Hedges on Hedge Funds

How to Successfully Analyzeand Select an Investment

JAMES R. HEDGES IV

John Wiley & Sons, Inc.

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Innodata0471701025.jpg

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Hedges on Hedge Funds

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John Wiley & Sons

Founded in 1807, John Wiley & Sons is the oldest independent publishing com-pany in the United States. With offices in North America, Europe, Australia,and Asia, Wiley is globally committed to developing and marketing print andelectronic products and services for our customers’ professional and personalknowledge and understanding.

The Wiley Finance series contains books written specifically for financeand investment professionals as well as sophisticated individual investors andtheir financial advisors.

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Hedges on Hedge Funds

How to Successfully Analyzeand Select an Investment

JAMES R. HEDGES IV

John Wiley & Sons, Inc.

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Copyright © 2005 by James R. Hedges IV. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmittedin any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United StatesCopyright Act, without either the prior written permission of the Publisher, or authorizationthrough payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc.,222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600, or on theweb at www.copyright.com. Requests to the Publisher for permission should be addressedto the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ07030, 201-748-6011, fax 201-748-6008.

LJH Global Investments, LLC provides advisory services in the areas of hedge funds andalternative investments. Not all products and services are available in all locations, and notall investments are suitable for all investors.

Any discussion of investment and investment strategy of funds (including current invest-ment themes, research and investments processes and portfolio characteristics) representsthe views of LJH Global Investments, LLC as reported by the publication, at the time ofpublication. All expressions of opinion included herein are subject to change withoutnotice and are not intended to be a guarantee of future events.

This book is supplied for information only and does not constitute a solicitation to buy orsell securities. Opinions expressed herein may differ from the opinions expressed by otherbusinesses and activities of LJH Global Investments, LLC. Although information and opin-ions in this article have been obtained from sources believed to be reliable, LJH does notwarrant the accuracy or completeness and accepts no liability for any direct or consequen-tial losses arising from its use.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used theirbest efforts in preparing this book, they make no representations or warranties with respectto the accuracy or completeness of the contents of this book and specifically disclaim anyimplied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The adviceand strategies contained herein may not be suitable for your situation. You should consultwith a professional where appropriate. Neither the publisher nor author shall be liable forany loss of profit or any other commercial damages, including but not limited to special,incidental, consequential, or other damages.

For general information on our other products and services, or technical support, pleasecontact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books.

For more information about Wiley products, visit our web site at www.wiley.com.

Library of Congress Cataloging-in-Publication Data

Hedges IV, James R., 1967–.Hedges on hedge funds : how to successfully analyze and select an investment /

James Hedges.p. cm.

Includes index.ISBN 0-471-62510-8 (cloth)

1. Hedge funds. I. Title.HD4530.H3884 2005332.64′5—dc22

2004011591

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

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http://www.copyright.comhttp://www.wiley.com

To Lundy, Evans, and Malone

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Contents

Foreword ix

Preface xiii

Acknowledgments xxi

CHAPTER 1The Hedge Fund Alternative 1

CHAPTER 2Cutting through the Black Box: Transparency and Disclosure 23

CHAPTER 3The Operational Risk Crisis 43

CHAPTER 4Best Practices in Hedge Fund Valuation 53

CHAPTER 5Does Size Matter? 65

CHAPTER 6Directional Investing through Global Macros and Managed Futures 75

CHAPTER 7Profiting from the Corporate Life Cycle 93

vii

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CHAPTER 8Evaluating Arbitrage and Relative Value Strategies 111

CHAPTER 9The Time Is Now for Equity Market Neutral 133

CHAPTER 10Long-Short Strategies in the Technology Sector 143

CHAPTER 11The Expansion of European Hedge Funds 151

CHAPTER 12The Dynamic World of Asian Hedge Funds 167

CHAPTER 13Hedge Fund Indices: In Search of a Benchmark 187

GLOSSARY 199

ABOUT THE AUTHORS 217

INDEX 221

viii CONTENTS

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Foreword

Does the world need another book on hedge funds? For that matter,does the world need another hedge fund? More fundamentally, doesthe world need another equity, convertible bond, straight bond, option,foreign exchange contract, swaption, or any of the myriad securitiesthat underlie all hedge fund strategies? The per se answer to all of thesequestions is no, but the practical reality is that we will have more—much more—of all of the above. More books, more funds, more exoticcombinations of securities.

Why? Because it is in the nature of markets to innovate. Because thehistorical record of risk-adjusted returns of the various hedge fund cat-egories is compelling. Because the barriers to hedge fund creation arenearly nonexistent. Because there is a tidal wave of capital that wantsbetter returns with less risk; pension funds, endowments, individuals,and even nations that have not yet supped at the hedge fund trough.

Will the marginal investor reap the risk-adjusted returns that theyenvision? Maybe. Will the incremental hedge fund operator succeed inproviding those returns and therefore prosper? Some. Will various hedgefund strategies tend toward saturation—both by investors and praction-ers—thereby driving down incremental benefits? Definitely!

As the hedge fund industry enters early maturity, investors and fundmanagers need to look beyond the immediate imperative of producingattractive returns and contemplate the risks and opportunities in a longertime frame. We should be concerned not only with the durabilty of our

ix

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strategies, but also such issues as the scalability of individual firms, strate-gies, and the industry; adequate disclosure and communication (trans-parency); the evolving regulatory environment; organizational behaviorand health; and terminal value—both in terms of product offering andbusiness economics. We need to think about the “going concern” attrib-utes of individual funds and the industry.

As chairman of Cumberland Associates LLC, one of the longest run-ning hedge funds on the planet, these long-term concerns are at least asimportant as the quotidian requirements of identifying undervalued andovervalued securities through a well-honed research process. I need toattend to the psychological and economic well being of my fellow mem-bers and staff, communicate with investors and prospects, cultivate thehuman and process capital that will be required for succession of own-ership and management of our firm, and above all, make sure that westay focused yet adaptable.

Central to the process of staying competent and adaptable is what Ithink of as a willingness to ask “dumb questions”; I have built a careeron dumb questions asked of thousands of company managements, mycolleagues, myself. What I am really talking about is a willingness andeven a need to return constantly to fundamental issues as the context ofan individual, a company, an industry, or the world evolves. My allies inthis process are colleagues, both internal and external, who believe thatwhile they know a thing or two, realize that the shelf life of an insightgets shorter every day.

For the past fifteen years, one of my most valued correspondents inthis professional dialectic has been Jim Hedges. I have known him as ananalyst, a client, and the proprietor of his own successful advisory andfund of fund business. Jim’s hallmarks are the courage, curiosity, and con-fidence to think broadly, probe deeply, synthesize, and express suc-cinctly. I have always prized his input, even when he made me squirm!

Now you too can experience the pointy end of Jim’s intellect andexperience. In this book, Jim has posed the “dumb” and sophisticatedquestions that all investors and investment managers should be askingthemselves and has set forth his thoughts for our benefit. But this workis more than a compilation of his own observations and opinions; he has

x FOREWORD

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Foreword xi

called upon commentators and practitioners who have earned his respectto broaden and deepen this offering.

The utility of this book to the hedge fund investor, particulary thenovice, is readily apparent. I happen to think that it should be requiredreading for the hedge fund professional as well. One of the salientweaknesses of the hedge fund industry is the predominance of the “sole-proprietor” model, in which one personality dominates the deploymentof capital. This structure inherently lacks strong checks and balances. Ifthis sounds like your firm you should read this book.

Investors need to recognize that the combination of low barriers toentry and lucrative returns has attracted thousands of new hedge fundproprietors. Investors have exhibited a fairly marked tendency to try todiscover “hot” new managers; have overemphasized facile quantitativemeasures of risk; have underemphasized qualitative, ethical, and struc-tural elements of managers; and have unrealistically projected short ornonexistent performance records. In so doing, they have often incurredmuch greater risk and/or disappointing returns than they expected.

The explosion in new hedge fund capital is coinciding with broad-ening distribution and access. The offerings will reach marginally lesssophisticated investors—be they institutions or individuals—as theoverall probability of gaining “excess” returns diminishes for the hedgefund universe as a whole. The rate of innovation, number of vehicles,and risks in the hedge fund world will proliferate at an ever faster pace.It is incumbent upon investors to educate and protect themselves; thisbook is an excellent place to start or revew that education.

Bruce G. Wilcox, ChairmanManagement Committee, Cumberland Associates LLC

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Preface

The bull market of the late 1990s created significant wealth, yet subse-quent bear market years diminished many investor portfolios. Natu-rally, investors find the concept of shrinking assets to be unacceptableand seek ways to generate greater wealth. Emulating the best practicesof the world’s most successful investors has led to increasing “retailiza-tion” of hedge funds, funds that formerly were available only to theworld’s richest individuals.

Although hedge funds are not yet sold at the corner bank branch orATM, that is not beyond the realm of possibility. The industry contin-ues to experience exponential growth with studies predicting $4 trillionin hedge fund assets by 2010—up from close to $800 billion in 2004.(See Figure P.1.) Because hedge fund investing is based on a dynamicapproach that is uncorrelated to general market conditions, its appealcontinues to expand and more investors than ever seek ways to capital-ize on the hedge fund opportunity. As a result, there are more hedge fundsaround than ever, a number of new products, and increasing confusion.

Indeed, hedge fund investing is a complicated task even for thosewith substantial resources or investment experience. The hedge fundindustry is rife with both deliberate mystification and legitimate com-plexity. This book demystifies hedge funds and clarifies the built-incomplexities to enable more investors to introduce, in a prudent man-ner, absolute return-oriented investment strategies and vehicles intotheir overall investment program.

Misconceptions regarding hedge fund investing stem largely fromhigh-profile stories about large, highly secretive and speculative hedge

xiii

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funds that either blew up or made a bundle on a multibillion-dollar gam-ble, in either instance taking down a national economy or two as aresult. But as the hedge fund industry has grown and evolved, the head-lines and the stories that followed have taken on a lot more of the sub-stance and nuance required to do justice to the complexities of hedgefunds and the hedge fund industry. Figure P.2 presents a history of thehedge fund market.

Although scandalous headlines still show up with disturbing regu-larity, it is increasingly common to see stories that report on the real

xiv PREFACE

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03

A. Number of Hedge Funds (Growth from 1991–2003)

7,500*

$0

$100

$200

$300

$400

$500

$600

$700

’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03

$700-$800B*$700–

$800B*

2003–+$70Binflows*

2003:+$70B inflows*B. Hedge Fund Assets (Growth from 1990–2003)

FIGURE P.1 The historical growth of hedge funds.Source: Hedge Fund Research, Inc.

*Approximate industry estimations

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Preface xv

substance behind the dramatic growth of hedge funds: the growingdemand for opportunities to pursue absolute as opposed to relativeinvestment returns.

This book summarizes what hedge funds are and how they can helpus all to make more money. Most important, it looks at where theindustry is headed and what smart investors need to do now to accom-plish their investment goals. Table P.1 shows the difference in riskbetween hedge funds and more “traditional” investments.

Chapter 1 outlines the hedge fund alternative, including the basicattributes of hedge funds, the major strategies they use to pursue theirinvestment objectives, the comprehensive process of manager evaluationand selection, and some of the complexities associated with hedge fundinvesting through what is known as a fund of funds (FOFs) or fund ofhedge funds (FOHFs).

Chapter 2 explores how to cut through the black box and timelyissues related to hedge fund disclosure and transparency, which is thedegree to which investors and/or regulators can or should be informed

INNOVATIONEARLY ADOPTION

STRONGGROWTH

EXPLOSIVEGROWTH

• 1949: Alfred W.Jones & Co.investment model

•

•

•

•

•

1970s & 1980s:gradual growthestimated at $40B:

George Soros

Barton Biggs

Warren Buffet

Michael Steinhardt

•

•

•

Growth drivers:

Financial marketconditions

Educated investor& media attention

Increased supply ofhedge fund product & distribution

New segment demand(high net worth segments, pensions,Europeans)

• Estimated 7,000+hedge fundsworldwide

• Estimated $800B inassets.

•

•

•

•

Estimated hedge

funds net inflows

worldwide:

$8.0B in 2000

$31.1B in 2001

$72.B in 2003

1950s–1980s 1990s 2000 & Beyond

•

•

Figure P.2 History of the hedge fund market.

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TABL

E P.1

Key

Dif

fere

nces

in R

isk

betw

een

Hed

ge F

unds

and

“T

radi

tion

al”

Inve

stm

ents

Tra

diti

onal

Hed

ge F

unds

Inve

stm

ent

Port

folio

sIm

plic

atio

n

Inve

stm

ent

styl

esD

efin

ing

char

acte

rist

ic.

Var

y m

oder

atel

y.•

Inve

stor

mus

t m

ap r

isk.

Var

y su

bsta

ntia

lly.

•C

ross

-sty

le, -

man

ager

agg

re-

gati

on o

f ri

sk a

re d

iffi

cult

.

Exp

osur

eto

V

arie

s fr

om m

ulti

ples

of

− 1

All

sect

or/s

tyle

indi

ces

have

b•

Man

ager

“sk

ill”

impo

rtan

t.m

arke

t(s

hort

sel

ler

wit

h le

vera

ge)

to

to t

he m

arke

t of

aro

und

1.•

“Pro

cess

ris

k” m

ore

rele

vant

.+

1 (l

ong-

bias

wit

h le

vera

ge).

Stan

dard

for

mat

to

Non

e: d

iffe

rent

hed

ge f

unds

Wel

l est

ablis

hed—

can

map

•R

equi

res

deta

iled

indi

vidu

alm

easu

re/

map

ris

k di

ffer

entl

y, o

ften

m

utua

l fun

d ri

sks/

retu

rns

exam

inat

ion

of f

unds

.re

port

ris

kus

e de

riva

tive

s.on

to s

tand

ard

asse

t cl

asse

s.

Val

ue a

t R

isk

(VaR

) L

imit

ed v

alue

: VaR

mea

sure

s

Of

grea

t va

lue—

tim

e ho

rizo

ns,

•R

isk

anal

ysis

app

lied

to lo

ng-

diff

er w

idel

y ac

ross

co

nfid

ence

leve

ls, a

sset

on

ly m

anag

ers

insu

ffic

ient

man

ager

s.m

ixes

gen

eral

ly c

ompa

rabl

e.fo

r he

dge

fund

man

ager

s.

Ris

k pr

ofile

sD

iffe

r co

nsid

erab

ly: −

e.g

.,W

ell-

defi

ned

risk

pro

file

s,•

Inve

stor

as

“glo

bal r

isk

man

-ta

ke c

redi

t ri

sk.

anal

ytic

s.ag

er”—

man

ages

ris

k se

lect

sfu

nds

wit

h di

ffer

ent

styl

es,

expo

sure

s.

xvi

fpref_hedges.qxd 8/26/04 3:20 PM Page xvi

Liq

uidi

ty c

risi

s ri

skV

ulne

rabl

e—ex

acer

bate

d to

E

qual

ly v

ulne

rabl

e—ca

n af

fect

•Q

uant

ific

atio

n of

inte

rpla

yex

tent

use

leve

rage

, les

s liq

uid

hedg

e fu

nds

and

long

-onl

yof

liqu

idit

ies,

ris

k, le

vera

ge,

mar

kets

/inst

rum

ents

/sty

le.

man

ager

equ

ally

.st

yles

, etc

., is

cri

tica

l.

Perf

orm

ance

dat

aSu

bjec

t to

a n

umbe

r Su

bjec

t to

far

few

er b

iase

s.•

Ris

k of

infl

ated

exp

ecta

tion

s.of

ris

k bi

ases

.•

Req

uire

s so

phis

tica

ted

due

dilig

ence

and

mon

itor

ing.

Shar

pe r

atio

Part

ially

app

licab

le—

but

Fully

app

licab

le—

deve

lope

d fo

r•

Req

uire

s de

taile

d in

divi

dual

does

not

ful

ly c

aptu

re h

edge

lo

ng-o

nly

“lin

ear”

inve

stm

ents

.ex

amin

atio

n of

fun

ds.

fund

non

linea

rity

.

Shor

t vo

lati

lity

bias

Shor

t op

tion

s ex

posu

re c

an

Lim

ited

, if

any,

opt

ions

sho

rtin

g.•

Ris

k of

ove

rallo

cati

on.

boos

t Sh

arpe

rat

io, l

eadi

ng t

o•

Scru

tini

ze h

igh

Shar

pe.

over

allo

cati

on, h

ighe

r ri

sk.

•Sc

rutin

ize

use

of s

hort

opt

ions

.

Inte

rpla

y of

ris

ksN

ot o

nly

the

grea

ter

vari

ety

Mar

ket

risk

—eq

uity

, int

eres

t ra

te,

•M

ust

scru

tini

ze r

isk

in

of r

isk

but,

cri

tica

lly,

and

cred

it r

isk—

driv

e ri

sk-

aggr

egat

e.th

eir

over

all i

nter

play

dri

ves

adju

sted

ret

urns

.•

“Int

ellig

ent”

div

ersi

fica

tion

ri

sk-a

djus

ted

retu

rns.

is c

riti

cal.

xvii

fpref_hedges.qxd 8/26/04 3:20 PM Page xvii

about a fund’s actual investments and investment practices. Currenttransparency issues relate to both investor demand for increased trans-parency and pending regulations, which are prompting hedge funds todramatically rethink approaches to this issue.

Chapter 3, written by two principals from LJH’s partner company,Capco, underscores the challenges involved in due diligence and port-folio monitoring by relating the findings of a comprehensive study ofover 10 years of hedge fund blow-ups. Investors will learn more aboutwhat to watch out for when making a hedge fund investment decision.

Chapter 4 focuses on the single largest category of hedge fund fraud,improper valuation of portfolio holdings. It outlines the red flagsinvestors need to watch out for and tells investors why valuation is apotential “industry black eye” they need to monitor.

Chapter 5 delves into the issue of size versus performance in the hedgefund industry, a study that points to the need for investors to evaluatemanagers of all sizes when making hedge fund allocations.

Chapter 6 looks at two fast-growing directional strategies, the globalmacro strategy and managed futures investing, and outlines howinvestors can profit from the global economic markets and commodi-ties trading.

Chapter 7 is an overview of distressed securities and merger arbi-trage, two of the principal event-driven strategies that present investorswith an opportunity to profit from events that occur during the corpo-rate life cycle.

Chapter 8 covers two prominent nondirectional or relative valuestrategies, convertible bond arbitrage and fixed income arbitrage.

Chapter 9 delves into a third relative value strategy, equity marketneutral, which helps investors profit in either up or down markets.

Chapter 10 looks at technology sector investing and how this volatileand dynamic investment sector can lead to profits.

Chapter 11 begins a discussion of geographic sector investing bylooking in the current prospects for investing in Europe, a region whoselevel of international prominence is expanding.

Chapter 12 examines investment opportunities in Asia, whereinvestors have an opportunity to take advantage of Japan’s tumultuousmarket, rule changes, and volatility.

xviii PREFACE

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Chapter 13 looks at hedge fund indices, including the new investableindices, and helps investors to understand how to track with reasonableconfidence the directionality of hedge fund performance.

The glossary contains commonly used hedge fund terms aimed atclarifying oft-used words in the industry.

Before we begin, however, I want to give you a sense of my own back-ground, how I developed my particular take on the world of hedge funds,and why I approach this introduction to the industry a little differentlyfrom how others might.

For over a decade now, I have been the president and chief invest-ment officer of LJH Global Investments, an investment advisory firmfounded with a focus on introducing the benefits of absolute returninvesting to high-net-worth individuals, institutions, and their advisorsthrough the creation of custom tailored hedge fund portfolios.

From the beginning, the LJH approach has been to identify and pro-vide access to top hedge fund managers who have passed a rigorous duediligence conducted by a team of hedge fund research analysts who spe-cialize by individual strategy. During the last 10-plus years, we havehelped some of the world’s wealthiest families invest in hedge funds andhave established ourselves as a leading global hedge fund advisory firmcalled on by financial services firms as a subadvisor to build, manage, andservice FOHF products. We also have served as direct advisors to pensionfunds, family offices, and other high-net-worth individuals in the con-struction of individual hedge fund portfolios, and have provided FOHFsproducts for direct distribution to qualified investors. Our firm was oneof the first to develop fund of hedge funds registered with the Securitiesand Exchange Commission (SEC), an insurance clone product, and anarray of structured hedge fund products.

I want to make two points about how this background has both moti-vated me to write this book and influenced its content.

First, this book is the logical outcome of LJH’s commitment tothought leadership in the hedge fund industry, stemming from a beliefin the fundamental importance of promoting realistic expectationsregarding hedge funds as an asset class. This commitment has beenexpressed in several ways and in a variety of forums. For over a decade,LJH has hosted an annual client summit where many of the best minds

Preface xix

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in the industry gather to discuss and debate timely issues of importanceto investors. LJH speakers also address industry issues at investmentconferences and before regulatory agencies in the United States andabroad. In 2002 I was the first fund of hedge funds expert ever invitedto speak to executives from the Bank of Japan. In the spring of 2003 Iwas one of the experts invited to testify before the SEC in its most recentreexamination of the hedge fund industry.

In addition to the ongoing publication of a series of thought-provoking and practical white papers on a range of industry issues, LJHexperts are also sought out for commentary by financial publicationsincluding Forbes, Institutional Investor, the New York Times, Barron’s,and the Wall Street Journal, and have appeared on business televisionshows including CNN, CNBC, and Bloomberg. Outstanding productdevelopment combined with these robust, ongoing investor educationactivities are the keys to thought leadership in our industry.

Second, this book strives to provide the reader with a wealth of infor-mation that can be put to practical use. Much of this information is rep-resentative of the intelligence that our firm has gleaned from leadinghedge fund managers and others within the industry. Making a hedgefund investment is very much an act of trust, and judgment regardingthe character of managers to whom one might entrust a significant por-tion of one’s assets is perhaps the most practical element in the entireinvestment allocation process.

xx PREFACE

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Acknowledgments

This book is a compilation of many of our firm’s best ideas and wouldnot be possible without the talented team of people who haveworked with us through the years. Thank you also to all of the LJHclients for whose hedge fund investing journey we have managed and tothe other friends of LJH who have contributed to our firm’s success. Iwould also like to thank the numerous hedge fund managers withwhom I have spent countless hours over the years. Your stories, firms,expertise, and success are the foundation of our business. Most of all, Iwish to express my greatest appreciation to my partner, Charlotte Luer,without whose support, creativity, and energy this book would havenever materialized.

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Hedges on Hedge Funds

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