capital access index - Milkeninstitute

December 2006

Capital Access Index 2006

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2006 Capital Access Index

2006 Capital Access Index Best Markets for Business Finance Special Topic

Hedge Funds: Risks and Returns in Global Capital Markets

By James R. Barth, Tong Li, Triphon Phumiwasana, and Glenn Yago Milken Institute December 2006

Acknowledgements An abbreviated version of the hedge funds section of this paper was submitted for publication in International Financial Instability: Cross-Border Banking and National Regulations (World Scientific), the proceedings of the Federal Reserve Bank of Chicago’s 2006 International Banking Conference. Douglas D. Evanoff, George G. Kaufman, and Raymond La Brosse are the editors.

The Milken Institute is an independent economic think tank whose mission is to improve the lives and economic conditions of diverse populations in the U.S. and around the world by helping business and public policy leaders identify and implement innovative ideas for creating broad-based prosperity. We put research to work with the goal of revitalizing regions and finding new ways to generate capital for people with original ideas. We do this by focusing on human capital – the talent, knowledge and experience of people, and their value to organizations, economies and society; financial capital – innovations that allocate financial resources efficiently, especially to those who ordinarily would not have access to it, but who can best use it to build companies, create jobs and solve long-standing social and economic problems; and social capital – the bonds of society, including schools, health care, cultural institutions and government services, that underlie economic advancement. By creating ways to spread the benefits of human, financial and social capital to as many people as possible – the democratization of capital – we hope to contribute to prosperity and freedom in all corners of the globe. We are nonprofit, nonpartisan and publicly supported.

© 2006 Milken Institute

CAPITAL ACCESS INDEX 2006

Milken Institute

Table of Contents I. Executive Summary............................................................................................1 II. Rankings: Best Markets for Business Finance . ..................................................7 III. Hedge Funds: Risks and Returns in Global Capital Markets..........................11 IV. An Overview of the Hedge Fund Industry......................................................13 V. Some Statistical Analyses..................................................................................69 VI. Conclusions...................................................................................................77 VII. References.....................................................................................................79 VIII. Appendixes..................................................................................................83

A. Methodology.......................................................................................83

B. Capital Access Index Subcomponents..................................................86

C. Literature Review................................................................................93

IX. About the Authors..........................................................................................95


Milken Institute

I. Executive Summary The Capital Access Index (CAI) ranks countries around the world in terms of the financial infrastructures that support entrepreneurial activity by providing access to capital. We look at such factors as macroeconomic environments, financial and banking institutions, the development of the equity and bond markets, and alternative capital sources. Because a firm’s access to capital allows it to implement innovative ideas and contribute to technological advancement, job creation, and quality of life, the index is a tool for measuring how countries can act to reduce more fully their financing barriers. Each year the index also addresses an important development in global financial markets. This year’s focus is on the hedge fund industry. In September 2006, the multistrategy hedge fund Amaranth Advisors, based in Connecticut, reported one-month losses of 65 percent, and losses of 55 percent, or $6 billion, for the year. Yet while the story made front-page news, the financial markets barely reacted. How times have changed since the near-collapse of Long-Term Capital Management (LTCM) in 1998, when that hedge fund also lost more than $1 billion in a single month and generated widespread institutional and investor panic that resulted in a federal bailout. Nevertheless, the sudden and huge losses suffered by Amaranth raise serious issues about the performance and risk of hedge funds, which are helping to reshape global capital markets as they exploit market inefficiencies. The number of countries covered by this year’s index rose slightly, from 121 in the 2005 report, to 122. With the availability of more data, we were able to include Ecuador. Individual countries are scored in the following subcomponents: • macroeconomic environment • economic institutions • financial and banking institutions • equity market development • bond market development • alternative capital • access to international capital In addition, we compiled 56 quantitative and qualitative variables—ranging from bank soundness and collateral registration costs to securities exchange regulations, venture capital funds, and credit ratings—from multiple data sources that underlie these subcomponents in each country. All the variables capture elements that affect the ability of businesses to access capital. The average composite score declined over the past year by 0.04, to 4.64, while the median score increased by 0.06, to 4.39. In all, these 122 countries account for 82 percent of world land mass, 93 percent of the world’s population, 92 percent of global GDP, and 90 percent of the world’s financial assets.

See Appendix A for definitions, sources, and composition of subcomponents. Appendix B provides the seven subcomponent scores for 122 countries.

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Milken Institute

2006 Capital Access Index Rankings The composite scores for the 122 countries are presented in table 1. Hong Kong moved to first place in this year’s index, up from second place in 2005. Singapore and the United Kingdom rank second and third, respectively. Hong Kong maintains its ranking as one of the top two countries for business financing, as it has for the past four years. Its composite score improved slightly over the past year due to its equity market, which produced a higher ratio of total market capitalization to GDP. The Hong Kong Stock Exchange also saw more domestic and international initial public offerings (IPOs), especially those of large Chinese companies. The development of Hong Kong’s bond market also improved over the past year. While the private-sector bond market is still small relative to many industrialized nations, the private-sector bond-to-GDP ratio increased by 10 percentage points. And the issuance of securitized instruments increased nearly tenfold, from 0.6 percent to 5 percent of GDP. Hong Kong’s general financial environment is among the world’s best, with a sound banking system, a relatively large equity market, and diversified sources of business funding, including venture capital.

For the purposes of this index, we designate certain regions, such as Hong Kong and Taiwan, as countries. See Xinhua Finance/Milken Institute China IPO Indicator for the performance of Chinese IPOs over recent years, http://www.milkeninstitute.org/chinaindicators/.

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Milken Institute Table 1: 2006 Capital Access Index

RANK RANK 2006 2005 1 2 2 3 3 1 4 10 5 4 6 7 7 12 8 13 9 10 10 5 11 8 12 16 13 9 14 6 15 15 16 19 16 14 18 21 19 30 20 23 21 22 22 18 23 20 24 17 25 27 26 26 27 34 28 39 29 28 30 33 31 36 32 24 33 48 34 25 35 37 36 31 37 40 38 45 39 32 40 46 40 35 42 29 43 43 44 47 45 49 46 53 47 38 48 43 49 50 50 40 50 42 52 53 53 51 54 60 55 55 56 58 57 66 58 69 59 51 60 68 61 81

COUNTRY Hong Kong SAR Singapore United Kingdom Canada United States Australia Switzerland Netherlands Ireland Sweden Norway Malaysia Finland Denmark Germany Japan New Zealand Estonia Thailand South Korea Austria Chile France Spain Israel Portugal Kuwait United Arab Emirates Belgium Saudi Arabia Hungary South Africa Lebanon Taiwan, China Oman Italy Panama Poland Czech Republic Latvia Lithuania Greece Mexico El Salvador Peru India China Slovakia Colombia Brazil Jordan Bulgaria Russia Turkey Slovenia Philippines Argentina Jamaica Tunisia Botswana Romania

CAI 2006 8.07 8.00 7.79 7.61 7.59 7.55 7.52 7.50 7.46 7.35 7.16 7.12 7.09 6.99 6.92 6.88 6.88 6.83 6.61 6.58 6.53 6.45 6.44 6.42 6.39 6.37 6.18 6.08 6.05 6.00 5.94 5.81 5.78 5.76 5.75 5.63 5.61 5.54 5.34 5.32 5.32 5.25 5.24 5.23 5.19 5.18 5.15 5.10 5.03 4.95 4.95 4.80 4.79 4.74 4.73 4.67 4.57 4.55 4.49 4.44 4.42

0

MEAN: 4.64

10

RANK RANK 2006 2005 62 62 63 57 63 85 65 74 66 63 66 64 68 65 69 59 70 71 71 56 72 71 73 74 74 61 74 98 76 67 77 76 78 70 79 80 80 79 81 73 82 92 82 94 84 84 85 82 86 101 87 89 87 77 89 88 89 97 91 91 92 86 93 77 94 90 95 93 95 88 97 87 98 99 99 113 100 115 101 96 102 103 102 94 104 100 105 117 106 108 107 83 108 104 109 107 110 114 111 117 111 104 111 115 114 102 115 112 116 119 117 110 118 108 119 111 120 106 121 121 122 120

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COUNTRY Papua New Guinea Indonesia Uruguay Pakistan Croatia Sri Lanka Armenia Morocco Ghana Costa Rica Ukraine Macedonia Namibia Vietnam Dominican Republic Nicaragua Moldova Venezuela Iran Kenya Egypt Nigeria Honduras Tanzania Senegal Ecuador Uganda Belarus Paraguay Guatemala Bosnia and Herzegovena Mongolia Bolivia Lesotho Mozambique Bangladesh Zambia Cameroon Central African Republic Cambodia Benin Burkina Faso Mauritania Laos Mali Syria Malawi Haiti Yemen Madagascar Sierra Leone Zimbabwe Angola Ethiopia Guinea Rwanda Burundi Togo Niger Chad Republic of the Congo

CAI 2006 4.35 4.34 4.34 4.23 4.21 4.21 4.19 4.08 4.07 4.06 4.02 3.90 3.86 3.86 3.83 3.81 3.72 3.70 3.66 3.64 3.60 3.60 3.59 3.55 3.52 3.49 3.49 3.44 3.44 3.43 3.41 3.40 3.37 3.33 3.33 3.32 2.92 2.90 2.83 2.82 2.79 2.79 2.74 2.71 2.63 2.62 2.60 2.58 2.56 2.50 2.50 2.50 2.47 2.45 2.35 2.33 2.29 2.26 2.25 1.94 1.81

0

MEAN: 4.64

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Milken Institute

Singapore moves up one position to rank second this year. Factors underlining its strength include a robust equity market and the availability of alternative sources of funds, such as credit cards, private capital funds, and venture capital funds. More than 70 percent of the indexed countries extended more credit to the private sector relative to GDP in 2006. Singapore however, did not, which limited its improvement relative to Hong Kong’s. The United Kingdom drops from last year’s first-place ranking to third place in 2006, due mainly to a decline in its macroeconomic environment score, which takes into consideration such variables as inflation rates, lending and tax rates, and a country’s general financial sophistication. This drop in ranking does not necessarily indicate a deterioration in performance but instead reflects the greater progress competitors have made in controlling inflation, relaxing lending rates, and reducing interest rate volatility. Canada improves significantly, moving up from 10th place last year to fourth in 2006, passing the United States. In some areas (e.g., bond market depth, securitization, and venture capital funds), the United States ranks higher than Canada but does not fare so well in terms of lower inflation, lending rates, and corporate and personal tax rates. Canada achieves the most improvement in its scores for alternative sources of capital (moving from 30th place to 15th) and access to international capital (from 40th place to 18th). Among the top ten countries, seven saw improvement in their equity market ranking from the previous year. But all the countries also saw their rankings fall in terms of access to international capital. Australia improves its composite ranking, moving to sixth place and just behind the United States. Switzerland, at seventh, and the Netherlands, at eighth, are new additions to the top ten countries, and Ireland rounds out the list. Among countries ranked in the top half of the index, the largest improvements in both scores and rankings appear in the Middle East. The United Arab Emirates (28th) shows the greatest rise in absolute score, attributable to an improvement in its economic institutions (e.g., the effectiveness of judicial independence and the burden of local government regulations), as well as improvements in alternative sources of funding, including the number of private placements and availability of venture capital. Lebanon (33rd) shows the largest improvement in relative ranking due to its improved banking environment, such as a higher bank asset-to-GDP ratio. Denmark (14th) had the largest drop in score, while Greece (42nd) experienced the largest drop in ranking, down from 29th in 2005. China’s ranking dropped from 38th to 47th in the index. However, despite declines in scores for its macroeconomic environment and international access, China made significant improvements in its institutional environment and alternative sources funds. Among countries ranked in the bottom half of the index, Vietnam (74th, up from 98th in 2005) has the largest composite improvement due to its stable macroeconomic environment and an increase in bond market activity, including some securitization deals. Syria (107th, down from 83rd) suffers the greatest drop in composite ranking, due to increases in both the inflation and corporate tax rates.

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Milken Institute

Table 2 represents average composite scores and average scores by each of the subcomponents broken down by region. Industrialized countries score higher across the board than developing countries, and among these, the Middle East enjoys the highest scores, ahead of Asia, which led in 2005. As the table shows, the sound macroeconomic environment is the strongest component contributing to all CAI scores, while the alternative source of funding is its weakest component. Table 2: Average of subcomponents for 2006 Capital Access Index 2006 CAI

Macroeconomic Environment (ME)

Economic Institutions (IE)

Financial and Banking Institutions (FI)

Equity Market (EM)

Bond Market (BM)

Alternative Capital (AC)

International Access (IA)

7.00

7.10

7.89

7.29

6.77

6.58

5.63

6.31

Industrialized Countries Middle East

4.87

6.92

5.41

4.7

4.65

2.98

2.06

3.48

Europe

4.72

6.99

4.97

5.04

2.76

3.37

1.83

4.36

Asia Americas and the Caribbean Africa

4.64

5.73

5.16

4.63

3.78

3.89

2.78

4.14

4.32

5.86

4.91

3.71

2.82

3.44

2.46

3.91

3.06

4.39

4.34

2.81

1.48

1.32

0.62

2.56

The classification of regions is similar to that used in International Financial Statistics, released by the International Monetary Fund, except for Hong Kong and Singapore, which are typically classified as industrialized countries.

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Milken Institute

II. Rankings: Best Markets for Business Finance Table 3, on the following pages, compares country rankings in 2006 with those of the previous two years. There has been relatively little change in the average composite score for all countries; for 2006, the average is 4.64, compared to 4.59 in 2005 and 4.60 in 2004. The median scores for 2004, 2005, and 2006 are 4.37, 4.34, and 4.39, respectively. From 2005 to 2006, alternative capital funds and macroeconomics institutions were the two factors most responsible for lower composite scores. Bond market development, in contrast, was most responsible for an increase in scores. The average score for countries ranked in the top half of the index is 2.2 (4.97 – 2.77) points higher than the average for countries in the bottom half, lower than the 2.7-point difference last year. The gaps between countries in the top half and those in the bottom half widened for each of the following factors: macroeconomic environment, economic institutions, financial and banking institutions, and alternative capital funds.

Ecuador is not included in the previous reports due to the lack of sufficient data. Ecuador’s CAI score in 2005 is recalculated for purposes of comparison.

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Milken Institute Table 3: Capital Access Index and country rankings, 2004-2006

Hong Kong SAR Singapore United Kingdom Canada United States Australia Switzerland Netherlands Ireland Sweden Norway Malaysia Finland Denmark Germany Japan New Zealand Estonia Thailand South Korea Austria Chile France Spain Israel Portugal Kuwait United Arab Emirates Belgium Saudi Arabia Hungary South Africa Lebanon Taiwan, China Oman Italy Panama Poland Czech Republic Latvia Lithuania Greece Mexico El Salvador Peru India China Slovakia Colombia Brazil Jordan Bulgaria Russia Turkey Slovenia Philippines Argentina Jamaica Tunisia Botswana Romania

2006 CAI 8.07 8.00 7.79 7.61 7.59 7.55 7.52 7.50 7.46 7.35 7.16 7.12 7.09 6.99 6.92 6.88 6.88 6.83 6.61 6.58 6.53 6.45 6.44 6.42 6.39 6.37 6.18 6.08 6.05 6.00 5.94 5.81 5.78 5.76 5.75 5.63 5.61 5.54 5.34 5.32 5.32 5.25 5.24 5.23 5.19 5.18 5.15 5.10 5.03 4.95 4.95 4.80 4.79 4.74 4.73 4.67 4.57 4.55 4.49 4.44 4.42

Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 16 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 40 42 43 44 45 46 47 48 49 50 50 52 53 54 55 56 57 58 59 60 61

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2005 CAI 7.84 7.77 8.01 7.42 7.75 7.60 7.39 7.20 7.42 7.62 7.47 6.88 7.46 7.61 6.93 6.76 7.04 6.59 5.71 6.37 6.41 6.78 6.62 6.80 6.19 6.31 5.52 5.14 6.17 5.56 5.36 6.36 4.87 6.34 5.30 5.66 5.13 4.98 5.58 4.92 5.51 5.85 5.05 4.90 4.69 4.58 5.17 5.05 4.68 5.13 5.11 4.58 4.67 4.37 4.56 4.44 4.23 4.09 4.67 4.11 3.62

Rank 2 3 1 10 4 7 12 13 10 5 8 16 9 6 15 19 14 21 30 23 22 18 20 17 27 26 34 39 28 33 36 24 48 25 37 31 40 45 32 46 35 29 43 47 49 53 38 43 50 40 42 53 51 60 55 58 66 69 51 68 81

2004 CAI 8.00 7.99 7.92 7.53 7.76 7.63 7.63 7.51 7.52 7.81 7.33 7.22 7.78 7.61 7.06 6.55 6.60 6.57 6.30 6.20 6.26 6.60 6.62 7.08 6.21 6.29 5.21 5.07 6.51 5.40 5.59 6.03 5.13 6.43 5.08 5.67 5.09 4.93 5.46 5.09 5.41 5.58 4.69 4.94 4.79 4.69 5.04 4.99 4.56 5.56 4.91 4.37 4.71 4.21 4.50 4.71 3.67 4.35 4.67 4.47 3.68

Rank 1 2 3 10 6 7 7 12 11 4 13 14 5 9 16 21 18 20 24 28 26 18 17 15 27 25 37 42 22 36 31 29 38 23 41 30 39 46 34 39 35 32 51 45 48 51 43 44 57 33 47 61 49 66 58 49 76 63 54 60 75

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Milken Institute Table 3: Capital Access Index and country rankings (cont.)

Papua New Guinea Indonesia Uruguay Pakistan Croatia Sri Lanka Armenia Morocco Ghana Costa Rica Ukraine Macedonia Namibia Vietnam Dominican Republic Nicaragua Moldova Venezuela Iran Kenya Egypt Nigeria Honduras Tanzania Senegal Ecuador Uganda Belarus Paraguay Guatemala Bosnia and Herzegovena Mongolia Bolivia Lesotho Mozambique Bangladesh Zambia Cameroon Central African Republic Cambodia Benin Burkina Faso Mauritania Laos Mali Syria Malawi Haiti Yemen Madagascar Sierra Leone Zimbabwe Angola Ethiopia Guinea Rwanda Burundi Togo Niger Chad Republic of the Congo

2006 CAI 4.35 4.34 4.34 4.23 4.21 4.21 4.19 4.08 4.07 4.06 4.02 3.90 3.86 3.86 3.83 3.81 3.72 3.70 3.66 3.64 3.60 3.60 3.59 3.55 3.52 3.49 3.49 3.44 3.44 3.43 3.41 3.40 3.37 3.33 3.33 3.32 2.92 2.90 2.83 2.82 2.79 2.79 2.74 2.71 2.63 2.62 2.60 2.58 2.56 2.50 2.50 2.50 2.47 2.45 2.35 2.33 2.29 2.26 2.25 1.94 1.81

Rank 62 63 63 65 66 66 68 69 70 71 72 73 74 74 76 77 78 79 80 81 82 82 84 85 86 87 87 89 89 91 92 93 94 95 95 97 98 99 100 101 102 102 104 105 106 107 108 109 110 111 111 111 114 115 116 117 118 119 120 121 122

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2005 CAI 4.31 4.48 3.48 3.79 4.30 4.27 4.26 4.40 3.88 4.49 3.88 3.79 4.34 3.10 4.13 3.78 3.93 3.65 3.66 3.87 3.24 3.18 3.53 3.60 2.92 3.36 3.73 3.36 3.12 3.30 3.46 3.73 3.32 3.19 3.36 3.43 3.07 2.54 2.46 3.14 2.80 3.18 3.03 2.36 2.59 3.59 2.74 2.66 2.50 2.36 2.74 2.46 2.88 2.55 2.24 2.57 2.59 2.56 2.67 1.62 1.63

Rank 62 57 85 74 63 64 65 59 71 56 71 74 61 98 67 76 70 80 79 73 92 94 84 82 101 89 77 88 97 91 86 77 90 93 88 87 99 113 115 96 103 94 100 117 108 83 104 107 114 117 104 115 102 112 119 110 108 111 106 121 120

2004 CAI 3.63 4.68 3.53 3.94 4.26 4.48 4.36 4.57 3.82 4.63 3.53 3.88 4.32 3.45 4.14 3.91 4.07 3.17 3.95 3.89 3.30 3.54 3.56 3.63 3.07 n.a. 3.60 3.11 3.07 3.52 3.60 3.58 3.41 3.27 3.27 3.00 3.14 2.50 2.33 3.18 2.71 2.82 2.54 2.35 2.72 3.22 2.76 2.90 2.54 2.79 2.40 2.79 2.81 2.73 2.39 2.45 2.67 2.72 2.36 1.81 1.80

Rank 77 53 84 70 65 59 62 56 74 55 84 73 64 87 67 71 68 94 69 72 89 83 82 77 97 n.a. 79 96 97 86 79 81 88 90 90 99 95 113 119 93 109 101 111 118 107 92 105 100 111 103 115 103 102 106 116 114 110 107 117 120 121

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Milken Institute

There are some significant changes in the 2006 top twenty rankings. In 2005, industrialized countries only accounted for sixteen of the top twenty rankings. In 2006, France and Spain dropped four and eight places, respectively. Emerging Asia countries—Malaysia (13th), Thailand (19th) and South Korea (20th)—now account for three of the top twenty rankings. (In 2005, Malaysia was the only emerging Asian country that ranked in the top twenty.) African countries remain at the lower part of the CAI rankings. Indeed, sixteen of the bottom twenty countries are African countries. Laos remains the only Asian country ranked in the bottom twenty. Table 4 shows the average score of each of the index subcomponents by ranking. Bond market development was consistently among the lowest subcomponents over the past four years. However, in 2006, the average bond market development ranking for all countries increased to 3.46 from 2.38 in 2005. All countries, as well as those in the top twenty and bottom twenty, ranked lowest in alternative capital. The widest gap between the top twenty countries and bottom twenty is found in equity market development, followed by alternative capital access. Table 4: Average subcomponents of 2006 Capital Access Index by ranking 2006 CAI

Macroeconomic Environment (ME)

Economic Institutions (IE)

Top 20

7.28

7.55

8.18

Financial and Banking Institutions (FI) 7.49

Top 50%

6.03

7.01

6.61

6.18

All

4.64

5.95

5.40

4.56

Bottom 50%

3.25

4.89

4.20

2.93

1.51

1.65

0.91

2.80

Bottom 20

2.30

3.53

3.37

2.25

0.44

0.88

0.17

2.04

Equity Market (EM)

Bond Market (BM)

Alternative Capital (AC)

International Access (IA)

6.98

6.63

5.93

6.45

5.46

5.27

4.03

5.32

3.48

3.46

2.47

4.06

It is notable that alternative sources of capital constitute the weakest component in this year’s index. Therefore, it is appropriate to focus our current report on hedge funds as the dominant emerging component within the alternative sources of investment. These funds represent an ever more important investment vehicle, one that is reshaping the funding and operations of businesses throughout the world. With less than $100 million in assets, hedge funds were relatively unimportant to investors in 1980. Today, the funds hold approximately $1 trillion in assets. And while about half the total assets are held by hedge funds domiciled in the United States, two-thirds of total assets represent investments overseas. This clearly indicates that hedge funds are a global phenomenon. As hedge funds invest in countries worldwide, portfolio investment and foreign direct investment are increasingly affected.

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Milken Institute

III. Hedge Funds: Risks and Returns in Global Capital Markets Unlike hedge funds, mutual funds are widely available to the public and therefore must be registered with the Securities and Exchange Commission. In addition, they are limited in the strategies they can employ. Hedge funds, on the other hand, are set up as limited partnerships and generally not constrained by regulatory limitations on their investment strategies. Indeed, although the word “hedge” refers to the hedging of the value of assets through the use of derivative instruments or the simultaneous use of long positions and short sales, most hedge funds do not involve hedging in this traditional sense. Many, in fact, do just the opposite. In this section, we examine some of the different strategies to determine differences in performance and risk. The impact of hedge funds on global financial stability and the need for greater regulation are important and timely issues, and it is no surprise that economists have tried to address them. But the results of these efforts have been less than successful. For example, in a recent study attempting to quantify the potential impact of hedge funds on systemic risk, Chan, Getmansky, Haas, and Lo (2005, p. 97) state that “... we cannot determine the magnitude of current systemic risk with any degree of accuracy.” Similarly, Garbaravicius and Dierick (2005, p. 55) conclude, “It is very difficult to provide any conclusive evidence on the impact of hedge funds on financial markets. ...” Timothy Geithner (Geithner, p. 8), president of the Federal Reserve Bank of New York, gave a lecture in Hong Kong in September 2006, and addressed the issue of hedge fund regulation. “Clearly, capital supervision and market discipline remain the key tools for limiting systemic risk,” he said. “The emergence of new market participants such as leverage institutions does not change that.” In addition, Danielsson, Taylor, and Zigrand (2005, pp. 26–27) argue that while there exists a “… need for a credible resolution mechanism to deal with the default of systemically important hedge fund(s) … the procedural issues and related incentive effects [to do so] are complex …[and] … require further consideration in order to provide the correct incentives for the various parties.” Given the conclusions of these efforts, we have decided not to try to expand upon this line of enquiry here. Instead, we provide a comprehensive examination of some important aspects of the global hedge fund industry. This examination is based on a dataset assembled by HedgeFund.net that starts with eight hedge funds with $57 million in assets in 1981 and grows to 6,445 funds with $969 billion in assets as of June 2006. We use this dataset to examine differences among hedge funds over time and by the strategies they employ. We pay particular attention to changes in the performance and risk of funds over time, and to the impact of various strategies on these differences. We also use regression analyses to examine the associations between characteristics of a fund and its performance and risk, and to examine the associations between characteristics and the likelihood that a fund will remain alive or enter the graveyard. This examination necessarily requires numerous tables and charts. We hope the reader will bear with us in this regard and, more importantly, be motivated by the material to identify problems or issues that merit further consideration.

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Milken Institute

IV. An Overview of the Hedge Fund Industry A. Growth and Size The recent flurry of news stories about hedge funds might lead some to think that such funds are relatively new. But Fung and Hsieh (1999) report that the first hedge fund was actually formed in 1949. It employed a long/short equity strategy and operated on the basis of leverage, two characteristics of many hedge funds today. They add that this first hedge fund remained fairly obscure until a magazine article in 1966 touted its high returns relative to those of mutual funds. The number of hedge funds subsequently grew fairly rapidly for a few years but fell back into obscurity due to losses suffered in several downturns in the equity market. The industry rebounded once again in 1986, when another magazine article reported that a newly established hedge fund had earned an extraordinary return in its first few months of existence. Tables 5 and 6 document the growth in the industry over the past quarter-century. In terms of both numbers and assets, the industry has experienced continuous and rapid growth, with the exception of a decline in the number of funds during the first six months of 2006. From 1981 to June 2006, funds grew in number at an average annual rate of 30 percent, while total assets grew at an average annual rate of 47 percent. Not all funds that entered the industry during this time period remained alive until the ending date, of course. In fact, the following two tables show that as of June 2006, 3,100 funds with $257 billion in total assets had exited the industry. Despite these exits, 6,445 funds remained, with $969 billion in total assets (see also charts 1 and 2). Table 5: Total number of hedge funds

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 June 2006

Total Number

Change in Number of Funds

8 12 18 27 33 46 58 76 98 139 209 300 424 563 815 1,117 1,522 2,041 2,733 3,250 3,825 4,596 5,333 6,235 6,526 6,445

na 4 6 9 6 13 12 18 22 41 70 91 124 139 252 302 405 519 692 517 575 771 737 902 291 -81

Number Entering

Number Exiting

Number in Graveyard (Accumulation of Exiting Funds)

na 4 6 9 6 13 12 18 22 41 70 91 124 139 252 302 405 525 740 740 915 1,117 1,176 1,372 1,057 381

na na na na na na na na na na na na na na na na na 6 48 223 340 346 439 470 766 462

na na na na na na na na na na na na na na na na na 6 54 277 617 963 1,402 1,872 2,638 3,100

Of which

Note: Data on exiting funds have been available since 1998.

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Milken Institute

Table 6: Total assets of hedge funds ($ Millions) Of Which

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 June 2006

Total Assets

Change in Assets of Funds

57 78 228 531 944 1,177 1,486 2,328 3,254 5,006 7,569 9,553 17,182 19,697 25,497 35,535 58,261 76,906 140,265 170,494 237,871 281,837 508,811 698,593 839,069 968,690

na 21 151 302 413 232 310 842 926 1,752 2,563 1,984 7,629 2,515 5,801 10,038 22,726 18,645 63,359 30,229 67,377 43,966 226,974 189,783 140,476 129,621

Asset of Entering Funds

Assets of Exiting Funds

Change in Assets of Existing Funds

Assets of Funds in Graveyard (Accumulation of Assets of Exiting Funds)

na 8 157 8 37 35 68 104 259 726 976 1,248 1,596 894 2,008 2,952 4,793 5,565 15,506 21,406 18,601 25,849 59,503 50,824 45,262 16,467

na na na na na na na na na na na na na na na na na 125 2,022 12,436 10,115 25,490 15,552 74,791 67,725 48,582

na 13 -6 295 377 197 241 738 667 1,026 1,587 736 6,033 1,621 3,792 7,086 17,933 13,205 49,875 21,259 58,891 43,606 183,023 213,749 162,939 161,735

na na na na na na na na na na na na na na na na na 125 2,147 14,584 24,698 50,188 65,740 140,531 208,256 256,838

Note: Data on exiting funds have been available since 1998.

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Milken Institute Chart 1: Total number of hedge funds 7,000

6,526 6,445 6,235

6,000 5,333

5,000

4,596 3,825

4,000

3,250

3,000

2,733 2,041

2,000

1,522

1,000 0

139 209 8 12 18 27 33 46 58 76 98

1981

1986

300 424

1991

563

1,117 815

1996

2001

June 2006

Chart 2: Total assets of hedge funds ($ Billions)

1,200

969

1,000 839

800

699

600

509

400 238

200

0

140