Book Review: Hedge Fund Investing
Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance wears several hats. A plain-language learning tool, the book provides a useful introduction to hedge funds for practitioners with varying degrees of exposure to the space. In particular, it serves the fledgling professional investor learning about the topic for the first time in the context of the field’s increasing depth and complexity. Also, it is an instructive work of financial history. It traces the field’s evolution for the past 60 years up to the state of hedge fund investing in 2016.
The book’s organization lends itself well to instructional use. Part One positions hedge funds in relation to other alternative investment opportunities, such as private equity and real estate, and to investing in general. The very first chapter contains a particularly useful brief comparison of hedge funds with mutual funds across numerous investment dimensions. Indeed, this chapter serves as a synopsis of the book, touching on the common challenges of leverage, illiquidity, and valuation as well as discussing structures, domiciles, and critical organizational roles in a hedge fund. The second chapter provides a robust overview of single-manager hedge fund strategies that the author parses in far greater detail in the second part of the book. In the third chapter, a brief overview of academic research that supports hedge fund investment addresses these funds’ place in the investment allocation process. It also, however, acknowledges the controversy surrounding this research from the late 1990s to the mid-2000s. The chapter on trends, flow, and characteristics permits the reader to view the bigger picture of how the hedge fund business has developed in the context of the investment industry and investment regulation.
Part Two of the book describes the main categories of hedge funds in detail, allowing the reader to gain a rapid, if cursory, understanding of them. Each chapter offers some historical context for the category, highlights the varieties of ways in which managers approach and execute the strategy, and indicates risks and rewards inherent in each strategy. Reviews of organizational structure, portfolio characteristics, fund terms and conditions, and flows and performance for each category deepen the reader’s understanding of how the strategies operate. Profiles of each strategy’s leading practitioners provide entertaining real-life examples of managers who have excelled in the space, making the learning experience all the more accessible. Finally, each chapter contextualizes risk evaluation and return measurement for the strategy under discussion, addressing useful metrics and challenges in their application.
The final chapter of Part Two, “Portfolio Finance and Secondary Market Trading,” initially appears out of place. It seems to belong in the book’s final part, a how-to on risk and reward measurement and operations. Then, one realizes that financing relates to the strategy being financed. So, this chapter is actually well placed. It allows the reader, who is now familiar with the strategies, to understand how hedge fund managers obtain money to operate and how funding plays an all-important role in their performance.
Part Three of the book is geared toward research and compliance. Its evaluation of hedge fund strategies begins with performance measurement and evaluation. Importantly, however, it extends to holistic due diligence that encompasses not only items directly related to each strategy, such as investment process and philosophy, but also to the all-important topics of risk control, cybersecurity, trading, business continuity, disaster recovery, and management succession plans. The unglamorous topics of fund administration and prime brokerage services are accorded proper treatment that reflects their critical importance in a hedge fund’s overall health. A brief discussion of audit services, legal counsel, and technology providers instructs the reader on their significance. Ignorance of such operational aspects has led to reputational concerns and, worse, investor losses, as the Bernie Madoff boondoggle reminds us.
Treatment of the book’s varied subject matter is practical rather than theoretical in nature. Worked examples of hedge fund math illustrate such concepts as leverage and returns while reinforcing critical concepts. This type of practicality substitutes for recondite formulaic expression and makes for an accessible study. The brief treatment of value at risk, however, is more reportorial than editorial, so it avoids any discussion of the controversy about this risk metric’s effectiveness. Although that approach appears to be in line with the book’s educational focus, it is inconsistent with how the text frequently situates concepts and events in historical context.
Particularly interesting is the cautionary overview of funds of hedge funds. The 2008 market plunge exposed the hazards of investing in smaller funds of funds attracted to the space by low barriers to entry and modest start-up costs. The allure of such a strategy — rapid exposure to an asset class or a more remote corner of the hedge fund space — may overshadow such risks as the lack of access by some fund of funds’ managers to key decision makers at the underlying funds. Uneven risk and performance reporting as well as limited transparency among these same managers create challenges, including mismatches in liquidity terms between the fund of funds and its underlying managers. Lackluster performance has continued to plague this space.
Rounding out this thorough yet practical textbook are a glossary and a robust section of references and additional readings. These latter two sections include a wealth of articles by practitioners and academics, company references, websites, and industry white papers. To reinforce the learning process, a companion website provides practice questions and guideline answers for use in the classroom and self-study.
Its practicality of instruction and use of historical reference make Hedge Fund Investing a good point of departure for those desiring to learn more about hedge funds and possibly invest in them. As the author reminds us, however, finance is dynamic. So, those who work in it must be constantly on alert for changes.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.