The Oxford Handbook of Hedge Funds by Douglas J. Cumming

The Oxford Handbook of Hedge Funds by Douglas J. Cumming

CHAPTER 1

INTRODUCING HEDGE FUNDS

DOUGLAS CUMMING, SOFIA JOHAN, AND GEOFFREY WOOD

1.1 INTRODUCTION TO THE OXFORD HANDBOOK OF
HEDGE FUNDS

HEDGE funds have been the subject of media attention in the United States
(“US”) and around the world pursuant to the Bernard Madoff scandal and
the more recent allegations against the Galleon Group. Given the
pronounced growth of the hedge fund sector in recent years and the
comparative dearth of regulations faced by hedge fund managers, this
attention is probably appropriate. One concern shared by market participants
and many regulators around the world is that the size of the hedge fund
industry coupled with potential agency problems, activist investment
practices and herding behavior exacerbates financial instability.
Hedge funds are not prohibited from employing a variety of investment
instruments in pursuing their investment strategies (i.e., the primary mandate
of a hedge fund), many of which would not be permitted by other funds such
as mutual funds and private equity funds. This is possible by compromising
on the extent to which their products or funds are able to be offered to the
public. In the US and the UK for example, hedge funds can only be
distributed by private placements. Hedge funds, for example, may utilize
derivative instruments, may short sell and leverage rather highly to achieve
their investment goals. Commonly observed hedge fund strategies include
investment in distressed companies, commodity trading advisors managed
futures, short biased and small micro capitalization (hereafter “micro cap”)
focused strategies, among numerous other strategies identified herein.
There are, as in any form of financial intermediation, inevitable agency
problems associated with hedge fund management. While these specific
agency problems will be described in more detail in another section of this
chapter, we would like to briefly outline the extent to which potential agency
problems may arise. First, in a more direct manner, hedge funds might
pursue investment strategies and/or prepare financial reports that benefit the
hedge fund manager at the expense of their investors. For example, hedge
funds are much more likely to report marginally positive monthly returns
than returns that are marginally negative, and this type of returns
manipulation significantly aids capital raising efforts of hedge fund
managers (see e.g. Bollen and Pool, 2006, 2008, 2009). Second, in a more
oblique manner, hedge funds’ investment strategies might be counter to the
interests of the other shareholders of portfolio companies in which hedge
funds invest (see Kahan and Rock, 2007, for examples of this category of
agency problem). For example, hedge funds that acquire significant voting
rights in a company may seek to act in ways that primarily bring about
financial benefit to the fund (and therefore its investors), at the expense of
the company’s other shareholders. (see e.g. Hu and Black, 2006). Such
active participation in portfolio companies by hedge funds have been labeled
in both a flattering manner, as hedge fund activism, and in a more critical
manner, as vulture fund activity.
This chapter first provides a definition of a hedge fund. We explain what
the main service providers hedge funds use, including custodians, prime
brokers, and administrators, among others. Further, we compare hedge funds
to private equity funds and venture capital funds.
The chapter then provides an historical overview of the size of the hedge
fund industry around the world. We go on to discuss the frequency of hedge
fund research over time, and show that research on hedge funds peaked prior
to the financial crisis, and has since dropped in the last decade. By contrast,
research on financial regulation has steadily increased over the years.
Thereafter, we introduce some theoretical perspectives on hedge funds,
including agency theory, theories on financializaton, and comparative
institutional theory. With a large extent of literature focused on agency
theory, we provide a separate section detailing various agency problems in
fund management.
With this backdrop, we introduce the chapters that comprise the Oxford
Handbook of Hedge Funds. We summarize each of the chapters in this
introduction, including the data that they reference, the countries and time
periods analyzed, and the main issues and results covered in each chapter.

The Oxford Handbook of Hedge Funds by Douglas J. Cumming