Hedge Fund Assets Reach $2 Trillion Mark

Hedge fund assets passed the $2 trillion mark in the first quarter of 2011.  In the past 12 months, there was a net  increase of 295 funds.  684 funds were liquidated.  The range of returns decreased to 55.3%.  The best funds gained 41.3% and the worst funds lost 14%.  Management fees are holding steady but incentive fees are decreasing.  Funds opened in the last 12 months charged an average of 17.2%.

The source for this post is here.

New Bottoms Up Approach to Hedge Fund Investing

Investcorp, an investor in hedge funds with $5 billion in assets under management, has created a proprietary, bottoms-up method for choosing the best managers.  Deepak Gurnani, the Chief Investment Officer, started the Alpha Project in 2003.  The research approach consists of reviewing the performance of trades for each hedge fund strategy.  For example, for merger arbitrage, Investcorp examined every merger since the 1990's and analyzed the performance of that classic trade.  These individual trades are compiled into fund returns.  The results are used for tactical asset allocation among different funds, manager selection and investing Investcorp's assets.  Its portfolio has a better risk adjusted return (as measured by the Sharpe Ratio) even after subtracting fund costs (i.e. prime brokerage and stock loan).  This is in stark contrast with traditional research that looks at the performance of equity markets, volatility, credit spreads and currencies to explain hedge fund returns. There are four issues with this approach:

• Fund strategy contributes to returns
• Investors only receive 25%-50% of alpha returns because of the 2 and 20 incentive fee structure
• Risk and transparency issues such as style drift, side pockets and insider trading
• Liquidity

Managed Futures Basics

Managed futures funds invest in futures and forward contracts on currencies, commodities, financial indices and ETFs.  The funds, called commodity pools, are run by a commodity trading advisor (CTA).  The management fees are between 0% to 3% of assets under management (AUM) and the incentive fees are between 10% to 35% of profits.  The fees are also called "2 and 20".

Most CTAs use a black box to establish trading rules.  There are managers that act as mutual fund managers and create their positions.  They are a minority though.  The rules are not static and adjusted constantly due to copycats, poor trade execution, AUM growth and changing market conditions.  The three types of black boxes are trend following, non-trend following and relative value.

Trend following strategies are based on action of the asset prices; much like technical analysis for stocks.  The moving average strategy uses the average price of an asset to buy or sell.  The moving average may be calculated in various ways:  any number of days or different weighting of prices.  If the current price is higher than the moving average, the fund buys.  If the current price is lower, the fund sells.  This strategy works well when the asset moves steadily in one direction.  It does not work well in a volatile market or a market in a narrow trading range.  The break-out strategy uses the same buy and sell signals as the moving average strategy.  Instead of using the average of prices to trigger the trade, the fund uses the price range of the asset.

Non-trend following strategies include countertrend and pattern recognition strategies.  Countertrend strategy uses models to identify trades.  Pattern recognition is similar to technical analysis of stock charts where the CTA will find trading opportunities based on the price action of the asset.

Relative value strategies invest in related futures contracts that have experienced a short term price difference. The manager may perform an arbitrage trade as the prices return to their historical relationship.

Further information on managed futures can be accessed at Attain Capital's managed futures blog.

Sample Calculation of Private Equity Fees

In the previous post, it was noted that profits for a private equity fund can be based on an aggregate level or individual transactions.  Let's take a quick look at a simplified calculation, using round numbers, to compare the methodologies.  For a fund, the manager has invested $150 million in two portfolio companies.  The first company was bought for $100 million and sold for $120 million.  The second company was bought for $50 million and sold for $30 million.  For this exercise, the hurdle rate is 10% and there is no clawback option.

If you total all the numbers, $150 million were invested and $150 million were realized.  There was no gain on the investments and the manager would not receive an incentive fee.

If you look at each investment separately, the first investment would have a return of 20%.  This triggers the performance fee calculation of $20 million x 20% = $4 million.  The second company has a return of -40% and would not trigger any incentive fees.  The fund manager would still receive $4 million.

How Profits Are Distributed for a Private Equity Fund

There are a number of different methods of calculating private equity fees for general (fund manager) and limited partners (investors).  These terms are spelled out in the limited partnership agreement.  The purpose of the fee structure is to align the interests of the investors and fund manager in order to obtain the best returns possible.  The most important fees are the management fees and carried interest.  Management fees are between 1%-2.5% of committed capital.  Carried interest is usually about 20% of profits.

Profits for a fund can be based on an aggregate level or individual transactions.  For the investor, it is best if the aggregate calculation is used.  For the manager, it is best if profits are based on an individual investment basis.  The manager shares in the profits as soon as the IPO or other exit strategy is done.  This approach may cause the manager to exit his investment prematurely, before its full value is realized.

To earn the carried interest, the manager has to hit a target return rate.  The average rate is 8%.  They are usually 5%-10% and tied to the risk-free rate.  The hurdle rate is applied to buyout and European venture capital funds.  There are two types:  hard and soft.  The hard rate allows the manager to share in the profits above the hurdle rate.  This is used in European funds.  US funds are more likely to use the soft rate calculation which allows the manager to share in all the profits.  The distribution of the fund's proceeds follow this pattern:

• Investors' capital is returned
• Investors' profits are paid up to the hurdle rate
• Fund manager's profits are paid up to the hurdle rate
• Any profits above the hurdle rate are split between investors and manager according to the limited partner agreement

An additional clause to protect the investor called a clawback can be added to the limited partner agreement.  It ensures that the investor receives, at least, the hurdle rate return.  The manager must return any incentive fees to the limited partners.  However, the effectiveness of the clawback is dependent on the ability of the manager to re-pay the money owed.  The investors can have some of the carried interest placed in an escrow account to cover any possible clawback.

Unlike hedge funds, private equity fees are paid out as profits are realized.  Hedge funds are paid out based on the current market value of the portfolio.

The information above is a summary of a paper written by Didier Guennoc, Pierre-Yves Mathonet and Thomas Meyer called Distribution Waterfall and is part of the CAIA curriculum.

A New Dynamic Between Institutional Investors and Hedge Funds

There was an interesting article in Reuters about how institutional investors are getting more leverage with hedge funds.  They are asking managers to reduce fees and for more flexible redemption terms.  They are doing more due diligence;  sometimes doing six months of research before investing.  Recently, D.E. Shaw reduced fees. A manager profiled in the article actively looks for hedge funds that charge management fees of 1%-1.5%.  He also test drives a fund by investing a smaller amount before committing a large amount of capital.  The increase in investments by pension funds is another factor driving this shift.  Pension fund money is placed in the largest hedge funds.  In the past, pensions used to invest in funds through a fund of funds to escape the extra layer of fees.  They demand more transparency and a monthly redemption cycle.

Hedge Fund vs Private Equity Fund Fees

Both hedge funds and private equity funds have similar management and incentive fee structures.  Hedge funds have the famous "2 and 20".  Private equity charge 1% to 3.5% management fee with a 20% to 30% incentive fee.  However, hedge funds charge fees differently:

• Hedge fund fees are calculated based on net asset value while private equity fees are based on realized gains
• Hedge fund fees are collected on a quarterly or semiannual basis
• Incentive fees can be collected before any return of investor capital
• No clawback agreement
• Lower hurdle rates.  The manager will not charge performance fees until the hurdle rate is met.

Some More Details on Venture Capital

Many mutual fund managers invest in specific areas depending on their areas of comfort.  They may be split by the capitalization/size, sector or the geographic region of the company.  The general partner or managing director of the venture capital fund raises capital and manages the investment portfolio.  Limited partners or shareholders are the investors.  Venture capitalists focus their investments based on the sector or geographic region of the company.  There is a third and most important category - the stage of financing that the target company is in.  The five stages are:

• Angel Investing - Funds are usually from friends and family.  Someone has an idea and a prototype and business plan has to be created.  Capital needs may range from $50,000 - $500,000.  Venture capitalists do not invest at this stage.
• Seed Capital - Smaller venture capital firms invest at this stage.  The prototype is being tested by clients for free to receive their feedback.  About $1 - $5 million are needed to finish and market the final prototype.
• Early Stage Venture Capital - The product is being made on a large scale and being testing by clients.  Unlike the Seed Capital stage, the product is not provided at no cost to the customer.  The financial goal is to break even.  About $2 million are needed at this stage.
• Late Stage Venture Capital - The new company is not losing money any more.  About $5 - $25 million are needed to expand production facilities and staff.
• Mezzanine Stage - The business is making money.  About $5 - $25 million are needed for the company to bridge the gap to the exit strategy - either going public or being sold to another company.  Money can also be used to buyout earlier investors and may be a loan or convertible offering through Rule 144A.

The venture capitalist has to complete different due diligence for each stage.  That is why they invest in particular ones.

Like hedge fund managers, the general partner charges management and incentive fees.  Management fees range from 1% - 3.5% of capital committed to the fund.  The incentive fee is also 20%.  Unlike hedge funds, venture capitalists are subject to a clawback provision.  This prevents them from charging fees if there are no profits at the end of the investment period, usually 7 - 10 years.  Incentive fees are not paid until all investments are paid back to the investors.

Hedge Fund Indices: Can They Be Used as Performance Benchmarks?

One of the requirements of institutional investors such as endowments, foundations and pension funds is a performance benchmark for a fund.  For mutual funds, there are a series of well-defined indices that serve in this capacity.  For Large Cap Equity in the US, there is the S&P 500 or Dow Jones Industrial Average.  The Small Cap Equity benchmark in the US is the Russell 2000.  A country may have an index such as Great Britain's FTSE 100 or Japan's Nikkei 225.  Bonds have their own indices based on their type"  US Treasury, High Yield, Mortgages, etc.  This allows the investor to compare a fund's returns relative to their investment universe's benchmark and find their outperforming and underperforming managers.

It is more difficult to find a proper index for hedge fund managers.  The more famous ones are the Dow Jones Credit Suisse, Hennessee Group, Eurekahedge, Barclay and MSCI.  Mutual fund indices are transparent to the public.  On the other hand, the opaqueness of hedge funds creates issues with finding a proper index for a manager.  The following issues are highlighted in Mark Anson's Handbook of Alternative Assets which is one of the source books for the CAIA program.

• Indices do not contain the same hedge funds
• Survivorship bias is a problem for newly created indices.  Since surviving funds are still in business because of superior returns, they cause the index to overestimate the return of all funds by 2.6% to 5% annually.  Most funds that close do not report their returns as they have more important responsibilities such as returning cash to their investors.  Survivorship bias may not affect indices' return history because the failing managers' performance data are retained in the historical data.
• Instant history bias occurs when the manager, after a period of good performance, decides to add his fund to the index.  Unlike mutual funds, reporting is voluntary in the hedge fund industry.  In addition to the current period, the manager will provide his historical performance.  This causes backfilled performance to be overestimated by 1% to 5% per year. This does not affect indices are they do not re-state historical numbers.
• Liquidation bias increases the performance of indices as failing or closing funds will no longer report their returns.
• Each index has its own definition for categorizing hedge fund investment strategies.  Also, managers are able to use a different strategy if the original strategy is not working or does not have enough investing opportunities.
• Access bias happens because many funds are closed to new capital.  A complete index would have open (investable) and closed (non-investable) funds.  This affects indices that report returns on a daily basis as their fund universe is restricted.  They can only include investable managers that do not invest in illiquid assets.  Because of this, investable indices underperform noninvestable indices.  The better managers manage funds that are oversubscribed i.e. there are too many investors with too much capital.
• The 2 and 20 fee structure can distort index returns.  Indices take into account fees when calculating performance.  Incentive fees are paid out annually but indices report on a monthly basis.  The incentive fees have to be estimated each month.  The total of the monthly fees may be different that the actual fee.  Also, the funds in the index may have different fees.  They can range from 1 and 15 to 3 and 50.
• Indices' components and calculations are different
• Turnover due to funds that start reporting and high attrition rate
• Including Managed Futures funds
• Type of index:  asset versus equally weighted 

Anson's summary concludes, "Perhaps the best way to choose a hedge fund index is to first state clearly the risk and return objectives...With this as their guide, investors can then make an informed benchmark selection."

Hedge Fund Fees: A Study on Manager Behavior

There was an article in the Journal of Alternative Investments regarding the effect of hedge funds' fees and the risk-taking behavior of fund managers.  It was written by Andrew Clare and Nick Motson.  Fees are controversial because of the size of them and because they may not provide the proper incentives to managers.  From 1994 - 2006, performance fees averaged 5.15% per year.  Adding on the standard 2% management fee leads to the investor paying the manager 7.15%.  The average equity mutual fund manager's fee is 1.3%.  Also, the manager participates on the upside but not on the downside.  The floor is the management fee.

Risk is defined as the volatility of returns of the portfolio.  A high risk fund has the possibility of having wild swings in returns.  A low risk fund will plod along at the same conservative rate.  The article asked if managers were below their high watermark, would they invest in riskier assets to earn a performance fee?  Conversely, if managers were after their high watermark, would they invest in less risky assets.

Clare and Motson found that managers adjusted the risk profile of their funds depending on their performance in the first half of the year.  Managers who were 15% or more above their high watermark at that time decreased their risk to lock in their performance fees.  Managers who were 10% or more below their high watermark also decreased their risk.  Since managers are large investors in their own funds, they would want to preserve their capital.  Also, there is a chance that other investors may withdraw their money. Managers that were in the middle increased their risk to try to earn incentive fees.

Another finding of Clare and Motson was that hedge fund managers are affected by their relative performance versus other managers.  They categorized managers after their performance in the first half of the year.  Those managers that were in the top half decreased their risk to maintain their rankings.  The managers in the bottom half increased their risk to move up in the rankings.  This is similar to the behavior of mutual fund managers.  It is called tournament behavior.

The article may be found here.

Hedge Fund Manager Fees: 2 and 20

Unlike mutual fund managers, hedge fund managers are paid from two fees:  management and incentive/performance.  Managements fees are based on assets under management and range from 1% to 4%, with the standard being 2%.  This can be paid out quarterly, semi-annually or annually.  The average equity mutual fund management fee is 1.3% and no performance fee.

Incentive fees are based on fund returns and are paid out on an annual basis.  The standard is 20% of profits although they can range up to 50%.  The fee is calculated against a high water mark at the end of the year.  For example, the net asset value (NAV) of the fund is at $100 at the start of the year.  If the NAV is $115 at the end of the year, the fee is calculated on the $15 gain i.e.e $15 x 20% = $3.  If there is no increase in the NAV, the manager receives no performance fee.  In the event that the fund manager loses money in one year, the high water mark may carry over to the next year.  For example, the NAV starts at $100 and goes to $90 in year one.  In year two, the NAV finishes at $110.  The performance fee is calculated off the initial mark i.e. ($110 - 100) x 20% = $2.  For managers that have large losses, they would have the incentive to reset the high water mark.  The best way to do this is to launch a new fund.  Of course, this would anger the original investors and the new fund would get most of the new attention from the manager.

Some funds have hurdle rates.  Incentive fees are not paid until the fund's return have met or exceeded the rate.  It may be based on an agreed upon rate, LIBOR or the yield on US treasury bills.  There are two types of hurdles:  hard and soft.  The hard hurdle is calculated only on returns above the hurdle rate.  Soft hurdles are calculated on the whole return.  For example, the beginning NAV is $100; the ending NAV is $120 and the hurdle rate is 10% (NAV = $110).

Hard hurdle calculation is:  ($120 - 110) x 20% = $2.
Soft hurdle calculation is:  ($120 - 100) x 20% = $4.

During the latest credit crisis, there was some talk of having clawback provisions for hedge funds, just like in private equity.  A clawback allows investors to recoup prior years' incentive fees if a fund underperforms.  I have not seen much news on this front in 2010.

Mutual Fund to Hedge Fund Move

Mark Mobius, Chairman of Franklin Templeton's Emerging Markets Group, is rumored to be opening a hedge fund in Asia.  He manages the Templeton Asian Growth Fund which has returned 500% over the last ten years.  It is the second best performing Asian fund in that timeframe.  He has managed emerging markets funds since 1987.

After all this time, why would Mobius be moving from managing a mutual fund to a hedge fund?  The freedom and fees.  The fund will be able to short securities and use leverage to enhance returns.  Hedge funds can charge a 2% management fee plus 20% of performance fee.  Mutual funds charge a management fee and no performance fee.  The "2 and 20" fees allows managers to participate in the upside of the fund and gives them a floor on the downside.  We will examine this in a later posting.

The Reuters article can be found here.