Diversification of Hedge Funds - Literature review Example

Diversification of Hedge Funds Name: Instructor: Course: Location: Date: Diversification of Hedge Funds Introduction A hedge fund can be described as an investment system involving a general partner and limited partners who utilize high risk methods of realizing large profits in a business operation or investment. The general structure of a hedge fund comprises of a general partner, also known as the hedge fund manager and the investors who are the limited partners. A hedge fund system is more flexible than the mutual fund in that the industries in which to invest are extensive. While a mutual fund invests in stocks and bonds alone, investments of a hedge fund can be stocks, bonds, land, real estate, derivatives and currencies. Many hedge funds operate on a system of remuneration known as the “two and twenty.” In this arrangement, a hedge fund manager will receive 2 percent of the total assets or capital invested by the members and 20 percent of the profits gained from investing in the assets annually. Generally, hedge funds are designed to employ certain strategies to ensure increase in profits regardless of how well or how poor the market is doing. This may prove to be a very risky type of investment especially due to the volatile nature of the markets they operate in. the paper will cover some of the key aspects of a hedge fund including the benefits, characteristics and limitations. Literature review More complex methods are applied in hedge fund project and this increases the risk of approximation of returns and other key indicators (Achleitner and Kaserer, 2005). The framework of the systems applied in the modern hedge funds are not easy to give a clear output of the returns, thus making the profitability of and investment to appear obscure. The authors however maintain that despite these limitations, hedge funds have increased immensely over the past two decades, and this is attributed to the diversification of markets in which the assets can invest. The risk that seems to be focused on is that of the investors and how financial losses can be minimized or prevented altogether. Hedge funds are actual financial investments and not just a system that is dependent on chance (Kosowski, Naik and Teo, 2006). This conclusion has been reached through the employment of the robust bootstrap analysis. In addition, the authors assert that the system is a cyclic one that can be predicted using the correct procedures. The Bayesian procedure helps to give good estimates on returns as well as help to project on the short-term challenges experienced by such risky investments. On average, this system gives an output of 5.5 percent increase in the hedge fund annually. Hedge funds are investment systems that have become common with institutional investors as well as individuals with high income (Garbaravicius, 2005). The author provides a comparison of the risks and returns associated with hedge funds and other forms of investments. Given that the hedge fund manager is at liberty to utilize the assets in a market that is most profitable, there are a number of limitations most likely to be experienced. These could include the level of transparency in risks as well as practical challenges during the investment (Garbaravicius, 2005). Many of the methods employed by modern hedge funds vehicles have not been preceded by a detailed evaluation of these risks and challenges. The author therefore concludes that it is imperative to carry out a comprehensive analysis of risks and returns of a market before venturing and diversifying. The economy is dependent on the hedge fund system to some extent. Investing in markets such as real estate or land may help businesses gain capital which would not have been possible (Oesterle, 2006). Thus the author suggests that it is important for the government to consider reduction of hedge fund regulations for a more flexible method of operation. This may include the markets in which the hedge fund vehicle intends to invest in as a method of diversification. Hedge funds have increased over the years and this is attributed to the fact that there has been over regulation from the government. Hedge funds have also been working hand to hand with banks in lending money in investments and therefore it is important to regulate these two systems to avoid overgrowth of one market at the expense of the other. Return of investment follows a cyclic and therefore predictable pattern (Agarwal, Daniel and Naik, 2007). Research has indicated that returns are higher in December than any other month of the year. This is true in hedge funds that are diverse in nature and those with a higher asset investment. For smaller hedge funds, the December increase may be so but not significantly as compared to those with high capital and incentives. Diversifying the markets means that the hedge fund will have opportunities to invest in other profitable markets. Naik concludes that hedge funds capitalize on the opportunities of the month of December through investing a significantly higher amount of capital than the other months, with the least portion of investment funds being January. This is an opportunistic method that most hedge funds use in order to realize higher profit on an annual basis. Hedge funds are regarded as asset class investments through the Markowitz structure. The market risk, also known as the beta, is reduced through engaging in innovation through utilizing certain strategies of investment (French, 2005). The manager skill is referred to as the alpha, and is one of the principle requirements that require the success of an investment. The primary aim of the properties of risk is to help the hedge fund manager and investors minimize risk during the time the market has experienced a downturn. This will ensure the hedge fund vehicle suffers minimal financial losses at the end of an investment period. By diversifying the market, hedge funds will be able to realize this goal. It has been agreed that the past twenty-five years has experienced the most impressive growth of hedge funds worldwide. However, the risks involved in such investments remain complex and those that require a keen analysis prior to operations (Getmansky, Lee and Lo, 2015). An academic review of the recent performance of hedge funds was analyzed by the authors in a bid to evaluate the risks, diversification, profit analysis, practical challenges and several other dynamics involved in hedge fund investment. Several points of view are also considered. This includes the perspective of the investor, portfolio manager, regulator and academy. It was concluded that the chief strategies for operation of such huge investment must take into consideration the Efficient Market Hypothesis and the financial regulation theory. Discussion Introduction Funds of hedge funds are portfolios that are more diversified forms of other forms of hedge funds, and are very popular among investment institutions (Brown, Gregoriou and Pascalau, 2012).The article attempts to explain the effects of diversification of a hedge fund with respect to the quantity of assets used in the investment, as shown in table 1. Brown and colleagues assert that diversification increases the risk. This will in turn increase the conscientiousness required due to the wide variety of markets a manager will be required to keep track of. As a result, diversification is known to reduce output of an overly involving hedge fund. This is most common in those hedge fund vehicles operating in more than 20 investments. Summary Over the past two decades, many investors have been supporters of hedge funds due to the ability to diversify and gain high returns despite the performance of the market as well as the commonly used investment histories such as bonds. There exists a limited source of information on how hedge funds operate, and this has been attributed to the Investment Company Act of 1940 which allows exemption of funds of hedge funds to register and be under supervision from the Securities and Exchange Commission, regarding their activities as solicitation. The managers will be able to collect capital from the investors and carry out the operations in place of the customers. The authors maintain that a hedge fund with as much as one hundred million dollars will be able to maintain a required level of diversification by investing in about ten to twenty markets, as recent studies indicate. Thus, it is possible to over diversify investment in such a way that will be counter-productive in the long run. In investments that operate with more than this amount, diligence is both very involving and exorbitant to maintain. Thus, the investment companies will turn to hedge funds in order to enable them carry out the tasks required to help them realize optimum profit. In a sample of over four hundred and fifty hedge funds analyzed between the period of 1994 and 2001, it was estimated that those funds bearing a higher quality in terms of operations and returns were those with less than 20 funds invested, Amin and Kat (2002). A similar study was conducted by researcher Lhabitant (2004), which indicated that standard deviation was inversely proportional to diversification, thus with increase in variety of hedge funds, there will be a reduction of the symmetry of probability of returns. This is attributed to the fact that hedge funds increase in operations and management with increase in diversification. On the other hand, concentrating on fewer hedge funds will improve performance thus increasing output. Brown and Liang (2008) offer two key reasons why diversification of hedge funds is not profitable to investors. First, brown and Liang (2008) maintain that these funds require a constant remuneration to the manager(s) for every market that is explored. This will be regardless of whether the hedge fund performs well or poorly. Thus, there will be little motivation on the side of investors to perform. In addition, the incentives given to the managers will come straight from the investors pockets. Secondly, a constant amount is required for each fund for the due diligence costs. Therefore larger funds will incur large to the funds of hedge funds. In the early days of availability of information on hedge funds, Henker (1998) used the diversification method to assess the financial effects of increasing variety in hedge funds. By selecting a sample of hedge funds during the bull market, he came to the conclusion that at a minimum of ten hedge funds is required to realize capital gains of investments. Park and Staum, (1998) argue that at least twenty hedge funds will suffice to reduce diversifiable risk of funds by about ninety five percent. Both the large and small sized funds were considered equally in the analyses with appropriate sources of bias taken into consideration. Results and Assumptions Monthly gross and net returns of hedge funds were analyzed from the Barclay Hedge system between the period of 2000 to 2010. Limited transparency and high cost of financial information has impacted the growth of hedge fund diversification significantly. Increase in risk and other unknown factors have limited the diversification to about ten or twenty funds. However, the current reality is that a large proportion of the hedge funds under study had well over twenty five funds. In addition, it was concluded that the funds under management will cost investors separately. Therefore, increasing diversification will only be more expensive especially if the markets are not optimal during that period. In addition, the exposure in tail risk is directly proportional to the increase in funds to be managed. Understanding of diversification In general, the highly volatile and sometimes unpredictable nature of the markets may introduce great challenges in the smaller funds, let alone the large and diversified ones. Conditions of the market may change unexpectedly and as a hedge fund manager and investor, one must be financially ready to face this and therefore limit losses. Many studies have agreed that diversification can bring about huge profits for a hedge fund vehicle. Even so, a comprehensive study of the market to invest in is imperative in order to evaluate exactly how the profits will be achieved. Investment in markets with no solid background information or for the sake of diversification without a clear goal in mind will be ill-advised. The funds of hedge funds investment must be clear enough to employ certain strategies that will provide a good estimate of the future returns. This may involve extensive research which is both time consuming as well as expensive. Therefore expenses may be reduced through minimizing these underlying funds and maintaining them within the range of ten and twenty. Hedge funds are generally less restrictive than other forms of investments due to the fact that the investors are accredited and the risks of losses can be handled. Therefore the hedge fund managers are at liberty to expand their markets. This may pose a risk to the assets under management especially if due diligence was not observed. Table 3 depicts the direct relationship of failure of the due diligence test with increase in underlying funds. Possible Directions for Future Research The future prospects of hedge funds are promising going by the current trend which illustrates a steady expansion of the industry. Institutional investors form the bulk of the customers of hedge funds, with an increase of three trillion dollars today from 626 billion dollars as at 2002 (Getmansky, Lee and Lo, 2015). Global recession has impacted the industry negatively. This is one of the major challenges that hedge funds and other forms of investments experience. Research on ways to minimize risks and losses during such times is much needed. This could be achieved through evaluating factors that improve the hedge fund alpha (the manager’s skill) and hedge fund beta (systematic taking of risks in investments). Reference ACHLEITNER, A. K., & KASERER, C. (2005). Private Equity Funds and Hedge Funds: A Primer. München, Center for Entrepreneurial and Financial Studies (CEFS). http://hdl.handle.net/10419/48439. Agarwal, V., Daniel, N. D., & Naik, N. Y. (2007). Do Hedge Funds Manage Their Reported Returns? Cologne, Centre for Financial Research. http://hdl.handle.net/10419/57729. BROWN, S. J., GREGORIOU, G. N., & PASCALAU, R. (2012). Diversification in Funds of Hedge Funds: Is It Possible to Over Diversify? Review of Asset Pricing Studies. 2, 89-110. French, C., W, (2005). Portfolio Selection with Hedge Funds. WBI investments. Garbaravicius, T. (2005). Hedge Funds And Their Implications For Financial Stability. Frankfurtam Main, European Central Bank. Getmansky, M., Lee, P. A., & Lo, A. W. (2015). Hedge Funds A Dynamic Industry In Transition. Cambridge, Mass, National Bureau of Economic Research. Kosowski, Robert, Naik, Narayan Y., & Teo, Melvyn. (2006). Do Hedge Funds Deliver Alpha? A Bayesian and Bootstrap Analysis. Institutional Knowledge at Singapore Management University. http://ink.library.smu.edu.sg/bnp_research/3. Osterle, D., A, (2006). Regulating Hedge Funds. Ohio State University, College of Law. Center for Interdisciplinary Law and Policy Studies Working Paper No. 47 Glossary Table 1Represents the performance of Hedge Funds and level of diversification Number of underlying funds (Diversification) Model 1 coefficient t-value Model 2 coefficient t-value Model 3 coefficient t-value 2 -0.0087 -2.44 -0.0600 -8.05 -0.0608 -9.36 3-4 0.0133 0.43 -0.0711 -5.72 -0.0647 -4.85 5-6 -0.0066 -1.54 -0.0583 -6.36 -0.0536 -5.38 7-8 0.0052 0.73 -0.0455 -4.15 -0.0390 -3.23 9-10 0.0008 0.27 -0.0508 -6.43 -0.0446 -5.07 11-12 0.0071 1.20 -0.0448 -6.88 -0.0381 -5.46 13-14 -0.0036 -0.83 -0.0558 -5.14 -0.0488 -4.07 The number of funds is evaluated under a sample t-test. The t-values represent the clustered standard errors. Table 2 represents the statistics funds of funds up by underlying funds between 9 and 20 as shown in the Barclay Hedge Database 9 Number of underlying funds N(funds of funds) Cumulative % Average Assets under management Average(in million $) 9-10 53 3.85 0.26 71 206.44 11-12 35 6.4 0.12 68 46.43 13-14 108 14.25 0.05 52 131.61 15-16 47 40.44 0.13 95 77.90 17-18 75 45.67 0.37 65 131.47 19-20 74 53.09 0.21 96 152.41 This table reports at least one year output fees of descriptive analysis of every U.S Dollar funds of hedge funds from the Barclay Hedge database. This is between the hedge funds that have between 9 and 20 underlying funds. Table 3 represents a due diligence test carried out to evaluate what proportion of the hedge funds will survive. Number of underlying funds N Average(in percentage) t-value 2 44 32 -9.71 3-4 18 6 -17.49 5-6 102 17 -12.58 7-8 42 24 -11.59 9-10 71 30 -23.00 11-12 68 10 -24.34 13-14 52 13 -18.28 The null hypothesis presented was whether the funds pass the due diligence test. The larger the sample t-values, the stringer the rejection the null hypothesis and thus we find that as the number of underlying funds increase, the greater the t-value and thus they do not pass the due diligence test. Read More