1. Hedge Funds Versus Mutual Funds
Mutual funds are regulated under the SEC Act 1933 and the Investment Company Act of 1940 and they must invest according to the stated goals in the prospectus. They are adjured to avoid ‘style drift.’
Hedge funds are not open to the general public. The primary investors are institutional investors but they are open to high net worth individuals. Most require minimum investments of $250,000, some go up to $1,000,000. A few now have a minimum investment of $25,000, but we will have to wait and see what kind of shakeout occurs after the financial crisis.
The following table provides a summary of the differences between hedge funds ...view middle of the document...
An example would be to buy bonds in anticipation of an interest rate decline. Recall if interest rates fall, bond prices will rise. Non-directional strategies are attempts to arbitrage a perceived mispricing. These procedures are typically a risky arbitrage. An example might be to exploit an abnormal bond spread. For example, suppose the spread between corporate bonds and Treasuries is believed to be too large so you buy the corporate bonds and short the Treasuries. This way you capture the increase in price of the corporate bonds as their yield falls when the spread narrows and you capture the price drop on the Treasuries that occurs when their yield rise. The offsetting long and short positions limit risk from interest rate moves. This position is said to be market neutral with respect to overall interest rates. Directional strategies are riskier, but neither is riskless. The strategy described above is termed an intermarket spread strategy or a convergence arbitrage and was commonly used by the hedge fund Long Term Capital Management (LTCM). When global risk premiums increased after the Asian currency crisis and the Russian foreign debt default, spreads increased beyond their historical norms for an extended time period. Because LTCM was so highly levered, they could not ride out the crisis and eventually had to be bailed out by their Wall Street clients. The bailout was arranged by the Fed but no public money was used.
Convertible bond arbitrage is a type of risky arbitrage strategy. If the fund thinks the convertible is underpriced it would buy the convertible and short the stock and then wait for the mispricing to be fixed.
These are risky strategies and they are bets on particular perceived mispricings, called “pure play” bets.
Statistical arbitrage uses quantitative math models and often automated trading strategies that attempt to identify small mispricings in multiple securities. This strategy involves placing small bets in hundreds of different securities for short holding periods (a matter of minutes). The strategy requires fast trading and low transactions costs. An example of this is so called “Pairs Trading” where the fund attempts to find two ‘twin’ stocks and then shorts the high priced one and buys the low priced one. The fund places small bets on large numbers of pairs hoping to rely on the law of large numbers.
5. Performance Measurement for Hedge Funds
Hasanhodzic and Lo (2007) find that style adjusted alphas and Sharpe ratios are significantly greater than these measures for the S&P500 for a large sample of hedge funds. Does this mean that hedge funds are earning abnormal returns? The answer is maybe, but probably not. On the surface, the results imply that hedge fund managers are highly skilled, but recent work by Aragon (2007) that controls for illiquidity of hedge funds with lockup periods and other redemption restrictions finds the alphas become insignificant after these adjustments. ...