Hedge funds and Private Equity - PES

ias by comparing the annual returns achieved by ‘live’ funds with a universe of live and defunct
funds over the period 1996-2003. They found that the arithmetic mean of the annual returns of
the live funds was 13.74% for the period whereas the arithmetic mean for all the funds (live and
defunct) was 9.32% – a difference of 4.42%. Naturally, all indices face problems with survivorship
bias. However, Malkiel and Saha report that survivorship bias produced an overstatement
of returns of 1.23% in mutual funds, compared to the 4.42% for hedge funds 17 .
– Risk, volatility and attrition rates: In the past, hedge funds tended to exhibit low standard
deviations (volatility) and correlation with general equity indices offering significant potential for
risk diversification. However, there appears to be a greater volatility in cross-sectional distribution
of returns risk, i.e. a great risk of choosing a poor performing fund. Thus, Malkiel and Saha
examined the cross-sectional standard deviation of different hedge fund categories over the
period 1996-2003. They found that the standard deviation of their returns is considerably higher
than it for mutual funds. In addition, Malkiel and Saha noted that the so called attrition rates –
the proportion of funds that fail to survive – were three or four times higher than for mutual funds
over the period 1994-2003. In other words, the range of returns is much wider so while investors
may face high rewards for selecting top-performing funds, they also face a high risk of picking a
bad performer or a failing one.
Assuming that hedge fund performance is overstated, what are factors in the current growth?
We cannot ignore the fact that some hedge funds have delivered impressive investment returns.
In addition, they do offer significant potential for risk diversification. However, we also believe
that there are other important reasons for the current growth of AUM. Two relate to matters that
we will deal with in greater detail in other parts of the report, so we will just briefly touch upon
them here: the high performance fees paid to hedge fund managers and the likelihood of lower
regulation and taxes.
In traditional investment funds, managers typically charge a management fee for their services
but do not take any profits. Hedge fund managers, by contrast, generally charge two fees:
management fees, averaging 1.5%, and performance fees, averaging 25% of the net profits (see
section 2.10). The high performance fees make it attractive to set them up. In other words, explanations
for the rapid growth in AUM by hedge funds should also be sought on the supply side.
In addition, the performance fee issue underlines the importance of calculating returns by HFs
net of the (often very high) performance fees – something that many publicly available statistics
do not do.
Hitherto, low regulation and/or tax exemptions appear to have provided another important
impetus to the growth of AUM by hedge funds, particularly the assets managed by offshore
funds. Offshore funds are unregistered pooled investment funds domiciled in offshore centres
like the Cayman Islands or the Virgin Islands. They are usually structured in a way that allows
them to avoid various portfolio management restrictions that apply to registered funds. This
might, for instance, be the case in terms of the use of leverage. In addition, offshore funds are
likely to pay no tax, or much lower tax than both registered and unregistered domestic funds.
Above, we showed how traditional institutional investors allocate ever more funds to hedge
funds. As a result hedge fund managers may be facing new choices: would they align themselves
with the large asset managers, who act as a distribution channel to institutional money
and therefore seek to comply with the institution’s demands for transparency, strong governance
and a robust operating environment? Or, would they choose to remain focused on the rich individuals
and endowments, which allow more flexibility in the standards and often also the locality
of operations? Given the size of traditional institutional investors, some managers are likely to
choose the former option, thereby increasing the reach of existing regulations regarding traditional
investment funds.
17 Op. cit. p. 83-84.
Part I – Hedge funds and private equity funds – how they work
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