VOORWOORD. Arjan de Boer

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1 VOORWOORD Arjan de Boer De laatste jaren is er veel te doen geweest over hedge funds. Maar wat zijn hedge funds eigenlijk? De klassieke definitie van een hedge funds is: a privately organized, pooled investment vehicle, investing primarily in publicly traded securities and derivatives. Maar er is niet één manier om een hedge fund te typeren. Het fenomeen hedge funds kan op verschillende manieren uitgelegd worden, al wordt algemeen aangenomen dat een hedgefund een ongereguleerde, agressieve vorm van beleggen is. Eind jaren negentig namen de mogelijkheden voor beleggers meer en meer af. De rendementen op aandelen kwamen onder druk te zitten en investeerders waren op zoek naar iets nieuws. Met de opkomst van hedgefunds leek het antwoord op de slinkende rendementen gevonden: een goede lange termijn belegging welke onafhankelijk rendeerde van een dalende beurskoers. Vooral de institutionele beleggers raakten enthousiast en de groei van hedge funds was daarom ook niet verwonderlijk. In de jaren negentig waren hedge funds nog voornamelijk toegankelijk voor beleggers die veel geld konden investeren, maar met de groei van funds of hedge funds zijn er nu ook voor kleinere beleggers legio mogelijkheden om in hedge funds te beleggen. Op het eerste gezicht lijken hedge funds goede alternatieven om te beleggen, of dat werkelijk het geval is, wordt door middel van zeven artikelen toegelicht. In het eerste artikel zal Richard de Jong informatie die data vendors over hedge funds naar buiten brengen onder de loep nemen. Aansluitend zullen Nolke Posthuma en Piete-Jelle van der Sluis hedge funds in het algemeen behandelen. Zij zullen stilstaan bij de betekenis van hedge funds en de variaties erin. De investering in hedge funds is de laatste decennia sterk toegenomen. Dat dit niet altijd goed gaat, bewijst het artikel van Frank van den Berg over Long-Term Capital Management. Daarna worden de verschillende strategiën beschreven door Erik-Jan Goris in zijn artikel Hedge fund strategies. Max Berkelder en Matthijs Storm behandelen non-listed real estate funds. Dit zijn niet echte hedgefunds maar zoals eerder gezegd, kan je hedge funds vrij breed interpreteren. Real estate funds proberen hoge return te genereren voor exclusieve beleggers (pension funds, wealthy individuals etc). Het heeft wel hetzelfde doel als een hedgefund, want Unlisted property is een vorm van investments wat veel financials gebruiken om de rendementen op te krikken. Het is zeer interessant om te kijken wat er gebeurt met de assets van zo n fund als de looptijd verstrijkt. Als laatste is een zrtikel van Age Bakker en Vinh Ho gepubliceerd. Zij zullen de noodzaak van toezicht op hedge funds beschrijven. 3

2 ADVERTEEDERS ABP 16 ABN Amro 41 Barclays Capital 45 COLOFON Fiducie is het vakspecialistisch magazine van de Financiële Studievereniging Amsterdam (FSA). De FSA is de studievereniging voor studenten die verbonden zijn aan de economische faculteit van de Vrije Universiteit te Amsterdam en de Universiteit van Amsterdam. De artikelen in Fiducie hebben betrekking op de vakgebieden Accountancy, Controlling, Treasury en Beleggingsleer. Redactie & Lay-out Arjan de Boer Bestuur FSA Freek Aalberts Arjan de Boer Niels Boon Thijs Bosch Maarten Erkamp Wouter Timmer Abonnementen en advertenties Fiducie verschijnt vier keer per jaar. De abonnementsprijs bedraagt 15,- (exclusief 6% BTW) per jaar. Betalingen op gironummer t.a.v. Financiële Studievereniging Amsterdam. Voor advertenties kan contact worden opgenomen met het bestuur van de FSA FSA Hoewel bij deze uitgave de uiterste zorg is nagestreefd kan voor de aanwezigheid van eventuele (druk)fouten en andersoortige onvolledigheden niet worden ingestaan en aanvaarden de auteur(s), redacteur(en) en uitgever in deze geen aansprakelijkheid. Alle rechten voorbehouden. Niets uit deze uitgave mag worden verveelvoudigd, opgeslagen in een geautomatiseerd gegevensbestand, of openbaar gemaakt, in enige vorm of op enige wijze, hetzij elektronisch, mechanisch, door fotokopieën, opnamen, of enige andere manier, zonder voorafgaande schriftelijke toestemming van de uitgever. De Nederlandsche Bank 57 Deloitte 53 Ernst & Young 32 Fortis 15 Goldman Sachs 6 IMC 4 ING Groep 34 Kempen & Co 50 KPMG 64 Lehman Brothers 46 Ministerie van Financiën 26 NIBCapital 8 Optiver 63 Philips 42 PricewaterhouseCoopers 2 Rabobank 25 Research Project Brazil 62 5

3 INHOUD FIDUCIE 9. HEDGE FUNDS ONDER DE LOEP GENOMEN Zijn hedge funds echt de heilige graal van beleggers? RICHARD DE JONG De laatste tijd wordt wereldwijd veel geschreven over hedge funds en met name over de resultaten van hedge funds. Veel beleggers zijn immers hard op zoek naar alternatieven. Aandelenrendementen blijven onzeker, vastgoedfondsen zijn al flink in koers gestegen en obligaties bieden op dit moment ook niet echt een hoog absoluut rendement. Veel instellingen die data verzamelen en deze vervolgens publiceren (data vendors) laten zien dat hedge funds beter presteren dan aandelen en obligaties. Wat zegt deze informatie? 17. UNVEILING HEDGE FUNDS NOLKE POSTHUMA EN PIETER-JELLE VAN DER SLUIS What are hedge funds? The classic definition of a hedge fund is a privately organized, pooled investment vehicle, investing primarily in publicly traded securities and derivatives. Combinations of short and long positions reduce exposures to general moves in markets, while the focus is on profiting from security selection. This definition of a hedge fund does not span the various trading strategies applied by hedge funds anymore. With the strong performance of stock and bond markets globally in the late nineties, many hedge funds have deviated from the classical definition by taking net positions that have been more than 100% long or, in rarer cases, substantially short. Due to the media attention of some large hedge fund blow-ups, it is often perceived that hedge funds are very volatile, use a lot of leverage, and take large speculative bets. We believe this is not true in general. 27. LONG-TERM CAPITAL MANAGEMENT: COLLAPSE OF A HEDGE FUND Like the Titanic, the mighty LTCM was supposed to be unsinkable FRANK W. VAN DEN BERG Like the Titanic, hedge fund Long-Term Capital Management (LTCM) was not supposed to ever sink. Yet, in the late summer of 1998, the Federal Reserve Chairman Alan Greenspan summoned the chief executives of all the major New York money center banks to his office. In this emergency meeting he strongly encouraged the persons present to pull their wallets and fork out several billions of dollars to save LTCM. They were kept in a room until 3.00 am the following morning, until they had hammered out an injection of $3.65 billion to keep LTCM alive. 35. HEDGE FUND STRATEGIES ERIK-JAN GORIS Since the 1990s hedge funds have experienced an explosive growth in both number of funds and assets under management. Although commonly referred to as hedge fund and seeking absolute returns, the strategies utilised by these funds to achieve their returns are as manifold as there are funds. This variety and the fact that the hedge fund industry is largely unregulated often makes it hard for investors to obtain insight into the investment focus, risk profile and track record of a particular hedge fund. 43. FUND OF HEDGE FUNDS JURGEN BOSBOOM Hedge funds hebben zich het afgelopen decennium mogen verheugen op een steeds grotere belangstelling. Volgens cijfers van TASS Research had de hedge fund industrie eind 1993 een omvang van bijna US$50 miljard. Zeven jaar later, eind 2000, was het beheerd vermogen inmiddels gegroeid tot US$217 miljard om in de daarna volgende drie jaren verder toe te nemen tot US$576 miljard. Het aantal fondsen groeide over dezelfde periode van 1277 in 1993 naar ruim 5000 begin Omdat echter geen enkele hedge fund database compleet is, is het zeer waarschijnlijk dat de totale industrie in werkelijkheid nog aanzienlijk groter is. 51. I WANT TO GET OUT OF THIS PLACE MAX BERKELDER EN MATTHIJS STORM Apart from debt and equity, property has become a specific investment category. Pension funds such as ABP and PGGM have invested up to 12% of their total investment portfolio in real estate. Most of the property investments of institutional investors are allocated in non-listed funds, as they are less sensitive to fluctuations on the stock market and suffer from less media scrutiny. 58. IS MEER INTENSIEF TOEZICHT OP HEDGE FUNDS NODIG? AGE BAKKER EN VINH HO De hedge funds industrie is het afgelopen decennium, zowel in beheerd vermogen als in aantal fondsen, fors gegroeid. Over de periode van vertwintigvoudigde het beheerde vermogen (van $38 miljard naar ruim $800 miljard) en is het aantal hedge funds toegenomen van ongeveer 2000 tot meer dan

4 RICHARD DE JONG HEDGE FUNDS ONDER DE LOEP GENOMEN Zijn hedge funds echt de heilige graal van beleggers? De laatste tijd wordt wereldwijd veel geschreven over hedge funds en met name over de resultaten van hedge funds. Veel beleggers zijn immers hard op zoek naar alternatieven. Aandelenrendementen blijven onzeker, vastgoedfondsen zijn al flink in koers gestegen en obligaties bieden op dit moment ook niet echt een hoog absoluut rendement. Veel instellingen die data verzamelen en deze vervolgens publiceren (data vendors) laten zien dat hedge funds beter presteren dan aandelen en obligaties. Wat zegt deze informatie? Zijn hedge funds echt de heilige graal van beleggers of is er toch meer aan de hand? In dit artikel zal ik nader ingaan op het fenomeen hedge fund. Het artikel is met name geschikt voor die lezers die (nog) weinig ervaring hebben met hedge funds. Eerst zal ik een omschrijving geven van wat hedge funds nu eigenlijk zijn en waar zij zich mee bezighouden. Daarna zal ik ingaan op de rendementen en de risico s van hedge funds. 9

5 Soorten hedge funds Een hedge fund wordt in de literatuur veelal omschreven als een meestal nietbeursgenoteerd beleggingsfonds dat minder restricties kent dan traditionele beleggingsfondsen. Zo kan een hedge fund in de regel short gaan (het verkopen van effecten zonder deze in bezit te hebben) en kan het gebruik maken van leverage. Tevens gebruiken hedge funds veelvuldig derivaten. In tegenstelling tot de meer traditionele beleggingsfondsen, zijn hedge funds meer gericht op absoluut dan op relatief rendement. Lastiger is het om aan te geven waarin en op welke wijze een hedge fund investeert. In principe volgt elk hedge fund namelijk een eigen strategie. Hoewel discutabel worden hedge funds vaak onderverdeeld in 3 strategieën (zie grafiek 1). De relative value strategieën maken veelvuldig gebruik van arbitrage. Er wordt gezocht naar vormen van inefficiënties in de markt op basis waarvan arbitrage gepleegd wordt. Bij pure arbitrage is het marktrisico nul. Deze categorie is in hoge mate marktneutraal, dat wil zeggen onafhankelijk van marktbewegingen. Doordat de winstmarges vaak klein zijn, wordt met name bij deze strategieën gebruik gemaakt van een hefboomwerking. Aangezien de over/onderwaardering vaak verborgen is door complexe derivaten is het tevens gebruikelijk om veel derivaten te gebruiken om deze over/onderwaardering bloot te leggen. De relative value strategieën blijken vooral goed te werken in sterk dalende markten. In deze markten is vaak sprake van paniek en ontstaan er inefficiënties waar hedge funds op kunnen inspelen. Per saldo geldt echter ook voor hedge funds dat zeer veel financiële onrust leidt tot lagere rendementen. Bij convertible arbitrage probeert men gebruik te maken van de soms aanwezige onderwaardering in converteerbare obligaties. Men koopt de ondergewaarde converteerbare obligatie en verkoopt het onderliggende aandeel waardoor het marktrisico gehedged is. Bij fixed income arbitrage proberen hedge funds gebruik te maken van de mispricings in en tussen de verschillende obligatiemarkten. Een belangrijke strategie binnen de relative value is de zogenaamde equity market neutral strategie. In het kort houdt deze strategie in dat een hedge fund bijvoorbeeld Koninklijke Olie koopt en tegelijkertijd BP verkoopt. De gedachte van de manager van een hedge funds is dat Koninklijke Olie ondergewaardeerd en BP Strategieën hedge funds overgewaardeerd is. De investering bedraagt 0 waardoor er geen marktrisico gelopen wordt. Deze hedge funds (alsmede een long/short hedge fund) lijken op een gewoon beleggingsfonds. Het verschil is echter dat een gewoon beleggingsfonds vaak niet short mag gaan. Indien de manager van het fonds negatief is over een bepaald aandeel kan hij hier weinig mee doen, behalve dan het niet opnemen van het fonds in de beleggingsportefeuille. Doordat een manager van een equity market neutral hedge fund wel short mag gaan, kan hij besluiten het aandeel te shorten en dit vervolgens op een lager niveau terug te kopen. Hoewel de hedge fund manager dus dezelfde visie heeft als de manager van het gewone beleggingsfonds, kan de hedge fund manager meer rendement behalen uit deze zelfde visie. De equity market neutral fondsen laten over de afgelopen 10 jaar bescheiden, maar stabiele rendementen zien. De event driven hedge funds richten zich op een bepaalde gebeurtenis (event) en niet zozeer op pure arbitrage. Hoewel discutabel is het gebruikelijk merger arbitrage hedge funds niet onder de arbitragestrategieën te scharen, maar onder de event driven strategieën. Bij merger arbitrage worden aandelen van het Relative value Event driven Market directional Grafiek 1 10

6 doelwit door het hedge fund gekocht en die van de overnemende partij verkocht. Het uitgangspunt is dus dat de aandelen van het doelwit nog verder zullen stijgen en die van de overnemende partij zullen dalen. De andere categorie binnen de event driven strategie zijn de hedge funds die zich richten op bedrijven die in grote financiële moeilijkheden verkeren. Hedge funds speculeren er in dit geval op dat de bedrijven uit de financiële problemen zullen geraken en dat de beurskoers zal herstellen. De categorie market directional is de meest riskante en tevens meest voorkomende strategie. Rendementen van deze strategieën zijn voor een groot gedeelte afhankelijk van de richting van de aandelen- en obligatiemarkten. Hedge funds die zich bezig houden met macro hedging richten zich op economische grootheden als rente en valuta. Hedge funds proberen trends in deze grootheden te ontdekken en trachten hier op in te spelen. Deze strategieën presteerden goed tijdens de bear market van 2001 en Net als bij een equity market neutral strategie neemt de manager van een long/short strategie tegelijkertijd een long en een short positie in. Het verschil tussen een long/short strategie en een equity market neutral strategie is, dat de eerste geen evenwicht tussen een long en een short posities hoeft te hebben. De long/short strategieën presteerden goed tijdens de bull market (tot maart 2000), maar presteerden slecht tijdens de laatste bear market (2001 en 2002). Short sellers anticiperen op een daling van de effectenmarkten door bepaalde effecten te verkopen met als doel deze op een lager niveau terug te kopen. De rendementen hangen daardoor sterk af van de ontwikkelingen op de verschillende aandelen- en obligatiemarkten. De managed future fondsen investeren in futures die betrekking hebben op verschillende indices in verschillende financiële markten, zoals de aandelenmarkt, de obligatiemarkt of de valutamarkt. Vaak is de strategie gebaseerd op het ontdekken van een trend met behulp van technische analyse. Volgens schattingen bestaat ruim 51% van de hedge funds markt uit de zogenaamde market directional strategieën, ruim 28% uit event driven strategieën en ongeveer 21% uit relative value strategieën. Van de afzonderlijke strategieën is de long/short strategie met een marktpercentage van ruim 30% de grootste. Ter vergelijking, in 1990 bestond ruim 87% van de hedge funds markt uit de market directional strategieën, ruim 7% uit event driven strategieën en ongeveer 5% uit relative value strategieën. Van de afzonderlijke strategieën waren de global macro hedge funds het meest vertegenwoordigd met een marktaandeel van ruim 71%. Om een goed beeld te krijgen van de toegevoegde waarde van hedge funds voor een beleggingsportefeuille, die bestaat uit aandelen en/of obligaties, is het raadzaam om in het achterhoofd te houden dat er dus een grote diversiteit in hedge funds is en dus ook in rendement, risico en correlatie. Om toch tot een maandrendement te komen, gebruiken hedge funds de laatst beschikbare marktprijs of schatten deze prijs zelf Vaststellen verschillende indices Om een goede rendementsvergelijking te kunnen maken tussen een belegging in aandelen, obligaties en hedge funds is het van belang representatieve indices te kiezen. Vaak kiest men voor aandelen de S&P 500 als index, voor obligaties de Lehman Brothers index en voor hedge funds de Credit Suisse First Boston/ Tremont index. Deze laatste index bestaat uit een gewogen gemiddelde van alle hierboven vermelde strategieën. Aangezien de Tremont index alleen data heeft vanaf 1994 kunnen we de drie indices dus slechts over de laatste 10 jaar met elkaar vergelijken. Hedge funds hebben het hoogste rendement Vanaf 1 januari 1994 tot eind september 2004 behaalden aandelen (de S&P 500 index) een cumulatief rendement van 189,93%, wat overeenkomt met een jaarlijks rendement van 10,41%. Obligaties leverden een totaal rendement op van 102,83%, oftewel een gemiddeld rendement van 6,8% per jaar. Hedge funds realiseerden een totaal rendement van 197,70% (een gemiddeld rendement van 10,68% per jaar). Hedge funds hebben dus over een periode van ruim 10 jaar het beste rendement laten zien. U zou nu kunnen concluderen dat u voortaan maar het beste in hedge funds kunt beleggen. Maar onthoudt: resultaten uit het verleden bieden geen garantie voor de toekomst!! Pas op met het vergelijken van rendementen Op het eerste gezicht lijkt het dat hedge funds beter hebben gepresteerd dan aandelen en obligaties. Hier moeten echter een aantal kanttekeningen bij geplaatst worden. De hedge funds indices hebben betrekking op de rendementen van hedge funds die nu nog bestaan. Sommige hedge funds zijn echter door slechte rendementen failliet gegaan. De resultaten van die funds worden niet meer meegenomen in een hedge funds index. De gepubliceerde data zijn hierdoor een overschatting van het werkelijk gemiddelde rendement over een bepaalde periode. De wetenschappers Brown, Goetzmann en Ibbotson (1999) kwamen tot de conclusie dat hierdoor het gemiddelde rendement van hedge funds sinds 1994 met bijna 3% per jaar wordt overschat. Dit zou betekenen dat het jaarlijks rendement over de afgelopen 10 jaar niet 10,68% maar 7,68% bedroeg. Bovendien geldt dat veel hedge funds investeren in illiquide aandelen/obligaties waarvan geen recente marktprijzen beschikbaar zijn. Om toch tot een maandrendement te komen, gebruiken hedge funds de laatst beschikbare marktprijs of schatten deze prijs zelf. Gevolg hiervan is dat een positie een zeer stabiele waardeontwikkeling laat zien terwijl dit niet het werkelijke illiquiditeitsrisico weerspiegelt. Daarnaast zijn hedge funds niet verplicht hun rendementen openbaar te maken. Het ligt voor de hand dat alleen die fondsen die goede rendementen hebben behaald deze naar buiten zullen brengen. Ook dit maakt dat de gepubliceerde data een overschatting van het werkelijk gemiddelde rendement over een bepaalde periode kunnen inhouden. HEDGE FUNDS 11

7 Toekomstig rendement Tot slot is het nodig om de toekomstige rendementen en dan met name die van de arbitrage strategieën kritisch te beschouwen. Want nu er steeds meer hedge funds op de markt komen die zich bezig houden met arbitrage, maar de arbitrage mogelijkheden per saldo gelijk blijven, kan dit een negatief effect hebben op het rendement. Voor de andere strategieën geldt dit argument minder. Daarnaast bleek dat de afgelopen maanden veel hedge funds last hadden van de afgenomen beweeglijkheid op de aandelenbeurzen. Zo zakte de beweeglijkheid van de AEX van 23 % naar 13 %. In dit soort markten hebben hedge funds weinig speelruimte. Mijn verwachting is echter dat de beweeglijkheid in de komende tijd wel weer zal aantrekken hetgeen de speelruimte voor hedge funds kan vergroten. Uit onderzoek van Agarwal e.a. (2004) blijkt tevens dat er een negatief verband is tussen de omvang van het beheerd vermogen en toekomstige resultaten van een hedge fund. Een mogelijke verklaring is dat het voor grote fondsen moeilijker is om voldoende kansen te vinden in de markt. Risico Vaak wordt geschreven dat het risico bij hedge funds lager is dan bij bijvoorbeeld aandelen of gelijk is aan dat van obligaties. Met risico bedoelt men de beweeglijkheid van rendementen, hetgeen gemeten wordt door middel van de standaarddeviatie. Hoe beweeglijker het rendement, hoe hoger het risico aangezien de kans op een ongewenste uitkomst toeneemt. In theorie wordt dus met risico ook een hogere uitkomst dan verwacht bedoeld. Laten wij nu eens kijken naar de harde cijfers. Vanaf 1 januari 1994 tot eind september 2004, was het risico bij aandelen 15,38%, bij hedge funds 8,22% en bij obligaties 4,10%. Op het eerste gezicht lijkt het er dus op dat het risico van hedge funds lager is dan dat van aandelen. Als we afzien van de hierboven beschreven kanttekeningen, ziet de rendement/ risicoverhouding bij hedge funds er zeer goed uit. Echter, ook hier is de werkelijkheid iets anders. De standaarddeviatie die gebruikt wordt om het risico te meten, is niet geschikt voor hedge funds. Brooks en Kat (2002) hebben aangetoond dat hedge funds rendementen niet normaal verdeeld zijn. De standaarddeviatie is hierdoor geen geschikte maatstaf om het risico te meten. Hedge funds hebben namelijk een hoog event risk. In normale economische omstandigheden leveren hedge funds inderdaad een superieur rendement op gegeven een bepaalde standaarddeviatie. De meeste hedge funds zijn echter zeer gevoelig voor onrust in de financiële markten. Te denken valt hierbij bijvoorbeeld aan de crises in Brazilië en Rusland (1998). Een flinke daling van de aandelenkoersen wordt immers vaak vergezeld door hogere spreads, toenemende volatiliteit en afnemende liquiditeit. Dit maakt het voor hedge funds moeilijker hun strategieën uit te voeren. Het is daarom van groot belang dat een hedge fund een lange geschiedenis heeft, zodat beoordeeld kan worden hoe het fonds zich in tijden van crises heeft gehouden. Zoals opgemerkt zijn hedge funds niet normaal verdeeld. Bij een normaalverdeling heeft de skewness parameter een waarde van 0 en de kurtosis parameter een waarde van 3. De skewness parameter geeft de scheefheid van de verdeling weer. Een negatieve skewness betekent dat de kans op een verlies groter is dan de kans op winst. Als de kurtosis een waarde heeft van groter dan 3, dan betekent dit dat er tussen de historische rendementen veel grote uitschieters waren (zowel positief als negatief). Een risico-averse belegger heeft dit liever niet. Uit bovenstaande tabel blijkt dat aandelen en obligaties normaal verdeeld zijn, waardoor de standaarddeviatie wel een goede maatstaf voor risico is. Wat opvalt is dat met name Fixed Income Arbitrage en Event Driven ver afwijken van een normaalverdeling (zeer negatieve skewness en/of hoge kurtosis). Met name het gebruik van leverage zorgt voor de hoge kurtosis, omdat leverage de kans op een hoog positief of negatief rendement verhoogd. Op basis van de standaarddeviatie zou men kunnen concluderen dat deze twee strategieën niet Index Cumulatief Gemiddeld jaar- Standaard Sharpe Skew- Kurtorendement lijks rendement Deviatie ratio* ness** sis** CSFB/Tremont Hedge Fund Index 197,7% 10,7% 8,2% 0,81-1,34 8,42 Convertible arbitrage 172,5% 9,8% 4,7% 1,23-1,66 4,08 Fixed Income Arbitrage 100,6% 6,7% 3,9% 0,70-3,28 15,19 Equity market neutral 189,8% 10,4% 3,0% 2,11-0,03 2,72 Event driven 215,0% 11,3% 5,9% 1,24-3,38 15,44 Macro hedging 302,0% 13,8% 11,7% 0,84-0,09 3,6 Long/short equity 227,1% 11,7% 10,7% 0,72-0,29 5,91 Distressed securities 281,2% 13,3% 6,8% 1,37-1,08 10,38 Short sellers -22,5% -2,3% 17,7% -0,36 0,91 5,49 Managed futures 87,9% 6,0% 12,2% 0,17 0,12 3,07 S&P ,9% 10,4% 15,4% 0,42-0,2 3,92 Lehman Brothers Bond 102,8% 6,8% 4,0% 0,70 0,56 4,29 *De risicovrije rente is op 4% verondersteld **Gemeten vanaf 1 januari 1994 tot 1 januari FIDUCIEE DECEMBER 2004 NUMMER 2

8 Grafiek 2 veel risicovoller zijn dan obligaties. Op basis van de kurtosis en skewness parameters komt men echter tot een veel minder rooskleurig beeld. Tevens blijkt dat de strategie Distressed Securities een zeer hoge kurtosis heeft. Dit komt mede doordat de winsten bij succes hoog zijn, maar tevens doordat verliezen bij een verkeerde keuze ook aanzienlijk kunnen zijn. Correlatie De grootste toegevoegde waarde van hedge funds heeft mijns inziens te maken met de correlatie van hedge funds met aandelen/ obligaties. Correlatie geeft de samenhang tussen rendementen weer. Bij een negatieve correlatie tussen twee beleggingen betekent een positief rendement van de ene belegging een negatief rendement van de andere en vice versa. De correlatie varieert van 1 tot +1. Is de correlatie lager dan +1 dan neemt de beweeglijkheid van de portefeuille af en dus het risico. Eind september 2004 bedroeg de correlatie van de CSFB/Tremont hedge fund index met aandelen 0,48. Dit houdt dus in dat als aandelen met 1 % dalen over een bepaalde periode, hedge funds met 1 % * 0,48 = 0,48 % dalen. De correlatie van de hedge funds index met obligaties is negatief. Het toevoegen van hedge funds in een obligatieportefeuille vermindert hierdoor het risico van de totale portefeuille. Tevens blijkt dat de verschillende strategieën uiteenlopende correlaties hebben met aandelen en obligaties. Short sellers hebben, zoals mag worden verwacht, een negatieve correlatie met aandelen (-0,76). Het toevoegen van deze strategie aan de portefeuille verlaagt dus de beweeglijkheid en het risico van de portefeuille. Opvallend is dat de equity market neutral strategie wel degelijk een correlatie heeft met aandelen. Volgens de theorie zou deze strategie echter geen correlatie (ook geen lage) met de aandelenmarkt moeten hebben. De strategie zou immers marktneutraal moeten zijn. Blijkbaar wordt er dus wel degelijk een beperkte mate van marktrisico gelopen. Long/short strategieën hebben gemiddeld een correlatie van 0,58 met de S&P 500 index. Hieruit blijkt dat long/short strategieën per saldo vaker een gekochte dan een verkochte positie hebben. Het rendement hangt hierdoor sterk af van de ontwikkelingen op de aandelenmarkten. De correlatie met obligaties is te verwaarlozen. Geconcludeerd kan worden dat op basis van correlatie hedge funds en obligaties beter samengaan dan hedge funds en aandelen. Tevens is vaak sprake van een lage correlatie tussen de verschillende strategieën onderling. Brealy e.a. (2001) schatten dat de correlatie tussen alle afzonderlijke strategieën ongeveer 0,13 is. Het opnemen van verschillende hedge fund strategieën (bijvoorbeeld door het kopen van een fund of hedge funds) leidt op portefeuilleniveau dus tot een verdere reductie van het risico. 13

9 Correlatie CSFB/Tremont S&P 500 Lehman Brothers Hedge Fund Index Bond Index Convertible arbitrage 0,40 0,13 0,12- Fixed Income Arbitrage 0,44 0,03 0,14- Equity market neutral 0,33 0,39 0,08 Event driven 0,66 0,55 0,17- Macro hedging 0,86 0,23 0,15- Long/short equity 0,78 0,58 0,05 Distressed securities 0,66 0,54 0,08- Short sellers -0,48-0,76 0,01- Managed futures 0,11-0,20 0,35 S&P 500 0,48 1,00 0,20 CSFB/Tremont Hedge Fund Index 1,00 0,48-0,12 LB Bond Index -0,12 0,20 1,00 Gemeten vanaf 1 januari 1994 tot 30 september 2004 Fund of fund Vanwege de lage correlatie tussen de verschillende strategieën onderling is een fund of hedge funds een goed alternatief voor individuele hedge funds. Daarnaast heeft een fund of hedge funds vaak toegang tot hedge funds die voor individuele beleggers al gesloten zijn. Vaak hebben deze gesloten fondsen mooie resultaten behaald in het recente verleden. Nadeel van een fund of hedge funds is de dubbele fee structuur. Agarwal e.a. (2004) komen tot de conclusie dat er bij een fund of hedge funds wel een positieve relatie is tussen de grootte van een fund en de toekomstige rendementen. Dit in tegenstelling tot individuele hedge funds, waarbij de relatie negatief is. Een fund of hedge funds lijkt dus te profiteren van schaalvoordelen. Conclusie Hedge funds vormen een diverse en gecompliceerde beleggingscategorie. De verschillende strategieën hebben verschillende kenmerken. De arbitragestrategieën zijn het minst afhankelijk van marktbewegingen en gebruiken vaak veel hefboomwerking. De marktafhankelijke strategieën zijn het meest afhankelijk van marktbewegingen en hebben hierdoor ook de grootste schommelingen in hun rendement. Hoewel de gepubliceerde rendementen vaak te optimistisch zijn, hebben hedge funds een goede rendement/risico-verhouding. Een ander pluspunt van hedge funds is de lage correlatie met aandelen en obligaties. Het toevoegen van hedge funds aan de portefeuille vermindert daardoor de beweeglijkheid en dus het risico van de portefeuille. Het grootste nadeel van hedge funds is echter dat de rendementen van hedge funds niet normaal verdeeld zijn. De portefeuille wordt gevoeliger voor extreme situaties op de financiële markten. Echter, hoe langer de financiële markten zich normaal gedragen zonder extreme volatiliteit, hoe positiever het toevoegen van hedge funds voor u kan zijn. drs RH.J. de Jong is vermogensbeheerder bij Van Lieshout & Partners N.V., private bankers. Geraadpleegde literatuur Agarwal, V. en N. Naik; Risk and Portfolio Decisions Involving Hedge Funds. The Review of Financial Studies, Vol. 17 (2004), pp Agarwal, V., N.D. Daniel en N. Naik; Flows, Performance, and Managerial Incentives in Hedge Fund. Working Paper London Business School (2004). Amin, G.S., H.M. Kat; Diversification and Yield Enhancement with Hedge Funds. AIRC Working Paper (2002). Amin, G.S., H.M. Kat; Stocks, Bonds and Hedge Funds: Not a free Lunch. AIRC Working Paper (2002). Brooks, C., H.M. Kat; The Statistical Properties of hedge Fund Index returns and their Implications for Investors. The Journal of Alternative Investments, Vol. 5 (2002), pp Brealy, R.A. and E. Kaplanis; Changes in the Factor Exposures of Hedge Funds. Working Paper London Business School (2001). Brown, S., W. Goetzmann and R. Ibbotson; Offshore Hedge Funds: Survival & Performance. Journal of Business, Vol.72 (1999), pp Brown, S., W. Goetzmann, R. Ibbotson and S.A. Ross; Survivorship Bias in Performance Studies. The Review of Financial Studies, Vol. 5 (1992), pp Fung, W., D. Hsieh; The Risk in Hedge Fund Strategies: Theory and Evidence from trend Followers. The Review of Financial Studies, Vol. 14 (2001), pp Jong, P. de; De Eigenschappen van Gediversificeerde Hedge Fund Portefeuilles. VBA Journaal, Vol 3 (2004), pp Kat, H.M.; Hedge Fund Mania: Some Words of Caution. VBA Journaal, Vol 2 (2001), pp Liang, B; Hedge Funds: The Living and the Dead. Journal of Financial and Quantitative analysis, (2000). Ruiter, A.J.C. de; De plaatsbepaling van hedge funds in een pensioenfonds portefeuille. VBA Journaal, Vol 2 (2001), pp UBS Warburg; Investing in Hedge Funds: In Search of Alpha. (2000) 14 FIDUCIEE DECEMBER 2004 NUMMER 2

10 UNVEILING HEDGE FUNDS 1 NOLKE POSTHUMA 2 EN PIETER JELLE VAN DER SLUIS 3 What are hedge funds? The classic definition of a hedge fund is a privately organized, pooled investment vehicle, investing primarily in publicly traded securities and derivatives. Combinations of short and long positions reduce exposures to general moves in markets, while the focus is on profiting from security selection. This definition of a hedge fund does not span the various trading strategies applied by hedge funds anymore. With the strong performance of stock and bond markets globally in the late nineties, many hedge funds have deviated from the classical definition by taking net positions that have been more than 100% long or, in rarer cases, substantially short. Due to the media attention of some large hedge fund blow-ups, it is often perceived that hedge funds are very volatile, use a lot of leverage, and take large speculative bets. We believe this is not true in general. Hedge funds may use speculative instruments such as options and futures, but they mainly do this in a very risk-controlled and conservative way. Hedge fund strategies are often very subtle. The returns of financial assets break down in several risk premiums. If one of these component risk premiums has a high return to risk ratio, a hedge fund can choose to take up only this component risk and hedge out the others. 17

11 The hedging out of the above component risks is often a delicate issue. We will give some examples below where we discuss the hedge fund styles in detail. Due to the fact hedge funds are largely unregulated they can gear up any of the above component risk premiums. Leverage is often needed to make the small risk premiums economically significant. Nowadays a hedge fund is best defined by its organizational structure and regulatory status. We will discuss these issues below. Any statement about a hedge fund is conditional on the investment style of the fund. Therefore we will classify hedge funds on basis of their styles. We do not consider hedge funds to be an asset class on their own. The investment styles are diverse and investing in hedge funds is also a bet on active management. Seasoned fund of funds managers understand that an external manager s track record of good past returns is no guarantee for future good returns. Instead they will focus on sustainability of the return generating process of the manager and do extensive due diligence on and daily monitoring of the funds they invest in. This paper is nothing more than an introduction to hedge funds. It is not a compendium for asset allocation decisions to hedge funds, nor a digest for doing hedge fund manager selection. The characteristics of hedge funds are such that the latter two key issues are very tough. We urge any potential hedge fund investor to seek advice from experienced hedge fund professionals. Due to the media attention of some large hedge fund blowups, it is often perceived that hedge funds are very volatile, use a lot of leverage, and take large speculative bets 1.1 Regulatory environment Hedge funds are usually private partnerships exempt from many regulatory controls common to more traditional investment funds. Hedge funds can be defined by their freedom from regulatory controls as described by the Investment Company Acts of 1933 and These controls limit fund leverage, short selling, holding shares of other investment companies, and holding more than 10% of the shares of any single company. Hedge funds do not have to comply with the Fulcrum rule, which forbids mutual fund managers to have different fees for gains and losses. Marketing of hedge funds is severely restricted by US law; they are not allowed to advertise to the general public. Word of mouth advertising and inclusion in databases are the most important options left to obtain funds. For regulatory purposes, before 1996, hedge funds had to limit the number of investors to 99 to qualify for exclusion from regulations governing public issuance of securities, including restrictions on public advertising and solicitation of investors. In 1996, the National Securities Markets Improvement Act modified the Investment Company Act by raising the ceiling on the number of U.S. investors allowed in unregulated funds to 500. In addition, recent rules by the SEC have further broadened the ability of hedge funds to attract individual and institutional money. Hedge funds can accept money from qualified investors, who have $5 million in capital to invest, and a sophisticated understanding of the financial markets. In addition, they can accept money from institutions such as pension funds that have at least $25 million in capital. Recently predominantly European governments have released new laws that provide hedge funds with more space for marketing activities. Generally speaking, European regulations are similar to those in the US. The extent to which regulators can regulate is limited due to the existence of many offshore fund structure possibilities. Additional regulation tends to drive hedge funds offshore where they are further out of reach. Note that hedge funds that invest in other hedge funds (fund of funds) could comply with US rules even when underlying funds are based offshore. Although hedge funds are not strictly regulated, they are regulated by the banks from which give them credit. The banks themselves are regulated and will not deal with anybody who cannot prove to have adequate capital or provide adequate margin. 1.2 Skill based and fee driven Hedge funds are predominantly comprised of a flexible staff to swiftly take advantage of market opportunities. Compared to traditional asset managers, hedge funds charge aggressive fees. Typical fee structures consist of 2% of assets under management, and 20% of cumulative profits on a yearly basis. The fast growth of the hedge fund industry provokes a greater variety in fee structures. Some performance fees are calculated on basis of quarterly or even monthly returns. It is noted that such performance fee is equivalent to giving an in the money option to the hedge fund manager each quarter or month. The value of these options increases with the volatility of the hedge fund, which is controlled by the hedge fund manager. This may give rise to a misalignment of interests with the investor and the manager. The costs of the organization could come in addition to the fees. High watermarks are applied to give hedge fund managers incentives to control risk taking. A high watermark determines that excess return fees cannot be paid before earlier losses have been compensated. The high watermark is an incentive to avoid loss, but when losses are made the coin turns, hedge fund managers have the incentive to take on extra risk in order to get above their watermarks, which delivers them performance fees. Hedge funds often require advance notice for redemptions of as short as one month, and as long as three years. Such notice or lockup periods are designed to limit the impact of fund redemptions on the investment strategy, which is often in illiquid securities. Hedge fund managers often invest a substantial amount of their own money in their funds. This practice is hoped to have the effect of aligning the interests of the managers with those of the outside investors. However, the emotional involvement of the manager might also lead to human deficits. The empirical evidence is as follows. Liang (1999) finds that average hedge fund returns are related positively to incentive fees, size of fund assets, and the lockup period. In particular, funds with high watermarks outperform those without. Note, in this research the author could only use reported returns, poor performance might not be reported by managers and could change results. 2. Hedge fund industry growth Hedge funds are commonly viewed as a phenomenon starting in the late-1980s. However, their history is actually considerably longer than that. Unofficial hedge funds have been around for centuries. Take for example 18 FIDUCIEE DECEMBER 2004 NUMMER 2

12 rice futures traders in 18th century Japan. The first official hedge fund on record, the Jones Hedge Fund, was established by Alfred Winslow Jones in The fund invested in US stocks, both long, and short in an attempt to reduce market risk, and focus on stock selection. Jones generated high returns while managing to avoid significant attention from the general financial community until 1966, when an article in Fortune (Loomis) led to increased interest in hedge funds. Two years later in 1968, the Securities and Exchange Commission (SEC) estimated that approximately 140 hedge funds were in existence. During the equity market downturn of 1969, assets under management and the number of funds declined with severely (70% for the largest registered funds) due to losses, withdrawals and closures. Perhaps (imitator) hedge funds could not resist the temptation to be leveraged long during the preceding bull market. As a consequence, hedge funds lost their popularity. Proprietary trading desks of banks were still trading hedge fund strategies. Only in the early 1980s did popularity rise again, with investments in Julian Robertson s Tiger fund going up from $8 million to $3 billion. Julian Robertson was unable to run his equity long short strategies anymore without a profound market impact. Therefore, he decided to apply new investment strategies. He began speculating on global currencies based on macro economic views, later a style called global macro. Since then, growth has continued tremendously in terms of number of funds, funds under management, as well as the number of investment strategies. Julian Robertson s Tiger fund closed down in February 2000 after missing the tech bubble. In retrospect his view on tech proved to be correct with the dramatic decline of the NASDAQ. Historically hedge fund investors were wealthy individuals and families. The economic expansion, combined with high compensation packages in, for instance, the high-tech, and financial sector, and the success of many familyowned and entrepreneurial business raised the number of wealthy individuals substantially. In the 1990s only a few institutional investors, university endowment funds such as Harvard and Yale, took the move to invest in these noninstitutional vehicles. The stellar performance of major macro funds until 1998 and of leveraged long equity funds during 1999 attracted advantageous market attention. As in the 1960s, many imitator funds started in the 1990s, and many funds closed down or liquidated during the liquidity crisis of 1998 and the equity market downturn in The liquidity crisis, especially the collapse of Long Term Capital Management (LTCM) attracted negative attention. However, institutional interest accelerated enormously with the slump in global equity markets combined with the bleak outlook. The perceived low correlation and favorable Sharpe ratios of hedge funds, draw many institutional investors into hedge funds. Tremont TASS - one of the leading database vendors - estimates the hedge fund industry s asset base at $870 billion in August Many me-too funds founded by former investment bankers and the vast amount of capital drawn in, revitalized Julian Robertson s issue of market impact and capacity. Since 2000, hedge funds have produced lower returns. An extensive and perhaps desperate search for new strategies is conducted. Former investment bankers who are now in hedge funds, have experience in financing and structuring deals. This could be the reason why financing catastrophe bonds, mortgage and asset backed securities, credit default swaps, complex derivative structures, and arbitrage on capital structures has become increasingly popular. These managers edge against traditional investment banks is their freedom to refrain from complying with several banking regulations and the upcoming liquidity restricting Basel II. Instead of competing with hedge funds, investment banks collect hefty fees for their services and even have their own embedded hedge fund hotels. Note that hedge funds that invest in other hedge funds (fund of funds) could comply with US rules even when underlying funds are based offshore 3. Classifications of hedge funds Hedge funds use various trading strategies, each of them having specific risk and return characteristics, and exposures to traditional asset classes (equity for example) that vary strongly from negative to positive. A level of aggregation makes it easier to probe into hedge funds. Data-vendors, practitioners and academics develop and use different classifications. Hedge funds can be classified along several dimensions, such as investment style, asset class and geographical focus, leverage, and incentive structures. The most general style labels are relative value, directional, and event driven. Relative value encompasses many trading strategies in equities and capital structure arbitrage. Event driven strategies, are also often relative value strategies. Relatively new capital structure arbitrage strategies, such as equity debt arbitrage, are booming with the increase in instruments like equity debt swaps. Known relative value opportunities may erode as many managers apply the same trades. Market capacities of directional strategies driven by geo-political circumstances are not easily eroded. Governments and central banks manipulate interest and exchange rates. This causes short-run inefficiencies in these markets, that hedge funds exploit. Below we describe some common style classifications. Notice that some for some strategies, multiple style classifications apply, and some classifications include many different strategies. Managers choosing their own benchmark might be tempted to choose the most favorable benchmark. Relative value Relative Value styles try to eliminate market risk and make use of market inefficiencies to obtain performance. Managers who primarily exploit mispricings between related securities are also often labeled as arbitrageurs. Equity Most managers classify their fund as Long Short Equity. Long short equity strategies include stock selection, timing, sector rotation, and alternative equity risk premium strategies. Many investors for instance perceive value, small stocks to carry a specific risk premium, which could be exploited. Most long short strategies have an exposure to the equity market between zero and 100% of capital. Dedicated Short and Equity Market Neutral are other equity trading styles, which 19

13 major differences are the amount of equity market exposure. A dedicated short manager attempts to have a negative exposure, while an equity market neutral manager attempts to eliminate exposure to the equity market. Emerging market Investing in equity and fixed income securities in emerging markets could result in returns differing from investing in developed markets. Market inefficiencies are potentially larger due to less coverage by analysts, lower transparency, less developed investors, different market structures, and government influence. Emerging Market is the hedge fund style that applies to managers who attempt to exploit these opportunities. Geopolitical risk is the risk for which these hedge funds commonly seek rewards. Fixed income strategies Fixed income strategies include bond selection, yield curve timing, term structure arbitrage, and exploiting liquidity and default premiums. Especially carry trades, i.e. buy long-term bonds, and sell short-term bonds, are quite popular amongst many hedge funds. Most money invested in securities is invested in fixed income securities. These vast markets are influenced by government and central bank politics. The desire for status quo (e.g. Keiretsu system Japan), integration within a larger trading block (e.g. EU), or the financing of budget deficits (US) might influence monetary decisions, which could deliver opportunities. Event driven The style classification Event Driven is reserved for managers that attempt to benefit from events, such as mergers, and changes in capital structures. An example is Merger Arbitrage, which managers often sell the bidder and buy the takeover target. The bidder offers a price for the target above the market value. If the merger succeeds a premium is collected. This risk premium is insurance for deal failure. Another example of an event driven strategy is the Distressed/High yield style. A specific event is a firm becoming financially distressed. Financial distress causes institutions such as banks and regulators to impose restrictions. Banks have larger capital requirements for non-investment grade compared to investment grade loans. Basel II requirements are likely to induce even more limitations on banks to supply capital to distressed firms. The regulatory freedom of hedge funds, places managers in a superior position to benefit from investing in distressed firms. Capital structure arbitrage Capital structure arbitrage funds exploit arbitrage opportunities in securities of the same firm. Convertible Arbitrage strategies were popular during the 90 s. Convertible bonds can be decomposed in an equity option and a bond. Firms who issue convertibles are often perceived as being more risky than the average firm. Issuing straight bonds would be too expensive, and issuing equity could be unsuccessful for these firms. The convertible is a bond with a relatively low yield, and equity is only diluted if the firm is successful. Investors who demand a risk premium for these firms convertibles could make convertibles cheap relative to the two components. Hedge funds are in an excellent position to profit from these arbitrage opportunities, as they have the skills to hedge dynamically differences in volatilities of the bond and equity part. Hedge funds of this convertible arbitrage trading style make up 60-80% of the convertible markets nowadays. SEC Regulation D allows public firms to sell shares privately to a limited number of accredited investors without formal registration. These shares are usually sold at a discount. The intention of the legislator is to help distressed firms acquire capital and become healthy again. There is substantial freedom in structuring private equity investments in distressed firms, structures include floating rate convertible preferred stock, convertible resets, common stock resets, or structured equity lines. Another example of capital structure arbitrage is the Equity Debt Arbitrage style. Managers of this style attempt to exploit mispricings between the firms debt and equity. High yield and credit default swaps are fixed income investments with an equity risk part. This equity risk part can be hedged and if the fixed income market prices the risk different from the equity market a premium can be obtained. Directional Global Macro The macro economic status and politics of countries and regions can have substantial impact on fixed income, foreign exchange and commodity markets. Global Macro managers attempt to exploit macro economic mispricings. A famous example of a global macro trader is George Soros, who made a fortune attacking the British pound, forcing it to devaluate below the European Monetary System exchange rate bound. Global macro traders tend to take leveraged directional bets. This investment style includes the popular Asian and gold carry trades. Exposure to capital markets typically exceeds the capital base, which makes these funds quite volatile. Global macro traders often use forwards and futures. This style exploits geopolitical risks. Managed futures Some managers predominantly trade futures. Futures on major 20 FIDUCIEE DECEMBER 2004 NUMMER 2

14 market indices, interest rate products, and commodities are highly liquid and easy to trade. Next to fundamental (macro economic) indicators, many traders use indicators for market sentiment and attempt to exploit patterns in prices and volatilities, which is called technical analysis. A trader could further use a judgmental or a systematic approach. Fundamental traders often use judgment, while technical traders (also called Commodity Trading Advisors) use a more rigid trading model. Managers who apply mixtures of these trading styles and select which markets to trade on are labeled discretionary. Fund of funds and structured products Large institutional investors have the resources to obtain knowledge and operations necessary for direct hedge fund investing and are able to construct diversified portfolios of hedge funds. Fund of Funds are invented to deliver smaller investors exposure to diversified portfolios of hedge funds. For their expertise in selecting managers fund of funds charge fees in excess of the fees paid to underlying hedge funds, resulting in higher fees. Many investors are risk averse and seek principal protection, or their regulators demand them to have some sort of principal protection on their investments. Several hedge funds capitalized on this demand and offer structured guaranteed products. We observe this to be a trend in the retail sector as well. Note that the structured product adds another cost layer on top of the fund of funds fees. This is sometimes referred to as triple dipping. Whether the increasing costs are worth the risk reduction depends on the preferences and alternatives of the investor. We conclude that hedge fund strategies and their outlooks are diverse. Note that hedge funds can apply multiple styles or strategies simultaneously. Breuer (2000) gives an example of how a hedge fund manager could layer five common hedge fund strategies on top of each other and increase the leverage factor in the process. It is quite possible that the strategies and the pyramid of strategies are vulnerable to the same factor, which is a liquidity crisis in Breuer s example. Style diversity does not necessarily protect investors in market turmoil. Due to the new money floating into hedge funds and the limited capacity of the field, hedge fund managers seek new opportunities in the more esoteric corners of finance. New trends include energy and weather derivatives, catastrophe bonds, car loan financing, writtenoff credit card debt and movie production financing. Tremont TASS estimates the hedge fund industry s asset base at $870 billion in August Returns and risk Section 4.1 explains the notions of absolute returns, and asset based factors. In section 4.2 we review some of the risks in hedge fund investing. We focus on the qualitative side of risks. For a more extensive treatment of the risks in hedge funds investing we refer to our own study Posthuma and Van der Sluis (2005b) and the references therein. 4.1 Absolute return and asset based factors Some hedge fund returns have been quite high. Due to incentives to create high returns and the absence of traditional benchmarks, the notion of an absolute return strategy has been introduced. Absolute return is return not related to benchmarks, but return delivered by skill based investing. Several researchers have tried to measure `absolute return or excess return above certain benchmarks or benchmark strategies. Because Sharpe ratio s are easily gamed, Kat and Amin (2003) analyzed whether hedge funds returns have efficient risk return profiles. They found many individual funds to be inefficient, but that add value on a portfolio level. Researchers found exposures to (lagged) equity markets, volatility, credit spreads, the term spread, and option trading strategies. Agarwal and Naik (2003) for instance used so-called location factors, which are buy and hold investments in traditional instruments such as equity, and bonds to explain hedge fund returns. They added strategy factors, which are returns of dynamic trading strategies. It turns out that strategies such as writing monthly out of the money put options on the S&P 500 explain a large part of the variation in hedge fund returns. Fung and Hsieh (2001) explain returns of trend following hedge funds with lookback straddles The nonlinear relationship with underlying markets and the non-normality of returns has important implications for performance attribution and risk management, see Posthuma and Van der Sluis (2005b). Co-skewness, co-kurtosis with and between risk premium factors induces phase locking crash events such as the liquidity crisis in September 1998, see also Lo (2001). The underlying fundamental factor of many strategies is providing insurance and liquidity for risks that other investors fear. We believe that the excess return over investable asset based factors is a measure that gives better insight in the capabilities of hedge fund managers than absolute returns. Style drift and shift The eyes of a predator could be the eyes on the wings of a butterfly. What you see is not necessarily what you get. Managers could change investment style or misclassify themselves, which results in investors being unaware about the risks that are taken. Asset liability management and portfolio construction based on wrongly perceived risk-return patterns could lead to dangerous sub-optimal portfolios. Posthuma and Van der Sluis (2005a) show how style shifts can be detected by means of a Kalman filter and asset based factors. Risks Beside market and factor risks, there are several other risks that are more difficult to measure. Many specific risks arise from the typical business of a hedge fund. To give an overview we classify specific risks in four main types: systematic, structure, trading/investment and organizational risks. Some specific risks can be placed under more than one main type of risk, 21

15 Systematic related risk Systematic related risks are risks beared by every fund of a group and are not specific for one fund. The first systematic risk is naturally market risk. Common factor risk arises in taking large positions in certain types of securities, such as stocks in specific industries, low-grade debt instruments or `deal stocks`. An example of positions in `deal stocks are merger arbitrage positions, consisting of a short position in the acquiring firm and a long position in the firm the targeted firm. Even if hedge funds construct and apply a market neutral strategy by offsetting long and short positions, systematic risk like the risk subject to merger and acquisitions transactions as a group remains. The third systematic related risk arises from derivative investments. The use of derivatives by hedge funds causes exposure to, for example, interest rate and volatility changes. These risks are often referred to as `Greeks risk`, because the changes in the value of derivatives due to changes in e.g. interest rate and volatility are labeled with Greek letters. Trading and investment related risks The possibility to trade assets efficiently is often taken for granted in academic literature. However, in the case of hedge funds trading and investment related risks could be substantial. An investment related risk is specific security risk, the risk remaining after effects of common risk factors have been removed. Even portfolios with closely matched long and short positions experience risk. Normally this risk is small, but the use of leverage can enhance the specific security risk substantially. Short positions lead to borrow risk, the risk that the borrowed security is called in by the lender. If replacement borrow cannot be found, the short position has to be closed out. And consequently the offsetting hedge position has to be unwound. Counterparty credit risk is also a risk that is gained by making deals with other parties. If a counterparty fails to close for instance an over the counter option, the loss can be substantial. Specific market opportunities are limited, which leads to capacity risk. Greater capital inflows will diminish excess return possibilities, and can in extreme circumstances disrupt markets, which increase the risk of having to sell illiquid assets below fair value (liquidity risk) to settle margin calls. Related with the liquidity risk is the stale pricing risk. Stale pricing is valuation of positions without recent market trades, which can lead to the use of accounting prices and a misspecification of the volatility and correlation characteristics of the investment. When the same opportunities are exploited by multiple managers at the same time, the resulting risk is called herding risk, see Eichengreen and Mathieson (2000). Brealey and Kaplanis (2001) studied herding by examining correlations in changes of fund exposures for individual funds. They found evidence of correlated changes in fund exposures, but this result can also be explained by a large shift in the independent variable. Another risk arising from big capital inflows is the risk that other market participants find out vulnerable positions of a manager and take advantage of this knowledge by revisiting their trading strategy (position risk). When the large positions of hedge fund Long Term Capital Management (LTCM) became known, investment-banking firms began trading against it, see Lowenstein (2000). One suddenly worsening position can surprise a manager and force him or her to close down other positions in a sub optimal way. A short squeeze can be especially painful since the theoretical loss is now unlimited. Structure related risk The structure of hedge funds gives rise to several risks. One risk stems from the freedom to leverage, leading to credit crunch risk. A tightening of credit facilities might force aggressively leveraged funds to liquidate positions at unfavorable times. The incentive structure and the lockup period give rise to the two other risks. The asymmetric feature of the performance fees rewards managers for taking risks, no cost for losses, higher fees of profits. A high watermark has been invented to minimize potential misuse of this fee structure. It states that managers have to recoup losses before they are entitled to performance fees. High watermarks may result in increased risk-taking, due to managers wanting to recoup losses fast. A personal investment of the manager in his own fund decreases this risk substantially. Liang (1999) discovers a positive relation between fund performance and the length of the lockup period. A short lockup period and redrawings can increase the risk of forced unwinding of a profitable long run trading strategy. Organizational risk A study by Capco (2003) on 100 hedge fund failures showed that the most common reasons for failure stem from misrepresentation of fund investments, misappropriation of funds and unauthorized trading. Only 38% of hedge fund failures were due to investment risk alone. Organizational risks including errors in analyzing, trading, or recording positions can be very damaging. If for instance the 22 FIDUCIEE DECEMBER 2004 NUMMER 2

16 portfolio rebalancing of a market neutral fund is incorrectly executed, market exposure results, which could be exacerbated by higher degrees of leverage. Most hedge fund managers have specific knowledge about a few or only one expertise area. This fact should lead them to focus on their area of expertise, and limit risks that are not in their field of knowledge. Due to diminishing specific opportunities for excess return in his field of expertise, a hedge fund manager can decide to shift style. This is potentially catastrophic; because it can cause the manager to take leveraged bets in a game he or she does not understand. Manager manipulation of the voluntarily reported figures to appear favorably to stakeholders and potential clients is called managed prices. Fee structures and greed increase incentives for fraud and front running. Fraud is a risk that has occurred in new small funds as well as in large established funds. Prices of small illiquid assets can be moved by a relatively small fund. Greedy managers might also be tempted to front run their own fund. To minimize the impact of catastrophe risk, such as a fire that destroys the office or a virus that ruins the IT system, managers should have proper backup systems. People risk is the risk of losing key people with essential knowledge and not being able to replace them in time. 4.2 Caveats in historical hedge fund data To explain hedge fund returns, it is necessary to have reliable data. Knowledge about the way the data is gathered gives insight in the potential biases in the data and the limitations of usage of the data. Voluntarily reporting and data collection by data-vendors give rise to the variety of biases that are potentially present in hedge fund data. Fung and Hsieh (2000b) distinguish between natural and spurious biases. Natural biases arise from the birth, growth and death processes of hedge funds, while spurious biases arise from sampling from an unobservable universe of hedge funds and the way data vendors collect hedge fund information. Natural biases are for example self-selection and survivorship biases. Other biases originate from the drive of hedge fund managers to present good performance combined with the opportunity to influence the return figures. The way research is carried out can also cause biases. One can think, for example, of regression analysis, which need funds with a certain number of periods to analyze, which will result in neglect of funds with small return histories. Survivorship bias Survivorship bias occurs if only funds existing at the end of the sample period are considered. Non-surviving funds drop from the database. Other reasons to stop reporting are for instance closure for new investors, mergers, bankruptcies, liquidations, and reporting policy changes. The survivorship bias is usually calculated by taking the performance difference between two portfolios: the surviving and the observable portfolio. Liang (2000) shows that poor performance is the main reason for a fund s disappearance. The last returns of liquidating funds are not always reported to database providers, as a consequence additional return activity can lead to a liquidation bias. Incentives to report negative performance to database providers are intuitively low or not present. The amount of money returned to investors can be monitored through the redemptions. Ackermann, McEnally, and Ravenscraft (1999) use information from the HFR database providers. They find that terminating funds are returning the money to their investors (redemptions), but can have additional return histories. The redemption of the Net Asset Value (NAV), i.e. the value that should be returned, does not necessarily occur at the end of the month. They find that post-reporting returns have a negligible impact on their results, and the overall average loss in fund value beyond the information contained in the database is 0.7%. Backfill and self-selection bias Due to voluntary reporting, funds may decide not to report or to stop reporting to databases. This is called the self-selection bias. The backfill or instant history bias appears when hedge funds with (good) track records decide to report and data providers backfill their files to show this track record. Park (1995) calls these records, instant histories. Good track records in comparison to the hedge fund universe lead to overestimating hedge fund performance, while bad track records are not backfilled or the funds with bad track records terminate and never report. Fung and Hsieh (2000b) calculated the backfill bias for the TASS database. They eliminated the first 12 months of returns, because the hedge funds existed on average 343 days before they reported to the database. This is called the incubation period, i.e. the period from inception till the first reporting date. The lasting mean performance was 1.4% lower over the period Posthuma and Van der Sluis (2003) eliminated the backfill periods per individual fund in the TASS database and found the backfill bias amount to 4% per annum over the period Limited history of hedge fund databases Many hedge fund styles are exposed to tail risks such as a market crash, a liquidity crisis, credit crunch, and political crisis. By definition these unpredictable events are rare, often a oncein-a-generation event. Hedge funds databases have reliable data as of the early 1990s. This means that risk measures solely based on this history will likely underestimate the risk. For example, during the 1974 international banking crisis, default spreads in the banking sector surged dramatically. This event falls outside the time span of the typical hedge fund database. One way to gain some insight in these risks is to use exposures of hedge funds to location and trading strategy factors that have longer histories. Scenario simulation and analysis is key to get a grasp of what could happen. The eyes of a predator could be the eyes on the wings of a butterfly. What you see is not necessarily what you get. 4.3 Managing Risk Measuring risk is one thing, managing risk is another and of crucial importance. Large sophisticated institutional investors are in the position to enforce transparency, to do extensive due diligence and manager searches. They have best practice risk systems and have the scale to daily monitor and audit their hedge fund investments. Prudent institutional investors are very keen on enforcing an alignment of interest between the manager and the investor. Furthermore, large institutional investors have torn apart the major hedge fund databases. They are fully aware of the potential 23

17 biases that may result from using them. They also know that an investment database is a research tool, not a compendium of investment opportunities. No investment should be taken principally on the basis of information provided by the database. 5. Conclusion The growth in hedge fund assets, number of funds, and investment styles has been enormous. Fee hungry fund managers exploit every alternative risk premium, besides the ones on traditional bonds and stocks. Several strategy fields have already been exhaustively grazed by herds of managers. Capacity limits have been met and new pastures are sought after. Hedge fund managers continue to discover and develop new alternative fields, pushing the financial frontier forwards. Even if returns are not high, most investors will benefit from the diversification benefits of hedge funds on traditional portfolios. The free and flexible nature of the hedge fund industry together with its lockup periods is its key asset, and a challenge for traditional institutional investors. Lack of transparency, and freedom to apply virtually every imaginable trading style, combined with organizational risks, result in an overall risk-return profile that is difficult to assess. Asset liability management and portfolio construction becomes harder if managers are able to switch style. Despite these difficulties, institutional investors commit vast amounts of money to hedge fund managers. We argue that worthwhile alternative risk premiums next to equities and bonds exist, and that regulatory freedom of hedge funds places them in a unique position to obtain these premiums. However, expectations of hedge fund return-to-risk ratios should be managed. Recent research taking into account biases has shown that in the past returns are overestimated and volatility is underestimated. Not all hedge funds will be able to make up for the hefty fees and the risks inherent in their organizations. Therefore manager selection and due diligence are key in the hedge fund business. Footnotes 1 The views expressed in this paper are those of the authors and do not necessarily reflect those of our employer and colleagues 2 Drs. N. Posthuma, Researcher ABP Investments 3 Corresponding author: Dr. P.J. van der Sluis, Project Coordinator Research, ABP Investments and Assistant Professor, Vrije Universiteit Amsterdam, affiliated to Post-graduate Program for Financial and Investment Analysts (VBA). 4 source: flows_8_16_04.htm References Ackermann, C., McEnally, R., and Ravenscraft D., The Performance of Hedge Funds: Risk, Return and Incentive, Journal of Finance, 54, Agarwal, V. and Naik, N.Y., 2003, Risks and Portfolio Decisions involving Hedge Funds, Review of Financial Studies. Brealey, R.A. and Kaplanis E., 2001, Hedge Funds and Financial Stability: An Analysis of their Factor Exposures, Journal of International Finance, Volume 4, Number 1, pp Breuer, P. 2000, Measuring Off-Balance-Sheet Leverage, IMF Working Paper No. 00/202. Capco, 2003, Understanding and Mitigating Operational Risk in Hedge Fund Investments, by Kundro, C. and Feffer, S. Eichengreen, B., and Mathieson D., 1999, Hedge Funds: What Do We Really Know?, Economic Issues No. 19, IMF, September, issues19/#1 Fung, W., and D.A. Hsieh. 2000, Performance Characteristics of Hedge Funds and CTA Funds: Natural Versus Spurious Biases, Journal of Quantitative and Financial Analysis 35 (2000), Fung, W., and D.A. Hsieh. 2001, The Risk in Hedge Fund Strategies: Theory and Evidence from Trend Followers, Review of Financial Studies, Volume 14, pp Kat, H. and Amin, G.S., 2003, Hedge fund performance : Do the money machines really add value?, Journal of Financial and Quantitative Analysis, Volume 38, Number 2, pp. 251 Liang, B., 1999, On the Performance of Hedge Funds, Financial Analysts Journal, Volume 55, no. 4 July/August, pp Lo, A.W., 2001, Risk Management for Hedge Funds: Introduction and Overview, Financial Analysts Journal, Volume 57, No. 6. Lowenstein, R., 2000, When genius failed, New York: Random House Posthuma, N. and Van der Sluis, P. J., 2003, A reality check on hedge fund returns, VU Research Memorandum Posthuma, N. and Van der Sluis, P.J. 2004, A critical examination of historical hedge fund returns. Chapter 13 in Intelligent Hedge Fund Investing: Successfully Avoiding Pitfalls through Better Risk Evaluation. Edited by Barry Schachter. Risk Books. Posthuma, N. and Van der Sluis, P. J., 2005a, Analyzing style drift in hedge funds. Forthcoming. Posthuma, N. and Van der Sluis, P. J., 2005b, The hedge fund paradigm. Forthcoming. 24 FIDUCIEE DECEMBER 2004 NUMMER 2

18 FRANK VAN DEN BERG 1) LONG-TERM CAPITAL MANAGEMENT: COLLAPSE OF A HEDGE FUND Like the Titanic, the mighty LTCM was supposed to be unsinkable. Like the Titanic, hedge fund Long-Term Capital Management (LTCM) was not supposed to ever sink. Yet, in the late summer of 1998, the Federal Reserve Chairman Alan Greenspan summoned the chief executives of all the major New York money center banks to his office. In this emergency meeting he strongly encouraged the persons present to pull their wallets and fork out several billions of dollars to save LTCM. They were kept in a room until 3.00 am the following morning, until they had hammered out an injection of $3.65 billion to keep LTCM alive. This event amounts to one of the biggest financial emergency packages to keep a private financial institution afloat, at least for a while. Later on, it appeared that the rescue mission had been successful, LTCM could unwind its financial positions and the banks recovered their money. More importantly, the feared implosion of the financial markets had not incurred. 27

19 Of course, the world has also seen the tens of billions injected by the French government in the 1990 s to save Crédit Lyonnais and even a larger sum to keep the Savings and Loans Banks in the 1980 s in the USA afloat. Nowadays we witness the special tax and interest treatment in China and Japan to keep their banks from toppling over. All these situations can be classified as measures by governments to prevent their financial systems from collapsing. These banks are too large to fail. Economists call this situation moral hazard. In a market economy these bail-outs are not supposed to happen. For political reasons that may be understandable, but there certainly are negative side effects. One can think for instance about a lack of countervailing power for top managers to keep their business under control, to manage their businesses prudently. With higher profits their status and incomes rise, and they don t have to be concerned that the entrepreneurial risks are irresponsible: Après nous le déluge. The issue is whether LTCM fell in this category as well. In the case of LTCM, it was only a very young private institution, where at its peak hardly 200 people worked, albeit very bright, experienced and exceedingly well paid, including even two Nobel Price winners, Robert Merton and Myron Scholes. They had received the Economics Nobel Price in 1997 for their development of the Option Pricing Model, the so-called Black 2 - Scholes formula. The office of LTCM was located in a small but opulent building in the posh suburb of Greenwich, Connecticut, some 40 miles North of Wall Street. The fund was run by John Meriwether, formerly a well-known trader of bonds and shares at Salomon Brothers. He had assembled a group of high-powered traders and arbitrageurs, including some 25 with an PhD. Several had been professors. Also a highly respected, former vice-chairman of the Federal Reserve System was on board. Banks appeared to have been willing to lend at an incredibly generous debtequity ratio of 50:1 LTCM has now ceased to exist. The 14 financial institutions 3 which bailed it out in 1998, recovered all their money in the end. The rescue plan of these institutions required them to supply an additional $ 3.65 billion of funds to LTCM in exchange for a tight management control of funds and a 90% reduction in the managers equity stake. By 2000, the fund had been wound down. The financial crisis Greenspan was concerned about, and rightly so, never occurred. The original investors in LTCM, of course, lost their money, insofar they had not taken out their money before. By late 1997 the net shareholders equity of the fund stood at some $ 4.3 billion, at least on paper. The amazing thing of LTCM was that it was only founded four years earlier in 1994 by a handful of professional financial traders, with an original capital of $ 1.3 billion 4, the largest start-up ever. LTCM required a minimum investment of $ 10 million. Several participants forked out $ 100 million a piece. The fund raising was coordinated at the time by Merrill Lynch, which lined up a long line of interested financial parties, including the firm itself and some of its top managers. The track record and prestige of the founders attracted such a large flow of funds. The founding partners themselves invested in total $ 146 million. Some of them even borrowed additional sums to increase their investment. This, by itself, created a lot of confidence with the co-investing institutions. The founding partners certainly put their money, where their mouth was Right from the start, LTCM leveraged its holdings up to several billions of dollars, by borrowing from the very same banks, which rescued it later on. At its height, in the latter half of 1997, equity went up to close to $ 7 billion, at least on paper. It is estimated that from time to time LTCM had total net positions of up to $ 200 billion. Banks appeared to have been willing to lend at an incredibly generous debt-equity ratio of 50:1. Some $ 3 billion of its equity was paid back late 1997 to several of its investors. Those who decided not to participate in this equity pay-back were to regret that later on. By the middle of 1998 equity stood again at close to $ 5 billion with a total portfolio of some $ 100 billion in securities and more than $ 1 trillion of notional value in derivatives (options, futures, forwards, swaps). An original investment of $ 1,000 in 1994 was worth more than $ 4,000 four years later in early summer 1998; within four months in the fall of 1998 that wealth had evaporated. Hedge funds in general claim to be investment funds with an above-market performance. Certainly, LTCM had that ambition and realized it indeed for a while. The literal meaning of the word hedge fund says in fact nothing else than that it hedges itself against risk. It builds a hedge or a fence around itself as protection. It differs from common investment funds or mutual funds that it does more than just stock picking, whether or not in conjunction with bonds and/or real estate. Index funds also fall in the category of mutual funds, in that its share composition mirrors a stock index like the S&P 500 or AEX. On average all mutual funds underperform vis-à-vis the average market return, if only for the fact that managers charge management fees of an average of 1.5 %, sometimes even higher. In an efficient financial market it is impossible to consistently outperform the average market return, any way. That has been demonstrated continuously, also in the case of hedge funds, although these may show temporarily abovemarket returns. The perception is that hedge funds are risk-free, that the risks are hedged. That, of course, is a misnomer. It is good for marketing these funds to the public though. Also, managers of hedge funds usually claim for themselves a much higher compensation for running the fund, in the form of a 1-2% management fee plus a performance fee, up to some 20-25% of the profits (in the case of LTCM: a 2% management fee plus a 25% profit fee). Not that all hedge funds have let their investors down, of course. Indeed, successful and wellmanaged hedge funds do certainly exist. However, as we know, historic performance is no guarantee for future success. Hedge funds work for instance with options (writing calls, buying puts), or make use through arbitrage of price differentials at different markets, or make a play on perceived abnormal exchange rate movements, or -even bolder- speculate on the commodities market, like oil or gold. In the latter case one can not really speak of hedging. LTCM claimed to use market-neutral strategies. It was aware that e.g. the price of Royal Dutch Petroleum shares, traded at the time- in guilders in Amsterdam, 28 FIDUCIEE DECEMBER 2004 NUMMER 2

20 was not in line with Shell Transport and Trading shares, traded in pounds in London. The Dutch company should represent 60% of the total value of the company and the English company 40%. The English firm had historically traded at an 8 percent or so discount to its Dutch cousin. There was no good reason for such a large price differential, other than that the Dutch stock was more liquid and more widely and internationally traded, also in New York. LTCM bet some $ 2.3 billion -half of it long on Shell, the other half short on Royal Dutch- that the spread would contract. Indeed, this happened and LTCM made money on this enormous position. LTCM also noted a high interest rate on Italian government bonds compared to German, French or Dutch bonds. With the upcoming Euro introduction, the perception was that this interest yield differential in 1997 and 1998 would decline. The common Euro in 1999 should lead to European interest rates on government bonds, which should fall more or less in line with a common monetary policy. Pricing differentials should only be the result of the credit risk differences between the governments and the liquidity in these markets. Some higher Italian rate was to be expected, not the substantial difference as observed in the mid nineties. LTCM also here went long on Italian bonds and short on other main stream European bonds and indeed guessed correctly. Similar positions were taken by LTCM in emerging markets. Their models had indicated that the spread on interests yields between US Treasuries and Brazilian and Argentinean dollar denominated bonds were too high by historical standards. They went short on Treasuries and long on South American dollar bonds, and indeed made money. LTCM got also involved in risk arbitrage, a bet that announced acquisitions would actually close. Until the deal legally closed, the stock often trades at a discount. That creates a profit opportunity, which LTCM took. Many mergers fall through, though. Another ploy was to borrow in yens at low interest rate and to invest in dollars at higher rates. If the yen does not or only a little appreciate vis-à-vis the yen, this strategy pays off. In a risk-neutral strategy one can buy yens in the forward market or buy yen-futures to pay back the loan. However, in a perfectly efficient market the forward rate will exactly reflect the interest differential, according to the interest rate parity theory. So one can only benefit through arbitrage trading, if there are small pricing differentials. With its research team LTCM was after those perceived temporary anomalies and tried to make use of them. The fund also invested in high-yield bonds (junk bonds), as such not a hedging strategy, but a bet that a well diversified portfolio generates an above market return, even though some junk bond issuing corporations default. LTCM was active in so-called paired shares. BMW and Volkswagen, for instance, list an ordinary share and a preference share, the latter with superior voting rights. However, their economic claim on the share of profits is identical. Telecom Italia, Louis Vuitton and Dior have similar arrangements. The price differentials of these different classes of shares are too big to be explained by the differences in legal entitlements. LTCM made a bet by going long and short at the same time that the price differences would narrow. Shares traded in fragmented markets also show price differences; arbitrage should narrow these. Examples are shares of European companies also traded in New York as depository shares, e.g. Philips, Unilever, Royal Dutch. At the Chinese stock market in ShenZhen A and B shares of the same companies are listed, for domestic and foreign investors. All these financial instruments should have similar prices, but sometimes don t. Arbitrage opportunities exist here, although it is not known whether LTCM benefited here as well. In the end LTCM got in trouble when it thought that the spread between prices on long-term Treasury bonds and long-term corporate bonds was too high, at least in light of historic trends. It bet that this anomaly would disappear and that the spread would narrow. So, also here LTCM went short on Treasuries and long on corporate bonds. It so happened that the collapse of the Russian financial system in the summer of 1998 caused investors the increase their assessment of the riskiness of corporate securities. The ruble declined some 75% in value. The IMF had to put together a rescue package of $ 23 billion. The financial markets were already jittery in the aftermath of the Asian currency crisis in In those circumstances the market flees in quality, away from corporate bonds and certainly from less creditworthy bonds into high quality Treasury bonds. The spread between corporate bonds and Treasuries rose therefore in 1998 rather than narrowed as LTCM had predicted. The result was that LTCM occurred huge losses on its positions, eating up its equity position. The paper losses on its bonds play were some $ 14 billion in September If LTCM had been forced to unwind its positions at that time, there probably would not even have been a market. At the very least, it would have driven down considerably the prices on corporate bonds. With the benefit of hindsight, it can be said that the demise of LTCM was caused by market risk in the short term and liquidity risk in the long term. The fund had a temporary liquidity problem; if it had not leveraged the company up to the hilt it could have ridden out the storm. In the end its positions on the yield difference between corporates and Treasuries worked out all right. LTCM s bet on that was as such correct, but it should not have taken such large positions on this play. In the short term LTCM suffered from market risk, because prices moved away from what it expected. This may have been a temporary movement, but an investor should take those adverse fluctuations into account. The founding partners lost all the potential value of their equity stake in the company. However, they had been rewarded handsomely in the good years before 1998, they had withdrawn some portion of their equity earlier on and most of them had bought or built some lavish estates. No legal steps were undertaken against them; some Swiss, German, Japanese and Italian banks would have reason to pursue that path. Apparently they decided that a legal battle would reflect badly on themselves as well. The two Nobel Price professors lost some face, but did certainly financially a lot better than when they would have continued their positions full time at their universities. And nobody disputes the brilliance of their Black- Scholes option pricing formula. The founding partner John Meriwether happily started again in the same hedge fund business with some of 29

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