Hedge Fund Modelling and Analysis Using Excel and VBA E-Book

Paul Darbyshire

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Series
• Sprache: Englisch

Seitenzahl: 332

Veröffentlichungsjahr: 2012

Beschreibung

Co-authored by two respected authorities on hedge funds and asset management, this implementation-oriented guide shows you how to employ a range of the most commonly used analysis tools and techniques both in industry and academia, for understanding, identifying and managing risk as well as for quantifying return factors across several key investment strategies. The book is also suitable for use as a core textbook for specialised graduate level courses in hedge funds and alternative investments. The book provides hands-on coverage of the visual and theoretical methods for measuring and modelling hedge fund performance with an emphasis on risk-adjusted performance metrics and techniques. A range of sophisticated risk analysis models and risk management strategies are also described in detail. Throughout, coverage is supplemented with helpful skill building exercises and worked examples in Excel and VBA. The book's dedicated website, href="http://www.darbyshirehampton.com/" target="_blank">www.darbyshirehampton.com provides Excel spreadsheets and VBA source code which can be freely downloaded and also features links to other relevant and useful resources. A comprehensive course in hedge fund modelling and analysis, this book arms you with the knowledge and tools required to effectively manage your risks and to optimise the return profile of your investment style.

Leseprobe

Contents

Cover

Series

Title Page

Copyright

Dedication

Preface

EXCEL SPREADSHEETS

EXCEL AND USER-DEFINED VBA FUNCTIONS

HYPOTHETICAL HEDGE FUND DATA

BOOK WEBSITE

1: The Hedge Fund Industry

1.1 WHAT ARE HEDGE FUNDS?

1.2 THE STRUCTURE OF A HEDGE FUND

1.3 THE GLOBAL HEDGE FUND INDUSTRY

1.4 SPECIALIST INVESTMENT TECHNIQUES

1.5 NEW DEVELOPMENTS FOR HEDGE FUNDS

2: Major Hedge Fund Strategies

2.1 SINGLE- AND MULTI-STRATEGY HEDGE FUNDS

2.2 FUND OF HEDGE FUNDS

2.3 HEDGE FUND STRATEGIES

3: Hedge Fund Data Sources

3.1 HEDGE FUND DATABASES

3.2 MAJOR HEDGE FUND INDICES

3.3 DATABASE AND INDEX BIASES

3.4 BENCHMARKING

APPENDIX A: WEIGHTING SCHEMES

4: Statistical Analysis

4.1 BASIC PERFORMANCE PLOTS

4.2 PROBABILITY DISTRIBUTIONS

4.3 PROBABILITY DENSITY FUNCTION

4.4 CUMULATIVE DISTRIBUTION FUNCTION

4.5 THE NORMAL DISTRIBUTION

4.6 VISUAL TESTS FOR NORMALITY

4.7 MOMENTS OF A DISTRIBUTION

4.8 GEOMETRIC BROWNIAN MOTION

4.9 COVARIANCE AND CORRELATION

4.10 REGRESSION ANALYSIS

4.11 PORTFOLIO THEORY

5: Risk-Adjusted Return Metrics

5.1 THE INTUITION BEHIND RISK-ADJUSTED RETURNS

5.2 COMMON RISK-ADJUSTED PERFORMANCE RATIOS

5.3 COMMON PERFORMANCE MEASURES IN THE PRESENCE OF A MARKET BENCHMARK

5.4 THE OMEGA RATIO

6: Asset Pricing Models

6.1 THE RISK-ADJUSTED TWO-MOMENT CAPITAL ASSET PRICING MODEL

6.2 MULTI-FACTOR MODELS

6.3 THE CHOICE OF FACTORS

6.4 DYNAMIC STYLE BASED RETURN ANALYSIS

6.5 THE MARKOWITZ RISK-ADJUSTED EVALUATION METHOD

7: Hedge Fund Market Risk Management

7.1 VALUE-AT-RISK

7.2 TRADITIONAL MEASURES

7.3 MODIFIED VaR

7.4 EXPECTED SHORTFALL

7.5 EXTREME VALUE THEORY

References

Important Legal Information

Index

For other titles in the Wiley Finance series please see www.wiley.com/finance

This edition first published 2011 © 2011 John Wiley & Sons Ltd

Registered officeJohn Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom

For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book please see our website at www.wiley.com.

The right of the authors to be identified as the authors of this work has been asserted in accordance with the Copyright, Designs and Patents Act 1988.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher.

Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.

Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners. The publisher is not associated with any product or vendor mentioned in this book. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold on the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional should be sought.

Library of Congress Cataloging-in-Publication Data

Darbyshire, Paul. Hedge fund modelling and analysis using Excel and VBA / Paul Darbyshire and David Hampton. p. cm. ISBN 978-0-470-74719-3 (hardback) 1. Hedge funds–Mathematical models. 2. Microsoft Excel (Computer file) 3. Microsoft Visual Basic for applications. I. Hampton, David. II. Title. HG4530.D37 2012 332.64′5240285554–dc23 2011046750

A catalogue record for this book is available from the British Library.

ISBN 978-0-470-74719-3 (hbk) ISBN 978-1-119-94563-5 (ebk) ISBN 978-1-119-94565-9 (ebk) ISBN 978-1-119-94564-2 (ebk)

Mum and Dad To whom I owe everything. P.D. and D.H.

1

The Hedge Fund Industry

The global credit crisis originated from a growing bubble in the US real estate market which eventually burst in 2008. This led to an overwhelming default of mortgages linked to subprime debt to which financial institutions reacted by tightening credit facilities, selling off bad debts at huge losses and pursuing fast foreclosures on delinquent mortgages. A liquidity crisis followed in the credit markets and banks became increasingly reluctant to lend to one another, causing risk premiums on debt to soar and credit to become ever scarcer and more costly. The global financial markets went into meltdown as a continuing spiral of worsening liquidity ensued. When the credit markets froze, hedge fund managers were unable to get their hands on enough capital to meet investor redemption requirements. Not until early 2009 did the industry start to experience a marked resurgence in activity, realising strong capital inflows and growing investor confidence.

This chapter introduces the concept of hedge funds and how they are structured and managed, as well as discussing the current state of the global hedge fund industry in light of the recent financial crisis. Several key investment techniques that are used in managing hedge fund strategies are also discussed. The chapter aims to build a basic working knowledge of hedge funds and, along with Chapters 2 and 3, to develop the fundamentals necessary in order to approach and understand the more quantitative and theoretical aspects of their modelling and analysis developed in later chapters.

1.1 WHAT ARE HEDGE FUNDS?

Whilst working for Fortune magazine in 1949, Alfred Winslow Jones began researching an article on various fashions in stock market forecasting and soon realised that it was possible to neutralise market risk1 by buying undervalued securities and short selling (see Section 1.4.1) overvalued ones. Such an investment scheme was the first to employ a hedge to eliminate the potential for losses by cancelling out adverse market moves, and the technique of leverage2 to greatly improve profits. Jones generated an exceptional amount of wealth through his hedge fund during the 1950s and 1960s and continually outperformed traditional money managers. Jones refused to register the hedge fund with the Securities Act 1933, the Investment Advisers Act 1940, or the Investment Company Act 1940, his main argument being that the fund was a private entity and none of the laws associated with the three Acts applied to this type of investment. It was essential that such funds were treated separately from other regulated markets since the use of specialised investment techniques, such as short selling and leverage, were not permitted under these Acts, nor was the ability to charge performance fees to investors.

So that the funds maintained their private status, Jones would never publicly advertise or market the funds but only sought investors through word of mouth, keeping everything as secretive as possible. It was not until 1966, through the publication of a news article about Jones's exceptional profit-making ability, that Wall Street and high net worth3 individuals finally caught on, and within a couple of years there were over 200 active hedge funds in the market. However, many of these hedge funds began straying from the original market neutral strategy used by Jones and employed other apparently more volatile strategies. The losses investors associated with highly volatile investments discouraged them from investing in hedge funds. Moreover, the onset of the turbulent financial markets experienced in the 1970s practically wiped out the hedge fund industry altogether. Despite improving market conditions in the 1980s, only a handful of hedge funds remained active over this period. Indeed, the lack of hedge funds around in the market during this time changed the regulators’ views on enforcing stricter regulation on the industry. Not until the 1990s did the hedge fund industry begin to rise to prominence again and attract renewed investor confidence.

Nowadays, hedge funds are still considered private investment schemes (or vehicles) with a collective pool of capital only open to a small range of institutional investors and wealthy individuals and having minimal regulation. They can be as diverse as the manager in control of the capital wants to be in terms of the investment strategies and the range of financial instruments which they employ, including stocks, bonds, currencies, futures, options and physical commodities. It is difficult to define what constitutes a hedge fund, to the extent that it is now often thought in professional circles that a hedge fund is simply one that incorporates any absolute return4 strategy that invests in the financial markets and applies non-traditional investment techniques. Many consider hedge funds to be within the class of alternative investments, along with private equity and real estate finance, that seek a range of investment strategies employing a variety of sophisticated investment techniques beyond the longer established traditional ones, such as mutual funds.5

The majority of hedge funds are structured as limited partnerships, with the manager acting in the capacity of general partner and investors as limited partners. The general partners are responsible for the operation of the fund, relevant debts and any other financial obligations. Limited partners have nothing to do with the day-to-day running of the business and are only liable with respect to the amount of their investment. There is generally a minimum investment required by accredited investors6 of the order of $250,000 to $500,000, although many of the more established funds can require minimums of up to $10 million. Managers will also usually have their own personal wealth invested in the fund, a circumstance intended to further increase their incentive to consistently generate above average returns for both the clients and themselves. In addition to the minimum investment required, hedge funds will also charge fees, the structure of which is related to both the management and performance of the fund. Such fees are not only used for administrative and ongoing operating costs but also to reward employees and managers for providing above average positive returns to investors. A typical fee basis is the so-called 2 and 20 structure which consists of a 2% annual fee (levied monthly or quarterly) based on the amount of assets under management (AuM) and a 20% performance-based fee, i.e. an incentive-oriented fee. The performance-based fee, also known as carried interest, is a percentage of the annual profits and only awarded to the manager when they have provided requisite returns to their clients. Some hedge funds also apply so-called high water marks to a particular amount of capital invested such that the manager can only receive performance fees, on that amount of money, when the value of the capital is more than the previous largest value. If the investment falls in value, the manager must bring the amount back to the previous largest amount before they can receive performance fees again. A hurdle rate can also be included in the fee structure, representing the minimum return on an investment a manager must achieve before performance fees are taken. The hurdle rate is usually tied to a market benchmark, such as LIBOR7 or the one-year T-bill rate plus a spread.

Figure 1.1 A schematic of the typical structure of a hedge fund

1.2 THE STRUCTURE OF A HEDGE FUND

In order for managers to be effective in the running of their business a number of internal and external parties covering a variety of operational roles are employed in the structure of a hedge fund, as shown in Figure 1.1. As the industry matures and investors are requiring greater transparency and confidence in the hedge funds in which they invest, the focus on the effectiveness of these parties is growing, as are their relevant expertise and professionalism. Hedge funds are also realising that their infrastructure must keep pace with the rapidly changing industry. Whereas in the past some funds paid little attention to their support and administrative activities, they are now aware that the effective operation of their fund ensures the fund does not encounter unnecessary and unexpected risks.

1.2.1 Fund Administrators

Hedge fund administrators deal with many of the operational aspects of the successful running of a fund, such as compliance with legal and regulatory rulings, financial reporting, liaising with clients, provision of performance reports, risk controls and accounting procedures. Some of the larger established hedge funds use specialist in-house administrators, whilst smaller funds may avoid this additional expense by outsourcing their administrative duties. Due to the increased requirement for tighter regulation and improved transparency in the industry, many investors will only invest with managers who can prove that they have a strong relationship with a reputable third-party administrator and that the proper processes and procedures are in place. The top five global administrators in 2010 were CITCO, HSBC, Citigroup, GlobeOp and Custom House.

Hedge funds with offshore operations often use external adminis-trators in offshore locations to provide expert tax, legal and regu-latory advice for those jurisdictions. Indeed, it is a requirement in some offshore locations (e.g. the Cayman Islands) that hedge fund accounts must be regularly audited. In these cases, administrators with knowledge of the appropriate requirements in those jurisdictions would fulfil this requirement.

1.2.2 Prime Brokers

The prime broker is an external party who provides extensive services and resources to a hedge fund, including brokerage services, securities lending, debt financing, clearing and settlement, and risk management. Some prime brokers will even offer incubator services, office space and seed investment for start-up hedge funds. The fees earned by prime brokers can be quite considerable and include trade commissions, loan interest and various administration charges. Due to the nature of the relationship between the prime broker and hedge fund, in particular being the counterparty to trades and positions, only the largest financial institutions are able to act in this capacity. The top five global prime brokers in 2010 were Goldman Sachs, JP Morgan, Morgan Stanley, Deutsche Bank and UBS.

For this reason the prime brokerage market is relatively small and each prime broker tends to service a large number of hedge funds and therefore takes on an extremely high degree of risk. Some major restructuring occurred amongst prime brokers in 2008 and 2009, for example the acquisitions of Bear Stearns by JP Morgan, Merrill Lynch by Bank of America, and Lehman Brothers by Barclays Capital. This resulted in a shift in market share from some former investment banks to commercial banks and saw the prime brokerage industry begin to consolidate. In order to alleviate investor concerns since the collapse of several major financial institutions, many fund managers are cautious in employing a single prime broker and prefer to subscribe to multiple prime brokers.

1.2.3 Custodian, Auditors and Legal

Hedge fund assets are usually held with a custodian, including the cash in the fund as well as the actual securities.8 The custodian is normally a bank that will offer services, such as safekeeping of hedge fund assets, arranging settlement of any sales or purchases of securities and managing cash transactions.

The general structure of a hedge fund precludes them from the requirement to have their financial statements audited by a third party. However, in order to satisfy investors, many hedge funds have their accounts and financial reviews audited annually by an external audit firm. It is important that the auditing firm is seen to be independent of the hedge fund to give credence to their reports and services.

The legal structure of a hedge fund is designed to provide investors with limited liability, so that if a fund suffers a severe loss the maximum amount an investor can lose is only the level of capital invested in the fund. That is, an investor cannot be made liable for losses over this amount or any other outstanding debt or financial obligation of the hedge fund. In addition, the legal structure is also chosen to optimise the tax status and legal liability of the hedge fund itself. To facilitate this, there are a small number of standard hedge fund structures, such as the master–feeder structure, which is adopted by a large number of funds. These comply with the legal requirements of the various jurisdictions where the hedge funds operate and obtain the optimal tax treatment. The master–feeder structure is a two-tier structure where investors invest through a feeder vehicle which itself invests in the hedge fund. There can be a number of feeder vehicles, located and domiciled in a number of different jurisdictions. Each can have a different legal form and framework. Depending on their tax status, investors can decide which feeder vehicle they wish to invest in. As a general rule the tax regime of an investor will depend on the location of the investor, i.e. on- or offshore.9

Figure 1.2 Growth in the global hedge funds industry since 1998

Source: Eurekahedge

1.3 THE GLOBAL HEDGE FUND INDUSTRY

After exceptional growth since 1998, total assets managed by the hedge fund industry peaked at $1.97 trillion in 2007. After the credit crunch and financial crisis of 2008, with well-publicised frauds and scandals as well as the collapse of several major financial institutions, the hedge fund industry suffered severe losses and investor loyalty. Not until early 2009 did the industry start to experience a marked resurgence in activity, realising strong capital inflows and growing investor confidence, as shown in Figure 1.2.

It is estimated that the total amount of AuM in the industry at the end of 2010 stood at over $1.60 trillion, with a strong stream of asset flows into hedge funds over the past several years (see Figure 1.3). It is widely assumed that the industry will cross the all-time high set in 2007 and exceed $2 trillion by the end of 2011.

Figure 1.3 Monthly asset flows since December 2008

Source: Eurekahedge

Over the last decade, the global hedge fund industry has consistently outperformed the underlying equity markets, as can clearly be seen in Figure 1.4.

Figure 1.4 Performance of global hedge funds over equities since 1999

Source: Eurekahedge

North American funds still remain the most important global hedge fund market, making up around two-thirds of the global industry, followed, quite a long way behind, by Europe and then Asian sectors (see Figure 1.5).

Figure 1.5 Geographical location of hedge fund

Source: Eurekahedge

1.3.1 North America

Despite periods of high volatility and market swings, North American hedge funds have consistently posted record returns since reaching their lowest point in early 2009. The total size of the industry at the end of 2010 was estimated at $1.08 trillion, managed by over 4,500 funds (see Figure 1.6). This is a clear indication of the confidence investors began to show in North American funds after the fallout from the global financial crisis of 2008, when billions of dollars were redeemed and funds suffered massive performance-based losses. Since then, hedge fund managers have provided significant protection against market downturns as well as addressing investors concerns over counterparty risk by engaging multiple prime brokers instead of the usual singular relationship. Moreover, managers have increased redemption frequencies, allowing investors better access to their capital, allowed for more transparency across investment strategies and implemented more stringent risk management controls. Such changes, together with a much improved outlook on the US economy and the introduction of quantitative easing,10 have led to increased investor confidence and substantial asset flows into North American hedge funds, a situation which looks set to continue well into 2011.

Figure 1.6 Growth of the North American hedge fund industry since 2000

Source: Eurekahedge

1.3.2 Europe

The rapid growth of the European hedge fund industry over the first seven years of the last decade was eventually slowed by the onset of the financial downturn in 2008. As with North American hedge funds, the European sector experienced huge losses and increased pressure for redemptions from investors which continued until early 2009 when the global economy began to see a potential recovery (see Figure 1.7).

Figure 1.7 Growth of the European hedge fund industry since 2000

Source: Eurekahedge

The European sector has shown some interesting trends with regard to fund launches since the market began to rebound in 2009. Although attrition rates have been relatively high, launches have gained strength on the back of the new UCITS III regulation.11 The popularity of UCITS III has seen the launch of many new start-ups seeking investment capital in the increasingly competitive hedge fund arena. Many new hedge fund launches have suffered from the investment bias towards allocating to much better-known and larger hedge fund names. However, it is anticipated that this trend is likely to change as a result of the increased diversification offered by European hedge funds and a new regulatory environment over the coming years.

1.3.3 Asia

Like the European hedge fund sector, Asian funds have seen tremendous growth over the last decade up until the slowdown during the financial crisis starting in 2008. After the second half of 2009, the Asian sector has shown a steady improvement, with over 1,200 active funds; however, the sector has not seen a repeat of the growth experienced before 2008. This is mainly due to speculation that the Asian markets may suffer from a possible double-dip recession as a result of the debt contagion passing from Europe (see Figure 1.8).

Figure 1.8 Growth of the Asian hedge fund industry since 1999

Source: Eurekahedge

In the Asian sector, hedge fund managers have struggled to generate asset flows and this, together with the highly volatile markets, has led investors to be extremely cautious about investing in the current climate. However, the desire for Asian governments to attract global hedge fund managers to the region, reductions in hedge fund set-up costs compared to other Western locations, the availability of a growing range of financial products and the easing of access and market restrictions in regions such as China and India should see an increased growth in the sector through 2011 and beyond.

1.4 SPECIALIST INVESTMENT TECHNIQUES

1.4.1 Short Selling

A short sale is the sale of a security that a seller does not own or that is completed by delivery of a borrowed security. The short seller borrows the securities from a prime broker in return for a daily fee, and promises to replace the borrowed securities at some point in the future. The transaction requires the prime broker to borrow the shares from a securities lender and make delivery on behalf of the short seller. Prime brokers can borrow securities from custodians who hold large institutional investments, e.g. mutual and pension funds, or from their own proprietary trading accounts. The cash from the transaction is held in an escrow account12 until the short seller is in a position to replace the borrowed shares (or until they are called back by the lender). Since the short seller borrows the securities from the prime broker and has a future commitment to replace them, collateral must be posted in the form of cash, securities or other financial assets. The collateral, in addition to the fee for borrowing the securities, provides the prime broker with additional income in the form of interest until the shares are returned.13 In addition, the short seller must cover any dividends paid on the shares during the period of the loan, and in the event of any stock splits, e.g. a two-for-one split, the short seller must pay back twice as many shares.

The eventual buyer of the shares from the short seller is usually unaware that it is a short sale, so the seller must make arrangements to cover the delivery obligations. The shares are transferred to the buyer with full legal ownership, including voting rights, which can pose a severe problem for the short seller if the prime broker requires the securities back (or called away), for example, if the original securities lender requires them for a company shareholder meeting. Although this rarely happens in practice, short selling does carry a great deal of risk, especially if the shares are held over a long period of time and the stock fails to decline as expected, making it necessary to post further margin and eventually forcing the short seller to close out their position at a significant loss. However, when stock prices fall, short sellers make a profit from the short sale, and usually between 60% to 90% of the interest income charged by the prime broker on the cash deposit (the short rebate).

It is often the case that hedge funds do not disclose the names of companies they are selling short for fear of a short squeeze. Unexpected news on short selling activity can cause share prices to suddenly rise due to potential price manipulation through long investors buying additional shares or forcing securities lenders to recall loaned shares. In this case, short sellers’ demand for stocks to cover their short positions can cause a mismatch in the availability of shares and thus drive prices up further. To avoid short squeezes, hedge funds employing short selling only normally invest in large cap companies which have a greater amount of liquidity and volume of shares available from prime brokers. In the US, hedge funds are only allowed to engage in short sales with those securities whose recent price change was an upward movement.14 Such restrictions are used to prevent hedge funds investing in stocks that are already declining so as to avoid the possibility of sending the market into free fall. Nevertheless, short sellers are often thought of as providing efficient price discovery as well as market depth and liquidity. It is important to investors that they are confident that prices represent fair value and that they can get easy access to liquid markets in which they can readily convert shares into cash. Through short selling, hedge funds provide this level of confidence by forcing down overvalued stocks and generating liquidity within the markets.

1.4.2 Leverage

Leverage is using borrowed cash, or a margin account, to increase purchasing power and exposure to a security (or investment) with the aim of generating higher returns. Financial instruments, such as options, swaps and futures (i.e. derivatives), are also used to create leverage. A premium is paid to purchase a derivative in the underlying asset which gives various rights and obligations in the future. This premium is far less than the outright price of the underlying asset and thus allows investors to buy an economic exposure to considerably more of the asset than would otherwise be possible.

Although generally misunderstood, leverage is an extremely widespread investment technique, especially in the hedge fund industry. A great deal of confusion often arises from the various definitions and measurements of leverage. In terms of hedge fund leverage, the debt-to-equity ratio or percentage is often the preferred indicator. For example, if a hedge fund has $50 million equity capital and borrows an additional $100 million, the fund has a total of $150 million in assets, with a debt-to-equity ratio of 2 and a leverage of 67% (=$100 m/$150 m). Leverage ratios are typically higher than traditional investments and generally more difficult to measure due to the sophisticated use of various financial instruments, such as derivatives and investment strategies. Since adding leverage to an investment inherently increases risk, investors often equate a highly leveraged hedge fund with a high risk investment. However, this is not normally the case since hedge funds often use leverage to offset various positions in order to reduce the risk on their portfolios.15 For this reason, it is not advisable for investors to solely rely on leverage ratios as proxies for hedge fund risk. It makes more sense to correctly analyse the nature of the strategy in more detail before making a decision on the riskiness of the hedge fund.

1.4.3 Liquidity

Although hedge funds can generate abnormal returns by exploiting the value from investing in illiquid16 assets, there is always a need to access market liquidity. Liquidity is the degree to which an asset can be bought or sold without adversely affecting the market price or value of the asset.17 Liquidity plays a critical role in the financial markets, providing investors with an efficient mechanism to rapidly convert assets into cash. During the recent financial turmoil, hedge funds experienced an unprecedented volume of requests from investors to withdraw their capital, creating a serious liquidity problem.

As already mentioned, the recent credit crisis was a result of the bursting of the growing bubble in the US real estate market which led to an unprecedented level of mortgage defaults linked to subprime debt. In reaction, many financial institutions began tightening credit facilities, selling off bad debts at huge losses and pursuing fast foreclosures on failing mortgages. The resultant liquidity crisis that followed made credit much harder to source and, when available, extremely expensive. Eventually financial markets around the globe went into free fall as the worsening liquidity position escalated. Hedge funds with assets linked to the debt disaster suffered massive losses which were further exacer- bated when investors tried to withdraw capital from their funds. As credit markets froze, hedge fund managers found it increasingly difficult to source available capital to meet investors' redemption requirements.

Hedge funds that had assets linked to the subprime debt disaster and other related securities suffered huge losses. Problems were amplified further when investors tried to withdraw capital from their funds, to which it subsequently became apparent that there was a liquidity mismatch between assets and liabilities. When the credit markets froze, hedge fund managers were unable to source sufficient capital to meet investor redemption requirements. This forced managers to restructure their liquidity terms and impose further gated provisions,18 increase the use of side-pocketing19 and enforce lock-ups.20 This had a negative effect on investor relations which was exacerbated by the selective and insufficient disclosure of performance being made by hedge fund managers. For example, many managers were seen to be reporting side-pocket performance only to investors while relaying much better liquid performance in publications with only a passing note of disclosure about the exclusion of side-pockets. In the case of lock-ups, there exists a clear conflict of interest between locking up investors’ capital and continuing to charge management fees. Investors have since argued that it would be more acceptable for gated provisions and the issue of involuntary side-pockets to be tied to deferrals or a reduction in management fees until the hedge fund returns to an appropriate liquid position. The aftermath of the financial crisis has clearly highlighted many of the shortcomings of the hedge fund industry and heightened the debate over the need for increased regulation and monitoring. Nevertheless, it has since been widely accepted that hedge funds played only a small part in the global financial collapse and suffered at the hands of a highly regulated banking system. Indeed, many prominent institutional and economic bodies argue that their very presence provides greater market liquidity and improved price efficiency whilst aiding in the global integration of the financial markets.

1.5 NEW DEVELOPMENTS FOR HEDGE FUNDS

1.5.1 UCITS III Hedge Funds

One of the major developments in the hedge fund industry over the past several years has been the exceptional growth in UCITS III hedge funds in comparison to the global industry. As of September 2010, the UCITS hedge fund industry stood at an estimated $131 billion managed by over 600 individual funds (see Figure 1.9). UCITS is a set of directives developed by the EU member states to allow cross-border investments. The aim of the directive is to improve the financial opportunities offered to UCITS-compliant hedge fund managers whilst addressing the needs of investors in terms of effective risk management procedures, and increased transparency and liquidity, especially in light of the recent financial crisis.

Figure 1.9 Growth in number of UCITS III hedge funds since December 2007

Source: Eurekahedge

The original version of the directive was introduced in 1985 with the goal of establishing a common legal framework for open-ended funds investing in transferable securities set up in any EU member state i.e. developing a pan-European market in collective investment schemes. Unfortunately, the framework suffered from many obstacles, such as the extent of different marketing rules and taxation allowed across member states. Not until December 2001 was a directive formally adopted under the UCITS III banner which has since undergone several further amendments with a view to including the use of additional asset classes (e.g. hedge fund indices) and a more diverse range of derivative products (see Figure 1.10). Such inclusions have allowed UCITS III funds to pursue a number of different investment possibilities, such as absolute return strategies, in ways that were simply not possible under previous UCITS frameworks.

Figure 1.10 UCITS III hedge funds by investment strategy

Source: Eurekahedge

The increased number of eligible asset classes and available use of derivatives has led to a greater number of multi-strategy funds being launched in the UCITS III sector in comparison to that of the European multi-strategy industry. Despite this, however, almost half of UCITS III funds over the last two years have adopted the long/short equity strategy for several reasons:

1. Long/short equity is by far the largest global hedge fund strategy and therefore those existing managers launching new UCITS III vehicles would naturally prefer this strategy.

2. Operating the long/short equity strategy under the UCITS III framework is relatively straightforward.

3. The simplicity of the long/short equity strategy lends itself well to marketing and liaising with retail investors who may not have the knowledge and understanding of the markets like a typical hedge fund client.

Despite the strong link in the use of the long/short equity strategy, the regulatory constraints within the UCITS III framework mean that there are very few similarities elsewhere across industry sectors. For example, there are very few event-driven UCITS III hedge funds and practically no distressed debt based funds primarily due to the liquidity restrictions placed on UCITS III compliance. Nevertheless, a major advantage of UCITS III funds is the ability of managers to utilise their experience in a proven investment strategy whilst offering potential investors the added incentive of investing in a regulated market. The key features of UCITS III hedge fund regulation and fund structure are as follows:

1. Only investment in liquid securities is permitted, i.e. those that can be sold within 14 days without substantial loss of value.

2. Funds cannot have exposure to more than 10% in one stock.

3. Managers can utilise leverage up to 100% of the net asset value21 of the fund.

4. Managers can employ shorting techniques through the use of derivatives.

5. The ease of marketing such funds across the EU and registering them in member states.

6. The implementation of effective risk management procedures and processes.

7. Funds must be domiciled in an EU member state as opposed to offshore locations.

The development of UCITS III funds has also opened up the sector to new sources of capital, e.g. from retail investors wishing to make use of the alternative investment market but with the assurance of stricter regulatory controls. In addition, improved redemption rules and transparency have helped in building investor confidence, especially after the much debated issue surrounding the use of gated provisions that stopped investors withdrawing large amounts of capital from their funds during the period of huge losses following the financial crisis in 2008. Indeed, the much anticipated release of UCITS IV and the development of other European directives, such as the new EU passport (see below), which will give hedge funds marketing rights throughout the EU, will broaden the investment appeal of UCITS-compliant funds even further.

1.5.2 The European Passport

In November 2010 the European Union passed a new set of laws governing the use and regulation of the alternative investment industry, named the Alternative Investment Directive (AID). The AID aims to provide hedge funds (and private equity funds) with a so-called passport