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There are many reasons to categorize hedge funds and group them into subsets

Types of Hedge Funds

CLASSIFYING HEDGE FUNDS

With thousands of hedge funds in existence, classifying individual funds into 10 or 20 groups in a challenge. Some funds might fit in more than one category or none of the categories used to classify hedge funds. Nevertheless, fund managers and investors rely on hedge fund classifications.

Importance of Classifications

There are many reasons to categorize hedge funds and group them into subsets. Investors often study a hedge fund style by reviewing aggregate performance data, selecting a sector, then reviewing funds within the sector. The classification makes the average return a meaningful benchmark and permits the investor to match up with the right fund manager.

To make the classifications meaningful, many investors prefer hedge funds that fit neatly into a single strategy. Style purity measures how much a hedge fund keeps to a single, identifiable strategy. The investor preference for style purity is easy to understand. Suppose an investor researches several hedge fund styles and decides that a particular style would be an attractive addition to the investors existing portfolio of assets. That investor would be sorely disappointed if the individual fund selected failed to track the composite.

For a variety of reasons, funds may choose to pursue multiple strategies in a single hedge fund. In some ways, the aggregate performance resembles a fund of funds that gains some benefits from diversification. Academic writers are often quick to point out that well-healed investors can accomplish the same diversification (perhaps more efficiently). However, some investors nevertheless prefer the multistrategy funds, either because they lack the financial resources to get the maximum benefit from diversification or because the multistrategy fund avoids a layer of fees present in the fund of funds.

Who Categorizes Hedge Funds ?

Many types of organizations label hedge funds according to the style or investment philosophy they follow. Hedge funds frequently categorize themselves in their disclosure documents and marketing literature. Hedge fund data providers such as Evaluation Associates Capital Markets (EACM), CSFB Tremont, Hennessee, Hedge Fund Research (HFR), and the Center for International Securities and Derivatives Markets (CISDM) track thousands of hedge funds and assign most of them to 10 or 15 styles. (Data from these providers can be used to study the characteristics of the types of hedge funds discussed here.) A growing industry of hedge fund indexers begins by creating a benchmark that can be replicated; then the indexers invest in individual funds to create a portfolio that tracks their benchmarks. The media often classifies hedge funds, sometimes without regard to the facts. Finally, analysts and academic researchers may categorize hedge funds based on their actual performance, explaining returns based on broad economic factors like interest rates, stock returns, default risk, volatility, and other factors.

Inconsistency of Hedge Fund Categorizations

Regardless of how and why hedge funds are classified, the results are occasionally inconsistent. Sometimes categories overlap, so the choice of strategy is a bit arbitrary. Sometimes a fund will shift strategies gradually (called style drift); one data provider might classify the fund by the current strategy and another might include it in the style previously followed. Some funds may be tough to categorize because the manager deviates from the announced strategy. Other funds may follow multiple strategies so cant fit into a single category. Finally, some funds may be erroneously classified either because of human error or because there arent enough categories to match all hedge funds.

SHARE OF THE MARKET BY STRATEGIES

The changing popularity of individual hedge fund strategies has led to changes in the composition of the hedge fund universe. Popular strategies become a large part of the mix of hedge fund assets. Out-of-favor strategies may shrink in size.

Size Shifts

The largest category of hedge funds contains mostly common stocks, although they may pursue several different strategies. Although the first hedge funds were also predominately equity funds, different styles have come in and out of favor over the years.

For example, global macro hedge funds (see descriptions of this and other styles later in this chapter) were very popular in the early 1990s, offering high returns and high risk. Later in the same decade, various fixed income arbitrage funds provided low risk and low returns; however, this latter style went out of favor after several high-profile fixed income funds suffered large losses. Investors are returning to equity strategies seeking an attractive combination of moderately high returns and moderately low risk.

Prevailing Trends

By 1990, the public had become aware of hedge funds, primarily because of the trading activity of the global macro hedge funds. These funds were large, traded large positions, and frequently influenced market prices. Figure 2.1 suggests part of the reason for this notoriety: This group controlled 43.99 percent of all hedge fund assets. Other sources put the global macro portion as high as 70 percent of all hedge fund assets in 1990.1

Figure 2.2 shows the same hedge fund groups in 2003. Global macro hedge funds constitute the sixth largest group, comprising only 5.57 percent of the total. Most other groups have grown at the expense of global macro hedge funds.

The same styles are listed in Figure 2.1 and Figure 2.2, both ranked in order of assets in 1990. Long/short equity hedge funds have risen from 20.99 percent of the total in 1990 to 45.19 percent in 2003.

HEDGE FUND CATEGORIES

Although individual funds vary within the following categories, a description of a strategy typical for the group provides a definition for each category. Note that his list includes subcategories not broken out

Equity Hedge Funds

Equity hedge funds include those categories that invest primarily in common stocks.

Equity Long Biased This group of hedge funds is the most familiar style to many people. The group may carry short positions, but the size of the long positions is usually larger than the size of the short positions. This group is one of several styles that are included in the broader category in Figure 2.2 and 2.2. The managers usually seek to generate returns by selecting a narrow portfolio of common stocks. Individual managers may seek to supplement the returns from stock selection by overlying a market-timing strategy. The stock selection may be based on fundamental analysis or, less commonly, on technical analysis. Often, hedge funds employ proprietary strategies to construct the portfolio. The portfolios in this group generally have low leverage (2 to 1 or less).

The equity long biased hedge funds have produced returns somewhat higher than broad equity returns, with risk (volatility of returns) about equal to index returns. Not surprisingly, the performance of long biased hedge funds correlates highly with stock returns (70 percent) but not particularly with interest rates. The VIX index measures implied volatility on equity options. Correlation between the long biased funds and this measure is high but somewhat less than stock index returns.

Equity Market Neutral Equity market neutral hedge funds may use a variety of strategies. Arbitrage trading includes trading between futures and underlying common stocks (basis or basket trading), buying and selling related classes of common stock (pairs trading) or certain options strategies. The category also includes hedge funds that balance long and short positions (matched issue by issue or as a portfolio) to hedge market impact.

Equity market neutral hedge funds have provided returns about equal to those of broad indexes while assuming much less risk than a portfolio of common stocks (perhaps half the volatility of returns of the S&P 500 index). Despite the name given to this category, the group remains somewhat linked to market stock returns (30 to 40 percent). The equity market neutral hedge funds are much less linked to uncertainty in the financial markets than a traditional pool of common stocks. The correlation of the S&P 500 index to the VIX index of volatility is above 65 percent versus the equity hedge funds, which have a correlation about 20 percent to the VIX index.

Equity Arbitrage This strategy is sometimes incorporated in the equity market neutral category. While the equity market neutral group is broad and a bit too inclusive, the equity arbitrage group includes funds that trade definable, tradable relationships between securities.

When data vendors provide a separate breakdown of equity arbitrage from other equity market neutral strategies, the arbitrage group provides higher returns and somewhat higher risk (as measured by the standard deviation of returns). The high risk and return is probably attributable to the higher leverage in the arbitrage funds compared to other equity market neutral strategies. As a portfolio investment, this higher risk may be forgivable because the volatility remains well below traditional stock returns. In addition, the performance of the equity arbitrage funds is less correlated to stock returns (about 25 percent) than any other equity hedge fund strategy.

Long /Short Equity Generally, this category includes hedge funds that may be either long or short.2 In particular, the funds can be levered long (probably no more than 2 to 1), market neutral, or modestly short. Performance depends both on stock selection and market timing.

The performance of this group depends on the data source. The group of long/short hedge funds tracked by both CSFB Tremont and CISDM between January 1, 1990, and December 31, 2003, had higher returns than the S&P 500 index while the data from EACM reported returns only half the level of the S&P 500 return. Although differences are common between data providers, this discrepancy is untypically large. The hedge fund group was a bit more consistent over time than the S&P (as might be expected from a group of nondirectional investors) so the differences depend more on the return of the index than the returns in the group. The returns for long/short hedge funds can be rather volatile, although usually less than an investment in a market portfolio of common stocks such as the S&P 500 index. The correlation of the long/short group to stock returns ranges from very high to very low across different data vendors, although the correlation has been low recently.

Event Driven The event driven category includes several strategies often tracked separately. This group includes hedge funds involved with risk arbitrage (also called merger arbitrage), bankruptcy and reorganization (and other high-yield variations), spin-offs, and Regulation D funds. The category includes funds that invest purely in one of these strategies and multistrategy funds that may pursue several of the strategies.

The individual event driven strategies (risk arbitrage and Regulation D funds) are described separately. As a group, the strategies provide returns and risk typical of hedge funds. That is, they provide returns about equal to stock returns (more or less depending on the particular strategy) and substantially less risk than stock returns (about median among hedge fund returns). The performance is fairly correlated to stock returns (50 percent) and has a fairly high correlation to market uncertainty (correlation to VIX around 40 percent).

Risk Arbitrage Risk or merger arbitrage generally involves buying the target company of a takeover after an attempt is announced and selling short the acquiring company. Although complicated terms may require more complicated positions, the typical position includes a long position that can be delivered to close out the short position if the deal is completed.3

Risk arbitrage provides relatively low returns (somewhat less than stock returns), compared to other hedge fund strategies but involves rather low risk. Early returns were higher than recent and a wave of deals may raise the return in the future. Returns remain highly correlated to stock returns (45 to 50 percent) and are sensitive to market uncertainty (correlation to VIX around 50 percent).

Regulation D This group of hedge funds buys private equity positions in young, often very small companies. Frequently, these investments may be structured as convertible bonds with features designed to provide downside protection.

Performance on this section ranks among the highest of hedge fund strategies, up to twice the return on the S&P 500 index. Return volatility is very low when based on monthly net asset value (NAV) data, but the NAV is probably not as stable as the data suggest. The returns on private equity positions are frequently more volatile than the reported performance would indicate because hedge funds often dont mark private equity positions to market. Likewise, a low correlation to the VIX index probably understates the sensitivity of these positions to market sentiment.

Convertible Arbitrage Convertible bonds and convertible preferred stock are fixed income instruments that may be exchanged for common stock. The typical issuers of convertible securities are young and fast growing and have a low debt rating. The debt structure might appear to offer some downside protection if the investor expects to get back the full principal value of the investment as a worst case. In practice, the market value of the debt is usually closely tied to the market value of the common stock because the company can reliably repay the bonds if the company does well, and if the company does well the common stock does well.

The option to convert is an option to exchange the bonds for stock. This type of option is more difficult to value than a simple call option. To further complicate matters, convertible securities may include call options, put options, and features to force the holder to convert to stock.

In its purest form, the convertible arbitrage fund buys the convertible instrument, sells short the common stock, buys or sells options on the common stock, and perhaps hedges the interest rate risk(s). In practice, the fund may not be able to hedge all the risks or may choose to hedge only some of the risks.

The performance of convertible arbitrage funds approximates the return of a basket of unlevered common stock, although the volatility of return is considerably lower for the convertible strategy than for the stock portfolio. The strategy has fairly low correlation to stock and bond returns and market uncertainty. It is somewhat sensitive to changes in credit spreads.

Sector Funds Sector funds include a collection of long-only or long biased hedge funds invested in a narrow sector of the stock market. Sector funds pursue a wide range of sectors, but the most common sector funds involve health care companies, biotechnology, the technology sector, real estate, and energy. Because these sectors tend to be volatile anyway, these hedge funds use little or no leverage. The returns on the individual funds depend on stock selection, but a major part of the return is determined by the performance of the sector.

These sectors have substantially outperformed broad stock indexes like the S&P 500 (except for real estate, whose returns have roughly matched the S&P). The returns published by the major hedge fund data providers for most sector funds have been more or less as volatile as stock returns, which means they are much more volatile than most other hedge funds. Because of their narrow concentration, their performance is relatively uncorrelated with broad market returns (30 to 50 percent correlation to the S&P 500 index) so they might be a good choice for an investor seeking to diversify a traditional stock portfolio. Many sector funds are concentrated in technology stocks, so they would not be as effective in diversifying a technology-heavy portfolio.



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