The Specialized Investment Fund Rules, 2075 state the Hedge Fund as a fund established to invest in any risky sectors. While this meaning is very incomprehensible and the Board, SEBON, has yet to issue a directive on operation of the hedge fund in Nepal, this article aims to shed some light on the different hedge fund strategies, features, performances, and evolving issues of the industry.
Hedge funds are alternative investment vehicles that pool investments like mutual funds but are private in nature, target high- to ultra-high-net-worth accredited investors or institutions (limited partners), and adopt various involved strategies that limits/hedge the financial risks to produce positive absolute returns. The industry enjoys the least regulation (including legal) and transparency, with a large investment universe to bet on to seize market anomalies; nonetheless, portfolios are highly concentrated.
Despite the several ups and downs, the Hedge Fund industry has seen significant growth over the decades, soaring from approx. $500 billion in 2000 to the current level above $4.5 trillion, a 10.5% CAGR, although growth from 2023 to 2028 is projected to be a 3.14% CAGR. The industry found its major boom in the 1990s (despite the 1998 LTCM collapse) and 2000s, thanks to the dot-com bubble burst that drew the major interest of institutional investors. The 2008 Global Financial Crisis (GFC) not only eroded one-fourth of the total asset size but also brought in regulatory intervention. The growth was further shadowed by the dismal performance of the hedge fund (that questioned the merits of fees charged, i.e., 1-2% management fee plus 20-30% performance fee) in the second half of the 2010s until the outburst of COVID-19 in 2020. The industry is heavily concentrated in North America - US, which manages approx. three-fourths of the total industry’s AUM and has approx. two-thirds of the total active institutional investors (limited partners) and find managers (general partners). Big funds like Bridgewater Associates, Renaissance Technologies, AQR Capital Management, etc. are based in the US. [Note: Since the industry is least transparent and regulated, the records of the industry's size, growth, and performances are susceptible to biases like survivorship, selection, etc. which hide the true picture].
Hedge funds are found to maintain a low correlation with traditional asset classes, acting as diversifiers and return enhancers for portfolios. Empirical studies (1998 - 2018) spot the outperformance of the majority of hedge funds over the MSCI World Index but underperformance over the S&P 500 Index, despite a significantly low standard deviation. As per the Aurum Hedge Fund (Aurum) report, in 2022, global equities and global bond markets suffered 20% and 16.7% losses, respectively, while the hedge fund industry reported just 2.4% drawdown (demonstrating hedge funds tendency to thrive in volatile markets). 5 years (2018-2022) scrutiny of hedge fund composite vs. Equities vs. Bonds showed hedge funds outdoing the others in terms of returns (4.22% vs. 2.95% vs. -1.95%), volatility (5.91% vs 17.99% vs 6.44%), and Sharpe ratio (0.46 vs 0.16 vs -0.52). YTD 2023 (i.e., till 12 Sept.) returns of Hedge fund is 4.74%, lagging tellingly behind equities. The performance of a hedge fund can be screened based on its strategy. [Note: The performances as delineated here are based on the report of Aurum, which scrutinizes the data of approx. 3500 active hedge funds representing approx. $3 trillion AUM.] Some major hedge fund strategies are:
A. Equity Strategy
Approx. half of the total hedge funds and one-third of total portfolios around the world are managed under equity strategies. Popular funds under this strategy are: i) Equity long bias, which takes a net long position on the undervalued equities than short to the overvalued equities; ii) Equity short bias, which shorts the stocks to benefit during a bear market; iii) Equity market neutral, which, unlike the preceding two, effectively reduces the market risk exposure/portfolio beta to zero by taking both long and short positions on the equities. Aurum reports the Equity long/short (-9.63%) and long biased strategy (-13.15%) as the worst performers of 2022, but among the top performers (7.04%% and 4.66%, respectively) in YTD 2023.
B. Event Driven Strategy
Corporate events like M&A activities, bankruptcy/distressed securities provide an opportunity for Hedge fund to arbitrage the potential mispricing of securities. Despite huge idiosyncratic risk, this strategy (along with the Relative value strategy, next) reports the lowest standard deviation. Some funds it includes are: i) merger arbitrage, where funds bet/long the securities that are agreed to be acquired at a premium and short the securities of the acquiring company; ii) distressed securities – bets are made on the securities of distressed companies that are believed to revive again; iii) Activist - assume the same function as that of Private Equity like acquiring ownership and participating in the management of generally undervalued companies, but the process may turn hostile. Aurum finds a net loss of 8.34% in 2022 for Event strategy (Activist -9.4%, Merger +1.8%, Distressed -3.82%). YTD 2023, event strategy reported net return of 4.99% (Activist +11.18%, Distressed +5.48%, Merger +3.08% despite deal risk).
C. Macro and Managed Future Strategy
Both of these strategies produced the most diversification during the 2008 GFC; in fact, managed future funds or systematic diversified funds generated the positive returns. The strategy takes the broad investment perspective and invest in the market of currency, commodity, equity, bond, interest rates, emerging economy, etc. around the world so as to benefit the directional or relative value movement in such portfolios. In 2022, Macro Fund yielded 6.73% net return where Global macro and Commodities segments produced 12.23% and 11.48% return respectively. Emerging markets made a net loss of 9.01%. Managed futures, aka. CTA (Commodity Trading Advisors that invest in futures or other derivatives in systematic ways), yielded the most in 2022 i.e. 15.19%. Coming to 2023, Global macro and CTA produced loss of -0.81% -2.51% respectively while Commodities and Emerging market segments generated 2.19% and 5.43% respectively.
D. Relative Value or Arbitrage Strategy
This strategy also tends to exploit the mispricing of the same or related securities by taking long on undervalued and short on overvalued assets, thus limiting market risk and profiting through price correction by convergent strategies. Fixed income arbitrage, convertible arbitrage, volatility arbitrage, etc. are some funds under this strategy. In convertible arbitrage, convertible bonds are purchased while corresponding stocks are shorted simultaneously; volatility arbitrage profits from the difference between the implied volatility and (future) realized volatility in the option market, i.e. the Fund long the option for lower estimated implied volatility and vice-versa. The arbitrage strategy produced 3.58% net return in 2022 while Tail Protection strategy (i.e. abnormal movements of market/securities) gained 10.15%, volatility arbitrage 6% but convertible arbitrage -4.85%. YTD 2023, arbitrage strategy is the least performer, yielding only 0.57% net return; Tail -7.19%, volatility arbitrage 0.98%, and Convertible bond 5.59%.
Apart from the above, some other popular strategy/funds are Credit strategy (focus on credit instruments like high-yield bonds), Multi-strategy (adopts multiple strategies), Quant strategy (performs quantitative analysis), etc. Fund of these all strategies tend to have a single manager while Funds of (Hedge) Funds (which invest in other Hedge funds) are managed by multiple managers.
Contrary to hedge fund strategies, which are supposed to offset investment risks, many a time Funds are exposed to colossal risks of demise. The situation gets worse because of its highly leveraged position. One classic case, perhaps the biggest in the industry, is the fall of US based Hedge Fund known as Long-Term Capital Management (LTCM). LTCM came into operation in 1994 with a $1.25 billion fund. They adopted the arbitrage or relative value strategy (along with market neutral) which hinged on the price convergence principle. The strategy yields return as long as the market function normal and rational. By early 1998, LTCM had the balance sheet size above $125 billion with equity only $5 billion, massive leverage of 30 to 1 which rocketed to above 50 in August 1998 before things started to fall apart. Not only this, the off-balance size of LTCM (swap and future exposure) was worth over $1.2 trillion. Among the several position LTCM had taken, the company had a long position on US interest rate swaps while shorting US government bonds (a position LTCM would have gained had the spreads narrowed), as well as shorting equity options at high implied volatilities. Although warning flames ignited in July 1997 when the Asian Financial Crisis happened, real trouble began on July 17, 1998 when Salomon Brothers started liquidating its dollar interest arbitrage position precipitating 10% loss to LTCM; to top it all off, disaster occurred on August 17 when Russia declared moratorium (stoppage) on 281 billion Ruble ($13.5 billion) of its Treasury debt following the devaluation of its currency Ruble. This led investors deluge into fight-to-quality instruments (spurring a liquidity run), widening the spreads and shooting up the actual volatility, producing more than 65% losses on its swaps and equity volatility. The company was forced to disclose its classified strategies and its financial picture to prospective investors which further created chaos in the market. The huge on-and off- balance-sheet leverage position/exposure of LTCM posed a systemic threat to the global financial system. Thus, on September 23, a consortium of 14 Banks led by the Fed bailed out LTCM through an injection of $3.65 billion funds for a 90% equity stake.
The evolution of artificial intelligence, including machine learning, cryptocurrencies, a decentralized environment, digital assets, global concern over climate change, pandemics like COVID-19, increasing pressure for transparency and regulation, etc., are forcing the hedge fund industry to devise their strategies and products accordingly, such as hybrid hedge/private equity strategies. Over this period, the hedge fund industry has gone into a consolidation phase, limiting the number of funds and cooling off the heated market. In fact, a study finds that over 90% of hedge fund assets are managed by only 30% of fund managers. Institutional investors are more inclined toward large hedge funds.
In Sept. 2022, Ministry of Finance (Nepal) brought in the “Hedging Related Regulation, 2075” that allowed NRB to provide hedging to project constructions with foreign investments: i) Hydro projects of at least 100 MW; ii) at least 200 KVA transmission line of at least 30 km; iii) Rail, metro, mono rail of at least 10 km; iv) Fast tract of at least 50 km; v) Infrastructure like health, education, agriculture, tourism, IT, etc. of at least Rs. 2 billion investments. Lastly, the prospect of Hedge Fund market in Nepal is futile for a foreseeable period due to its very unfit characteristics, like the requirement of the least regulation/transparency, high leverage, innovative products, derivatives, AI-ML support, high net worth investors, industry talents, etc. Despite South Asia being the most emerging market, Nepal finds no investment inflows from foreign hedge funds, but if this is to happen, the Nepalese market will likely experience major disruptions and volatilities.
By Jeewan Pun
Pun is a former CFA Charter-holder and Certified Financial Risk Manager (FRM). He currently holds the position of Head of the Research and Product Department at Garima Capital Limited.