Performance Evaluation of How Hedge Funds Research Proposal

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¶ … Performance Evaluation of How Hedge Funds Can Be Used to Augment the Overall Efficiency in German Pension Funds

Much attention has been given to hedge funds over the last few years, but the industry itself remains to a large degree, opaque. A lack of clarity and understanding of how these funds work, what they do, and how they can be used in conjunction with other kinds of funds is at the forefront of the knowledge and beliefs of most people when it comes to these funds.

High and unseen risks are involved when investing in these vehicles. However, the returns generated have attracted the attention of a growing number of institutional investors, including those who work with pension funds. Past studies have suggested that investments in these risky vehicles can improve the return expectation of a portfolio.

For pension funds, the results have shown that even small investments in hedge funds can generate a more efficient portfolio, but the numbers of hedge funds that fail each year is high. In the current financial crisis, the growth trend in the hedge fund industry has halted and is now showing signs of decline. This puts into question whether investing in hedge funds really is a wise decision. Some investments will bear fruit whilst others will have to be written off as losses.

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This study looks at pension funds and how hedge funds can be used in order to augment and supplement their efficiency. Whether this can be done is a topic for debate, because hedge funds have not performed as well in recent years as they did in the past. In addition, they can be confusing and hard to understand for a lot of people, so many individuals are not comfortable using them as an investment vehicle.

The objective of the study is to look carefully at hedge funds and how they work, as well as pension funds and how they work, in order to determine whether they are actually a good fit for one another.

In order to do this, data will be analyzed that will show the performance of both of these vehicles and explain their inner workings more carefully. From that data, both quantitative and qualitative information can be collected and conclusions can be drawn.

TABLE OF CONTENTS

Research Proposal on Performance Evaluation of How Hedge Funds Can Assignment

iiiABSTRACT

vLIST OF ILLUSTRATIONS

1 CHAPTER ONE: INTRODUCTION

Statement of the Problem

Problem Driver

Importance of the Study

Hypothesis

Objectives

Rationale for the Study

Methodology and Overview

10 CHAPTER TWO: REVIEW OF LITERATURE

What are Pension Plans?

What are Pension Funds?

What are Hedge Funds?

Using Hedge funds in pension funds

Investment Risk

Pension Funds, Hedge Funds, and Risk Management

Type and Number of Assets

Management Risk

Hedge Fund Databases

46 CHAPTER THREE -- RETURN AND RISK MEASUREMENT METHODS

Measuring Returns

Modern Portfolio Theory

Standard Deviation / Variance

Coefficient of Variation

Sharpe Ratio

Volatility Attribution Model

Marginal Contribution to Volatility

Inclusion of New Assets in a Portfolio

57 CHAPTER FOUR: EMPIRICAL ANALYSIS

Types of Pension Funds

Types of Hedge Funds

Method

63 CHAPTER FIVE: CONCLUSION

Findings

Limitations

Conclusion

Suggestions for Future Research

72 BIBLIOGRAPHICAL REFERENCES

80 APPENDICES

Table 2.1 The use of leverage by the different hedge fund styles as of December 2001

3

Table 5.1 Preliminary Calculations

69

Table 5.2 Sharpe ratio and 1 / Coefficient of Variation comparison

71

LIST OF ILLUSTRATIONS

Figure 2.1.1

The master / feeder structure

39

Figure 2.2

Security market line (SML)

44

Figure 3.1

Removing unsystematic risks through diversification

54

CHAPTER ONE: INTRODUCTION

Statement of the Problem

The issue of hedge funds is one that has been misunderstood for many years. There are individuals that study these funds and discuss how significant they are for investing, and there are others that see them as some kind of risky endeavor that is really not important enough to focus on or that should be avoided. Both of these are valid points-of-view but, in recent years, it has generally been accepted that hedge funds are growing in popularity, and that the study of them is important, especially when it comes to considering them as investment vehicles that tie into pension funds. For a study such as this one, it is important to discuss hedge funds, but it is more important to look at how hedge funds affect pension plans and whether they are a good or bad investment vehicle. To that end, both hedge funds and pension funds must be discussed and understood well.

There has been dramatic growth in hedge funds over the last ten years. This growth is shown both in terms of assets under management and in the number of funds. The assets under management in hedge funds have grown from U.S.$40 billion in 1990 to U.S.$600 billion in 2003 (Schachter, 2004) to over U.S.$2.65 trillion as of April 2008, according to Hedge Fund Intelligence (2008). The numbers of hedge funds that currently exist, however, is difficult to obtain. In 2003, industry reports estimated that there were around 6,000 hedge funds worldwide. Both Schlachter (2004) and Lhabitant (2004) concurred with those figures. According to Hamilton (2008), there were 10,000 registered hedge funds in the Cayman Islands alone as of June 2008.

Over the last few years the growth of hedge funds has been dramatic, and the hedge fund industry has experienced a number of changes as the motives to invest in these vehicles have evolved over time. In the 1990s, according to Borla and Masetti (2003), money managers from big institutions defected to the world of hedge funds in pursuit of an ostentatious life style. They invested a large portion of their own financial wealth into their own funds in the hopes of generating a high return by finding niches to generate so called 'absolute returns' while limiting their portfolio risk. The effectiveness of these processes however is questionable due to the opacity of the hedge fund industry.

As hedge funds invest in a vast array of different instruments which include securities, options, futures, and other derivative instruments, standards for risk and return measurement have yet to be defined. Furthermore, the existing hedge fund databases are affected to a greater or lesser degree by several biases and inaccuracies. This raises the question of whether hedge funds are suitable investment vehicles for pension funds, or whether they subject the pension fund owners to too much risk.

Problem Driver

The issue driving this study is to not only show the seriousness of the problem in question, but to come up with ideas that will help to show how this problem can be reduced in size. The best way to do this is to first analyze the problem to determine just how serious it actually is, and then use that seriousness as a wake-up call for those who have been looking the other way and avoiding dealing with the issue. Many pension fund managers are believed to have done this because they want to ensure that they get good commissions, but when they do not fully inform their clients about hedge funds it can end up being detrimental to all of the parties involved.

Hedge funds are relatively unregulated, as they are typically structured in such a way to benefit from the majority of regulatory exemptions. This allows those who work with hedge funds to pursue broad investment policies and encompass a wide variety of asset classes, with no strict limits on leverage, shorting, and the use of derivatives. The financial regulations set in place for other types of institutional markets essentially pursue three objectives:

To protect the investors from abuse and default through licensing / registration, minimum disclosure requirements and increased transparency.

To reduce systemic risks while ensuring soundness and integrity of the financial system by imposing capital adequacy and margin requirements.

To ensure market price stability though position limits / trade practice restrictions (Lhabitant, 2002).

Only a few advanced countries, such as the U.S. And Europe, have basic regulations for hedge funds. These regulations encompass aspects such as which investors are allowed to invest in hedge funds and the size limits that are placed on unregulated hedge funds. Due to the lack of regulation, hedge fund managers are accorded broad freedoms with respect to transparency as well as the risk and return profile of the hedge fund strategy to be pursued, potentially to the detriment of those who are expecting to see their pension funds continue to grow (Lhabitant, 2002).

Hedge funds are often associated with the pursuit of absolute return strategies. The term 'absolute return' refers to managers exploiting investment opportunities, while protecting their principal investment from potential financial loss. Long positions are secured by selling short, buying futures, options or by using other financial instruments to secure their investments (Ineichen, 2003). The combination of the misnomer 'hedge fund' and the idea that hedge funds will produce returns regardless of the direction of the larger market can greatly deceive investors. As the number of funds multiplies, the quest for earning absolute returns means taking aggressive positions that leave the fund exposed to… [END OF PREVIEW] . . . READ MORE

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