Tag Archives: Joseph Healy Healthcor

Problems with Collateral Fund Obligations

16 May

Although the hedge fund industry growth has been predominantly driven by high net worth individuals, private foundations and endowments, more institutional investors are finding this asset class attractive and portfolio enhancing. The future driver of hedge fund growth will be other institutional investors such as insurance companies, various pension funds, and banking institutions. Many institutional investors lack the investment mandate to gain exposure in alternative assets and below investment grade fixed income securities. Beyond legal restrictions (i.e. ERISA), institutional investors demand liquidity and transparency in their investments based on their fiduciary duty to act in accordance with the prudent investor rule that most institutional managers are governed by.

Concurrently, institutional investors seek capital preservation, enhanced risk-return opportunities and diversification benefits (i.e. low correlations). For a sophisticated investor, generating high absolute returns provides zero value if risk is increased commensurately. Any investor can achieve high returns by picking risky securities, but to generate more alpha (risk-adjusted returns) is extremely valuable for institutional investors. Therein lies the rift between hedge funds and traditional institutional investors.

Hedge funds customarily lack both transparency, based on their proprietary investment strategies, and liquidity, based on their lock-in periods; however, hedge funds provide precisely what institutional investment mangers’ portfolio objectives demand, capital preservation, higher alphas, and lower correlations. Furthermore, with the current financial markets in turmoil, all the value enhancing synergies that hedge funds provide to a diversified portfolio become increasingly important.

As unregulated investment partnerships, hedge funds have the financial flexibility and economic incentives to create innovative investment strategies which maximize risk-return tradeoffs. Additionally, hedge funds are able to furnish diversification benefits not based on the specific assets invested in but rather how the assets are invested in. The ability to short securities (idiosyncratic risk) and the market (systematic risk) and use derivatives to hedge away undesired risk is extremely value enhancing, especially in a market decline when other asset classes are falling. By mitigating liquidity and transparency issues between hedge funds and investors, capital flows will improve; however, understanding how the needs differ between both parties will create a more complementary solution.

Liquidity is a problem for investors due in part to the investment styles of hedge funds. For instance, a spread arbitrage would fail, if investors withdrew funds prior to the contraction and during a margin call. Likewise, distressed debt investments require substantial time for returns to materialize given the slow nature of the bankruptcy process. Conversely, the same bankruptcy process also creates inefficiencies in the market and the subsequent premiums for investors. Liquidity could easily be resolved by creating a secondary OTC market for tradable hedge fund securities.

Transparency is another issue hindering institutional investors from allocating more capital to alternative investments. However, it is very important to understand what investors need in terms of transparency. Although hedge funds may not want to divulge their positions and trading strategies, investors are only concerned with having access to information to understand, evaluate and verify the risk-adjusted performance of their investments. This is essential and an underlying principle of the prudent investor rule.

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Brief history of hedge funds

5 Feb

Putting it in a nutshell, hedge funds are designed to handle a wide range of trading and investing activities. It must be mentioned, though, that hedge funds are open solely for certain types of investors. Generally speaking, investors can deposit and withdraw funds regularly, and this is only one of the advantages of these investment funds. In this article I will present you a short history of hedge funds, from the beginning until now.

The first hedge fund was founded back in 1949 by Mr. Alfred Jones. Jones had the idea of creating investment funds in 1948, when he was working as a journalist and he was writing an article about the main trends in investment forecasting. It was then when Alfred Jones reached the conclusion that he could develop a more efficient system for managing money. The term “hedged fund” refers to a specific investment strategy that involved purchasing assets whose price was believed to increase and afterwards selling the assets whose price was about to decrease. By doing so, Jones wanted to minimize the risks associated with the trading industry.

Despite the fact that hedge funds were blossoming, the unique strategy developed by Jones was brought to the public eye in 1966, in an article about the success of Alfred Jones and provided statistics regarding the benefits of hedge funds. After the article was published, more and more investors became interested in hedge funds. Nonetheless, it turned out that this strategy was not suitable for just any investor, and most of them simply stopped doing it. As expected, the number of hedge funds dropped significantly.

Hedge funds started to gain popularity again around the 1990s. Even though the strategy is basically the same, new hedging tools have emerged and made hedging safer. In addition, the concept of hedging has remained the same as well: hedge funds are still very exclusive clubs and, as stated above, they are designed only for certain types of investors that are specified by regulators.