hedge fund issues and performance 1 l6: hedge fund issues and performance

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  • Slide 1
  • Hedge Fund Issues and Performance 1 L6: Hedge Fund Issues and Performance
  • Slide 2
  • Hedge Fund Performance 2008 was a watershed year in the hedge fund industry Assets under management (AUM) by hedge funds dropped by unprecedented levels and the concept of managing for absolute returns (positive returns) was, in part, invalidated by significant losses As a result of these losses, investor withdrawals increased substantially This withdrawal activity, combined with reductions in asset values, resulted in a drop in AUM by approximately 25%, from almost $1.9 trillion at the end of 2007 to just over $1.4 trillion by the end of 2008 Part of the problem during 2008 was that too many funds bought the same assets and as markets fell, many hedge funds sold these assets to gain liquidity, pushing prices even lower Compounding this problem was the need for some institutions to raise cash when the equity market decline caused minimum equity allocation benchmarks to be breached, triggering a need to take money out of hedge funds and reinvest directly in equity instruments. 2 L6: Hedge Fund Issues and Performance
  • Slide 3
  • Hedge Fund Performance The Fund Weighted Composite Index tracked by Hedge Fund Research (HFR) fell by 19.0% during the year compared to the drop in Standard & Poors 500 stock index of 38.5%, including dividends Therefore, even though hedge fund losses were significant, they were substantially less than the broader equity market 2008 marked only the second calendar year of negative returns for hedge funds since 1990 Approximately two thirds of the decline in assets during 2008 was a result of poor hedge fund performance and the remaining one-third came from clients withdrawing their assets Fund of hedge funds underperformed hedge funds, losing 21.3% for the year. Despite the overall poor performance, however, it is important to reemphasize that hedge funds (both in aggregate and across the major investment strategies) still outperformed the broader market 3 L6: Hedge Fund Issues and Performance
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  • Searching For Returns Hedge funds have traditionally been associated with alpha based returns which are independent of market conditions, but, increasingly, hedge funds participate in the same investment activity as traditional fund managers To differentiate themselves, hedge fund managers have had to search for new sources of returns in new markets, but this search has pushed them into less liquid investments, including private equity investments and other private transactions This activity extends their investment horizon, requires longer lock-ups and results in the need to hire new managers who have long-term investment expertise Hedge funds have become active participants in leveraged bank loans, mezzanine financings, insurance-linked securities and in LBO transactions In other words, hedge funds have moved a significant amount of their investment base from public transactions to private transactions in their search for alpha-based returns 7 L6: Hedge Fund Issues and Performance
  • Slide 8
  • Fund of Funds 2008 ended on a bad note with the disclosure of over $20 billion in losses experienced by those who invested in Bernard Madoffs investment funds While Madoff wasnt a hedge fund manager, a number of fund of funds that allocate investor money to hedge funds also allocated money to Madoff through feeder funds This created concern about the quality of fund of funds due diligence processes and the ensuing crisis of confidence in fund of funds resulted in many investors withdrawing money from these funds, which in turn, caused money to be taken out of hedge funds Fund of funds have sold themselves to investors on the basis that they offer three key benefits: diversification, access to sought-after managers and due diligence The financial crisis weakened the first two benefits from the perspective of many investors The Madoff scandal significantly undermined the third benefit 8 L6: Hedge Fund Issues and Performance
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  • Fund of Funds Compounding the difficulties of fund of funds was the leverage employed by these funds. Many fund of funds borrowed money to supplement investor money when they made investments in various hedge funds Since most of the hedge funds they invested in were already leveraged, this doubling up of leverage created enhanced losses beyond the losses of the underlying funds In part, because of this leverage, average losses from fund of hedge funds during 2008 were 21%, compared to average losses for hedge funds of 19% With lenders retracting credit, fund of funds were forced to dump assets, putting further pressure on hedge funds and the markets in general As a result, a number of high profile hedge funds liquidated or froze redemptions during 2008, traumatizing the investor base and triggering additional requests for redemption by some investors who sought liquidity wherever they could find it (even from hedge funds that were generating positive returns) 9 L6: Hedge Fund Issues and Performance
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  • Benefits Revisited Historically, hedge fund managers have articulated the following benefits for investors who place money in their funds Attractive risk-adjusted returns, focusing on positive returns, low volatility and capital preservation Low correlation with major equity and bond markets Investment flexibility to invest long or short, using a variety of instruments, investing in segments of the market that suffer from structural inefficiencies and in smaller asset pools Focus on marketable securities Structural advantages including performance-based compensation, managers personal investment (which aligned interests) and the ability to attract the best and brightest 10 L6: Hedge Fund Issues and Performance
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  • Benefits Revisited An analysis of these benefits in light of the major dislocations of the market during 2007 and 2008 suggests the following about hedge funds Achievement of positive (absolute) returns has become a problematic objective during periods of major market dislocation Achievement of low correlation with major equity and bond markets is difficult to obtain during periods of major market dislocation Investment flexibility continues to be a major benefit of hedge funds Some hedge funds have invested a portion of their assets in nonmarketable securities, creating a mismatch between asset maturities and investor withdrawal requirements Structural advantages, including performance-based compensation and aligned interests 11 L6: Hedge Fund Issues and Performance
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  • Transparency Hedge fund investors historically have not required a significant amount of investment transparency from hedge fund managers Many investors are now pushing for greater position-level transparency, but some managers resist this based on their concern that disclosure of strategies will benefit competitors and cause arbitrage opportunities to disappear Managers are generally willing to provide organizational and process transparency regarding assets under management, profit and loss attribution, key investment themes, new product initiatives, and personnel In addition, risk transparency is usually provided through disclosure of credit exposure, volatility exposure, long verses short positions, leverage, geographic focus, portfolio concentration, industry focus and market capitalization focus However, hedge fund managers will attempt to keep specific investment strategies, ideas, and short positions confidential, so investors must decide whether the level of overall transparency provided is adequate in the context of the risks and benefits associated with investing in hedge funds 12 L6: Hedge Fund Issues and Performance
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  • Fees Following the poor industry performance during 2008, some hedge funds decided to reduce fees from 2% to 1% Renaissance Technologies, one of the largest and most successful hedge funds, waived all management fees for 2009 for its Renaissance Institutional Futures fund and the fund agreed to not receive any performance fees until 2008 losses of 12% were recovered Other funds, including Highbridge Capital Management, launched new share classes with lower fees in exchange for longer lock-up periods At the end of 2008, Citadel Investment Group gave back about $300 million in fees it had previously collected, after completing a money-losing year and other firms also gave back fees and remained committed to not receiving performance fees until they reached their high water marks At some funds, fee cuts came principally from performance fees, rather than management fees, based on the view that management fees are essential to keeping the funds operational 13 L6: Hedge Fund Issues and Performance
  • Slide 14
  • High Water Mark A hedge fund high water mark is a mechanism that is implemented to make sure that managers do not take a performance fee in the current period when the fund has had negative performance over previous performance fee periods The high water mark is the colloquial term for a cumulative loss account A cumulative loss account starts with a zero balance at the beginning of any performance period (monthly, quarterly, or yearly, as determined by the firm) and it records net losses during that period It was estimated that only one in 10 hedge funds received performance fees during 2008 because of losses and application of high water marks This created significant compensation pressures for many funds since their management fees were insufficient to keep th