Subject 2. Hedge funds

To "hedge", according to Webster's dictionary, is "a means of protection or defense (as against financial loss), or to minimize the risk of a bet." The term "hedge fund" includes a multitude of skill-based investment strategies with a broad range of risk and return objectives. A common element is the use of investment and risk management skills to seek positive returns regardless of market direction.

A hedge fund is a private "pool" of capital for accredited investors only and organized using the limited partnership legal structure. The general partner is usually the money manager and is likely to have a very high percentage of his/her own net worth invested in the fund.

The fund has an offering memorandum, which is intended to provide much of the necessary information to support an investor's due diligence. Among several topics, the offering memorandum will specify the trading style, hedging strategies, and instruments to be employed by the fund at the discretion of the general partner (e.g., being long and /or short stock; use of puts, calls, and futures; use of OTC derivatives).

Hedge funds utilize alternative investment strategies for the purpose of achieving superior returns relative to risk (i.e., return vs. standard deviation). Performance objectives range from conservative to aggressive. The degree of hedging varies. In fact, some do not hedge at all while others simply use S&P put options and futures in lieu of shorting equities. Consequently, there is a broad spectrum of expected risk and return within the hedge fund universe.

Hedge Fund Strategies

Hedge funds can be classified in a variety of ways. Here is one way of classification (by investment strategy):

  • Event-driven investing is an investing strategy that seeks to exploit pricing inefficiencies that may occur before or after a corporate event, such as a bankruptcy, merger, acquisition or spinoff.

    • Merger arbitrage. Before the effective date of a merger, the stock of the acquired firm typically sells at a discount to its announced acquisition value. A risk arbitrage involves buying stocks of the acquired firm and simultaneously selling the stocks of the acquirer. However, there is the risk that the merger may fall though.
    • Distressed debt investing. The securities of companies having financial problems usually sell at deeply discounted prices. Distressed securities funds take bets on the debt and/or equity securities of such companies. For example, if a fund manager believes such a company will successfully return to profitability, he or she will buy its securities. If the manager believes the company's situation will deteriorate, he or she will take a short position in its securities.
    • Activist. A fund takes large positions in companies and uses the ownership to participate in the management.
    • Special situations, such as corporate spin-offs.

  • A relative-value arbitrage strategy seeks to take advantage of price differentials between related financial instruments, such as stocks and bonds, by simultaneously buying and selling the different securities - thereby allowing investors to potentially profit from the "relative value" of the two securities. Examples include fixed income convertible arbitrage, fixed income asset backed, fixed income general, volatility, and multi-strategy.

  • Macro funds take bets on the direction of a market, a currency, an interest rate, a commodity, or any macroeconomic variable. For example, George Soros of the Quantum fund took a billion dollar profit from his historical bet against Sterling and the Bank of England in September 1992.

  • Equity hedge strategies take long and short positions in equity and equity derivative securities. For example, the key feature of market neutral funds is the low correlation between their returns and the general market's movements. Other examples include fundamental growth, fundamental value, quantitative directional, short bias and sector specific strategies.

In terms of performance, hedge funds are generally viewed as having:

  • Net returns higher than those available for equity or bond investments.
  • A low correlation with conventional investments.

However, the performance data from hedge fund databases and indices suffer from serious biases such as self-selection bias, instant history bias and survivorship bias.

Hedge Fund Fees and Other Considerations

Hedge funds almost always have a fee structure that includes both a fixed fee and a management fee. The most common fee structure is "2 and 20", meaning 2% management fee and 20% incentive fee.

  • Hurdle rate. Incentive fees are not paid until the returns exceed the rate. It may be based on an agreed upon rate, LIBOR or the yield on U.S. treasury bills.
  • High water mark. Investors in hedge funds enter the fund at a certain net asset value, which we'll call the entering NAV. If the fund loses money in a given year and then makes back that money in a subsequent year, the investor is usually not required to pay a management fee on any portion of the upside in the subsequent year that was below the entering NAV. The high water mark limits the risk taking of the fund. Without it, the manager gets all the upside from big bets but suffers little from the downside.

A fund of funds invests in a portfolio of hedge funds to provide access, diversification, risk management and due diligence benefits to investors. Such funds of funds generally charge a fee for their services. Recently funds of funds have been criticized for the significant incremental costs they impose.

Although some hedge funds don't use leverage at all, most of them do. Leverage in hedge funds often runs from 2:1 to 10:1, depending on the type of assets held and strategies used. High leverage is often part of the trading strategy and is an essential part of some strategies in which the arbitrage return is so small that leverage is needed to amplify the profit. As in any other investments, however, leverage also amplifies losses when the market direction turns out to be unfavorable.

Investor redemptions can also magnify losses for hedge funds.

Hedge Fund Valuation Issues

Questions to ask:

  • Which price to use? Bid price, ask price, average price or estimated value?
  • Any liquidity discounts? The lack of liquidity under extreme market conditions can cause irreversible damage to hedge funds whose strategies rely on the presence of liquidity in specific markets.

Due Diligence

Generally, due diligence refers to the care a reasonable person should take before entering in an agreement or transaction with another party. The due diligence that has to be performed by an institutional investor when selecting a hedge fund is highly specialized and time consuming, given the secretive nature of hedge funds and their complex investment strategies.

The key factors to consider include investment strategy, investment process, competitive advantage, track record, size and longevity, management style, key-person risk, reputation, investor relations, plans for growth, and systems risk management.

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