Hedge Funds Alternative Investment Strategies and Portfolio Models Wolfgang Mader

Hedge Funds Alternative Investment Strategies and Portfolio Models Wolfgang Mader

1 Introduction
1.1 Motivation
The hedge fund industry is moving out of the alternative corner and into the main-

stream. Investments in hedge funds have experienced considerable and steady
growth in recent years, both in terms of the number of funds and asset volume.
In the years from 2002 to 2005 net asset flows to hedge funds of 70 to 100 billion
dollars were reported on an annual basis. According to leading hedge fund data
providers, the estimated assets under management reached more than one trillion
dollars in 2005. This amount is invested in approximately 6100 single hedge funds
and 1800 funds of hedge funds.
Investments from institutional investors in particular have increased considerably.
Some well-known and sophisticated investors already hold significant proportions
of hedge funds. While high net worth individuals are currently believed to own
two thirds of the global hedge fund capital, research institutes predict substantial
growth in the institutional area. It is expected that up to 50% of hedge fund assets
will be owned by institutional investors by 2007.

While institutional investors in some countries already allocate substantial parts of
their portfolio to hedge funds, institutional investors in Germany are rather reserved
about this new asset class. The German hedge fund market was stimulated by
the so-called “Investmentmodernisierungsgesetz” of 2004. Prior to this, hedge fund
managers were prohibited from operating in Germany and investors were subject to
punitive capital gains tax. In 2004 investment regulations were relaxed and single-

strategy funds and funds of hedge funds were permitted to be domiciled in Germany.
Furthermore, domestic investors were allowed to allocate money to domestic and
offshore funds. The new investment legislation gives equal tax treatment to domestic
and foreign funds, but the requirements to be met by hedge funds in order to obtain
this taxation status (so-called “tax transparency”) are relatively strict.
More than 20 domestic hedge funds are currently authorized by the German “Bun-

desanstalt f¨ur Finanzdienstleistungen” (BaFin) but by 2005 only about 1.5 billion
dollars’ worth of funds had been sold to investors in German single hedge funds and
funds of hedge funds. Institutional investors, especially insurance companies, one
important group of investors, are reluctant to invest in hedge funds as the BaFin has
placed restrictions on the amounts which may be invested in hedge funds and has
also introduced strict risk management requirements. These regulatory restrictions
apart, however, the majority of institutional investors are suspected of not being
adequately informed about how hedge funds and the strategies they employ really
work

Hedge Funds Alternative Investment Strategies and Portfolio Models Wolfgang Mader