45 Pages Posted: 3 Apr 2011
Date Written: April 7, 2010
Treatments of the future of hedge funds represent daunting tasks, not in the least because understanding hedge funds’ past is still a subject of intense academic, industry practitioner, regulatory and legislative examination. Even the very definition of a hedge fund defies easy characterization, an unusual irony given that, at least for the foreseeable future, hedge funds stand a substantial chance of remaining fixtures on the global landscape of wealth management. I do not spend much time here on the very definition of a hedge fund, perhaps the clearest expression of which may simply reference a compensation contract and little else, systematically speaking. Other useful definitions may reference the fact that hedge funds in the U.S. and in many countries find certain safe harbors from the 1940 Investment Company Act, the Securities Act and other regulations which may facilitate certain investment strategies and trades including those that require the use of substantial leverage and great degrees of illiquidity. What is clear from both the academic and practitioner literatures is that hedge funds do not necessarily hedge.
In this article, I cover a number of items deemed to be important elements of the present and future hedge fund industries. By nature, this examination is subjective and incomplete. I first study the results of a survey of those who guide institutional investors, from where most asset flows into hedge funds come from: institutional consultants. In addition, I consider returns-based sources of interest in hedge funds, examining the historical record of what happened in two recent large equity market declines, with an eye toward the future of risk exposure heterogeneity in the space and the likely future value of hedge funds in investor allocations. As part of this assessment, I discuss a recent phenomenon that I predict will persist at least in the way it has made clear that hedge funds represent blended exposures to risk rather than traditional pure alpha: hedge fund replication. I point out their proliferation, their returns-based characteristics, their underlying exposures, and demonstrate how they would have added value to some allocations historically (e.g., small endowment portfolios taken from a well-known tabulation of endowment portfolios and their performance, The 2009 NACUBO-Commonfund Study of Endowments). To do so I also show how hedge fund risk exposures change over time and over the crisis. Value added in the form of elusive alpha also changes and in fact strongly declines in the crisis, when the strongest effects are exposure-led.
Moreover, I consider the risk-exposure measurement issues arising from the required adoption of Statement of Financial Accounting Standards 157, which has altered and perhaps improved the ability to characterize hedge fund risk based on reported returns, despite results apparent in the preceding consultant survey. I show that its use has a strong correlation with increases in the measurement of market risk, as one would expect, where one would expect. The implication is that, in the future, less liquid classes will show greater levels of volatility and the like, even without requiring analysts to employ sophisticated adjustment technologies. Of course, distinguishing that from certain crisis effects is not easy.
Since any discussion of the future of hedge funds is exposed to regulatory uncertainty, especially following the crisis and events such as the revelation of the massive fraud perpetrated by Bernard Madoff (although it would be a legitimate point to make that Madoff, per se, did not run a hedge fund), I briefly discuss Madoff as well as the rapidly and unpredictably changing regulatory and enforcement environment. For instance, I point out that in the year following the Madoff shock, the U.S. Securities and Exchange Commission litigated in about sixty cases of Ponzi and similar alleged financial schemes, a rate substantially higher than in the preceding year (roughly thirty-five). In addition, I discuss both direct regulations of hedge funds, which currently appears to be highly likely, as well as indirect regulation like the recent partial reinstatement in the U.S. of the uptick rule for short-selling of stocks.
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