the one implied by their model. There are many variants of this type of strategies. Again, the majority of these strategies have both a long and a short position.

Many of the intra-day or short horizon strategies fall within the category of strategies that aim to exploit inefficiencies. To the extent that an asset price reacts with a delay to a piece of information released to the market, managers can profit, provided they have successfully identified the leaders and laggers. In addition, they help markets become more efficient by reflecting information faster and more accurately. Again, this is a desirable by-product of these strategies with obvious social benefits. In short, whereas there is a plethora of strategies followed by hedge funds, they all fall within one of the two broad categories discussed above.

Is there herding among hedge fund managers?

There has been some discussion lately about potential herding behavior in the hedge fund industry. To what extent can such behavior arise? And does my classification above reinforce any worries of such behavior? Note that a herding behavior is undesirable because it can precipitate financial crises. Much of the speculation about herding has come about from the recent disappointing performance of some hedge funds involved in convertible bond arbitrage.

I believe that herding behavior is not a concern in the hedge fund world. The reason is that there is not sufficient information flow among hedge funds to generate a herding behavior. First of all, hedge funds are little constrained in terms of the kind of strategies they run, which may change quite a bit over time. Second, even if other hedge funds know that XYZ hedge fund has a convertible bond strategy, they have no way of knowing what convertible bonds they bought today, or whether they are actually active in the convertible bond strategy at this point in time. Herding can occur among mutual funds because their trades are more readily observable. This is not the case with hedge funds. Due to their rather unregulated status, they do not need to report much information about their activities on a regular basis. In short, the secrecy surrounding the hedge fund strategies and trades safeguards against herding behavior.

There is one scenario, however, under which a herding-type of effect can be observed in the market. Suppose that a convertible-bond fund realizes losses, as happened recently in the market, fueled by the downgrading of GM and Ford. The investors of the fund may respond by withdrawing their money. This action creates liquidity constraints to the fund which will need to further liquidate part of its position so as to meet the demand for redemptions. By liquidating its position, and provided that it is large enough, it may put further downward pressure to the prices of convertible bonds, leading to further losses. Such a downward spiral may have spillover effects to other funds trading these instruments. However, the scale of a crisis spurred by this scenario is limited. The reason is that most hedge funds, and especially the larger ones, have clauses that limit the ability of investors to withdraw their funds quickly. In other words, they have lock-in periods, and require long notices before a withdrawal is possible. Such clauses, will automatically limit the extent of a crisis based on the scenario just described. In short, I think the danger of herding is limited to nonexistent in the hedge fund industry.

The recent losses from convertible bond strategies and their implications.

How should we understand the recent losses of some hedge funds in connection to their convertible bonds' trades? First we need to review briefly the essence of those trades.

Convertible bonds are hybrid securities that contain a call option to buy the stock of the firm. The maturity of the imbedded option is typically quite long, for instance 5 years. Pricing such long options is not easy, because it is difficult to estimate the appropriate volatility parameter for the pricing model. In addition, any traded options on the stock are of shorter maturity, usually around one year. It is generally believed that these imbedded options in the convertible bonds are " cheap" , that is underpriced. Of course, whether they are truly underpriced or not depends on one' s expectations about the volatility of the underlying stock during the maturity of the option. In addition, convertible bonds contain a credit risk element, because of course the firm may default. Hedge funds are natural buyers of convertibles. The reason for that is twofold: First, they are hybrid securities and therefore, they are not easy to justify in mutual fund bond or stock portfolios. Second, because of their credit risk and imbedded option, they are not easy to price. Hedge funds typically have the expertise and the risk appetite for holding such instruments.

For the issuers of these bonds to induce investors to buy them, they tend to sell the imbedded call option cheap. Hedge funds buy the convertible bond, and delta-hedge its option component, by selling the stock. The replicating portfolio they sell for their delta-hedging is more expensive than what they paid for the option. Their profit consists of pocketing the difference. Some hedge funds may also buy credit risk insurance, while others may choose to keep the credit risk exposure.

This was a great game in town for a long time. Once somebody discovers a good game in town, it is bound to be imitated over time. With the arrival of new entrants, the demand for convertible bonds goes up. Given that, issuers of convertible bonds do not need to underprice the embedded options by as much to induce investors to hold them. Over time, the options become fairly priced, and the profits from this trade converge to zero, and it may be negative after transaction costs. Hedge funds that are focused primarily on such trades, they will start seeing large losses. The losses will be followed eventually by withdrawals by the investors which may induce more losses. In this process, some hedge funds may go under.

As mentioned earlier, the funds that are bound to be most affected by it are smaller funds, or funds that are mainly invested in convertible bonds. Whereas this process may lead to some bankruptcies, it is highly unlikely in my view to lead to any big crisis in the industry. Again, the reason for that is that most big funds are well diversified in terms of the strategies they follow, and they also have long lock-in periods. Therefore, all the talk about an eminent crisis in the hedge fund business or the financial system, reminiscent of the 1998 near collapse of LTCM, which required an orchestrated bailout by some of the world' s biggest banks, is speculation, and in my view highly unlikely. The losses from convertible bonds and related trades simply do not have the ability to generate the systemic risk required for such a crisis to take hold. In addition, the LTCM experience has brought some lasting changes to the hedge fund business.

The lessons learned from the LTCM experience

LTCM did not find itself on the brink of collapse because of massive withdrawals of funds from its investors. It was not brought down by the actions of other hedge funds.
Three factors led to its collapse:

    1. The decision of its partners to return half of their capital (about $6bn) to their investors in order to boost returns. Exactly because some of their good games had started being imitated by other market participants, their profit margins had been squeezed.
    2. Their decision not to decrease the size of their positions after they returned half of their capital. That doubled their leverage that reached towards the end the astronomical level of 100 to 1.
    3. Their inadequate risk management procedures. Meriwether was both the chief risk manager, and the chief investment officer. This created obvious conflicts of interest. In addition, risk management was not taken sufficiently seriously at that time.

What are the lessons learned since then?

    1. Lower leverage. The levels of leverage used by hedge funds these days are drastically lower than those used by LTCM.
    2. More emphasis on risk management. Prior to the LTCM incident, risk management was a much neglected occupation within financial institutions. This has changed.

It is worthwhile to note that both changes were imposed by the investors. It was the investors who started scrutinizing the levels of leverage employed by the hedge funds. And it was investors who demanded stricter risk management rules before they commit their money to the funds.

And this brings us to the issue of regulatory supervision.

Should hedge funds be more closely regulated?

This is a topic that has gained a lot of interest among regulators, hedge fund managers, and investors over the past several years. There are various opinions on the topic that cover almost the whole spectrum of possible answers. Therefore, and in the interest of time, I will only state and explain mine.

I believe that intensifying regulatory supervision on the hedge fund business is unnecessary. In my view, regulators in this context have two main functions. First, to ensure a well-functioning financial system, and second, to protect the interests of small, uninformed investors. The reasons I oppose tighter supervision of hedge funds are the following:

1.   Hedge funds are investment vehicles of primarily high net wealth investors, and regulatory bodies are not meant, in my       view, to cater to them.
2.   Hedge funds investors possess the necessary sophistication to perform their own due diligence, and enforce, through their capital power, reforms in the way hedge funds conduct their business. A relatively recent evidence of this are the structural changes implemented in the hedge fund industry after the LTCM incident.
3.   Regulators are concerned about systemic risk. After all, the reason the Federal Reserve orchestrated the LTCM bailout was because they were concerned that the world financial system was at risk. However, if we look deeper into the LTCM case, we realize that the reason LTCM was able to potentially inflict so much damage to the world' s financial system, is because the banks with which they transacted were too lax in their lending policies. Lured by the size of the transactions they could initiate with LTCM, and the profits they would realize from them, they were willing to lend to the hedge fund at unusually favorable terms. In addition, some top executives from some of LTCM' s counterparties had investments themselves in the hedge fund, creating an obvious case of conflict of interests. If anything, one could argue that the regulators should intensify regulations in banking, with the aim to avoid high concentration of idiosyncratic risk in the banks' portfolios and inadequately collaterized loan obligations.

There are two more issues we need to tackle though. The first one is the rapid expansion of the fund of funds business which makes hedge funds accessible to smaller investors. Whereas the initial minimum investment to a hedge fund is usually more than $1m, funds of funds offer baskets of hedge funds to investors with as little as $10,000 of initial investment. This of course implies that, if the fund of funds business continues its recent rapid growth, the hedge fund industry will become less and less the exclusive investment vehicle of high net wealth individuals. Does this mean that regulators should regulate hedge funds?

Again, in my view, the answer is no. Instead, I think they should direct their attention towards potentially regulating the fund of funds business. There are two reasons for that. First, the clientele of funds of funds is typically small to medium size investors, who may or may not be financially savvy. Second, most funds of funds invest primarily in smaller-size hedge funds, simply because it is easier for them to obtain access. Some of the bigger hedge funds are closed to new investors. In addition, they may systematically avoid funds of funds because they consider their investments " hot money" , that is, money that can be easily withdrawn once the hedge fund goes through a short period of less than stellar returns. Just like small firms have a higher probability of default than large firms, other things being equal, small hedge funds are more likely to go under than some of the bigger ones. In other words, the product that funds of funds offer may be too risky for the size and risk appetite of their clientele.

The second issue that needs to be addressed is the fact that increasingly pension funds and foundations invest part of their assets in hedge funds. How much should regulators be concerned about these investments? One could argue that protecting the retirement income of future pensioners is within the scope of the existing regulatory bodies. I would argue again that the regulations should be imposed on the pension funds and foundations. In the US, pension funds operate under tight constraints, and I think that this is appropriate.

The reason you see me so much opposed to regulations for hedge funds has to do with the function that these investment vehicles serve. Apart from generating at times high returns for their investors, hedge funds, by virtue of the fact that they are unregulated, they help make markets more efficient and improve risk sharing. Both are desirable effects for a financial system and should be preserved. Regulations are constraints. They take the form of restrictions in the type of trades they can perform, or they generate additional operating costs for the institutions that are subjected to regulations. In both cases, their contributions to the financial system are compromised. To the extent that regulations do not lead to a Pareto improvement, they should be avoided.

The prospects of the hedge fund industry

My involvement with the hedge fund industry in the past few years, which has been intensified recently, has led me to conclude the following about the prospects of this business.

1. The sum of assets under management in hedge funds will continue to grow in the foreseeable future (5-10 years).
2. As assets under management grow, opportunities for high returns will become more limited, putting downward pressure on the average returns earned by hedge funds.
3. The above will lead to some consolidation in the industry. The rate of increase in the number of hedge funds that we have seen in the last few years is unlikely to continue for much longer in the future. There are large benefits from economies of scale, even in the hedge fund world. They facilitate the ability of hedge funds to exploit available investment opportunities, better control the risk of their portfolios, through more rigorous -and expensive- risk management, and expand to a larger array of strategies and instruments, as well as provide enhanced returns.

With these thoughts, I would like to conclude my presentation. I would be more than happy to answer any questions that you may have. Thank you very much for your attention.

4.
Table 1. Source: Barclay Group

 

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