Journal Issue

Back to Basics: Demystifying Hedge Funds

International Monetary Fund. External Relations Dept.
Published Date:
June 2006
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HEDGE FUNDS may have an aura of exoticism and modernism, but their goals are as old as the art of investing itself. They seek a positive annual return (the higher the better), limited swings in value, and, above all else, capital preservation. They do so by using the best of what modern financial science can provide—rapid price discovery; massive mathematical and statistical processing; risk measurement and control techniques; and leverage and active trading in corporate equities, bonds, foreign exchange, futures, options, swaps, forwards, and other derivatives.

Because of their nature, hedge funds are restricted to large-scale investors. Historically, they have attracted high-net-worth individuals and institutional investors, and the array of the latter has widened significantly in recent years to include pension funds, charities, universities, endowments, and foundations. Funds of funds are starting to introduce hedge funds to retail markets, but on a rather limited scale. Currently, there are about 8,500 hedge funds operating worldwide, managing over $1 trillion in assets. Quite a leap from the 2,800 hedge funds, managing $2.8 billion in assets in 1995, not to mention the amounts involved in the earliest hedge fund-type investments in the days of Aristotle (see Box 1).

What is hedging?

A few key features distinguish hedge funds from other investment vehicles: the focus on absolute returns, and the use of hedging, arbitrage, and leverage.

Absolute versus relative returns. Over very long periods, buy-and-hold strategies almost always do well. The problem is the length of time and starting point: it can matter enormously when you buy. For example, over hundreds of years, stocks returns have averaged about 8 percent a year, but there can be several decades when stock prices don’t increase in value at all. The Standard & Poor’s (S&P) index, which fell sharply after reaching a peak in 1968, failed to return to its 1968 level in inflation-adjusted terms until 1992! Back in the 1970s, these swings in value prompted investment managers to focus on returns relative to benchmarks, such as the S&P 500 stock index. That way, good performance was expressed in terms of asset managers’ performance relative to standard asset-class indices, and the better the relative performance, the more investors were attracted. In other words, managers attracted more investors—and were paid more money—even if the fund declined in value, so long as it did not decline as much as the benchmark index.

In contrast, hedge fund managers focus on risk-adjusted absolute returns—that is, their objective is to maximize the increase in investment value per year rather than to simply perform better than the average. Consequently, most hedge fund managers are paid based on how much they increase investors’ wealth—a percent of the return—not on how well they do relative to a benchmark, thus focusing their performance exclusively on positive returns. Although managers are also paid a 1 or 2 percent commission a year for assets under management, most of their compensation depends on delivering a positive absolute return. In addition, managers typically invest significant amounts of their own capital in the fund, which aligns their interests with the investors and discourages reckless risk taking. And, when used, a “high-water mark”—whereby capital losses have to be made up before a performance fee is paid—introduces a strong incentive toward capital preservation. In this context, minimizing swings in value and immunizing the hedge fund’s portfolio from general swings in market values, through hedging, become key to long-term return maximization.

Box 1It all began with olives

The first recorded hedge fund–style investment was a “call option” trade and appears to have occurred about 2,500 years ago. Aristotle told the story of a poor philosopher, Thales, who proved to doubters that he had developed a “financial device, which involves a principle of universal application,” by making a profit from negotiating with owners of olive presses for the exclusive rights to use their equipment in the upcoming harvest. Olive press owners were happy to pass on the risks of future olive prices and to accept payment now as a hedge against a bad harvest later. As it turns out, Thales correctly predicted a bountiful harvest, and the demand for olive presses rose. He sold his rights to use the presses and made a profit. Thales’s “call option” risked only his down payment. Although he did not invest in fields, workers, or olive presses, he participated actively in olive production by taking on a kind of risk olive growers and press owners were unable or unwilling to take—in the process enabling them to concentrate on growing and processing olives. They made a profit from their work, and he made a profit from his.

Modern hedge fund history began with Alfred Winslow Jones, a sociologist and journalist who wrote about market behavior in the 1930s and 1940s and founded one of the first hedge funds in 1949. Jones’s fund used leverage and short selling to “hedge” its stock portfolio against drops in stock prices. There was little widespread interest until 1966, when an article in Fortune magazine generated considerable interest by pointing out that Jones was earning 44 percent higher returns than the best-performing equity asset fund—even though he charged a fee equaling 20 percent of the fund’s gain. By 1968, there were about 200 hedge funds, although many failed in the 1969–70 and 1973–74 market downturns. Hedge fund business really picked up in the 1990s, fueled mainly by new wealth generated during the 1990s equity bull market.

Hedging, arbitrage, and leverage. What is hedging? It is a technique aimed at protecting a portfolio against sharp movements in market values. It essentially implies buying and holding assets that have good long-term prospects while simultaneously selling assets that have doubtful prospects. The latter technique, short selling, involves borrowing someone else’s shares of stock and selling them, with the intent to buy the shares back at a lower price and return them to the original lender. The difference between what the shares are sold for and what needs to be paid to buy them back is the profit. The development of market-traded stock and stock index futures, options, and related derivatives over the past half-century has created a near-infinite number of ways to engage in short selling and hedging (see Box 2).

The technique of arbitrage tries to profit from the fact that sometimes an asset trades at a different price in different markets at the same time. Because an asset should have the same price in all markets at the same time, a way to capture a low-risk profit is to sell the higher-priced asset in one market (sell it short) and buy the lower-priced asset (buy it long) in the other market. When the prices converge, an arbitrage profit can be captured by selling the formerly low-priced asset and buying back the formerly high-priced asset. A typical example of potential arbitrage opportunities is company bonds that are convertible into equity shares of the company.

A hedge fund manager focuses on achieving absolute returns by finding as many profit opportunities as possible that are immune to market gyrations—in industry lingo, generating alpha (returns uncorrelated to market performance) rather than beta. Because these opportunities often involve small trading margins, the use of leverage and prudent risk management seeks to achieve good returns with lower volatility. The key performance variable is risk-adjusted returns. The most widely used measure is the Sharpe ratio—the rate of the mean of the return to its standard deviation. Higher values mean the risk-adjusted return is higher, given a particular measure of risk.

The bottom line is that hedge fund profits arise not from accurately predicting the direction of prices but from being able to identify transient pricing opportunities. To believe in the ability of hedge funds to be successful, one must disbelieve, or at least relax, the well-known efficient markets hypothesis, which says that on average no model projecting directional movements in asset prices will be significantly superior to tossing a coin. In fact, however, the operations of hedge funds may be viewed as promoting efficient markets: by actively seeking to eliminate market mispricing, hedge funds contribute to a faster and more efficient convergence of prices toward a market equilibrium, diminish market pricing errors, reduce price extremes, and can help to stabilize markets, “buying low and selling high.”

Box 2Basic hedge fund arbitrage strategies

Convertible arbitrage. A strategy in which managers purchase a portfolio of securities that are convertible into other kinds of securities. For example, corporate bonds are often convertible into equity shares of the issuing companies. Normally, the prices of the bonds and shares trade in a close relationship. Sometimes bond and stock market conditions cause the prices to get out of line. Hedge funds buy and sell the bonds and stocks simultaneously, pushing the prices back into line and profiting from market mispricing.

Distressed securities. A strategy in which managers use borrowed funds to invest in the debt and equity of companies that are currently or recently in bankruptcy reorganization, or may declare bankruptcy in the near future.

Event-driven/merger. A strategy in which managers invest in opportunities created by significant transactional events, such as spin-offs, mergers and acquisitions, bankruptcy reorganizations, recapitalizations, and share buybacks.

Global macro. A strategy in which managers employ “top down” global approaches and may invest in any markets using any instruments to profit from inaccurately priced market movements resulting from shifts in world economies, geopolitical conditions, global supply and demand balances, or other large-scale changes.

Long/short. Strategies in which managers take long positions in securities expected to rise in value and short positions in securities expected to fall in value in an effort to insulate the portfolio from market volatility. One example of this strategy is to build a portfolio made up of long positions in the strongest companies in an industry and corresponding short positions in the weakest companies.

Market neutral. A category of long/short strategies in which managers invest the same amount of capital in offsetting long and short positions, maintaining a portfolio with zero or near-zero net market exposure.

Volatility arbitrage. A strategy in which managers sell short-term call and put options to profit from option premium decay and volatility mean-reverting tendencies using index options and/or options on futures contracts.

Debunking hedge fund myths

In recent years, there has been a lot of debate and hand wringing about hedge funds, their effects on global financial stability—especially since a major U.S. hedge fund had to be bailed out in 1998 (see Box 3)—and the degree of regulation or supervision to which they are subject. The reality is that these worries are overblown. Take two of the biggest myths.

Myth 1: Hedge funds can move financial markets for their own gain or cause market turmoil. After exhaustive analysis, the U.S. Securities and Exchange Commission (SEC) recently determined that there is little evidence that hedge funds can move markets, and several research studies have found no evidence that hedge funds were a cause of the Asian crisis or other world economic turmoil (Eichengreen and others, 1998). The unwinding of “carry trades” (borrowing at a low interest rate and lending at a higher one) did contribute to Europe’s 1993 exchange rate mechanism crisis, the 1994–95 peso crisis, and the 1997–98 Asian crisis. But the key problem underlying these events was the misalignment of exchange rates with respect to their fundamentals—not the intervention of financial market participants. In fact, the IMF study led by Eichengreen found that hedge funds, by being willing to take the risk of buying some of the assets that had already fallen significantly in price, contributed to limiting the downfall during the Asian crisis and advancing the recovery.

Box 3The LTCM debacle

In all markets there are failures, and hedge funds are not immune to them. The most famous case is that of Long-Term Capital Management (LTCM), a well-known hedge fund that lost all its capital in the fall of 1998. A sudden spike in market volatility in the summer of 1998 led to a very rapid increase in LTCM’s losses, forcing its liquidation. In addition to the doubtful soundness of some of its strategies, LTCM’s failure happened for two main reasons: risk management systems in LTCM and its banks were weak; and LTCM’s investment positions had become too large relative to the total market volume in those assets. When prices turned against it, LTCM could not sell its holdings quickly enough. And as it engaged in fire-selling to adjust its portfolio, its losses snowballed. Because its positions were so large and were linked to so many other financial institutions, LTCM became a potential systemic risk, convincing the authorities to intervene.

As a result of a thorough review of the hedge fund business following the LTCM failure, companies that interact with hedge funds have tightened counterparty risk management. And national and foreign financial regulatory institutions have upgraded their supervisory oversight of hedge funds. But perhaps even more important, there has been a rethinking within the hedge fund industry itself, with leading hedge fund companies establishing best practice guidelines for the industry. And follow-up evaluations, such as the one by the Financial Stability Forum in 2002, show that risk management discipline has increased and leverage has fallen.

The reality is that hedge fund activity makes financial markets more efficient and, in many cases, more liquid, as has been widely recognized by the U.S. Federal Reserve, the SEC, and the IMF. Not only do hedge funds contribute to the adjustments of markets when they overshoot, they also help banks and other creditors unbundle risks related to real economic activity by actively participating in the market of securitized financial instruments. And because hedge fund returns in many cases are less correlated with broader debt and equity markets, hedge funds offer more traditional investment institutions a way to reduce risk by providing portfolio diversification.

Myth 2: Hedge funds are unregulated and unsupervised. The fact is that hedge funds in the United States are regulated and supervised directly or indirectly by seven U.S. government agencies (the Federal Reserve, the Department of Treasury, the SEC, the Commodity Futures Trading Commission, the National Futures Association, the Comptroller of the Currency, and the Federal Deposit Insurance Corporation) and by numerous international agencies.

Here to stay

In sum, hedge funds are called hedge funds because they use a full array of hedging techniques to reduce portfolio volatility. They are becoming increasingly popular, as private ownership of capital expands worldwide and large-scale capital owners seek to preserve their wealth in volatile markets. In an effort to soothe worries about transparency and supervision, public authorities are trying to develop new approaches to meet the public’s need for financial system stability and investor protection while enabling investors to enjoy the benefits that hedge funds bring to financial markets.

Angel Ubide is Director of Global Economics, Tudor Investment Corporation.


    EichengreenBarry J. and others1998Hedge Funds and Financial Market DynamicsIMF Occasional Paper No. 166(Washington: International Monetary Fund).

    Financial Stability Forum2002“The FSF Recommendations and Concerns Raised by Highly Leveraged Institutions (HLIs): An Assessment(Basel).

    International Monetary Fund2004Global Financial Stability Report: Market Developments and IssuesSeptember2004World Economic and Financial Surveys(Washington).

    International Monetary Fund2005Global Financial Stability Report: Market Developments and IssuesApril2005World Economic and Financial Surveys(Washington).

    Managed Funds Association2003“2003 Sound Practices for Hedge Fund Managers”(Washington).

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