Introduction

• Fund managers invest money on behalf of individuals and companies. Funds from different clients are pooled, and the fund managers choose investments in accordance with stated investment goals and risk appetites. There are several advantages to this approach.
  • Fund managers may have more investment expertise than their clients.
  • Transaction costs (as a percentage of the amount traded) are usually lower for large trades than for small trades.
  • It is difficult for a small investor to be well diversified, but a large fund with billions of dollars should not have any difficulty in achieving diversification.
• Mutual funds (which are called “unit trusts” in some countries) and ETFs serve the needs of relatively small investors, while hedge funds seek to attract funds from wealthy individuals and large investors such as pension funds. Mutual funds and ETFs are required to explain their investment policies in a prospectus that is available to potential investors.
• Hedge funds are subject to much less regulation than mutual funds and ETFs. They are free to use a wider range of trading strategies than mutual funds and are usually more secretive about what they do.

Mutual Funds

• One of the attractions of mutual funds for the small investor is the diversification opportunities they offer. Diversification improves an investor’s risk-return trade-off. However, it can be difficult for a small investor to hold enough stocks to be well diversified. In addition, maintaining a well-diversified portfolio can lead to high transaction costs. A mutual fund provides a way in which the resources of many small investors are pooled so that the benefits of diversification are realized at a relatively low cost. An investor in a mutual fund owns a certain number of shares in the fund.
• The most common type of mutual fund are open-end funds, which have grown very fast since the Second World War. The assets managed by open-end mutual funds in the United States were over $16 trillion by 2016. These funds continue to sell and purchase shares after their initial public offering. The investors receive a proportional ownership interest (in the form of shares) in the open-ended mutual fund based on the dollar amount that they have invested in the fund The number of shares goes up as new investors arrive and goes down as investors withdraw assets. The investors can exit their investment in the fund by redeeming their shares directly from the fund company, and withdrawal is facilitated either by a check or a by digital transfer of the value of their investment to their account by the fund company.
• In the US, mutual funds are valued at 4 P.M. each day. This involves the mutual fund manager calculating the market value of each asset in the portfolio so that the total value of the fund is determined. This total value is divided by the number of shares outstanding to obtain the value of each share. The latter is referred to as the net asset value (NAV) of the fund. Shares in the fund can be bought from the fund or sold back to the fund at any time. When an investor issues instructions to buy or sell shares, it is the next-calculated NAV that applies to the transaction. For example, if an investor decides to buy at 2 P.M. on a particular business day, the NAV at 4 P.M. on that day determines the amount paid by the investor.
• The investor usually pays tax as though he or she owned the securities in which the fund has invested. Thus, when the fund receives a dividend, an investor in the fund has to pay tax on the investor’s share of the dividend, even if the dividend is reinvested in the fund for the investor. When the fund sells securities, the investor is deemed to have realized an immediate capital gain or loss, even if the investor has not sold any of his or her shares in the fund. To avoid double counting, the purchase price of the shares is adjusted to reflect the capital gains and losses that have already accrued to the investor.

• Mutual funds incur a number of different costs. These include management expenses, sales commissions, accounting and other administrative costs, transaction costs on trades, and so on. To recoup these costs, and to make a profit, fees are charged to investors.
• A front-end load is a fee charged when an investor first buys shares in a mutual fund. Not all funds charge this type of fee. Those that do are referred to as front-end loaded. In the United States, front-end loads are restricted to being less than 8.5% of the investment.
• Some funds charge fees when an investor sells shares. These are referred to as a back-end load. Typically the back-end load declines with the length of time the shares in the fund have been held.
• All funds charge an annual fee. There may be separate fees to cover management expenses, distribution costs, and so on. The total expense ratio is the total of the annual fees charged per share divided by the value of the share.

• A closed-end fund does not create new shares when a new investor wants to buy shares. Instead, an existing investor has to sell their shares to the new investor. The total number of shares in issue is fixed. Closed-end funds are like regular corporations whose shares are traded on a stock exchange and can be bought and sold during any time of the day.
• For closed-end funds, two NAVs can be calculated.
  • One is the price at which the shares of the fund are trading.
  • The other is the market value of the fund’s portfolio divided by the number of shares outstanding. The latter can be referred to as the fair market value. Usually a closed-end fund’s share price is less than its fair market value. Research suggests that this is because of the fees paid to fund managers.
• Closed-end funds are much less popular than open-end funds. In 2016, their assets in the United States totaled $262 billion.

Mutual Funds – Open-End Versus Closed-End

• The number of shares outstanding varies from day to day in an open-end fund as individuals choose to invest in the fund or redeem their shares, but a closed-end fund’s number of shares remains the same.
• Open-end fund investors can simply redeem their shares from the fund company, whereas closed-end fund investors cannot simply redeem their shares from the fund company but they need another investor to buy their shares.
• Open-end funds always transact at the next available NAV, whereas a closed-end fund can transact at a price other than NAV. It is very common for a closed-end fund to trade at either a discount or a premium to its actual NAV.
• Open-end mutual funds tend to invest in broader areas like a diversified emerging markets fund, whereas closed-end funds tend to invest in niche areas like specific emerging markets.

Mutual Funds – Types

• Based on portfolio makeup, mainly four types of funds can be identified
  • Money market mutual funds invest in interest-bearing instruments, such as Treasury bills, commercial paper, and bankers’ acceptances, with a life of less than one year. They are an alternative to interest-bearing bank accounts and usually provide a higher rate of interest because they are not insured by a government agency. In normal market conditions, investors get a positive return after management fees. But occasionally the return is negative so that some principal is lost. This is known as “breaking the buck” because a $1 investment is then worth less than $1.
  • Bond funds that invest in fixed-income securities with a life of more than one year.
  • Equity funds that invest in common and preferred stock.
  • Hybrid funds that invest in stocks, bonds, and other securities.

• Equity mutual funds are by far the most popular.
• Money market mutual funds are short term funds whereas the other three are generally long-term funds.

Exchange-Traded Funds

• An exchange-traded fund (ETF) is an investment fund traded on stock exchanges. An ETF holds assets such as stocks, commodities, or bonds and generally operates with an arbitrage mechanism designed to keep it trading close to its net asset value, although deviations can occasionally occur. Most ETFs track an index, such as a stock index or bond index.
• ETFs are created by institutional investors. Typically, an institutional investor deposits a block of securities with the ETF and obtains shares in the ETF (known as creation units) in return. Some or all of the shares in the ETF are then traded on a stock exchange. This gives ETFs the characteristics of a closed-end fund rather than an open-end fund. However, a key feature of ETFs is that institutional investors can exchange large blocks of shares in the ETF for the assets underlying the shares at that time. They can give up shares they hold in the ETF and receive the assets or they can deposit new assets and receive new shares. This ensures that there is never any appreciable difference between the price at which shares in the ETF are trading on the stock exchange and their fair market value. This is a key difference between ETFs and closed-end funds and makes ETFs more attractive to investors than closed-end funds.

• ETFs have a number of advantages over open-end mutual funds
  • ETFs can be bought or sold at any time of the day.
  • They can be shorted in the same way that shares in any stock are shorted.
  • ETF holdings are disclosed twice a day, giving investors full knowledge of the assets underlying the fund. Mutual funds by contrast only have to disclose their holdings relatively infrequently.
  • When shares in a mutual fund are sold, managers often have to sell the stocks in which the fund has invested to raise the cash that is paid to the investor. When shares in the ETF are sold, this is not necessary as another investor is providing the cash. This means that transactions costs are saved and there are less unplanned capital gains and losses passed on to shareholders.
  • Finally, the expense ratios of ETFs tend to be lower than those of mutual funds.
• The popularity of ETFs is increasing. By 2016, their assets had reached $2.5 trillion.

Net Asset Value (NAV) Of Open-Ended Funds

• Net asset value (NAV) represents a fund’s per share market value. This is the price at which investors buy (“bid price”) fund shares from a fund company and sell them (“redemption price”) to a fund company. It is derived by dividing the total value of all the assets (cash and securities) in a fund’s portfolio, minus any liabilities, by the number of shares outstanding

• NAV computation is undertaken once at the end of each trading day based on the closing market prices of the portfolio’s securities.

Active Versus Passive Management

• An actively managed investment fund is a fund in which a manager or a management team makes decisions about how to invest the fund’s money. Active management is when managers actively pick investments in an effort to outperform some benchmark, usually a market index. Since the objective of a portfolio manager in an actively managed fund is to beat the market, the manager must take on additional market risk to obtain the returns necessary to achieve this end. Actively managed funds tend to have much higher expense ratios.
• Passive management is when a fund manager attempts to mimic some benchmark, replicating its holdings and, hopefully, performance. So most passively managed funds, simply follow a market index. Managers select stocks and other securities listed on an index and apply the same weighting. The purpose of passive portfolio management is to generate a return that is the same as the chosen index instead of outperforming it. It does not have a management team making investment decisions. Index funds are branded as passively managed because each has a portfolio manager replicating the index, rather than trading securities based on his or her knowledge of the risk and reward characteristics of various securities. Because this investment strategy is not proactive, the management fees assessed on passive portfolios or funds are often far lower than active management strategies.

• Two key questions for researchers are:
  • Do actively managed funds outperform stock indices on average?
  • Do funds that outperform the market in one year continue to do so?

The answer to both questions appears to be NO.

• In a classic study, Jensen (1969) performed tests on mutual fund performance using 10 years of data on 115 funds. He calculated the alpha for each fund in each year. The average alpha was about zero before all expenses and negative after expenses were considered. Jensen tested whether funds with positive alphas tended to continue to earn positive alphas. The results show that, when a manager has achieved above-average returns for one year (or several years in a row), there is still only a probability of about 50% of achieving above-average returns the next year. The results suggest that managers who obtain positive alphas do so because of luck rather than skill. It is possible that there are some managers who are able to perform consistently above average, but they are a very small percentage of the total. More recent studies have confirmed Jensen’s conclusions. On average, mutual fund managers do not beat the market and past performance is not a good guide to future performance. The success of index funds shows that this research has influenced the views of many investors.

Undesirable Trading Behavior

• Because they solicit funds from small retail customers, many of whom are unsophisticated, mutual funds and ETFs are heavily regulated. The SEC is the primary regulator of these funds in the United States. The funds must file a registration document with the SEC. Full and accurate financial information must be provided to prospective fund purchasers in a prospectus. There are rules to prevent conflicts of interest, fraud, and excessive fees.
• Despite the regulations, there have been a number of scandals involving mutual funds. One of these involves late trading. Late-day trading is the practice of placing orders to buy or redeem mutual fund shares after the net asset value has already been calculated. These trades enable the purchaser to profit from information released after the mutual fund price is fixed each day, but before it can be adjusted the following day. For example, a large component of a mutual fund may announce earnings after-hours that may have a material impact on the fund’s value the next day. Late-day trading can dilute the value of a mutual fund’s shares, harming long-term investors.
• Another scandal is known as market timing. This is a practice where favored clients are allowed to buy and sell mutual funds shares frequently (e.g., every few days) and in large quantities without penalty. It may be illegal for the mutual fund to offer special trading privileges to favored customers because the costs (such as those associated with providing the liquidity necessary to accommodate frequent redemptions) are borne by all customers.
• Other scandals have involved front running and directed brokerage. Front running occurs when a mutual fund is planning a big trade that is expected to move the market. It informs favored customers or partners before executing the trade, allowing them to trade for their own account first. Directed brokerage involves an improper arrangement between a mutual fund and a brokerage house where the brokerage house recommends the mutual fund to clients in return for receiving orders from the mutual fund for stock and bond trades.

Hedge Funds Versus Mutual Funds

• Hedge funds are different from mutual funds in that they are subject to very little regulation. Examples of the regulations that affect mutual funds are the requirements that shares be redeemable at any time, NAV be calculated daily, investment policies be disclosed, the use of leverage be limited etc. Hedge funds are largely free from these regulations. This gives them a great deal of freedom to develop sophisticated, unconventional, and proprietary investment strategies. Hedge funds are sometimes referred to as alternative investments.
• Another characteristic of hedge funds that distinguishes them from mutual funds is that fees of hedge funds are higher and dependent on performance.
• Hedge funds chase the big fish – investments that are high risk, high reward. Mutual funds, on the other hand, stick to the shallows where they can catch smaller but more reliable returns.
• The management style of hedge funds is generally more aggressive than mutual funds.
• Hedge funds accept funds only from high-net-worth financially sophisticated individuals and organizations, whereas mutual funds are available to the general public.

Fee Structure of Hedge Funds

• An annual management fee that is usually between 1% and 3% of assets under management is charged. This is designed to meet operating costs-but there may be an additional fee for things such as audits, account administration, and trader bonuses. Moreover, an incentive fee that is usually between 15% and 30% of realized net profits (i.e., profits after management fees) is charged if the net profits are positive. This fee structure is designed to attract the most talented and sophisticated investment managers. Thus, a typical hedge fund fee schedule might be expressed as “2 plus 20%” indicating that the fund charges 2% per year of assets under management and 20% of net profit. On top of high fees there is usually a lock-up period of at least one year during which invested funds cannot be withdrawn. Some hedge funds with good track records have sometimes charged much more than the average. An example is James Simons’s Renaissance Technologies Corp., which has charged as much as “5 plus 44%”.
• The agreements offered by hedge funds may include clauses that make the incentive fees more acceptable for the investors
  • There is sometimes a hurdle rate. This is the minimum return necessary for the incentive fee to be applicable.
  • There is sometimes a high-water mark clause. This states that any previous losses must be recouped by new profits before an incentive fee applies. Because different investors place money with the fund at different times, the high-water mark is not necessarily the same for all investors. There may be a proportional adjustment clause stating that, if funds are withdrawn by investors, the amount of previous losses that has to be recouped is adjusted proportionally. Suppose a fund worth $200 million loses $40 million and $80 million of funds are withdrawn. The high-water mark clause on its own would require $40 million of profits on the remaining $80 million to be achieved before the incentive fee applied. The proportional adjustment clause would reduce this to $20 million because the fund is only half as big as it was when the loss was incurred.
  • There is sometimes a clawback clause that allows investors to apply part or all of previous incentive fees to current losses. A portion of the incentive fees paid by the investor each year is then retained in a recovery account. This account is used to compensate investors for a percentage of any future losses.

• In this chapter, it will be assumed that the management fee is calculated on the assets at the beginning of the year and that the incentive fee is calculated after subtracting management fees. But it should be noted that some hedge funds do try to use a more aggressive fee structure where the management fee is calculated based on the end-of year asset value (making it greater if the fund’s value has increased) and the incentive fee is calculated before subtracting management fees (which is also more valuable to the hedge fund managers if the value of fund has increased).
• The incentive fee can be thought of as a call option on the net profit produced by the hedge fund for an investor in a given year. Consider the 2 plus 20% fee schedule. Using the assumptions mentioned above, the incentive fee can be calculated as:

where

A is the assets under management at the beginning of the year and

R is the return on the assets during the year.

This is the payoff from a call option on the dollar return with a strike price equal to 2% of the assets under management. As is well known, the value of a call option increases as the volatility of the underlying assets increases. This means that the hedge fund manager can increase the value of the option by taking risks that increase the volatility of the fund’s assets. This creates a situation where a hedge fund has an upside for the managers, but no downside. As an example, suppose that a hedge fund has USD 100 million of investors’ funds and its fees are 2 plus 20%. Consider the following three strategies:

• • Strategy A: Choose a safe investment that will produce a profit of USD 3 million with certainty. The expected return is 3% (= 3/100)
  • Strategy B: Choose a riskier strategy that has a 50% chance of producing a profit of USD 5 million and a 50% chance of producing a profit of zero. The expected return is 2.5%(=0.5×5%+0.5×0%).
  • Strategy C: Choose a highly risky strategy that has a 50% chance of producing a profit of USD 10 million and a 50% chance of a loss of USD 10 million. The expected return is 0%[=0.5×10%+0.5×(-10%)].

Strategies B and C make no sense because the risk-return trade-off is negative (i.e., the expected return decreases as risk increases). Nevertheless, strategies B and C could be attractive to hedge fund managers.

The management fee for all three strategies is USD 2 million (i.e., 2% of USD 100 million).

• The fees to the hedge fund for each of the strategies are calculated in this table. For the first strategy, the profit after the management fee is USD 1 million and the incentive fee is thus USD 0.2 million (i.e., 20% of this profit). For the second strategy, there is a 50% chance that the incentive fee will be zero, and a 50% chance that it will be 20% of USD 3 million. For the third strategy, there is a 50% chance that the incentive fee will be zero, and a 50% chance that it will be 20% of USD 8 million.

Strategy	Management Fee	Expected Incentive Fee	Total Expected Fee
A1	2	0.2	2.2
B1	2	0.3	2.3
C1	2	0.8	2.8

The table shows that the expected incentive fee increases as the strategy becomes riskier even though the expected gross return declines as this occurs.

Hedge Fund Strategies – Long/Short Equity

• • Long/Short Equity continues to be among the most popular of hedge fund strategies. The hedge fund manager identifies a set of stocks that are considered to be undervalued by the market and a set that are considered to be overvalued. The manager takes a long position in the first set and a short position in the second set. Typically, the hedge fund has to pay the prime broker a fee (perhaps 1% per year) to rent the shares that are borrowed for the short position.
  • Long/short equity strategies are all about stock picking. If the overvalued and undervalued stocks have been picked well, the strategies should give good returns in both bull and bear markets. Hedge fund managers often concentrate on smaller stocks that are not well covered by analysts and research the stocks extensively using fundamental analysis, as pioneered by Benjamin Graham. The hedge fund manager may choose to maintain a net long bias where the shorts are of smaller magnitude than the longs or a net short bias where the reverse is true.
  • An equity-market-neutral fund is one where longs and shorts are matched in some way.

< li>A dollar-neutral fund is an equity-market-neutral fund where the dollar amount of the long position equals the dollar amount of the short position.

• A beta-neutral fund is a more sophisticated equity-market-neutral fund where the weighted average beta of the shares in the long portfolio equals the weighted average beta of the shares in the short portfolio so that the overall beta of the portfolio is zero. If the capital asset pricing model is true, the beta-neutral fund should be totally insensitive to market movements. Long and short positions in index futures are sometimes used to maintain a beta-neutral position.
• Sometimes equity-market-neutral funds go one step further. They maintain sector-neutrality where long and short positions are balanced by industry sectors or factor neutrality where the exposure to factors such as the price of oil, the level of interest rates, or the rate of inflation is neutralized.

Hedge Fund Strategies – Dedicated Short

• Managers of dedicated short funds look exclusively for overvalued companies and sell them short. They are attempting to take advantage of the fact that brokers and analysts are reluctant to issue sell recommendations—even though one might reasonably expect the number of companies overvalued by the stock market to be approximately the same as the number of companies undervalued at any given time.
• Typically, the companies chosen are those with weak financials, those that change their auditors regularly, those that delay filing reports with the SEC, companies in industries with overcapacity, companies suing or attempting to silence their short sellers, and so on.

Hedge Fund Strategies – Distressed Securities

• Bonds with credit ratings of BB or lower are known as “non-investment-grade” or “junk” bonds. Those with a credit rating of CCC are referred to as “distressed” and those with a credit rating of D are in default. Typically, distressed bonds sell at a big discount to their par value and provide a yield that is over 1,000 basis points (10%) more than the yield on Treasury bonds, if the required interest and principal payments are actually made.
• The managers of funds specializing in distressed securities carefully calculate a fair value for distressed securities by considering possible future scenarios and their probabilities. Distressed debt cannot usually be shorted and so they search for debt that is undervalued by the market. Bankruptcy proceedings usually lead to a reorganization or liquidation of a company. The fund managers understand the legal system, know priorities in the event of liquidation, estimate recovery rates, consider actions likely to be taken by management, and so on.
• Some funds are passive investors. They buy distressed debt when the price is below its fair value and wait. Other hedge funds adopt an active approach. They might purchase a sufficiently large position in outstanding debt claims so that they have the right to influence a reorganization proposal.

Hedge Fund Strategies – Merger Arbitrage

• Merger arbitrage involves trading after a merger or acquisition is announced in the hope that the announced deal will take place. There are two main types of deals:
  • Cash deals
  • Share-for-share exchanges.
• Consider first cash deals. Suppose that Company A announces that it is prepared to acquire all the shares of Company B for $30 per share. Suppose the shares of Company B were trading at $20 prior to the announcement. Immediately after the announcement its share price might jump to $28. It does not jump immediately to $30 because (a) there is some chance that the deal will not go through and (b) it may take some time for the full impact of the deal to be reflected in market prices. Merger-arbitrage hedge funds buy the shares in Company B for $28 and wait. If the acquisition goes through at $30, the fund makes a profit of $2 per share. If it goes through at a higher price, the profit is higher. However, if for any reason the deal does not go through, the hedge fund will take a loss.
• Consider next a share-for-share exchange. Suppose that Company A announces that it is willing to exchange one of its shares for four of Company B’s shares. Assume that Company B’s shares were trading at 15% of the price of Company A’s shares prior to the announcement. After the announcement, Company B’s share price might rise to 22% of Company A’s share price. A merger-arbitrage hedge fund would buy a certain amount of Company B’s stock and at the same time short a quarter as much of Company A’s stock. This strategy generates a profit if the deal goes ahead at the announced share-for-share exchange ratio or one that is more favorable to Company B.
• Merger-arbitrage hedge funds can generate steady, but not stellar, returns.

Hedge Fund Strategies – Convertible Arbitrage

• Convertible bonds are bonds that can be converted into the equity of the bond issuer at certain specified future times with the number of shares received in exchange for a bond possibly depending on the time of the conversion. The issuer usually has the right to call the bond (i.e., buy it back for a prespecified price) in certain circumstances. Usually, the issuer announces its intention to call the bond as a way of forcing the holder to convert the bond into equity immediately. (If the bond is not called, the holder is likely to postpone the decision to convert it into equity for as long as possible.)
• A convertible arbitrage hedge fund has typically developed a sophisticated model for valuing convertible bonds. The convertible bond price depends in a complex way on the price of the underlying equity, its volatility, the level of interest rates, and the chance of the issuer defaulting. Many convertible bonds trade at prices below their fair value. Hedge fund managers buy the bond and then hedge their risks by shorting the stock. Interest rate risk and credit risk can be hedged by shorting nonconvertible bonds that are issued by the company that issued the convertible bond. Alternatively, the managers can take positions in interest rate futures contracts, asset swaps, and credit default swaps to accomplish this hedging.

Hedge Fund Strategies – Fixed Income Arbitrage

• The basic tool of fixed income trading is the zero-coupon yield curve. One strategy followed by hedge fund managers that engage in fixed-income arbitrage is a relative value strategy, where they buy bonds that the zero-coupon yield curve indicates are undervalued by the market and sell bonds that it indicates are overvalued. Market-neutral strategies are similar to relative value strategies except that the hedge fund manager tries to ensure that the fund has no exposure to interest rate movements.
• Some fixed-income hedge fund managers follow directional strategies where they take a position based on a belief that a certain spread between interest rates, or interest rates themselves, will move in a certain direction. Usually they have a lot of leverage and have to post collateral. They are therefore taking the risk that they are right in the long term, but that the market moves against them in the short term so that they cannot post collateral and are forced to close out their positions at a loss. This is what happened to Long-Term Capital Management.

Hedge Fund Strategies – Emerging Markets

• Emerging market hedge funds specialize in investments associated with developing countries. Some of these funds focus on equity investments. They screen emerging market companies looking for shares that are overvalued or undervalued. They gather information by traveling, attending conferences, meeting with analysts, talking to management, and employing consultants. Usually they invest in securities trading on the local exchange, but sometimes they use American Depository Receipts (ADRs). ADRs are certificates issued in the United States and traded on a U.S. exchange. They are backed by shares of a foreign company. ADRs may have better liquidity and lower transactions costs than the underlying foreign shares. Sometimes there are price discrepancies between ADRs and the underlying shares giving rise to arbitrage opportunities.
• Another type of investment is debt issued by an emerging market country. Eurobonds are bonds issued by the country and denominated in a hard currency such as the U.S. dollar or the euro. Local currency bonds are bonds denominated in the local currency. Hedge funds invest in both types of bonds. They can be risky: countries such as Russia, Argentina, Brazil, and Venezuela have defaulted several times on their debt.

Hedge Fund Strategies – Global Macro

• Global macro is the hedge fund strategy used by star managers such as George Soros and Julian Robertson. Global macro hedge fund managers carry out trades that reflect global macroeconomic trends. They look for situations where markets have, for whatever reason, moved away from equilibrium and place large bets that they will move back into equilibrium. Often the bets are on exchange rates and interest rates.
• A global macro strategy was used in 1992 when George Soros’s Quantum Fund gained $1 billion by betting that the British pound would decrease in value. More recently, hedge funds have (with mixed results) placed bets that the huge U.S. balance of payments deficit would cause the value of the U.S. dollar to decline. The main problem for global macro funds is that they do not know when equilibrium will be restored. World markets can for various reasons be in disequilibrium for long periods of time.

Hedge Fund Strategies – Managed Futures

• Hedge fund managers that use managed futures strategies attempt to predict future movements in commodity prices. Some rely on the manager’s judgment; others use computer programs to generate trades. Some managers base their trading on technical analysis, which analyzes past price patterns to predict the future. Others use fundamental analysis, which involves calculating a fair value for the commodity from economic, political, and other relevant factors.
• When technical analysis is used, trading rules are usually first tested on historical data. This is known as back-testing. If (as is often the case) a trading rule has come from an analysis of past data, trading rules should be tested out of sample (that is, on data that are different from the data used to generate the rules). Analysts should be aware of the perils of data mining. Suppose thousands of different trading rules are generated and then tested on historical data. Just by chance a few of the trading rules will perform very well—but this does not mean that they will perform well in the future.

Hedge Fund Performance

• The performance measurement framework of the hedge fund industry is not mature. So it is not as easy to assess hedge fund performance as it is to assess mutual fund performance. Some of the biases in the performance data provided by the hedge fund databases and indexes are
  • Self-selection bias: For the Lipper hedge funds database (TASS), which is available to researchers, participation by hedge funds is voluntary. Small hedge funds and those with poor track records often do not report their returns and thus, not included in the data set.
  • Backfilling bias: This means that when a new hedge fund is added to an index, the past performance of the fund is back-filled in the index. For example, if the hedge fund is 3 years old, it’s record for the past three years will be added to the index, and the index values will be adjusted accordingly. The successful funds are more likely to be added to an index than an unsuccessful one, which creates a bias in the index. Studies suggest that backfill bias adds about 4% or more to hedge fund returns
  • Survivorship bias: This is the situation where unsuccessful funds are removed from the index, and the past index values are adjusted to remove the data of the dropped fund. Since a fund is more likely to be dropped from an index because of poor performance, such actions create bias in the index. Studies suggest that survivorship bias adds about 3% or more to hedge fund returns.

• It is not uncommon for hedge funds to report good returns for a few years and then “blow up”. Long-Term Capital Management reported returns (before fees) of 28%, 59%, 57%, and 17% in 1994, 1995, 1996, and 1997, respectively. In 1998, it lost virtually all its capital.
• Hedge funds tend to underperform in bull markets and outperform in bear markets. Some people have argued that hedge fund returns are like the returns from writing out-of-the-money options. Most of the time, the options cost nothing, but every so often they are very expensive.
• This may be unfair. Advocates of hedge funds would argue that hedge fund managers search for profitable opportunities that other investors do not have the resources or expertise to find, and they would point out that the top hedge fund managers have been very successful at finding these opportunities. Most strategies are not designed to follow market trends. For example, the long-short strategy is designed to either attenuate or eliminate the effects of market moves.
• Prior to 2008, hedge funds performed quite well. In 2008, hedge funds on average lost money but provided a better performance than the S&P 500. During the years 2009 to 2016, the S&P 500 provided a much better return than the average hedge fund. This becomes very clear when comparison of returns given by the Barclays hedge fund index is done with total returns from the S&P 500, as given in this table. The Barclays hedge fund index is the arithmetic average return (net after fees) of all hedge funds (excluding funds of funds) in the Barclays database.
• Hedge fund assets under management exceeded USD 3 trillion for the first time at the end of 2016. In view of the statistics in this table, a surprising fact is that hedge funds have been quite successful in attracting investors.

Year	Barclay Hedge Index Net Return (%)	S&P 500 Return Including Dividends (%)
2008	– 21.63	– 37.00
2009	23.74	26.46
2010	10.88	15.06
2011	– 5.48	2.11
2012	8.25	16.00
2013	11.12	32.39
2014	2.88	13.38
2015	0.04	1.38
2016	6.10	11.96
2017	10.36	21.83