Characteristics Of Hedge Fund

• Lower Regulations
  • Hedge funds have a wide playing field as compared to many types of public investment institutions. This allows hedge funds to take advantage of opportunities that many other institution simply can not exploit to a high degree. An example of this is short selling. Most mutual funds are not allowed to engage in short selling – a tool that has enormous upside if timed well based on idiosyncratic factors and economic scenario.
• High Leverage
  • Leverage is a double-edged sword which essentially magnifies the returns earned by a strategy. Most public institutions have restrictions on the use of leverage; however hedge funds have a free hand in using the tool to its fullest. An important point to note here is that leverage not just allows funds to exploit opportunities better, they also sometimes create new money- making opportunities. A good example of this can be how LTCM would take enormous leverage which made exploiting small mis-pricings extremely profitable. Without leverage, many of the strategies LTCM used would not have been viable. The reason to bring up LTCM in the discussion regarding leverage is not random, but a chosen decision as very few case studies can give the kind of insight into leverage in financial markets like LTCM can. The problem with leverage is that when returns are magnified, so is the risk. Even more importantly leverage can also turn paper losses into real losses by forcing the hand of  investors to sell the assets at a massive loss to avoid bankruptcy. This exposes funds like LTCM to extreme shock events. Without leverage, a fund can hold onto the loss making portfolio and tide over shock events. However, leverage can force the investors to liquidate their positions when the market would be at the lowest. This can be seen in the case of LTCM, where even though the fund’s strategies might have worked in the long run if they didn’t face the need to liquidate their positions at a few days’ notice amidst global economic problems.
• Exclusive Clientele
  • One of the main reasons why hedge funds do not have the regulatory scrutiny that the major public financial institutions face is that hedge funds have extremely exclusive clientele with rich individuals and institutions that have the resources to perform their own due diligence. Another major reason for this kind of clientele is that it allows the hedge funds to raise their capital from a relatively fewer investors who would be willing to lock in their investments for a decent amount of time to allow the hedge funds time to perform. In case of small investors, the money raised would be highly fragmented which would mean that there would be a high likelihood that these investors would exit the market when shocks begin to hit – triggering a situation where the hedge fund would need to go for a fire sale to allow withdrawals.

Hedge Funds V/S Mutual Funds

• Hedge funds are distinct from mutual funds in several important respects. Historically, hedge funds are private investment vehicles not open to the general investment public. This means that hedge funds face less regulation than publicly traded mutual funds, allowing them to hold substantial short positions to preserve capital during market downturns.
• Typically hedge fund managers generate profit from both long as well as short positions. However, some specialist hedge fund managers, who are particularly skilled in identifying “over-priced” assets and have the infrastructure to carry short positions over an extended period of time, do rely on shorting securities as their main source of profit. Mutual funds on the other hand are usually not allowed to short sell assets.
• The ability to take short positions not only helps to dampen sensitivity to the general market direction, it also allows managers to take large bets on perceived relative price discrepancies of assets. Therefore, it is common to find hedge fund balance sheets that substantially exceed in size, the equity capital of the vehicles. Mutual funds on the other hand do not use a lot of leverage and their assets are limited to the value of the investors’ funds.
• The private nature of hedge funds often suits both the needs of investors and managers. While wealthy investors of early hedge fund vehicles rarely imposed specific mandates on how  their investments should be managed, most if not all of these investors will demand their investment in the vehicle be kept private and carry limited liability. Mutual funds on the other hand are generally public.
• In addition, as individual capital commitments to a hedge fund manager tend to be small in relation to the investor’s overall portfolio, it is critical that a hedge fund investment carries the same limited liability protection as buying shares of a public company. This is especially important given the leverage used by most hedge fund managers.
• Hedge fund managers often claim to have complex proprietary strategies to generate outsized profits. To keep other traders from mimicking or “front running” their trades, they offer very little transparency, even to their investors. The opacity of hedge fund vehicles persisted for over half a century until the arrival of institutional investors in the new millennium. Mutual funds on the other hand are pretty much open books when compared to these secretive hedge funds.
• Another benefit of being lightly regulated investment vehicles is that hedge funds in the US are not subject to the legal restrictions on compensation that govern publicly traded mutual funds. A typical hedge fund charges a fixed management fee, which usually ranges between  one and two percent per annum, based on the value of assets they manage. The lower end of this range is comparable to the management fees charged by actively managed mutual funds.
• However, unlike mutual funds, hedge funds generally charge an incentive fee – typically between 10% and 20% of new profits of the fund. Incentive fees are only payable when new profits are made. This means that losses have to be carried forward until they are recouped, and the previous level of investors capital is restored – this level of capital is often referred to as the High-Water Mark.
• However, being lightly regulated does have unintended consequences. For one, performance records of hedge funds are generally not standardized and available reports are prone to measurement errors. Until the early 1990s, the historical performance of hedge funds was often as private as their investors, and the assessment of hedge fund performance was as much art as science. This lack of transparency makes hedge funds a repulsive investment avenue for many risk averse investors who would prefer the open and transparent nature of mutual funds.

Biases Commonly Associated With Hedge Funds

• Survivorship Bias
  • There is sort of a selection bias that arises when we limit a sample of funds to those for which returns are available over an entire sample period. This practice implies that we exclude from consideration all funds that were closed down over the sample period. The ensuing bias is called survivorship bias. It turns out that when even a small number of funds have failed, the upward bias in the performance of surviving funds can be substantial. Most mutual fund databases now include failed funds so that samples can be protected from survivorship bias.
• Instant History Bias
  • Instant History Bias (also called back-fill bias) is a phenomenon that can significantly overstate the performance of the hedge fund industry. As there is no regulatory compulsion on the part of hedge funds to report their returns, funds can stop reporting their returns when they face huge losses. This results in mainly only those firms reporting their results that are doing well leading to a much rosier image than reality.
• Reporting Bias
  • Reporting Bias is a scenario where hedge fund firms that never disclosed their information to commercially available databases, decide to start reporting their returns. This is commonly also referred to as selection bias or self-reporting bias in hedge fund databases.
• Smoothing Bias
  • Since a large portion of the assets at a hedge fund can be illiquid, they often have a degree of freedom in valuing their assets. This subjectivity can often result in hedge funds trying to window dress by taking parts of the data that show the firm in a better light.

History And Evolution Of The Hedge Fund Industry

• Until the early 1990s, the historical performance of hedge funds was often as private as their investors, and the assessment of hedge fund performance was as much art as science.
• By 1993, reports of hedge fund managers amassing billions of dollars of leverageable capital began to emerge. Unfortunately, this industry landmark was followed by dramatic losses from some well-known managers in the hedge fund industry in early 1994, triggered by the unexpected change in interest rate policy by the Federal Reserve.
• The events of 1994 had a profound impact on the way hedge fund investors assess their portfolios. It was the first recorded event in which the proverbial alarm, ‘everyone lost money’, rang throughout the hedge fund industry.
• Coupled with the growth of the hedge fund industry, the events of 1994 prompted investors to reexamine the perceived diversification of their hedge fund holdings. In turn, this aided the development of electronically available hedge fund databases with which more formal analysis of hedge fund performance and the attendant risks can be conducted.
• It was the arrival of electronic databases that made academic research in hedge funds a feasible proposition.
• The collapse of a large, well-known hedge fund LTCM (Long Term Capital Management) had a dramatic impact on the private world of hedge fund investors. It was a stark reminder that earning outsized returns from highly leveraged bets comes with spectacular event risks – namely, outsized draw downs that wiped out LTCM investors’ capital. This was an extreme event that did not have the same adverse effect on the equity market – during the worst months of the LTCM crisis from June to October of 1998, the DJCSI and HFRI lost 13.04% and 7.68% respectively whereas the SNP index only lost 2.62%.
• The circumstances leading up to the collapse of LTCM have been referred to “a ten sigma event”, which may well be true, nonetheless the dramatic loss from a well-known fund on such a major scale left an indelible scar on hedge fund investors’ confidence.
• Many people viewed this as a turning point in the capital formation process of the hedge fund industry. According to the Lipper-Tass Asset Flow Report, net of performance differences, investors increased their investments in the hedge fund industry by 45.62% over the 1996- 1997 period.
• The LTCM event raised many questions on how the risk of hedge fund investments should be measured. Many ad hoc statistics have been proposed to measure the tail risk of investing in  highly leveraged hedge fund strategies. Suffice to say that by the end of 1998, the hedge fund investment community had generally accepted that the first two moments of an expected return distribution may be woefully inadequate for capturing the risk of these dynamic, nonlinear, leveraged strategies.
• The two-year period, 2000-2001, witnessed the burst of the dot-com bubble. Although the hedge fund industry as a whole was not affected in a major way, there were some famous casualties.
• However, investors’ appetite for hedge funds improved during this time and the industry saw a net asset inflow of 19.82% over this period. This turn-around in the demand growth for hedge funds coincided with a major shift in the structure of the hedge fund industry. Not only had hedge funds outperformed the SNP index, their return standard deviations were just over half of the SNP index’s return standard deviation. This caught the attention of another major group of investors – institutional investors such as foundations, endowments, pension funds, and insurance companies.
• The subsequent two-year periods of 2002-2003 and 2004-2005 both experienced over thirty percent increase in net asset growth for the hedge fund industry, according to the same  Lipper-Tass Asset Flows Report.
• By the end of 2007, the total Assets-Under-Management (“AUM”) of the hedge fund industry had grown to $1,390 billion from $197 billion at the end of 1999 according to the Lipper- Tass Asset Flow Report. Taken together these observations are consistent with a shift in the investor clientele from an industry dominated by private wealthy investors to institutional investors.

Role Of Institutional Investors & Aum’s Growing Concentration

• Perhaps the most important event that shaped the modern-day hedge fund industry was the arrival of institutional investors. This major shift in investor clientele had a profound impact on the supply of hedge fund products.
• The corporate governance requirement of institutional investors worked in favor of large hedge fund management companies shaping the capital formation trend of the industry since the turn of the century. It is believed that the concentration trend of AUM in the hands of a small number of mega hedge fund management companies is pervasive.
• If this is the case, then the data gap generally noted between AUM serviced by hedge fund administrators and AUM reported to commercial databases comes mostly from successful, large hedge fund managers who elected not to disclose data to databases.
• Insight on the properties of this data gap is not only important to models of hedge fund strategies and performance but may potentially affect the future of hedge fund regulation. After all, regulating a small number of large management companies is quite a different proposition from regulating thousands of small private asset managers.
• However, if AUM concentration does continue without bounds, the probability of a convergence of risky bets like 1994 will rise, as increasing amounts of leverage-able capital would be concentrated in the hands of a few hedge fund managers. A convergence of opinions on certain risky assets could potentially lead to market disrupting events. More work is needed in this area of research. The continuing growth of industry AUM attests to the relative attractiveness of hedge fund strategies on average compared to their attendant risk (betas).

The Alpha Beta Seperation & Risk Management

• Much has been written about the generous fee structure which hedge funds command. After two decades of nearly unabated growth, the hedge fund industry is much larger (in AUM terms) and dominated by sophisticated institutional investors – investors who are not known for their generosity when it comes to fees.
• Yet, there is little sign that hedge fund fees are falling at a pace comparable to the industry’s asset growth. It is important to look at some of the discussions regarding the perceived value of investing in hedge fund strategies, and how the supply side of hedge fund products has responded and evolved to change investors’ demands.
• Hedge fund returns come packaged with an alpha-like component mixed with systemic risk exposures (betas). Some of these betas can be traced to asset-class factors that can be accessed via lower cost vehicles. For example, the eight-factor model explains 78.38% of monthly return variation of a hedge fund index like the HFRI.
• To the extent that the return from a persistent exposure to a factor beta represents the risk premium earned from placing capital at risk, it raises the question – can these risk premia from different factors be captured via lower cost alternatives to hedge fund vehicles? Answering this question requires a bottom-up approach to analyze this question.
• It can be seen that some of the more mature hedge fund strategies can be replicated with rule- based models using liquid assets that are readily executable in the marketplace. Therefore, a rule-based representation of a given hedge fund strategy can be thought of as the beta factor of that strategy or its strategy beta. Collectively, these strategies are often referred to as alternative betas.

Hedge Fund Strategies – Global Macro & Managed Futures Strategy

• Global Macro refers to the type of hedge fund strategy wherein a fund makes bets on its views regarding the various economic and political trends around the world.
• Such strategies can involve taking both long or short position in a variety of financial instruments ranging from equity to fixed income and commodities to futures.
• A good example of such a bet can be if a fund has the view that a certain country would devalue its currency in order to boost exports, it can do an in-depth analysis of both numerical data as well as go through the various news articles within the country to narrow down on when such a move can happen or what internal or external event might trigger it.
• It is important to note that though the expectations of most investors from managed futures and global macro strategies is similar – i.e., to ensure that their investments have a low correlation to major asset classes, especially when times are bad, the two strategies are very different. While the global macro strategy often involves investing into very illiquid financial instruments and the process is highly discretionary, managed futures deals with publicly traded futures contracts (that are usually liquid) and follows a much more systematic approach.
• The majority of managed futures funds employ a trend-following strategy. Managed futures  fund managers tend to employ systematic trading programs that largely relies upon historical price data and market trends. A significant amount of leverage is often employed since the strategy involves the use of futures contracts. They tend not to have a particular bias towards being net long or net short in any particular market.
• As most Global Macro as well as Managed Futures trades are one directional, the fund does have an enormous exposure at times. This is because though a fund can sometimes be neutral on many aspects by taking opposite positions in assets that have a positive correlation, sometimes idiosyncratic risk can be huge.

Hedge Fund Strategies – Risk Arbitrage & Distressed Strategy

• Risk arbitrage event driven hedge funds typically attempt to capture the spreads in merger or acquisition transactions involving public companies after the terms of the transaction have been announced.
• The spread is the difference between the transaction bid and the trading price. Typically, the target stock trades at a discount to the bid in order to account for the risk of the transaction failing to close.
• In a cash deal, the manager will typically purchase the stock of the target and tender it for the offer price at closing. In a fixed exchange ratio stock merger, one would go long the target stock and short the acquirer’s stock according to the merger ratio, in order to isolate the spread and hedge out market risk. The principal risk is usually deal risk, should the deal fail to close.
• Distressed hedge funds typically invest across the capital structure of companies subject to financial or operational distress or bankruptcy proceedings. Such securities often trade at discounts to intrinsic value due to difficulties in assessing their proper value, lack of research coverage, or an inability of traditional investors to continue holding them.
• This strategy is generally long biased in nature, but managers may take outright long, hedged or outright short positions. Distressed managers typically attempt to profit on the issuer’s ability to improve its operation or the success of the bankruptcy process that ultimately leads to an exit strategy.

Hedge Fund Strategies – Fixed Income Arbitrage Strategy

• Fixed Income Arbitrage Hedge Funds typically attempt to generate profits by exploiting inefficiencies and price anomalies between related fixed income securities. Funds often seek to limit volatility by hedging out exposure to the market and interest rate risk.
• Strategies may include leveraging long and short positions in similar fixed income securities that are related either mathematically or economically. The sector includes credit yield curve relative value trading involving –
  • Interest rate swaps, government securities and futures
  • Volatility trading involving options
  • Mortgage-backed securities arbitrage (the mortgage-backed market is primarily US-based and over-the-counter).
• An interesting example of such a hedge fund strategy is the one that was used by LTCM. This strategy focused on exploiting price inefficiencies in long-term bonds (30 years maturity period). The case study on this particular strategy of LTCM is a must read as it highlights most of the risks associated with such strategies from a practical and real life point of view.

Hedge Fund Strategies – Convertible Arbitrage Strategy

• Convertible Arbitrage Hedge Funds typically aim to profit from the purchase of convertible securities and the subsequent shorting of the corresponding stock when there is a pricing error made in the conversion factor of the security.
• Managers of convertible arbitrage funds typically build long positions of convertible and other equity hybrid securities and then hedge the equity component of the long securities positions by shorting the underlying stock or options.
• The number of shares sold short usually reflects a delta neutral or market neutral ratio. As a result, under normal market conditions, the arbitrageur generally expects the combined position to be insensitive to fluctuations in the price of the underlying stock.
• The main risk associated with such strategy is in the problem of effective and realistic pricing of the instrument.

Hedge Fund Strategies – Long/Short Equity Strategy

• Long/Short Equity Hedge Funds typically invest in both long and short sides of equity markets, generally focusing on diversifying or hedging across particular sectors, regions or market capitalizations.
• Managers typically have the flexibility to shift from –
  • Value to growth
  • Small to medium to large capitalization stocks
  • Net long to net short.
• Managers can also trade equity futures and options as well as equity related securities and debt or build portfolios that are more concentrated than traditional long-only equity funds.
• There are many risks associated with this strategy including the risk of adverse movement. Though the strategy focuses on diversifying away many of the risks by theoretically maintaining neutrality across sectors and regions, there is a high degree of idiosyncratic risk associated with most of the trades.
• Another major risk can be regarding liquidity especially while short selling various illiquid stocks. A short squeeze is a situation wherein a company is not able to buy back the stocks after shorting them due to a lack of liquidity in the market. This can lead to humongous losses and even bankruptcies as theoretically the price of a stock can go up to any level and if a short position is not closed off while the stock is taking off, it can become difficult to find sellers later.

Hedge Fund Strategies – Dedicated Short Bias Strategy

• Dedicated Short Bias Hedge Funds typically take more short positions than long positions and earn returns by maintaining net short exposure in long and short equities. Detailed individual company research typically forms the core alpha generation driver of dedicated short bias managers, and a focus on companies with weak cash flow generation is common.
• To affect the short sale, the manager typically borrows the stock from a counterparty and sells it in the market. Short positions are sometimes implemented by selling forward. Risk management often consists of offsetting long positions and stoploss strategies.
• As clearly evident here, the main risk in this strategy would come from adverse movement due to the unidirectional nature of the bets.
• A second major avenue of risk is the risk that liquidity might evaporate from the market leaving buying back stocks very difficult. As discussed in the previous slide, short selling opens up the short seller to enormous and theoretically unlimited risk in case there is an adverse movement in the price (while in a long position, the maximum loss is limited to the price of the security, there is no limit to the losses if the price of the security sky rockets). Such losses have occurred many times recently with stocks like GameStop and Tesla.

Hedge Fund Strategies – Emerging Markets Strategy

• Emerging Markets Hedge Funds typically invest in currencies, debt instruments, equities, and other instruments of countries with “emerging” or developing markets (typically measured by GDP per capita).
• Such countries are considered to be in a transitional phase between developing and developed status. Examples of emerging markets include China, India, Latin America, much of Southeast Asia, parts of Eastern Europe, and parts of Africa.
• The obvious risks associated with such strategies is that there is a much higher degree of uncertainty associated with these emerging economies as compared to the developed world. There have been many instances in the past wherein an emerging economy whose star was at the rise collapsed due to a combination of political and economic events.
• Countries like Venezuela and Iran were considered beacons of hope of economic stability in their respective regions until the political turmoil and bad economic policies completely destroyed the core of such belief.

Hedge Fund Strategies – A Word From The Content Writer

• Some of the material on the hedge fund strategies int his document has been taken from the Dow Jones Credit Suisse reports and readers are encouraged to go through their website to gather more information regarding various strategies and the type of data sets generally used for analysis of investment opportunities in these strategies.
• Another thing to keep in mind is that hedge funds are always looking for an edge over their competition, after all they are charging enormous fees and would have to provide something unique. Thus, most hedge funds do use one of the many strategies described earlier but they usually add some kind of additional filtering and selecting process over and above the basic strategy.

Portfolio Construction & Performance – Historical Trend

• In the early days of the hedge fund industry, before the academic studies on publicly available hedge fund returns and the attendant risk factors, investors often viewed hedge funds as “black boxes”, regarding them as a separate “asset class” that were not correlated to standard equity and bond indices.
• These early hedge fund investors had limited access to performance data and often had to rely on tools that were designed for evaluating long-bias funds investing predominantly in conventional asset classes. It is perhaps not surprising that portfolio construction and risk management often reduce to spreading risk capital across hedge fund managers with different sounding strategies.
• During these early days, manager selection was primarily driven by the reputation of individual hedge fund managers. Today, there is a greater emphasis on strategy and individual investors have greater preference regarding the exposure that one wants to take. Further, analyzing the various measures of the hedge fund manager’s performance like alpha, beta and various ratios like Sharpe ratio, Treynor ratio and Jenson’s alpha has allowed investors to choose a hedge fund manager with the risk profile and risk adjusted return that is in line with the investor’s risk appetite.
• Two important conclusions can be drawn from the recent data in many studies of hedge fund return –
  • Large hedge funds do provide a degree of alpha in a statistically significant way which points towards outperformance as compared to their peers in equities.
  • The hedge fund performance usually has a very low correlation to the equities markets which allows institutional investors to make diversified investments and allows for returns even when there is a slow down in the economy (as hedge funds are usually not biased towards long positions).
• Periodically, market events occur during which seemingly different strategies can undergo stress at the same time. When this occurs, an otherwise diverse portfolio of hedge funds can converge in terms of risk, or its portfolio diversification implodes.
• To gain insight on how convergence of risk factors can be managed, analysis of some of these incidents must be undertaken to underscore the special nature of hedge fund strategies.
• The first such recorded event occurred during the March to April period in 1994. Seven out of the ten style-specific sub-indices in the DJCS family lost money in these two months. The exceptions being Short Sellers and Managed Futures which delivered positive performance in both months, Risk Arbitrage with a positive return in March and Equity Market Neutral with a positive return in April. The overall DJCS Broad index is negative for both these two months. The reason for the negative performance across strategies is generally attributed to liquidation of leveraged positions following the unexpected rate hike by the US Federal Reserve.
• The next episode occurred in August 1998 leading up to the collapse of LTCM. In this month, eight out of the ten niche DJCS style sub-indices suffered sizeable losses ranging from — 23.03% for emerging market hedge funds to —0.85% for equity market neutral hedge funds. The exception being Short Sellers and Managed Futures funds which returned 22.71%  and 9.95% respectively.
• Much has been written about the events leading up to the collapse of LTCM, suffice it to say that the commonly accepted causes are market-wide liquidation of risky assets and the bloated balance sheet of LTCM from aggressive use of leverage. While wholesale liquidation of risky assets can occur globally for a variety of reasons inflicting stress on conventional long-biased strategies as well as hedge funds, it is the effect of leverage that makes hedge fund investment risk different from conventional long-bias strategies.
• Put differently, managing hedge fund investment risk applies to both side of the balance sheet – asset as well as liability – in that a diversified set of risk factor exposures from the asset side of the balance sheet is no guarantee that funding risk is simultaneously diversified.
• Events leading up to the 2008 financial crisis are a stark illustration of the damage that a market-wide funding crisis can inflict on leveraged positions. August 2007 marked the first ever month in the reported history of DJCS’s hedge fund indices in which all nine specialist style sub-indices lost money – the only exception being the positive return from specialist funds with a short focus or short sellers.
• Some authors have attributed the event to “fire sale liquidation of similar portfolios that happened to be quantitatively constructed”. This, however, would not explain how all other hedge fund styles lost money as well. Another clue lies with the extraordinary events leading up to the demise of Bear Stearns.
• Bear Stearns was among the first major Wall-Street victims of the credit contagion emanating from what we know with hindsight as the US housing market crisis. Around the peak period of the 2008 financial crisis between July and October of 2008, there were unprecedented consecutive months, July to September, during which all hedge fund styles except short sellers lost money. The precise reasons why different specialist hedge fund styles lost money are likely to be many and varied. The one common theme is the “forced liquidation” of leveraged positions driven by a combination of rising margin requirements, borrowing costs and investors withdrawing their equity. In short, there was a crisis on the liability side of most hedge funds’ balance sheet irrespective of the type of assets (risk factors) they hold (are exposed to) and their trading strategy.
• No major strategy category was spared. For example, a historically low volatility strategy like Convertible Arbitrage lost over 12% a month for both September and October of 2008 according to the DJCS style index for that strategy. These were the two left tail data points of this strategy shown in the figure below. Under normal market conditions, shorting the equity content of a convertible bond will eliminate most of the day-to-day price fluctuation thus creating a low risk portfolio to take advantage of perceived mispricing of convertible bonds. However, when these positions are leveraged, the latent risk of rolling over these positions can prove to be extremely costly in a credit crunch.

Risk Asymmetry – Between Principal & Agent In Hedge Fund Industry

• The question of risk asymmetry has become extremely controversial in not only the hedge fund industry but also in the finance industry in general especially after the 2008 crisis. Risk asymmetry is a situation wherein one of the parties has much greater risk as compared to the other even though both party are involved together in a certain process.
• Firms like Lehman Brothers went down spectacularly during the crisis. They were punished by the invisible hand of the market for being too reckless. However, as the dust settled around the crisis and millions of Americans lost their homes, people began to realize an extremely ugly truth – while Lehman Brothers as a firm had gone down, the various top management executives of the company walked away with millions of dollars that they had earned during the years preceding the crisis.
• All of a sudden it seemed like the big financial firms whose executives are protected by the concept of ‘limited liability’ can take huge amounts of risk and get their bonuses. However, when the firm fails due to excessive risks – the clients, investors and lenders lose money, but the executives don’t lose their private jets.
• In the hedge fund industry, this asymmetry is actually probably even greater than at the major investment banks as performance bonus forms a major part of the compensation of the hedge fund managers and they have nothing to lose financially if their fund makes losses and their capital evaporates.
• There are numerous examples of many hedge fund managers that crashed their fund into the ground and then were able to again raise money to start another fund. One of the main executives behind the creation of the legendary hedge fund LTCM – that collapsed so spectacularly that it threatened to suck the entire financial system of America with it – was able to start another fund within years of the collapse of LTCM. But the story doesn’t end there as after the second fund was battered by losses, John Meriwether was able to raise funding for a third fund! This may raise the question that are the hedge fund managers taking on any real risk after all?