Types of Investment Vehicles - Essay Example

?Question In the financial markets, there are many types of investment vehicles, and currently one of the vehicles that pay some of the highest returns are hedge funds. Hedge funds are investment funds used to undertake different types of investment and trading activities, much like mutual funds. However, some of the differences between mutual and hedge funds are in their management, the people who can join them and the compensation structures for their managers. From definition, hedge funds only take in specific investors, mostly highly financial people specified by regulators. In this part, the paper will discuss the compensation structure used by hedge funds. The discussion will include the rationale for this compensation structure, its mechanics and the agency issues that can be associated with the compensation structure. The hedge fund structure is usually composed of general partners who handle all the trading activity from the fund and limited partners who supply the capital that is invested in the fund. Other members include the portfolio manager, who is usually the owner of the management company. The investors in the portfolio are usually between 100 and 150 certified investors who are willing to let the portfolio manager manage their funds for profit. The administrators of the hedge funds maintain the books and records and process all the transactions in the funds. Since the investors are not involved in the day to day handling of the fund, it is up to the hedge fund managers to complete all the transactions in the fund and charge fees to the investors in form of compensation structures. As already stated, the compensation structures used by hedge funds are different from those used by normal mutual funds since they take more fees in a different manner. The managers in the hedge fund use different strategies to create profits from the funds, and the Limited Partners, also known as the investors receive a percentage of the profit. The compensation structure in hedge funds is usually set on two main types of fees; performance fees and management fees. The performance fee in a hedge fund refers to the fee in the investment fund that a manager charges investors as a percentage of the increase in value of the assets in which the funds are invested. The value of the funds investments is periodically calculated and the fund manager gets a performance fee, usually between 20 and 30% of the Net Asset Value, which is the increase in value. The performance fee in hedge funds is similar to that in mutual funds. However, other fees that are in the hedge fund and not in the mutual funds are the management fees. The management fee is usually 1 to 2% of the fixed fee of the assets in the mutual fund, and in addition, an incentive fee of between 10 and 30% of the assets in the fund is also charged. The contentious point about these fees is that the management fee is usually charged regardless of whether the fund has made any profits, which means that the managers will always earn profits even if the fund fails. However, the performance fee can only be charged if the fund makes a pre-specified level of return, which is usually set at a percentage or decided as an index. This level of return is referred to as an hurdle, and the managers strive to increase the level of performance of the hedge fund in order to earn extra fees. Hurdles typically reduce the size of performance fees and increase the reward for better management of the fund, a factor that accounts or its popularity with investors. Another terminology analogous with the compensation structure of hedge funds is the high water mark, a term used to refer to the performance of the fund. The highest value of a hedge fund in a year is called the high water mark, and if the fund’s value falls in the subsequent year, the managers are not paid performance fees. This means that in subsequent years, if the funds increase in NAV but does not exceed the high water mark, no performance is also charged on the investors since they do not make any additional profits. The agency problem associated with the compensation structures of the hedge funds is associated with the fees paid out to managers, where the managers can manipulate their performance in a bid to manipulate their fees. However, with the given distributions in fees and regulations concerning hedge funds, it is expected that the managers and possible agency theory is effectively managed. For example, when a fund’s return is lower than the fees that the manager charges, it is evident that the option has no intrinsic value. The most rational choice in this case would be for the manager to increase the volatility and hence increase the probability of expiring in the money. However, if the fees are lower than the return of the funds, the option has intrinsic value. This means that it would be rational to decrease the volatility of the fund and lock in the value of the returns. The two example of possible agency conflict are, however, reduced by the explicit and implicit terms of the compensation contract. From the compensation contract, there is a percentage of the upside that the managers are aware about, and the high water mark means that the managers will try to increase the value of the fund instead of locking in the value. Other factors in the compensation contract that reduce possible agency theory is the possibility of liquidation and the reputation concerns that the managers would be faced with if the fund drops in value. From the above analysis, it is evident that hedge funds compensation structures offer managers the possibility of agency theory, but with the factors mentioned above, coupled with the high returns, this possibility is minimized. In mutual; funds, there is no possibility of agency theory since the managers are not paid the same amount of fees that hedge fund managers are paid in their jobs. Question 2 In hedge fund investment, option strategies refer to the rights that investors have to purchase assets at specific prices in the future at prices stated today. Option strategies are usually priced using different formulas that determine the price of the strategies in the future. They can be favorable to movements in the assets in which they are invested by being bullish, bearish or neutral. Whenever mergers are announced, the target companies usually trade in prices lower than the original share prices. This difference in price is called the arbitrage spread or arbitrage risk. The success of the merger determines the loss or returns earned by the arbitrageur in the deal, since the failure of the merger incurs a loss and a success incurs a profit. The returns of risk arbitrage investments and the risks associated with the arbitrage. Option strategies are usually divided into three main strategies. The first of this is the bullish strategy, where the options trader hopes for an increase in the underlying price of the asset being invested in. In this case, it is prudent for the stock trader to determine how much the stock price will rise and the time that will be taken for the price to rise to an optimum price with which the trade can be made. This strategy is used by many new traders since it is the simplest strategy that can work in the market. The second option strategy is the bearish strategy, where the trader expects the price of the asset inherent in the option to decrease and selects an optimum strategy based on how and when the price will reach a certain low price. The simplest bearish option is also used by new traders in the market, where the traders buy simple put options in the stock market. However, since stock and hedge funds prices only rarely move downwards, the traders usually set a standard price which they target for their options and prices. Neutral strategies are option strategies in which the trader does not know the direction in which the fund price will move, meaning that the potential profit is based on the expected volatility of the underlying asset in the option. Unlike bullish and bearish strategies, the asset is not expected to move in price, it is non-directional, but the volatility strategy determines the profit that will be earned by the traders. According to Mitchell and Pulvino (2011), the different hedge fund strategies usually have returns that are similar to the returns provided by options. These returns are usually hard to explain using linear factor models, so analysts usually model them using option returns. The researchers use different models for the modeling process that simulate option returns, with an example being the trend-following model developed by Fung and Hsieh (2001). According to Fung and Hsieh (2001), hedge fund managers use varying trading strategies very similar to option strategies and seemingly have no systematic risk associated with them. Models like the one developed by Sharpe for modeling option strategies cannot be used to model these investment strategies since the trading strategies have non-linear characteristics like those found in standard benchmarks. In this case, investors might wrongly conclude that the strategies not have systematic risk. This mistake is corrected when researchers realize that the use of benchmark indices with option characteristics helps in finding the systematic risks of the portfolio. This is because the option like strategies has the standard features of the hedge funds and still contains the characteristics of the standard benchmarks being used. For hedge fund risk to be completely documented, the model must include the non-linear relationship seen in the hedge funds, a factor that allows for the identification of systematic risk. However, due to the absence on public information on the hedge funds, it is usually hard to find the factors inherent to hedge funds and is similar to the market. One of the models of option strategies used is trend following, and refers to the options where the trend-following funds are not correlated with standard equity investments or many other investment instruments. In Fung and Hsieh (1997), it is stated that these option strategies are similar to option-like features, since they are always positive during extreme times of the fiscal market. For example, the best trend following strategy is similar to a look-back straddle, where the owner of the straddle has the option and not the obligation to acquire the asset at the lowest price at any time in the life of the option. Conversely, a put option for the look-0back strategy allows the owner to sell at the highest price at any time in the life of the option. When these two options are combined, the investor achieves the look-back strategy which gives the best method for investing in the option strategies. Research has demonstrated that the use of the look-back straddle demonstrates characteristics similar to trend-following strategies used by fund managers in trading in hedge funds. In modeling the risk of the trend-following strategies, research indicates that these funds use different trading strategies to model behavior. In their findings, one of the conclusions postulated by Mitchell and Pulvino (2001) is that the characteristics of trend-following funds closely resemble those of world equity markets. As already stated, hedge funds risks are usually not linear, meaning that the estimation of systematic risk cannot be done using traditional models. The model developed above can be used to model the systematic risk of the hedge funds if the option strategies mentioned are included in the modeling benchmark. This model is optimally used by analysts to assure investors that the false confidence in lack of systematic risk in hedge fund strategies is eliminated. The use of option strategies included in hedge fund trading strategies can help in modeling the return and risk of the underlying assets in the hedge funds. This is done, as in the above case, y using the option strategies that have benchmark features as explanatory variables in the system. Question 3 The return distributions of many hedge funds usually show that their risk-adjusted performances are better than these displayed by other forms of investments. This assumption usually has different implications for investors since the models used; especially Sharpe’s and Markowitz’s usually understate the actual risk-return performance of hedge funds. Using man-variance portfolio analysis to analyze hedge fund indices usually over-allocates it and overstates the attainable benefits by understating the risk. From definition, hedge funds are privately organized investment vehicles that have fewer restrictions on the use of leverage, short-selling as opposed to other instruments like mutual funds. Many investors are trying to invest in hedge funds, and since they have to evaluate the risks of the funds, are resorting to comparing the mean-variance characteristics of the funds using publicly available hedge fund indices to model the hedge funds. As already stated, using this approach has many limitations, including the presence of many hedge fund data providers, all of which are significantly different, and the differences in the statistical properties of these fund providers. Hedge fund strategies are usually different from the strategies utilized when investing in traditional investment instruments. In this case, hedge funds form a very diverse group of investments, especially from the three main types of hedge funds; Global funds, Event-Driven funds, and market neutral funds. Global funds are the most common in the media, event driven funds usually deal with company securities in big events like mergers and market neutral funds use short and long positions as investment strategies. Other types of funds include funds-of-funds, which invest in other hedge funds across the whole sub-groups of hedge funds. Since hedge funds are not obligated to be publicly disclosed, the availability of hedge fund indices is severely limited, but since the fund managers want to attract investors, they sometimes release some information to the publicly. This information is collated into hedge fund indices which public investors rely on to make decisions on which funds to invest in. Many fund practitioners use Sharpe’s Ratio to gauge the performance of different hedge funds since it is known to measure the incremental profit per unit of risk taken in the portfolio. In this case, the Sharpe Ratio calculates somewhat high means and low risk measures for the hedge funds over other stock indices. This type of analysis only considers the first couple of instances of a return’s distribution, which is a disadvantage since non-normally distributed funds, cannot be gauged using only their standard deviations and means. () states that hedge funds predict abnormally high means and low standard deviations, which tends to give the investors the characteristics that they do not desire. In this case, the Sharpe Ratio will constantly overstate the real performance of a hedge fund compared to other investment opportunities. The investors who believe in these ratios simply substitute negative skewness and a high level of kurtosis for a false reading of the mean and standard deviation of a portfolio. Much in the same case discussed above, investors will sometimes evaluate possible portfolios using the mean-variance framework developed by Markowitz. In summary, the mean-variance framework states that investor will prefer the portfolios that have high levels of mean return and low levels of risk or variance. From the analysis above, it is evident that this approach has the same limitations of the Sharpe Ratio approach, since it glosses over other factors in favor of the mean and standard deviation. In this case, research indicates that portfolios that have better mean-variance trade-offs usually have unfavorable skewness-kurtosis properties. An analysis of the statistical properties of hedge funds analyzed using Markowitz’s mean-variance statement reveals that one of its main limitations is an increases chance of unconditional distribution. From analysis of risk arbitrage, convertible arbitrage and other forms of hedge fund indices, the return distributions are non-normal and display unfavorable skewness and kurtosis indices. The other failure of these models includes unfavorable time-series behavior, where the portfolio monthly returns display unusually high first order correlation. This means that the portfolios display delays in their reactions to market events. The correlation of these portfolios with other market classes and instruments is also unusually high, for example, the portfolios show high correlation with the stock markets and low correlation with bond markets. The statistical properties of different hedge funds analyzed using Markowitz’s mean-variance method and Sharpe’s Ratio analysis also indicate wrong correlation between different categories of hedge funds. This means that the monthly correlations between different correlations are highly similar, indicating a higher level of same systematic factors, which include systematic risk. As already mentioned, there is a high number of indices against which investors can base their judgment on which hedge funds to invest in. However, the analysis of these hedge fund indices reveals major differences between the indices of the same type, which misleads investors. In retrospect, both the Sharpe Ratio and Markowitz’s mean-variance analysis are unsuitable for evaluating the performance of hedge funds since they only analyze the mean and standard deviation. Analysis using the Markowitz’s mean-variance analysis also overstates the returns of hedge funds because of the excessive smoothness of the available monthly data. This means that the attainable improvement is overstated at the given levels of risk provided with the data. Including hedge funds in a portfolio that using analyzed using the mean-variance method improves the mean versus risk part of the portfolio but reduces the skewness and characteristics of the overall portfolio. In conclusion, the traditional mean-variance analysis proposed by Markowitz indicates that hedge funds are more attractive than other investment vehicles. However, this approach underestimates the risk of the portfolio and overestimates the returns since it takes into account only the mean and standard deviation. This method is also unsuitable since it negates the effect of kurtosis and skewness, which means that the investors take into account wrong information about the portfolio. From the statistical analysis of hedge funds using the mean-variance analysis and Sharpe’s ratio, this abnormally has been shown to exist and negatively affect portfolios containing hedge funds. Question 4 The popularity of hedge funds as an investment option cannot be denied since they offer large returns to the investor. The rise in the popularity of hedge funds has been regularly related to their constant high returns and the negative relation with traditional investment risk. However, the performance of hedge funds has been constantly misunderstood, leading to investors seeking new methods of investment. In this case, investors have turned to investing in funds of funds. By 2000, nearly 17% of the funds invested in hedge funds came from investments in funds of hedge funds, a proportion that increased to more than 35% by 2007. However, with the financial crisis that hit in 2008, this proportion reduced. In this part, the paper will explain the growing fascination with funds of funds despite the additional fees associated with the investment instrument. The investors chose to invest in funds of funds in order to diversify risk and get the added skill of trained analysts. From Keynes’ theory, it is evident that diversification is one of the best protections against less knowledge of investor knowledge. In this case, most individual investors and institutions prefer to gain diversification through investing in funds of funds. The two advantages of investing in funds of funds are the added diversification and the lack of monitoring of individual managers of the portfolio. Many investors diversify their investments in funds of funds in two methods; diversification by investment style, which involves investing in different strategies and investing in different managers to reduce the risk of single-manager investment style. Despite the numerous researches on the importance of diversification, there has been limited research on diversifying on hedge of hedge funds. Funds of funds are defined as funds that get money from individuals and institutions and invests the assets in hedge funds as some of the limited partners. As already stated, the hedge of hedge funds phenomenon was popular prior to the financial crisis but was they shrank fast during the financial crisis. This was due to the myriad questions about the performance and liquidity of the hedge of hedge funds. As already stated, the popularity of funds of hedge funds increased since investors do not have the time to pick out their own hedge fund portfolios. In this case, the investors prefer getting professional analysts who know the mechanics of hedge funds and can take fees for the option of investing the assets. The individual investors justify the fees that they pay to the portfolio managers since they get the advantage of not having to manage their own portfolios. In contrast, institutional investors also do not have the expertise to pick out portfolios on their own, so they chose investing through funds of hedge funds. The institutional investors know that the funds of funds managers have better qualifications to manage the portfolios and justify their risk. The institutional managers also believe that the diversification methods used by the funds of funds managers are the best strategies for managing the portfolios. However, research indicates that just a little over 5% of funds of funds justify the extra costs paid to their managers. This is because the investments that actually return value are lower that all the investments and investors would do well by just selecting the underlying hedge funds. The main limitation of investing in funds of funds is finding the best method for diversifying the risk among different hedge funds in the market. This is because investment in too many funds exposes the investor or the fund manager to too much risk. However, investment in too few funds increases the risk of loss in the investment, so the manager has to be prudent. The other challenge in investing in the funds of funds is the challenge of limiting off-setting exposure. For example, investors have to avoid being long a value as risk and related return may be hedged out of the portfolio. Diversification of a portfolio reduces the risk inherent to specific funds but does not eliminate the risk that investors explicitly target. This is because investors avoid having the funds of funds behaving like equity index funds. However, investment in funds of funds is the best way for individual investors to access the diversified returns of portfolio returns. As already stated, diversification in funds of funds is a method of avoiding the ignorance that comes with diversification. The spread of assets in a portfolio spreads the assets in a portfolio and reduces the accompanied risk. It also reduces the mathematical absurdities associated with modern portfolio theory. With diversification in funds of funds, the efficient frontier is closely achieved since the funds are diversified. However, with the many funds, the risk of investing portfolios can cause a failure or loss of assets. Very few hedge funds are usually completely diversified since the non-normality of hedge funds is hard to achieve. As stated previously, hedge fund distributions exhibit skewness and are not normally distributed. Mean-variance optimization of hedge funds requires specific forecasting of risk and correlation to put them into the best portfolio. In conclusion, it is imperative to chose the best options for portfolios since the number of portfolios do not solely determine the diversification strategies. An investor can reduce the risk inherent in a portfolio by investing in few funds that offer the best diversification. Randomly investing in many funds is not the best option for an investor, the investor can chose across different investment styles. This can be implemented wisely if the investor selects additional hedge funds that have investment styles not already included in the original portfolio. Portfolio diversification should be done through hedge funds despite the added fees for the managers since the investor gets the additional expertise without having to do individual investing. References Fung, W, and Hsieh, D. 2001. “ The Risk in Hedge Fund Strategies: Theory and Evidence from Trend Followers”, The review of financial studies, Vol. 14:2.313-341. Mitchell, M, and Pulvino, T. (2001). “Characteristics of Risk and Return in Risk Arbitrage”, The Journal of Finance, Vol. 56: 6. Read More