Hedge Funds: Truths and Myths

Abstract: Hedge funds have enjoyed increasing levels of popularity coupled with mysticism, opacity and obscurity, yet they are a trillion dollar industry worldwide. This paper aims at presenting some facts about the hedge fund sector, and to reflect on some of its myths. The paper reviews the industry, its products, its risks and proposes a way of thinking about them from the investor's viewpoint which takes into account their nature, very different to traditional investments. Resumen Los hedge funds, o fondos de cobertura, han despertado la atencion de los inversores con una aureola de misticismo y oscurantismo, y se han convertido en un sector de mas de $10 12 a nivel mundial. En este articulo se intenta simplemente presentar algunos hechos sobre el sector, y reflexionar sobre algunos de los mitos. En este articulo revisaremos la industria, sus productos, riesgos y plantea una manera de pensar sobre los hedge funds, desde el punto de vista del invesor, que tiene en cuenta sus diferencias respecto a las inversiones tradicionales. -2 -Executive summary Hedge funds have become financial companions in our everyday life; their presence encompasses many of the activities that were traditional to the banking sector and are being abandoned due to increased regulation, many new activities which are a reflection of new capital markets created every year, and of course an ubiquitous search for opportunity, risk and profit in capital markets in general. They have experienced tremendous growth over the last decade as an asset base for institutional and individual investors. The hedge fund's principal quality is their search for uncorrelated returns. Investors need uncorrelated returns for diversification. In an increasingly globalized world, economies are rapidly becoming highly dependent on each other's, and hedge funds owe their popularity largely to the fact that they present to the investors one of the few alternatives to economic-dependent, highly correlated investments worldwide. Hedge funds obtain returns by taking risks; understanding their risks therefore becomes the key factor to understanding them as an industry. Their risk is the glass through which we must look at their returns. This presents a need to depart from traditional portfolio theories, which view risk and return as different, unrelated quantities, and the need for a new portfolio theory arises, which we address in the sections below. We also address the main risk sensitivities; correlation, the principal benefit of hedge fund investing, will lead to the main sensitivity for us to study; if hedge funds are popular because of diversification, our main concern should be why and how that can go away; we will model it in the context of regime switching models, which provide an easy-to-understand picture of correlation breakdown phenomena