Table of Contents
2. Factors to consider
2.1 Legal consideration
2.2 Economic concerns
2.3 Marketing considerations
3. Analysis of the different hedge funds
3.1 Reconsideration of allocation percentages
This paper is based on “The Common Fund Hedge Fund Portfolio” case from the Harvard Business School (Harvard Business School, 1996). The data provided are taken from it. It aims to support David Storrs, CEO of the Common Fund Company, decision if and how to include a hedge fund into the overall portfolio. The Common funds have more than $17 billion assets under management for more than 1,000 educational institutions. Storrs considers establishing a fund of funds, which he can offer his clients as a means of diversification. A hedge fund is an alternative, unregulated investment vehicle that can take long as well as short positions, use high leverage and write options or futures. The central question asks how Storrs should allocate different hedge funds in the funds of funds portfolio, taking into consideration the legal, economic and marketing issues, beside performance and volatility.
The first section will touch upon the legal, economic and marketing issues of hedge funds with regard to the decision to take by Storrs. The second section is going to investigate the proposed allocation of assets and reconsiders the asset allocation. Thereby not only quantitative measures are taken into account but also qualitative factors. Finally, an advice is given on how Storrs should allocate the portfolio with regard to the circumstances of the Common Fund Company.
2. Factors to consider
2.1 Legal consideration
A hedge fund is a special investment vehicle not covered by the Securities Act of 1933 because they do not issue shares to the public. As a private investment partnership it does not have disclosure requirements and is therefore not supervised by the SEC. Therefore, a hedge fund has enormous flexibility in pursuing whatever investment strategy is appropriate in the general manager’s point of view. Most general partners, who manage the fund, are interested in capital preservation because in most cases the main reason to set up the fund was to manage ones own capital. Hence, the general partner has a high deal of power over their limited partners. A hedge fund is only allowed to have up to 99 investors (limited partners), even though this restriction was loosened recently.s
Research shows that lock up provisions enhance a funds performance because a manager can pursue more promising or risky strategies, for example in long positions of highly illiquid, yet promising securities and distressed securities or in short positions in the junk bond market (Liang, 1998). Due to the lock up provision they do not face the liquidity risk a normal investment manager in the mutual fund industry faces. This is due to the fact that hedge funds often have lock up provisions of capital, up to three years. In addition, a limited partner who aims at withdrawing his investment has to notify the hedge fund at least three months in advance. Afterwards a part of the withdrawn capital is held in an escrow account until the annual audit is completed. From the point of view of a limited partner, i.e. the Common Fund, this means liquidity risk and a long-term investment horizon.
Another factor to consider is leverage. Many hedge funds use extensive leverage due to the use of options, margins, futures or repos. In the past, some funds purchased at the overnight rate and invested it in intermediate treasury bonds. All this leads to high returns, sometimes up to 20 fold, but also to substantial risk because if the market turns against the funds position the losses are amplified. Additionally, matching short-term borrowings with medium-term investments, as in the above Treasury bond example, can lead to solvency problems as we saw during the financial crisis.
The lack of transparency is another important issue, since general partners have to disclose their holdings and performance only quarterly. Moreover, the partnership agreement states how extensively the manager discloses his strategies, market exposure, performance and holdings. In most cases the managers forego extensive reporting because they fear predatory investment attacks or short squeezes.
However, the above outlined issues are aligned with the limited partner’s interests due to the fee structure of hedge funds. Most hedge funds get a percentage base “salary” of assets under management. The main source of profit for the manager is the performance fee, which is calculated as 20% of the excess return to an in advance specified hurdle rate. In addition, many funds have “high watermark” provisions. If the fund experiences losses, the managers have to make up for the losses before they are entitled to a performance fee. This means that cumulative returns have to be above the hurdle rate. Liang shows that the existence of high watermark provisions enhances performance (Liang, 1998).