The Principles of Altern at IV Investments Management

EwelinaSokoowska
The Principles
of Alternative
Investments
Management
A Study of the Global Market
The Principles of Alternative Investments

Management
ThiS is a FM Blank Page
Ewelina Sokoowska
The Principles of Alternative

Investments Management
A Study of the Global Market
Ewelina Sokoowska
Department of Corporate Finance
Faculty of Management
University of Gdansk
Sopot, Poland
ISBN 978-3-319-13214-3
ISBN 978-3-319-13215-0
DOI 10.1007/978-3-319-13215-0
(eBook)
Library of Congress Control Number: 2015943397

Springer Cham Heidelberg New York Dordrecht London
Springer International Publishing Switzerland 2016
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Preface
A theory should be made as simple as possible, but not simpler.

Albert Einstein
The beginning of the twenty-first century was characterized by a rapid increase in

the value of the assets being managed as alternative investments. The process of
further development of the market continued, despite growing concerns regarding
the lack of its transparency and despite a potentially negative impact of selected
alternative investments on stability of the financial system.
The concept of alternative investments on contemporary international financial
market emerged relatively recently, that is, at the beginning of the twenty-first
century. Currently, the subject is attracting more attention due to the magnitude of
the capital involved in this sector as well as due to the impact of those investments
on functioning of the international financial market. Enrichment of selected social
groups and growing involvement of institutional investors in this sector imply
development of individual categories of alternative investments and affects the
increase in the number of transactions.
This work is a comprehensive study on the subject of alternative investments on
the financial market. The main purpose of this work is to collect, systematize, and
develop the subject of alternative investments, which is still little known. The
choice of the subject also has a practical implication. Enrichment of various social
groups affects the increasing demand for financial innovations, which would offer
more opportunities for investing funds to those willing to take risks.
Analysis of this sector of international financial market and indication of possible directions of its development seem to be extremely important, not only in terms
of its attractiveness in the process of portfolio diversification but also in terms of
the possibilities of achieving extraordinary return rates. The knowledge on the
development dynamics of individual alternative investment categories is significant
from the perspective of their purchasers who manage those investments as well as
from the perspective of the entities whose task is to create an appropriate legal
vi
Preface
framework for this market. It allows indication of the priorities in management of

these investments and also measuring additional risks which these investments bear.
This books purpose is also to verify the following research hypothesis: globalization and international integration of the financial market will cause the alternative investments on the securities market to penetrate into new areas, including the
European Union. The dynamics of this penetration and its development depends on
the pace of the citizens enrichment and on their knowledge about finacial innovations. Diversification of the specificity of alternative investments around the world,
resultant from cultural and historical predispositions as well as from differences in
economic development, can be expected.
The statistical data collected allowed application of research tools involving
econometric models. Mechanisms of different alternative investments, on a global
scale, have been described using empirical econometric equations. As a result, it
was possible to estimate forecast components of the global alternative investment
market.
Alternative investments in the literature on the subject are defined in two ways.
The first approach distinguishes particular categories within the definition of
alternative investments. The second excludes those categories which do not belong
to alternative investments. The sequence of subsequent chapters has been subordinated to a detailed analysis of particular classes of alternative investments. Despite
many different definitions of alternative investments, it can be assumed that a
classical definition includes hedge funds, funds of funds, managed accounts, managed futures, structured products, and private equity/venture capital. Despite the
expansion of the catalogue of possible alternative investment categories, it can be
considered that the above listed types of alternative investments constitute a classic
set and conceptualized in this way will constitute the subject of the considerations
in this work. Currently, the category of alternative investments also includes
investing in real estate funds and in raw materials, as well as emotional investments,
e.g., coins, artifacts, wine, or cars.
Chapter 1 introduces the concept of alternative investments as an innovative
form of investing on the international financial market and will describe their
possible classifications. Particular attention will be paid to additional types of the
risk associated with this category of investment. Practical ways of identification,
measurement, and management of this risk are proposed. Importance of alternative
investments on the international financial market is brought to attention as well.
Chapter 2 presents hedge funds, which currently are the most well-known
alternative investment institutions. Because of the hedge funds significant impact
on the financial market, much book space has been devoted to these institutions.
Development of the hedge fund market was fostered by limitations in the manner of
investing in traditional investment funds and pension funds as well as limitations in
their functioning. Their development also was a consequence of an evolution of
innovative financial instruments, such as derivatives. This chapter presents a
characteristic, classification, and the structure of modern hedge funds. Legal
forms of their creation, depending on the place of funds registration and the
Preface
vii
manner in which financial assets are invested, have been described. Hedge fund
databases and indices, which are an important source of information about the
activity of this sector, have been presented as well. Presentation of this issue was
not possible without indication of the errors the databases bear. In this chapter, an
attempt was made to indicate the impact of hedge funds on functioning of the
financial market. Data about the current state of the global hedge fund market were
presented as well. The chapter has been illustrated with numerous tables and
figures.
Chapter 3 is a continuation of the fourth. It will present hedge fund investment
strategies. Knowledge of applicable strategies is fundamental in order to create a
long-term coherent investment plan. Improper application of investment strategies
is associated with a possibility of incurring severe losses. It is the investment
strategies used by alternative funds which have a decisive impact on the performance of the institutions of collective investing. The range of instruments and
techniques designed for constructing strategies of various risk levels with a potential return rate goes beyond traditional instruments, such as stocks or bonds. This
chapter presents main groups of investment strategies: relative values strategies,
event-driven strategies, opportunistic strategies, as well as their sub-strategies.
Chapter 4 presents the concept of funds of funds. These institutions play an
important role on the market of alternative forms of investment, thus creating an
important demand side on the hedge fund market and on the PE market. It presents
the types and forms of funds of funds, as well as the pros and cons of choosing this
form of collective investing. One of the advantages are lower entrance levels, which
allow wider accessibility to investors. This chapter also presents the estimated data
illustrating the state of the hedge fund sector worldwide.
Chapter 5 presents Managed Futures transactions, which emerged on the market
as an alternative form of investing as early as the 60s of the twentieth century.
Currently, Managed Futures transactions are managed by professional investment
advisors, called Commodities Trading Advisors (CTAs), who conclude transactions
on the global derivatives market. Managed Futures investments belong to relatively
liquid investments. They allow release of cash funds within three months. The
funds, which engage their assets in transactions on the futures market, are called
commodity pool. They are obliged to register with the CFTC. An advisor once
defined as a CPO or a CTA is subjected to registration with the Commodity Futures
Trading Commission (CFTC). This part of the work presents the concept of
Managed Futures investments and their forms. Automatic transaction systems in
the activities of Commodity Trading Advisors have been briefly characterized
as well.
Chapter 6 characterized structured products, which are a blend of traditional
investments in stocks and bonds with investments in derivatives. The market of
structured products is much more developed in the EU countries than in the USA.
Possible forms of structured products, according to their payout profile, are
presented. As in previous chapters of this work, analysis of structured products
has been illustrated by numerical data representing the state of development of this
market worldwide.
viii
Preface
Chapter 7 presents PE/VC (private equity/venture capital) investments, which

belong to alternative forms of investment on the financial market. This approach
indicates a possibility of achieving extraordinary return rates as a result of financial
participation in the projects of high potential growth. Specificity of these investments entails operating in niche segments of the market, on one side associated with
a possibility of achieving high income and on the other bearing high risk. This
chapter also presents stock exchange and OTC (over the counter) markets of
alternative investments, including the Alternative Investment Market in London.
Each chapter dealing with the analysis of individual investment categories
contains an extensive empirical part, which presents my own research results
regarding alternative investments worldwide. Rapid development of this sector on
the international financial market and growing concerns about activities of individual funds raise questions about the future directions of development of individual
alternative investment categories.
Application of quantitative methods in the form of single-equation econometric
models, which were specified during the process of multiple testing of their
suitability for the developing market, mainly served the objectives of this work
and verification of the hypothesis. The prognoses constructed on their basis are
meant to present possible scenarios of the markets further development. Evolution
of the alternative investments segment leads to development of those categories,
which fulfill the expectations of market participants and meet the requirement and
expiration of the remaining investments, which do not attract investors and are no
longer accepted by them.
Other research methods will be used in this workbeginning with the method of
observation being the most basic method of scientific knowledge, through a comparative method, analytical method, monographic method, as well as expert method.
During the course of research, numerous contacts with representatives of foreign
financial institutions, whose knowledge was an important means of feedback on the
developmental perspectives of the alternative investment sector worldwide, were
established.
The work ends with an attempt to summarize new elements. It is a result of
investigations on these issues over many years. The need for further research on the
matters associated with continuous development of innovative instruments and
institutions on the financial market was indicated as well. Their development has
important implications for all financial market participants.
Sopot, Poland
Spring 2015
Ewelina Sokoowska
Contents
Alternative Investments on Contemporary Financial Market . . . . .

1.1
The Concept and the Essence of Alternative Investments . . . . .
1.2
Classification of Alternative Investments . . . . . . . . . . . . . . . . .
1.3
The Risk Associated with Alternative Investments . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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1
6
11
20
Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.1
Specificity of Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.2
Functioning of Contemporary Hedge Funds . . . . . . . . . . . . . . .
2.3
Classification of Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . . .
2.4
Legal Forms of Creating Hedge Funds . . . . . . . . . . . . . . . . . . .
2.5
The Structure of Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . . .
2.6
Hedge Fund Databases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.7
Database Errors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.8
Hedge Fund Indices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.9
Selected Hedge Fund Indices . . . . . . . . . . . . . . . . . . . . . . . . .
2.10 Hedge Funds and Their Impact on the Financial Market . . . . . .
2.11 The Global Hedge Fund Market . . . . . . . . . . . . . . . . . . . . . . .
2.12 The Forecasts of the Hedge Funds Market . . . . . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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Investment Strategies of Hedge Funds . . . . . . . . . . . . . . . . . . . . . .

3.1
The Concept of Investment Strategies and Their Risk . . . . . . . .
3.2
Classification of Investment Strategies . . . . . . . . . . . . . . . . . . .
3.3
The Relative Value Strategies . . . . . . . . . . . . . . . . . . . . . . . . .
3.3.1 The Convertible Bond Arbitrage Strategy . . . . . . . . . . .
3.3.2 The Fixed Income Arbitrage Strategy . . . . . . . . . . . . . .
3.3.3 The Equity Market Neutral Strategy . . . . . . . . . . . . . . .
3.4
Event Driven or Specialist Credit Strategies . . . . . . . . . . . . . . .
3.4.1 The Merger Arbitrage Strategy . . . . . . . . . . . . . . . . . . .
3.4.2 The Distressed Securities Strategy . . . . . . . . . . . . . . . .
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ix
Contents
3.5
Opportunistic Strategies (Directional-Trading) . . . . . . . . . . . . .

3.5.1 The Global Macro Strategy . . . . . . . . . . . . . . . . . . . . .
3.5.2 The Strategy of Short-Selling . . . . . . . . . . . . . . . . . . . .
3.5.3 The Long/Short Equity Strategy . . . . . . . . . . . . . . . . . .
3.5.4 The Emerging Markets Strategy . . . . . . . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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71
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77
78
79
Funds of Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.1
The Genesis of Funds of Funds . . . . . . . . . . . . . . . . . . . . . . . .
4.2
The Definition of Funds of Funds . . . . . . . . . . . . . . . . . . . . . .
4.3
The Types of Funds of Funds . . . . . . . . . . . . . . . . . . . . . . . . .
4.4
The Constructions of Funds of Funds . . . . . . . . . . . . . . . . . . . .
4.5
Advantages of Investing in Funds of Funds . . . . . . . . . . . . . . .
4.6
Disadvantages of Investing in Funds of Funds . . . . . . . . . . . . .
4.7
The Global Funds of Funds Market . . . . . . . . . . . . . . . . . . . . .
4.8
The Forecasts of Funds of Funds Market . . . . . . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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Managed Futures Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5.1
The Genesis of Managed Futures Investments . . . . . . . . . . . . .
5.2
The Concept of Managed Futures Investments . . . . . . . . . . . . .
5.3
Forms of Managed Futures Investments . . . . . . . . . . . . . . . . .
5.4
Application of Managed Futures Transactions . . . . . . . . . . . . .
5.5
Automated Transaction Systems in the Activity of Commodity
Trading Advisors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.6
The Forecasts of Managed Futures Investments . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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Structured Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6.1
The Concept of Structured Products . . . . . . . . . . . . . . . . . . . . . .
6.2
The Types of Structured Products . . . . . . . . . . . . . . . . . . . . . . .
6.3
The Construction of Structured Products . . . . . . . . . . . . . . . . . .
6.4
Structured Certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6.4.1 Index Certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6.4.2 Bonus Certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6.4.3 Basket Certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6.5
Structured Maximum Return Rate Products . . . . . . . . . . . . . . . .
6.5.1 Discount Certificates . . . . . . . . . . . . . . . . . . . . . . . . . . .
6.6
Structured Products with Capital Protection . . . . . . . . . . . . . . . .
6.6.1 Guaranteed Certificates . . . . . . . . . . . . . . . . . . . . . . . . .
6.6.2 Structured Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6.7
The Market of Structured Products in Europe . . . . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
113
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119
120
121
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122
122
123
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125
126
128
Contents
Private Equity/Venture Capital Investments . . . . . . . . . . . . . . . . . . .

7.1
Private Equity/Venture Capital: The Controversy Surrounding
the Concepts and Their Possible Interpretations . . . . . . . . . . . .
7.2
Classification of Venture Capital/Private Equity Investments . .
7.3
Legal Forms of Venture Capital/Private Equity Funds . . . . . . .
7.4
The Stages of Venture Capital/Private Equity Investments . . . .
7.5
Alternative Investments Markets in Europe . . . . . . . . . . . . . . .
7.6
Alternative Investment Market in London . . . . . . . . . . . . . . . .
7.7
The European Venture Capital/Private Equity Market . . . . . . . .
7.8
The Forecasts of Venture Capital/Private Equity Market
in Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
Chapter 1
Alternative Investments on Contemporary

Financial Market
1.1
The Concept and the Essence of Alternative

Investments
Investing constitutes an essential factor in economic growth and development.

Investments also function as the main manner of expanding capital. There are
many definitions of the term investment. One of most well-known definitions,
considered as a classic one, is the concept proposed by Hirshleifer (1958). He
claimed, that investing involves sacrificing the current goods in exchange for
uncertain benefits in the future. In an economic sense, an investment is a purchase
of goods that are not consumed today, but are used in the future to create wealth.
This definition indicates few important characteristics of investments. Firstly, an
investment denotes an investors abandonment of current consumption, for which
he/she expects a certain reward (a benefit). Secondly, an investment is realized
during a certain period of time, which means that the investor can receive the
reward in the future. Thirdly, future benefits constituting the reward are uncertain.
The concept of alternative investments on a contemporary international financial
market has emerged relatively recently, that is, at the beginning of the twenty-first
century. Currently, this matter is being described in literature more broadly,
whereas enrichment of selected social groups implies development of particular
categories of alternative investments as well as an increasing number of such
transactions. In the literature on the subject, alternative investments are defined in
two ways. The first approach consists in distinguishing specific categories within
the definition of alternative investments. The second approach excludes those
investment categories, which do not belong to alternative investments.
When analyzing the definitions excluding those investments that are not alternative in character, it can be noticed that they compose a wide variety of financial
products and services. In a broad sense, they are defined as investment products,
which fall outside the circle of traditional investments such as stocks, bonds, or
other money market instruments (http://www.investorwords.com/6401/alternative_
E. Sokoowska, The Principles of Alternative Investments Management,
DOI 10.1007/978-3-319-13215-0_1
1 Alternative Investments on Contemporary Financial Market
investments.html, Accessed 20 July 2009). Thereby, this term encompasses all

assets outside the investment categories considered as traditional. As such, this
group will include e.g.: hedge funds, funds of funds, managed futures investments,
structured products and various investments in emotional assets.
Investments of an emotional character include e.g. art, wine or coins. This type
of alternative investments generally is the domain of very wealthy people or
enthusiasts and it includes collectible items (collectible coins, artifacts, antiques,
vintage cars, private jets, as well as investment wine, especially from the Bordeaux
region wineries classified in 1855, or single malt Scotch whiskey). Investors
emotional attachment to the items she/he owns, such as a yacht, jewelry or a
valuable sculpture by a favorite artist, is a characteristic feature of investments in
emotional assets. It is also possible to invest in peoplein talented stage celebrities
and film stars, athletes, scientists or managers.
Non-financial alternative investments generally involve high initial costs and
necessary additional expenses, such as insurance on a liqueur or a painting, an
expert opinion or commission for an agent e.g. an art gallery, an auction house, or
firms specialized in numismatics. What is more, in case of investments realized
independently, it is necessary to first gain some expertise in order to avoid losses
resultant from inadequate market research.
An increasing share of alternative investments in the portfolios of wealthy
investors during the past years can be noticed. Figure 1.1 presents the breakdown
of HNWI alternative investments in 20062014. A percentage increase of alternative investments share, especially during the years 20132014, can be notices.
While in 2013 alternative investments in the portfolios constituted HNWI-10.1 %,
in 2014 the share in this category of investments increased up to 13.5 %. This
suggests an increasing interest in alternative investments used for diversification of
the investments portfolio.
Figure 1.2 presents breakdown of HNWI Alternative Investments in (%). Analysis of Fig. 1.2 confirms that the share of alternative investments in the portfolios
of wealthy individual investors has been increasing (excluding Latin America). The
wealthy individual investors have increased the global share of hedge funds in the
portfolios during the years 20132014 by 3.5 %. The growing interest in hedge
funds was most visible in North America (a 7.6 % increase of those investments in
the portfolios in 2013, and a 12.1 % increase in 2014) (Capgemini, RBC Wealth
Management and Scorpio Partnership Global HNW Insight Survey). A much higher
interest in hedge funds has been demonstrated by investors over 40 years of age. In
2013, investors in the HNWI sector were much more likely to invest abroad as well.
This caused an increase in the share of foreign investments in the HNWI portfolios
from 25 to 36.6 % in 2014.
The literature on the subject does not clearly define whether alternative investments should be regarded as a separate category of assets or as a subcategory of the
assets already existing on the financial market (Anson 2006). While citing definitions by different authors, it can be noted that Swedroe and Kizer (2008) define
alternative investments as various investments outside the area of well-known
categories of financial investments, such as: stocks, bonds, other debt instruments
1.1 The Concept and the Essence of Alternative Investments
120
100
80
Equies
Fixed Income
60
Cash and cash equivalents

Real Estate (b)
40
Alternave Investments (a)
20
0
2006
2007
2008
2010
2013
2014
Fig. 1.1 Breakdown of HNWI financial assets (%) in 20062014 (Capgemini, RBC Wealth
Management, and Scorpio Partnership Global HNW Insight Survey). (a) Includes structured
products, hedge funds, derivatives, foreign currency, commodities, private equity. (b) Excludes
primary residence
120
100
Structured products
80
Private Equity
60
40
Foreign Exchange
20
Commodies
0
Hedge funds
Other Alternave Investments
Fig. 1.2 Breakdown of HNWI Alternative Investments (%) in 20132014 (Capgemini, RBC
Wealth Management, and Scorpio Partnership Global HNW Insight Survey)
or traditional instruments offered by banks, such as e.g. deposit certificates

(Swedroe and Kizer 2008). Debski (2006) takes a similar position on defining
alternative investments and he describes this category as all investments that are
not included within the scope of traditional forms of investing on the financial
market.
In turn, Anson (2006) states that alternative investments are a sort of subset of
the already existing category of investments. As such, he opposes the opinion that
alternative investments constitute a separate category of assets. He also believes
that they bear a risk higher than traditional investments. The risk incurred is
rewarded by a promise of attractive return rates, even during a financial crisis. He
also points out to specific categories that can be assigned to alternative investments,
which according to Anson (2006) are: hedge funds, commodity funds, managed
futures, private equity, credit derivatives.
Commission of the European Communities in the Green Paper, in reference to
improving the legal framework of investment funds, has defined alternative investments as hedge funds and private equity funds, which provide the asset management entities with new benefits resultant from diversification, which attract
investors by promising higher returns, and which can increase the overall market
liquidity. Alternative investment strategies have been described as more complicated and involving higher investment risk than mainstream UTCTS funds.
In the European Union Directive, which aims at establishing common requirements governing authorization and supervision of AIFs, the term is defined as
(Directive 2011/61/EU):
(a) Collective investment undertakings, including investment compartments
thereof, which:
(i) Obtain capital from a number of investors, with a view to invest it in
accordance with a defined investment policy, for the benefit of those
investors; and
(ii) Do not require authorization pursuant to Article 5 of Directive 2009/65/
EC.
There is also the definition provided by EU AIF. According to the Directive,
European Union Alternative Investment Fund is:
(i) An AIF which is authorized or registered in a Member State under the
applicable national law; or
(ii) An AIF which is not authorized or registered in a Member State, but has its
registered office and/or head office in a Member State.
Dorsey (2008) includes the following in the alternative investments: hedge
funds, private equity funds, currencies, real estate, commodities and raw materials.
This definition, however, seems disputable, since commodities, currencies and raw
materials can also be classified as traditional investments.
Chorafas (2003) believes that precise defining of the term alternative investments causes many difficulties and that comparison of particular categories of
alternative investments is not easy either, due to their variety and non-standard
characteristics. He also attempts to define alternative investments in terms of the
investment strategies used by them, among which he mentions the following
(Chorafas 2003):
US long/short strategies, that is, those which use long and short positions on the
American market, enabling profiting during growth periods as well as during
price declines;
1.1 The Concept and the Essence of Alternative Investments
US equity short strategies based solely on the use of price declines on the US
market, which enable profiting;
European long/short strategies, that is, strategies using long and short positions
on the European market, enabling profiting during the periods of increases as
well as during price declines;
European equity short strategies solely based on the use of price declines on the
European market, which enable profiting;
US emerging growth strategies, that is, investments into developing companies
in the US;
Macro strategies, that is, aggressive strategies based on analysis of macroeconomic indices;
Event-driven strategies, that is, strategies using extraordinary events in order to
achieve an income;
Market-neutral strategies, that is, strategies that are neutral to the market, which
are designed to reduce the market risk;
Fixed income long strategies, which are based on taking long positions in the
securities characterized by a fixed level of interest rates;
Fixed income hedge strategies, where hedging activities are carried out using
securities that are characterized by a fixed level of return rates;
Capital-protected strategies, belonging to a category of strategies which ensure
capital protection;
Managed currencies strategies constituting a group of strategies using currency
trading;
Managed futures strategies, encompassing transactions on the futures markets by
specialized CTA consultants;
Credit derivatives strategies, aimed at trading credit derivatives;
Risk arbitrage strategies, which are type of the strategies using arbitrage
methods;
Private placement strategies, encompassing transactions on private markets;
Strategies of other instruments and cash, that is, the remaining strategies using
other instruments and cash funds.
In the absence of a unified definition, characteristic features are listed, which at
the same time are the conditions to qualify a given investment into a category of
alternative investments. These characteristics include (Leitner et al., 2007):
The potential to obtain higher return rates adjusted for the risk;
A relatively low correlation with traditional instruments;
Trading outside the traditional exchange-traded market on the OTC, which
implies difficulties associated with their objective valuation and a lack of access
to reliable historical prices;
Infrequency of transactions and thus their lower liquidity;
A long-term investment horizon and therefore a longer period of freezing the
capital;
Application of diverse investment strategies, including a financial leverage,
short-selling and derivatives;
The focus on achievement of absolute return rates, without referring to any

particular fixed benchmark;
Exposure to less financial regulations;
Higher costs and limited availability of investments.
Due to a large number of definitions referring to alternative investments, it seems
useful to specify the conditions which ought to be met, in order for a given type of
investment to be qualified within this category. These conditions can be describes
as follows (Sokoowska 2010):
A generally higher investment risk, in comparison to traditional financial
investments;
A negative correlation of the return rates with profitability of traditional
investing in stocks and bonds, or a lack of correlation with the market;
Assumption of a maximum return rate/value, in the absolute sense and not based
on a particular benchmark;
An investment requiring specialized knowledge, often non-financial;
A significantly lower liquidity compared to many other traditional investments
of the financial market;
Often a much longer investment horizon, in comparison to the average investment period on the capital market;
Focusing the target group on wealthy investors;
Occurrence of the so-called entry barriers, that is, the minimal amount of capital
enabling initiation of a given alternative investment;
Occurrence of the so-called entry limits, that is, limiting the number of potential
investment buyers;
Usually, the private nature of an investment;
Functioning within a market segment of lowered informational requirements and
of a lower transparency level.
Fulfillment of the above conditions authorizes qualification of a given investment within the category of alternative investments.
1.2
Classification of Alternative Investments
Most basic division of alternative investments classifies them into: physical investments and financial investments. Investments in physical assets are material in
nature, whereas the profit expected by an investor is the difference between the
future value of a given possession and its current value. Financial investments, on
the other hand, are immaterial in nature, whereas the investor can expect an increase
in the value of a given investments subject as well as a profit from its ownership.
Alternative investments can be both, physical as well as financial in character.
Alternative investments in physical assets include e.g.: investments in precious
metals, in real estate, artifacts, liquor or in other collectible items. The items being
1.2 Classification of Alternative Investments
the subject of a physical investment also have a value in use and can satisfy the
consumption needs. In financial investments, as opposed to physical investments,
the subject of an investment, i.e. a given financial instrument, does not represent
any use value in itself, but only a monetary value. Alternative financial investments
involve asset allocation mainly in hedge funds, funds of funds, managed futures
transactions or in structured products. Diverse classifications of alternative investments mainly result from the lack of their universal and uniform definition. Thus,
different ways of dividing alternative investments, depending on the adopted
classification criterion, will be presented.
Alternative Investment Services, an institution dedicated to the services on the
alternative investments market, has defined six categories helping to understand the
construction of individual products and to facilitate construction of modern, diversified investment portfolios (http://www.nwai.pl, Accessed 9 September 2009). The
category of alternative investments includes:
Hedge funds,
Funds of funds,
Structured/guaranteed products,
Managed futures and investment programs,
Private equity/venture capital funds,
Investments in real estate (REIT).
Hedge funds are currently most well-known alternative investment institutions.

Emergence of hedge funds is a consequence of development of other innovative
financial instruments, such as e.g. derivatives. The definitions of hedge funds
provided in the literature on the subject are not very consistent. Generally, descriptions of hedge funds underline the fact, that they are subjected to less restrictive
regulations. In addition, they invest investors assets both on the spot market and on
the futures market, as well as use financial leveraging in order to attain benefits for
their shareholders. For this reason they are very risky. However, it is exactly this
risk that attracts many sophisticated investors who believe higher risk leads to
higher return. Hedge fund investment strategies are rarely defined by accurate
distribution of their assets among particular classes of assets. Managers have
great flexibility in shaping their investment policies, depending on the current
situation on the markets. Their main target is to outperform the market. In contrast
to mutual funds, which are owned by public corporations, hedge funds are not
standardized. The term hedge fund, thus, is not adequate from the perspective of the
law according to which they are formed. Their legal form is determined by the type
of investors and by the place of their registration. Most common legal forms
include: limited partnership and limited liability company; therefore in this context,
the term hedge fund is applied improperly.
Most countries lack any formal definition of funds of funds (FOF). The term
fund of funds usually is understood as a type of a fund investing in other funds,
using various investment strategies. Managers of funds of funds select those funds
for their portfolio, which invest on the most prospective markets and which achieve
the highest return rates. FOF clients do not need to follow the market situation nor
make decisions regarding the changes in asset allocation. It is the managers who are
responsible for an appropriate choice of the units. Funds of funds also have a big
advantagethe allow less wealthy individual investors to access investment
values, which directly can only be bought by the wealthiest clients using wealth
management services. Additionally, the units bought wholesale enable achievement of preferential conditions and often are cheaper than if purchased directly by
an individual investor.
The term managed futures, often is translated as managed accounts and
investment programs. In fact, this term refers to the entire industry based on
advisory of specialized consultants. In their strategies they use derivatives, while
automated trading systems serve as tools for making a profit. The term managed
futures also signifies the manner of operating on the market through authorizing
the advisors to manage the clients money on the futures market. The term Commodity Trading Advisor literally refers to an advisor on the commodity market, so it
can be somewhat misleading.
Commodities, that is, goods and products, are associated with e.g. agriculture
products, precious metals, petroleum, and other physical assets which can constitute
the basis for transactions on the futures market. As far as financial terminology is
concerned, the term Commodity Trading Advisor (CTA) refers to professionals,
called the licensed advisors on the futures market, whose activities are also related
to currency exchange markets, financial instruments, as well as to stock indices.
Managers are supervised by an American institution regulating the futures markets
(National Futures AssociationNFA). A CTA license is issued by the Commodities Futures Trading Commission (CFTC).
Structured products are financial instruments whose price is dependent on the
value of a particular market index. Structured products combine traditional investments e.g. in stocks or bonds with derivatives. Exemplary market bases, which can
constitute the basis for calculating the amount of interest, include: stock exchange
indices, stock prices, raw materials, agricultural products, baskets of shares, baskets
of commodities or stock indices, as well as currency exchange rates or e.g. interest
rates. Combining traditional instruments with innovative ones is meant to generate
higher return rates. The purpose of applying a traditional instrument into an
investment is to protect the capital. A derivative is meant to enable multiplication
of an income, through asymmetrical risk profile. Creating asymmetrical payout
profiles is possible due to application of options. Thus, such structured products
formed in response to the demand for investments that are adapted to the decreasing
conditions on the financial market.
Definitions of the concepts private equity and venture capital as well as their
further interpretations differ significantly, depending on the place of their application. According to the definition published by the European Venture Capital
Association (EVCA) in 1995, private equity funds encompass investments in
companies at various stages of their development, from the moment of their
foundation and a start-up of their activity, throughout the stages of their expansion,
until they are sold. While defining the term private equity in a general sense, it can
be stated that it refers to all investments conducted on the private capital market,
1.2 Classification of Alternative Investments
in order to obtain medium-term and long-term profits from increases in the value of
the capital. The term venture capital also refers to private investments, which are
at early stages of their development. It can therefore be concluded that venture
capital is a type of private equity. The term venture capital most commonly is
interpreted as an investment in brand new projects, while private equity is an
investment in an entity that already exists and whose financing is oriented at its
further, more dynamic development. The concept of private equity, although often
used interchangeably with the term venture capital, is a much broader term.
Real Estate Investment Trust are investment companies which invest exclusively
in real estate and in mortgages. In general, real estate are assets of high value and
low liquidity. Therefore, for most investors, it is difficult to invest in them directly.
There are, however, ways to invest on the real estate market, without buying
apartments or land directly, and so avoiding any related problems. As such, the
following can be mentioned here: purchasing of real estate funds or acquisition of
the shares of the companies directly involved in buying real estate and profiting
from renting them or from an increase of their value. Regardless the form, investments in real estate are characterized by a relatively long time horizon. Investing of
an average of 80 % of the assets directly or indirectly into real estate is a characteristic feature of REIT. Generally, REIT should have at least 10 properties in its
portfolio, while the investor can own a maximum of 10 % of REITs net assets.
Apparently, attractiveness of these funds results from tax advantages which the
investor can receive by investing in this type of funds.
Alternative investments can also include various kinds of raw materials. However, it does not entail direct purchasing of tons of copper or a few barrels of
petroleum. Yet, each investor can make all or part of the value of his portfolio
dependable on the price changes of those assets, through acquisition of appropriate
derivatives, structured products or investment units. Raw materials that are most
popular among the investors include: precious metals (gold, silver, platinum),
energy resources (petroleum, natural gas), industrial metals (mostly aluminum,
copper), as well as agricultural products (wheat, corn, soybean, and cotton, sugar,
coffee, cocoa, and many others).
Emotional investments are tools which in addition to achieving high return rates
have hobbyist significance for the investors. These investments mainly include
collectible items such as: artifacts, liquors, vintage cars, numismatics. Most popular
investments in this group are investments in artifacts, which in addition to profit
prospects offer functional qualities. Emotional investments bear the highest risk,
but at the same time they have a potential for vary high returns. Figure 1.3 presents
an exemplary classification of alternative investments.
Stefanini (2006) divides alternative investments into the so-called traditional
alternative investments and hedge funds, private equity and venture capital funds,
securitization and physical assets. In the category of traditional alternative investments the author included: junk bonds, emerging markets and real estate funds. In
the physical assets the author included: land, real estate, as well as commodities,
precious metals and petroleum. According to a classification by Schneeweis and
Pescatore (1999), alternative investments have been divided into four basic groups:
10
Fig. 1.3 Classification of alternative investments
hedge funds, managed futures investments, commodities and the so-called traditional alternative investments. This classification also indicates that the goods
which often are the subject of alternative investments include: agricultural goods,
precious metals and energy. The following have been included in traditional
alternative investments: private equity funds, venture capital funds and real estate.
An innovative and at the same time controversial division has been made by
Swedroe and Kizer (2008). They have divided alternative investments into: good
investments, vitiated investments, bad investments and the worst ones. Classification of each investment into one of the above categories has been done on the
basis of the following criteria:
The expected return rate of an investment;
Volatility of an investment, measured by the size of a standard deviation;
Distribution of the return rate.
According to this classification, the category of good investments includes: real
estate funds, inflation-protected securities, commodities, international equity
issues, or stable value funds. Alternative vitiated investments, according to the
authors, include: high-yield junk bonds, private equity and venture capital, covered
calls, socially responsible mutual funds, precious metals equities, preferred stocks,
convertible bonds and emerging markets bonds. The category of bad investments
includes: hedge funds and leveraged buyouts. The worst alternative investments,
according to the authors, include: structured investment products and leveraged
funds. This classification shows a completely different perception on alternative
investment categories.
1.3 The Risk Associated with Alternative Investments
11
Anson (2006), while classifying alternative investments, listed the following:
Hedge funds,
Commodities and managed accounts,
Private equity,
Credit derivatives,
Corporate governance.
Alternative investments are often interpreted through the prism of applicable

investment strategies, which provide ample opportunities to shape the risk profile
and the return rate. Considering the payout profiles of those instruments, the
following combinations can be distinguished:
Combination of the traditional financial instruments with derivatives (most often
the structured products);
Application of complex investment strategies using short-selling, leverage and
other previously unavailable combinations of investment techniques and styles.
Alternative investments can also be classified according to the degree of their
liquidity. The least liquid alternative investments include investments of venture
capital or the leveraged buyout funds. Investments in hedge funds are relatively
liquid. Their investment horizon generally lasts from 3 months to 1 year. Managed
Futures are considered as investments with high liquidity. Table 1.1 summarizes the
characteristics, which allow comparison of traditional and alternative investments.
1.3
The Risk Associated with Alternative Investments
Risk is feature inherent in any investment. The term risk derives from Old Italian
risicare which means to have the courage. In this sense, risk can be associated
with free choice. The first concept of an economic risk theory was introduced by
Willett in 1901. He assumed, that risk is a term of various meanings that are
commonly used in everyday life. While associating the concept of risk with
uncertainty, and using philosophical determinism, he decided that this concept
should refer only to an impression or an illusion of randomness, which results
from insufficient knowledge about the laws governing the reality. Willett recognized risk as a state of the environment and he believed that risk should refer to the
degree of uncertainty whether a given result will actually occur, and not to a
probability of that result occurring. The risk understood as the state of the environment is objectively correlated with subjective uncertainty.
The second concept of measurable or immeasurable uncertainty can be considered a theory proposed by Knight in 1921. The main aim of his work was to
specify the features characterizing uncertainty, which ought to be rather associated
with risk, in comparison with uncertainty in its strict sense. According to Knights
concept, risk is an immeasurable uncertainty. Uncertainty which cannot be measured is considered as uncertainty in its strict sense (immeasurable).
Positive returns can be earned in bull markets

Strategy is successful if the return beats the reference portfolio, even if
the absolute performance is negative
None
Market
Strategies
Return
Benchmark
To a limited extent; not always
Regulated, subject to public supervision, very liquid

Only long positions
Correlation
Legal structure
Management
investment
Performancerelated fee
Traditional investments
1
Investment policy and instruments are limited by legislation
Table 1.1 Comparison of traditional and alternative investments
Management remuneration system that aligns managers

and investors interests
Manager often invests substantial sums
Alternative investments
Medium to low
Head office in offshore centers allows a flexible investment
strategy
Low regulation, access is often limited, illiquid
Long/short strategies, borrowing is permitted, derivatives
can be used
Positive returns can be earned in both bull and bear markets
Focus on absolute growth in value
12
13
Another remarkable concept was developed by the Commission for Insurance

Terminology in USA in 1996. The work of the committee resulted in two definitions of risk. The first one defines risk as an uncertainty referring to a specific event
in terms of two or more options. In this sense, it is a measurable uncertainty as to
whether the intended aim will be achieved. The second definition focuses on the
issues associated with insurance practice, stating that risk refers to an insured
person or entity.
Lange (1943) treats risk as an immeasurable uncertainty, to which statistical
measures cannot be applied. As such, risk is a broad term, therefore, it can be
classified in various ways. From a practical perspective, risk classifications are
useful, since they help answer the question how and when risk discloses itself. The
types of risk also emerge from different sources and can be classified according to
various criteria. Assuming the origin of the risk as a criterion, the following can be
distinguished:
Market risk (systematic),
Specific risk.
Market risk, also called systematic risk, refers to the factors which affect entities,
but cannot be controlled. This type of risk is related to the forces of nature as well as
to the economic conditions on a given market and on the global market. The sources
of systematic risk may include: changes of the interest rate, inflation changes, tax
law changes, changes in political and economic situation.
Specific risk, also called an individual risk, is related to the future events, which
partially can be controlled or predicted. The following can be mentioned as the
sources of specific risk: business management, market competition, availability of
raw materials, the companys liquidity and its profitability, or the level of a financial
leverage. According to possible alternatives, the following risk types can be
distinguished:
Clear risk,
Speculative risk.
Clear risk occurs when the only alternative to the present state of the things is
occurrence of a damage. In contrast, speculative risk is characterized by the fact that
unknown future events can cause both, losses as well as profits. The division of risk
into speculative and clear risks is essential in the insurance sector, since speculative
risk can be the subject of an insurance; therefore, clear risk and speculative risk
should be considered separately. Given the time criterion, the following can be
distinguished:
Operational risk,
Strategic risk.
Operational risk is short-term in nature and is associated with the activity of a
given entity, while strategic risk is long-term and is related to the long-term
decisions made. Taking into account measurability of the risk effect, it can be
divided into:
14
Financial risk,
Non-financial risk.
Measurability and the ability to directly capture its impact on the financial
market are characteristic features of financial risk. Non-financial risk is characterized by difficulties with direct measurement of its impact on the profit realized by
an entity.
Alternative investments are connected with all types of risk specified in the New
Basel Capital Accord, that is, with: credit risk, market risk and operational risk.1
Development of alternative investment market should, thus, lead to analysis of the
role of supervising institutions, which also play an important role in the process of
ensuring the security of functioning of entities as well as the security of the transactions involving innovative institutions and instruments. Supervising institutions,
thus, should actively participate in transformations of the financial market, while
adapting the regulations to the changing conditions. There are four broad categories
of the risk the investors in alternative assets can face: investment risk, liquidity risk,
operational risk and organizational risk. Investment risk can be further sub-divided
into three broad categories: primary risk, secondary risk and idiosyncratic risk.
Alternative investments are more complex than traditional financial instruments.
Analysis of the risk factors associated with this sector of the market is much more
difficult. The risk of alternative investments involves additional risk factors, which
should be considered while planning their inclusion in an investment portfolio. In
connection with functioning on an unregulated, disorganized market, we can speak
of the transaction transparency risk, which is associated with the lack of comprehensive information on these investments. Both, the managers and the investors, in
their activity, should account for the risk of a lack of transparency. Another
important type of risk, in case of alternative investments, indirectly associated
with transparency risk, is the risk involved with the transaction partner. It involves
the counterparty not meeting the transaction conditions specified in the agreement.
The history of financial disasters confirms the possibility of changing the investment policy on the part of the partner and his withdrawal of the financial assets,
which can lead to gigantic losses for the other party. The market of alternative
investments belongs to the sectors characterized by lowered informational requirements. Since settlement of these transactions is carried out in the conditions of a low
degree of control, we can speak of the control risk and of inability to assess the real
risks. Lack of transparency and a low level of control, both belong to the basic
sources of risk in the sector of alternative investments. Another important type of
risk is management risk. It refers to the risk associated with badly conducted
management by the persons who undertake this responsibility to the companies
and their owners, to the clients and to other entities, on behalf of which they make
the decisions. The return rate from alternative investments is highly dependent on
1
Capital Requirement Directive Basel II (New Capital Agreement), published by Basel Bank
Supervision Committee collection of most efficient market practices used within the scope of
financial market in the banking as well as banking practices of keeping a safe capital level.
15
the professionalism and abilities of those making investment decisions. An additional risk factor refers to a limited access to information. The data risk is associated
with a possibility of making wrong investment decisions, based on information
characterized by errors. The institutions operating in the alternative investment
sector are exempt from an obligation to report on their activity and on their results.
This means, that reporting on the results achieved by a fund can be carried out
selectively, based on selected time series.
In case of alternative investments, we are dealing with application of very
sophisticated investment strategies, which use short-selling, financial leverage, as
well as derivatives whose payout profiles often are asymmetrical. The use of a short
sale allows development of a profit during the price drops on the market. The risk of
short-selling, therefore, theoretically means a possibility of unlimited losses
incurred due to price increases of the securities. One way to avoid this risk is
using the hedging long positions which are more secure.
Using a short sale as an investment strategy, not as a securing strategy, can result
in severe losses. Another important source of risk on the alternative investment
market is a leverage risk. It means a possibility of severe losses incurred from
operating with a multiplied invested capital. Application of a financial leverage,
thus, brings in additional elements of risk into functioning of market entities.
Leverages are used in order to multiply the profits, in case of a transaction
failure, the investor, however, incurs multiplied losses. While underlining leverage
risk, many examples of spectacular loses which occurred due to leverage overuse,
can be indicated. The most well-known case of the consequences related to negative
aspects of leverage, is the case of Long Term Management Capital, which in
September 1998, shortly before its bankruptcy announcement, had a position of
125 billion UDS generated on the basis of a value of 4 billion USD. This meant
operating with nearly 30 times the actual capital. In case of the investments using a
financial leverage, it is also important to consider the risk of insolvency as well as
the risk of the so-called herd behavior. It is connected with concentration of the risk
in particular segments of the market and with a forced deleveraging.
Alternative investment managers usually have their management centers localized offshore, in the countries with liberal tax and business registration laws. Often,
such places also lack any restrictive requirements regarding submission of obligatory financial reports and preparing financial statements. The managers also are not
subjected to institutional verification and authorization of their activity.
These additional risk factors ought to be considered while making investment
decisions as well as during construction of an investment portfolio. According to
contemporary portfolio theory, the portfolio risk depends on the level of the risk of
the values making up that portfolio and on its structure as well as on the relations
between the values in the portfolio. The segment of alternative investments is
connected with a low liquidity level, since such investments usually are longterm. This means, that the investors must account for a risk of a lack of a possibility
of a fast change of the financial assets allocated in a given cash investment.
Other types of risk on the alternative investment market are: the risk of a
mismatch between the assets and the liabilities, the risk of a lack of adequate
16
capacity, or the risk of fraud. The risk of a mismatch of the assets and the liabilities
involves a lack of a match between the maturities of the assets and the liabilities.
The risk of adequate capacity is associated with a limited number of investors
who can participate in a given investment. It may happen, that the circle of investors
is limited for certain investments, due to capacity constraints.
The risk of fraud means a probability of abuses, which lead to loses or even to
insolvency on the part of a given economic entity. Most alternative investments are
concluded on the borderline of a regulated market, which means generating a
significantly higher risk of abuse than in case of transactions on a regulated market.
Thus, it is necessary to incorporate appropriate control mechanisms, which will
enable minimization of this type of risk. The strive to achieve a positive return rate,
in the absolute sense, is a characteristic feature of alternative investments. In
traditional investments, investment performance measurement is based on a comparison to a certain pattern called a benchmark. In the absence of a particular
pattern on the market of alternative investments, this sector is connected with a
risk of performance measurement. Alternative investments often constitute one of
the component of an investment portfolio.
The risk associated with alternative investments, therefore, can be analyzed from
the perspective of the investors. Most important types of risk, which investors must
consider, are:
The risk of unfavorable investment results,

The risk of incorrect investment strategy,
The risk of incurring high loses,
The risk of fraud.
Emergence and development of financial innovations, including alternative

investments, has highlighted new sources of risk on the international financial
market. In the era of globalization, reputational risk, for instance, is growing
rapidly. Consequently, there is an increase of personal responsibility of the managers as well. Despite numerous positive aspects of globalization, attention should
be paid to new threats. Globalization brings some new challenges, such as
(Chorafas 2003):
The need of dealing with cultural differences, as well as with the discrepancies
between the rules and regulations,
Greater complexities associated with appropriate application of those rules and
regulations.
The issue of excessive application of a leverage by alternative funds has been
widely discussed. Accurate measurement of the effects of leveraging requires
employment of competent managers, the use of advanced technologies, as well as
a proper use of available data.
Application of derivatives into investment strategies causes a necessity of
continuous monitoring and control of the risks associated with the changes of the
investors positions on the futures markets. While analyzing the types of risk
associated with alternative investments, appropriate management of the risk, by
Identified risk
category examples
Market risk
Credit risk
Liquidity risk
Transaction risk
Valuation risk
Operational risk
Other risk
(. . .)
The asset
concerned
Description of the
measures/control
Quantitative/
qualitative approach
Table 1.2 Examples of risk identification, measurement and its management

Approach to risks
constraints
Measurement
frequency
Reporting /
escalation
Owner/
controller

17
18
determining the methods of its measurement and by designation of an adequate risk

level for each alternative investment portfolio, seem crucial.
The procedure of risk management ought to determine appropriate tools, which
would be adequate for identification of the risk and for establishment of quantitative
and qualitative constraints for each category of risk. A practical template which can
be used to provide to an overview, as to whether each relevant risk is properly
addressed, is provided in Table 1.2.
One of the basic requirements for smooth functioning of economies in individual
countries is stable and efficient operation of the financial market. It enables
transferring of the capital between financial market participants, from the entities
holding excess capital to those characterized by its scarcity. Such actions should
allow increased efficiency of capital allocation in the economy. This role is very
important, due to the impact that the level of financial markets development has on
economic growth of a given country. This dependency has been noticed by numerous economists, including one of the pioneers of this theoryJ. Schumpeter, who
first pointed to it in 1955. The strive for financial market development, therefore, is
assumed to foster economic development of individual countries.
Alternative investments are contemporary financial innovations, which have
emerged as a response to increasing expectations of the investors, in the face of
rapidly changing market conditions. Increasing integration of the international
financial market has caused a decreased attractiveness of traditional forms of
investing. Lowering of the interest rated by central banks worldwide, in order to
stimulate the economy, has caused a decrease in the interest rates on the deposits.
This situation prevents the investors from generating attractive return rates while
using traditional forms of allocating their cash assets. At the same time, it has
influenced the search for new directions for investing the surplus cash assets by the
investors seeking possibilities of generating extraordinary return rates from the
invested capital. The years between 2000 and 2002 were particularly important
from the perspective of alternative investments and their development. That period
was characterized by a noticeable tendency for price declines on financial markets.
The cheap money policy incorporated in the United States since the year 2000, has
caused a decrease of the interest rates to the lowest level during the past 40 years. A
decrease in the interest rates of short-term treasury securities to the level of 1 %, in
the US in 2003, as well as a decrease in the interest rates of treasury bonds below
4.2 % in the year 2005, have decisively led to seeking other forms of investment,
which hopefully would achieve higher incomes.
There also has been interest in the investments which allow effective portfolio
diversification, while helping to broaden the spectrum of available products and
services.2 Due to the investors growing interest in allocating their assets on the
2
The research on diversification possibilities of a portfolio composed of traditional instruments
using alternative investments, was done by Thomas Schneeweis, Richard Spurgin, A comparison
of return patterns in traditional and alternative investments in Sohail Jaffer ed., Alternative
Investment Strategies, Euromoney, 1998.
19
international financial market, interest in alternative investment strategies has

emerged. Going back to historical beginnings, which initiated the development of
the alternative investments market, it must be mentioned that the first subject of
alternative investments described in literature was created in 1949 by a sociologist
Alfred Winslow Jones. He used a method of short-selling, which enabled the
investors to make a profit even during price drops on the market. In fact, short
selling is a sale of hypothetical assets, for their later buyout at a lower price.
In practice, it involves borrowing the assets that are priced too high, the price of
which is most likely to go down. The difference between the sale price and the
purchase price is the profit. The cost of renting the assets is subtracted from the
profit. Alfred Jones, in his investment fund management combined both, long and
short positions. He assumed, that proper selection of the securities being bought
allows a profit above the average return rate, while application of a leverage
multiplies the profit. Short positions in the portfolio decrease the potential profit
from that portfolio during price increases on the market. On the other hand, they are
meant to protect the portfolio against incurring losses during a market reverse.
The financial crisis in 2007 also contributed to a growing interest in alternative
investments on the part of the investors. The crisis provoked the market participants
to analyze its causes. It would be unjustified to say that it was invoked by financial
innovations, since they are and will be an integral part of the international financial
market. Supervising institutions and market regulators must adjust the regulatory
and organizational architecture to the changing conditions. The years 20072009
were the turning point in integration of the EU financial market. The global
financial crisis, which begun in 2007 on the mortgage market in the US, had
significant impact on functioning of the financial market in the EU. It turned out,
that despite the years of EUs efforts to build a stable financial market, existing
regulations did not meet the expectations of the participants, while stability of the
financial market in the EU was significantly disturbed. Work on introducing
changes to the financial market in the EU was intensified. In 2009 European
Commission published a document Driving European Recovery and another in
2010 Regulating Financial Services for Sustainable Growth. These documents
outlined the direction of EU financial markets development. An important change
introduced by the EU starting January 1st, 2011 was formation of the European
System of Financial Supervisors, ESFS as well as European System of Risk Board,
ESRB. These institutions supervise the financial market in the EU.
Despite a continuously expanding spectrum of possible investment methods and
techniques and the financial instruments offered, the principles applied by Jones are
still versatile. Achievement of a high return rate is highly dependent on proper
selection of the securities for the portfolio. Application of alternative investment
methods is also meant to enable the investors to achieve a positive return rate,
regardless the price changes on the markets. Another characteristic trait of alternative investments is based on an assumption, that achieving favorable results is
highly dependent on the managers professionalism. He/she should possess specific
skills needed for selection of adequate tools and for application of short and long
positions, which allow risk reduction and development of a positive return rate.
20
Clearly, alternative investments belong to complex transactions that are concluded on the markets with reduced informational requirements and low transparency. Therefore, the potential dangers associated with a very dynamic development
of this market segment should be indicated, while the investors should be made
aware of the risk associated with concluding transactions on the alternative investments market. Undoubtedly, it is more difficult to determine the dangers associated
with application of alternative investments, compared with the risk of traditional
investments. Moreover, application of complex investment strategies using a leverage, which involve significant amounts of capital, can pose a security challenge for
the entire financial system.
References
Anson, M. J. (2006). Handbook of alternative investments. New York: Willey.
Basel Committee on Banking Supervision. (2004). International convergence of capital measurement and capital standards. http://www.bis.org.
Capgemini, R. B. C. Wealth Management. (2014). World Wealth Report 2013.
Chorafas, D. N. (2003). Alternative investments and the mismanagement of risk. New York:
Palgrave Macmillan.
Debski, W. (2006). Structured products and hedge funds as alternative investments of the
capital market. In H. Mamcarz (Ed.), Financial markets. Lublin: UMCS.
Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and
Regulations (EC) No. 1060/2009 and (EU) No. 1095/2010, Brussels.
Dorsey, A. H. (2008). Active alpha: A portfolio approach to selecting and managing alternative
investments. Hoboken: Wiley.
Hirshleifer, J. (1958). On the theory of optimal investment decision. The Journal of
Political Economy, 66(4), 329352.
Knight, F. H. (1921). Risk, uncertainty and profit. New York: Hart, Schaffner and Marx.
Lange, O. (1943). A note on innovations. The Review of Economic Statistics, 25, 1925.
Leitner, C., Mansour, A., & Naylor, S. (2007). Alternative investments in perspective.
RREEF Research Paper.
Schneeweis, T., & Pescatore, J. F. (Eds.). (1999). The handbook of alternative investment
strategies. New York: Institutional Investor.
Schneeweis, T., Spurgin, R., & Sohail, J. (1998). A comparison of return patterns in traditional and
alternative investments. Alternative Investment Strategies, 10, 157188.
Sokoowska, E. (2010). Alternatywne formy inwestowania na rynku papier
ow wartosciowych.
Torun: Wydawnictwo Naukowe Uniwersytetu Mikoaja Kopernika.
Stefanini, F. (2006). Investment strategies of hedge funds. London: Wiley.
Swedroe, L. E., & Kizer, J. (2008). The only guide to alternative investments youll ever need:
The good, the flawed, the bad, and the ugly. New York: Bloomberg Press.
Union, P. (2009). Directive 2009/65/EC of the European Parliament and of the council. Official
Journal of the European Union L, 302, 33.
Willett, A. H. (1901). The economic theory of risk and insurance (No. 38). New York:
The Columbia University Press.
Chapter 2
Hedge Funds
2.1
Specificity of Hedge Funds
Currently, hedge funds are the most well-known alternative investment institutions.
They emerged on the capital markets in the 70s and 80s. They evolved as a consequence of development of new financial instruments, such as e.g. derivatives. Also,
limitations in functioning and in investing methods of traditional investment funds
and pension funds have contributed to development of hedge funds.
Problematic aspects of hedge funds raise a lot of controversy. The term hedge
fund has not been universally defined. Analysis of legal acts concerning the sector
of alternative investments proves that there is no precise definition of hedge fund.
The term has not been specified by any of the US legislative acts such as: Securities
Exchange Act of 1934, Investment Advisor Act of 1940 or the Commodity
Exchange Act. This term neither has been defined by the Securities Exchange
Commission, which has not presented any official definition.1 What is more, there
is no comprehensive definition of hedge fund by the European Union Directives.
According to the definition by Schneeweis et al. (2001), the term hedge fund can
refer to an investment fund that is subjected to unrestrictive regulations, which
invests the investors funds both on the spot market as well as on the futures market,
and which uses a financial leverage for the benefit of its shareholders. Another
definition describes a hedge fund as an aggressive investment portfolio using all
available speculative deals in order to generate income. Ineichen (2000) in his
definition of hedge funds indicates the importance of managers participation in the
funds and calls it a private company, in which a manager or a general partner
financially participate in the fund. Functioning of such a company is not subjected
to restrictive regulations, which allows the fund to use various investment strategies, including short-selling and leveraging. The author stresses the fact, that hedge
1
Securities and Exchange Commission, Registration under the Advisor Act of Certain Hedge
Fund Advisers, 17 CFR parts 275, 69 Federal Register 72054, December 10, 2004.

DOI 10.1007/978-3-319-13215-0_2
21
22
2 Hedge Funds
funds usually are created as limited partnerships or as civil law partnerships, located
in offshore areas, which makes their actions unrestricted by any tax or legal
regulations.
While citing various definitions of hedge funds, it is worth noting the controversies related to the lack of a universal model and its precise description. For
instance, the American Heritage Dictionary, 3rd Edition, defines a hedge fund as
an investment company that uses high-risk techniques, such as borrowing money,
selling short, in an effort to make extraordinary capital gains. Classifying hedge
funds as investment companies would allow regulation of their activities under the
Investment Company Act of 1940. Hedge funds, however, are not subject to
regulations of that Act.
Jaeger (2002), on the other hand, states that the term hedge fund is misleading,
because hedge funds often use risky leveraged strategies, rather than hedging
methods. Due to improper, as far as logic is concerned, use of this term, attempts
are being made to substitute it with the term arbitrage fund. Moreover, the term
hedge fund is not appropriate from the perspective of legal regulations under
which those funds are formed. Most common legal forms include: a limited
partnership or a civil law partnership, and as such, also in this context, the term
fund is used improperly. Following this logic, another definition can be quoted,
which describes hedge funds as entities that are not a bank, an insurance company
or any other regulated financial institution characterized by a very broad and
diverse spectrum of investment strategies used by it.
While presenting the concept of hedge fund that is used in business practice, a
definition provided by a prestigious financial institution Moneycentral Investor
http://moneycentral.msn.com/investor/home.asp can be quoted. It describes a
hedge fund as a risky investment fund open to wealthy investors, which is devoted
to finding investment opportunities characterized by a high return rate, but by a high
risk. Goldman Sachs & Co., in turn, describes hedge funds as entities using various
investment strategies, characterized by a high level of risk, yet providing a possibility of a high return rate at the same time http://www2.goldmansachs.com,
Accessed December 13, 2009. Hedge funds are investment instruments, which, in
comparison with traditional investments such as stocks or bonds, provide distinct
profit and risk profiles (Stefanini 2010). Clarification of this definition requires an
indication, that hedge funds use alternative investment strategies and styles, and
they are not subject to any regulatory restrictions that could hamper fulfillment of
the undertaken investment goals. Development of a positive return rate regardless
the direction of price changes on the market is a common goal of hedge fund
investments. Achievement of satisfactory investment results is highly related to the
unique characteristics and abilities of fund managers (Connor and Woo 2004).
Jobman (2002) also confirms the lack of a universal definition of a hedge fund.
Summing up all the widely accepted definitions, some characteristic features of
hedge funds can be distinguished, which include:
Focus on achievement of a definite profit that is not based on a known reference
standard called a benchmark;
2.2 Functioning of Contemporary Hedge Funds
23
Allowing the managers to use both, growths and declines on the market,
including long and short positions;
Rewarding the managers for their results;
High flexibility in the choice of investment styles and the use of short-selling
strategies, leverages and derivatives;
Ability to use various financial instruments in order to diversify the portfolio and
to reduce the risk, as well as to generate extraordinary profits.
The above presented definitions do not uniformly specify the term hedge funds.
However, they allow isolation of some characteristic features, which distinguish
these forms from other forms of collective investment.
2.2
Functioning of Contemporary Hedge Funds
The market of investment funds is very diversified. Nevertheless, the definitions of

hedge funds presented by different authors have some elements that are characteristic of the hedge fund sector. Hedge funds most commonly belong to private
investment companies, which are directed at wealthy individuals or single entities
(natural person and legal persons). They are not, therefore, widely available. High
amount of a deposit is its primary barrier, which only allows a selected group of
wealthy investors to have access to those funds. Investors of those funds have direct
access to hedge funds data through investment advisors of these funds.
Some hedge funds, mostly American ones, do not use third party persons as
trustees of its assets nor administrators (who calculate the net value of the funds
assets). This can lead to a conflict of interest, and in extreme cases even to
misappropriation of assets. For instance, Kirk Wright International Management
was accused of fraud and a breach exposing their clients to losses in the amount of
$180 million. In December 2008, Bernard Madoff was arrested for a fraud of $50
million in a Ponzi scheme.
Despite significant differences in functioning of hedge funds, there is one
characteristic feature common for all such fundsthe assumption of achieving a
positive return rate, in the absolute sense, that is, without using benchmarks as a
target reference standard.
One important element impacting functioning of hedge funds and influencing
their specific results is the relationship between the managers and a hedge fund,
involving their financial participation in a given funds well as their investing
abilities which generate the so-called additional alpha.
A two-stage system of compensating the managers, which is characteristic for
alternative investments, is a significant feature of hedge funds. The management fee
is deducted from the returns prior to their publishing. Commission from a generated
income enables establishment of a strong relation between those managing the
funds assets and the fund itself.
24
2 Hedge Funds
Investing own funds by the managers is a good protective measure against

occurrence of some mechanisms characteristic of a given agencys theory,2
according to which the investors and the investing have different goals. Compensation for the results is usually paid out after reaching the assumed break-even point
or after making up the losses incurred by the fund during preceding periods. Hedge
fund managers usually receive both, the fund management fees and commission for
the funds performance, which is also called a commission incentive. A typical
hedge fund manager charges a fee of 2 and 20. This term refers to a management
fee of 2 % of the funds net asset value, and to a commission incentive of 20 % of
the profit earned by the fund. Generally, management fees range from 1 to 4 %
annually (standard 2 %), but are calculated and paid out monthly or quarterly.
Business models of most fund managers assume the management fees to cover the
managers operation expenses, leaving the fees for performance as employee
bonuses. In large hedge funds, management fees can constitute a significant part
of the managers profit.
Commission from achieved results is a characteristic feature of hedge funds. The
amount of commission is calculated as percentage of the profit obtained by the fund.
Typically, hedge funds charge a commission of 20 % of the overall profits. The
scope of these fees, however, is diversified; well-known managers charge higher
fees. For instance, in the fund SAC Capital Partners an incentive fee is as high as
3550 %, while Jim Simmons from the Medalion Fund charges a fee of 45 % of the
overall profit. The model of incentive commission has been much criticized as
being the cause of excessive risk-taking on the part of managers, undertaken in
order to attain short-term profits. Managers should be focused on implementation of
long-term investment strategies. Goetzmann et al. (1998) have attempted an analysis of potential costs and benefits of a High-Water Mark system from the
investors perspective. There are many various commission models, however, the
most known systems include:
High-Water Mark,
Hurdle rate.
High-Water Mark literally means the mark of high water that is above the
highest level a given water reservoir has reached during a certain time interval.
This term is often used in figurative sense to describe the highest value level of a
given variable. In reference to the hedge fund sector, this term is used in conjunction with the managers fees (Stracca 2006). This means, that the managers receive
an incentive commission (positive performance fees), if the market value of the
fund exceeds a certain assumed level. Thus, when calculating commission, the net
asset value of the fund in a current year and the net asset value of the fund in a
2
In the 60s and 70s of the twentieth century, Arrow and Wilson attempted to describe the problem
of risk distribution, which arises when partners have different approach to risk. The agencys
theory, besides the risk distribution, has developed the problem of agencies, which arises when the
entities cooperating with each other have different goals.
2.2 Functioning of Contemporary Hedge Funds
25
Table 2.1 The mechanism of the high water mark commission system (Sokoowska 2014)
Year
2010
2011
2012
2013
Net asset value

(millions USD)
100
120
110
130
Change in net asset value

(millions USD)
+20
10
+20
The value of commission

(millions USD)
0.2 20 4
0
0.2 10 2
preceding year are compared. Commission is paid out, if the current net asset value
of a fund (NAV) is higher than the historical maximum value of those assets.
High-Water Mark contracts are important from the perspective of the investors
interests, since incentive commissions are paid out only at the time of fulfillment of
specific conditions. On the other hand, however, this mechanism can lead to higher
risk-taking on the part of the managers and to higher variations in return rates of
such funds.
Table 2.1 shows the mechanism of a High-Water Mark commission system. This
simplified diagram shows, that in 2013, despite an increase in the net asset value,
from $110 to $130 million, the incentive commission was paid out in the amount of
$2 million, because the value of $130 million is by $10 million higher than the
highest net asset value of $120 million, which was earned by the fund during
previous periods. Such construction of a commission mechanism is meant to
focus the managers on attainment of long-term investment objectives. This mechanism, however, is not devoid of drawbacks. It may happen, that the manager, who
suffered significant losses, can withdraw from managing a given fund without
suffering severe consequences.
Another known mechanism of an incentive commission payout is a hurdle rate.
Hurdle rate generally describes the minimum return rate of an investment. In the
system of compensating hedge fund managers, this term is going to describe a
return rate level, which should be reached by a hedge fund in order for its managers
to receive additional commission. This mechanism, therefore, allows the fund
managers to collect commission that is based solely on achievement of a performance above the pre-established reference standard (the so-called benchmark).
Thus, the commission fee is collected after the reference rate is exceeded, such as
a LIBOR rate or another predetermined benchmark. In case of the so-called soft
hurdle mechanism, commission fee is calculated based on the total annual return
rate. In case of a more restrictive mechanism, called a hard hurdle, the commission
level is calculated based on a return rate exceeding the benchmark.
Immediate withdrawal of the cash invested in a given fund is not possible. Most
funds often predetermine the so-called fund entrance and exit barriers. Each hedge
fund uses different rules regarding exiting an investment. Therefore, it may be a
month period or even 35 years. The clauses preventing fast withdrawal form an
investment are called lock-ups. Some hedge funds collect fees for cancellation of
shares (fees for a withdrawal from the market), if the investor intends to withdraw
the assets from the fund earlier. The fee for cancellation of the shares in a given
26
2 Hedge Funds
Table 2.2 Primary features of hedge funds

Investment goal
Investment strategies
Transaction costs
Headquarters
Legal form
Management
The investors
Restrictions
Regulations
Publicness of the
funds data
Achievement of a positive return rate, regardless the market conditions;

lack of reference to the so-called benchmarks
Broad spectrum of investment strategies using various investment
techniques (short-selling, leveraging), with application of complex
instruments (including derivatives); investing on various markets
A fee for managing the fund (management fee), usually around 12 %; a
charge based on the achieved result (performance fee)variable,
ranging from 10 to 40 %
Mostly offshore centers characterized by liberal legal and tax
regulations
Most common legal form is a limited partnership, limited liability
company, business trusts
Investment companya managing entity or a natural person, often a
support of independent investment advisors
Wealthy individual investors; institutional investors, who making a
capital contribution and create a capital pool; moreover, selecting
qualified investors, who are aware of the risk and know the strategies
used by the fund
Most hedge funds are characterized by a minimal capital input and by
restrictions regarding the number of investors
Usually, there are no regulations, or the scope of regulations is small
A voluntary or limited obligation to disclose data, as compared with
other institutions of collective investment
fund often is collected within a particular time from the date of investment (usually
1 year period). The cancellation of shares fee is meant to discourage investors from
short-term investments as well as to prevent withdrawal of the assets following a
period of unfavorable investment results. In contrast to fund management fees and
to an incentive commission, the fees for cancellation of shares are hoarded by the
fund and they multiply the capital of other investors; thus, they do not constitute
additional commission paid out to the managers.
Hedge funds use complex marketing strategies, which are analyzed in detail in
Chap. 3. As a rule, these entities undertake application of a specific investment
strategy determining its character and the level of the risk taken by the fund.
Characteristic features of hedge funds are summarized in Table 2.2.
2.3
Classification of Hedge Funds
The sector of investment funds, which operates on the developed financial markets,
distinguishes between two basic groups of funds (Wisniewska 2007a, b):
Traditional funds, such as equity funds, fixed income funds, hybrid funds and
money market funds;
Alternative funds, specified as: private equity funds, venture capital funds,
real estate funds, or hedge funds.
2.3 Classification of Hedge Funds
27
Hedge funds also can be divided according to a geographical criterion. Such

classification of hedge funds according to their location differentiates between two
types of funds:
Onshore hedge funds,
Offshore hedge funds.
Offshore hedge funds are entities located in places characterized by liberal legal
and tax laws. Estimates indicate that about 70 % of all offshore hedge funds are
registered in the Cayman Islands http://www.hedgefundsreview.com. An attractive
place of registration for those funds oriented at operating within the European
Union is Dublin (Ireland). In turn, Hong Cong or Singapore are the best places of
registration for the funds oriented at activities in the Far East.
Another criterion of hedge funds classification is the investment strategies used
by them. There is no single common division listing the strategies used by these
entities. Each major research center, such as CSFB/Tremont, TASS, HFR or Van
Hedge, use different rules of division. Analysis of different divisions of the particular investment strategies used by hedge funds enables their classification
according to two separate criteria:
The similarity criterion of the instruments used and of the direction of price
changes occurring between them,
The method of evaluating the market risk and the tools used for it.
Hedge funds can also be classified according to their availability. Under this
classification, we can distinguish the following hedge funds:
Private hedge fundsthis category includes vast majority of the hedge funds
operating on the market;
Public hedge funds, available to a wider group of investorsincluding the
funds, whose share units are issued e.g. in the form of certificates on selected
stock exchanges.
Yet another criterion of hedge fund division takes into account investment
policies, which are closely linked with the investment strategies that are used by
a fund. Within the scope of the strategies, we can distinguish the following hedge
funds:
Balanced hedge funds,
Aggressive hedge funds.
Depending on the manner of funds management, we can distinguish the following types of funds:
Discretionary hedge funds, that is, those using automated trading systems
designed to exclude the errors related to the human factor;
Qualitative hedge funds, which are managed using the managers knowledge
and experience.
28
2 Hedge Funds
2.4
Legal Forms of Creating Hedge Funds
A hedge funds legal form depends on the funds registration place and on the
manner in which the financial assets are invested. Since hedge funds have originated in the United States, the legal forms of creating hedge funds in this country
will be the object of analysis. These forms can serve as a reference point for the
hedge funds created elsewhere.
Business entities operating in the United States can conduct their activities in
various legal forms. These entities are subject to the American law, therefore they
often differ from legal entities in other countries. A synthetic approach to certain
American legal forms, presented below, does not mean that these forms function the
same in other places in the world.
Basic legal forms of business entities in the United States are:
Operating on the basis of an entry in the business activity register (sole
proprietorship),
Non-commercial/civil partnership (general partnership),
Limited partnership,
Limited liability company,
Corporate/joint-stock company (corporation).
It is also possible to organize entities as3:
A professional partnership (limited liability partnership),
A limited liability limited partnership.
Most of the above listed legal forms do not bear the characteristics adequate to
create a hedge fund. Vast majority of the companies in the US operate in the form of
a natural person conducting activity based on an entry in the business activity
register. This form of activity is suitable for individuals or for married couples,
however, it does not offer the right conditions for enterprises run by a larger number
of people. Basic problems associated with this activity are related to difficulties in
raising the capital, difficulties in distributing the profits or losses, as well as
problems associated with the scope of responsibility borne by each individual.
General partnership is a basic form of conducting any business activity on a
small scale. The creditors of a general partnership may, however, execute their
claims not only from the companys assets, but also from each partners private
assets.
There are two basic legal forms used to create hedge funds: a limited partnership
and a limited liability company. The legal form of a limited partnership does not
belong to popular modes of conducting business activity in the US; it is generally
reserved for the companies investing in real estate or in extraction of natural
resources (http://newyork.trade.gov.pl, Accessed June 1, 2014).
The forms presented here belong to less common ones.
2.4 Legal Forms of Creating Hedge Funds
29
A hedge fund established in the form of a limited partnership consists of at least

one general partner and one limited partner. A general partner is responsible for
running the fund and is personally responsible for the liabilities incurred. A limited
partner is responsible for the companys obligations up to the amount of his/her
declared contribution (limited liability amount).
In practice, in the US, general partners of limited partnerships are legal persons.
They are entitled to represent the company. Limited partners can only act as
proxies. If general partner is a legal person, the company is managed on his/her
behalf by the Board or by the persons appointed by him/her. Investors (limited
partners) do not bear any responsibility for the decisions made by general partners,
nor for the funds liabilities. The profits earned by the company are divided between
the partners, where the division criterion is based solely on the actual contributions.
Organizational structure of the fund operating in the form of a limited partnership is
illustrated by Diagram 2.1.
Another possible legal form of a fund is a limited liability company. Organizational structure of a fund operating as a limited liability company is presented in
Diagram 2.2.
Diagram 2.1 Organization

of a fund operating in the
form of a limited
partnership (Lhabitant
2011)
Investors
(limited partners)
The funds investment

advisors
Limited partnership
Diagram 2.2 Organization

of a fund operating as a
limited liability company
Taxable investors
(members)
Investment advisors
Limited liability
company
30
2 Hedge Funds
Since hedge funds are not registered investment firms, they are not required to
disclose any information. However, they publish memorandums for their investors,
which contain basic information on a given hedge funds activity an on the
strategies used by it. Moreover, the investors receive information on the funds
results, about risk analysis, and on the composition of its investment portfolio.
Despite a lack of such requirement, most hedge funds employ an auditor, who
makes an independent annual audit of the funds activity and provides a report on it.
2.5
The Structure of Hedge Funds
The structure of a hedge funds is determined by its legal and organizational form.
To a high degree, it depends on the laws in force in a given country. If the fund is
formed in accordance with the US law, it usually is determined as a domestic hedge
fund; if it is formed in accordance with the law of another country, it is called an
offshore hedge fund.
Another common variant of a funds organizational form is using the MasterFeeder structure. It involves joining the fund with a separate offshore fund, in
accordance with the US law, in order to benefit from numerous advantages. There
also is a possibility of creating a structure composed of a primary fund and at least
two feeder funds. The primary fund sells its shares to feeder funds, which are the
only entities authorized to acquire them. These funds offer their shares to investors.
Master-Feeder funds often are created in the form of a corporation, under the laws
different than those in the US (Lins 2002). Primary funds can also be arranged in the
form of a limited partnership. Organizational structure of a master-feeder fund is
presented in Diagram 2.3.
Another organizational structure of hedge funds activity is a structure called
side-by-side. In the side-by-side structure, investors, usually American, invest in a
limited partnership formed within the US, while offshore investors invest in a fund
Diagram 2.3
Organizational structure of
a master-feeder fund
Broker account
Primary fund
(MASTER FUND)
Domestic feeder fund

(DOMESTIC FEEDER)
Domestic investors
Offshore feeder fund

(OFFSHORE FEEDER)
Offshore investors
2.5 The Structure of Hedge Funds

Diagram 2.4
Organizational structure of
a side-by-side fund
31
Broker account
Broker account
Domestic feeder fund

(DOMESTIC FUND)
Offshore feeder fund

(OFFSHORE FUND)
Domestic investors
Offshore investors
formed in tax heaven. These funds, though, have the same investment goals and the
same managing entity (Diagram 2.4).
Hedge funds registered in the so-called offshore financial centers offer many
advantages associated with their functioning. Offshore locations allow conduction
of business activity free of income tax, or with a low-rate flat tax or a lump-sum tax.
Offshore regulations and conducting offshore activity are characterized by the
possibility of using all the advantages the tax heavens provide, without locating
there the Board, the personnel or the investors themselves. Tax regulations existing
at those locations have some characteristic features: limited availability of alternative funds for unskilled retail investors, protection of client confidentiality, and
the funds requirements independent of its management. This reduces the costs
associated with the funds operational activity. The headquarters located on an
offshore territory are formal in character. Physical control and management are
conducted from the entitys domestic headquarters or from another suitable place.
As opposed to hedge funds places of registration, their managers are based
primarily in the onshore countries. Most of hedge funds managers come from the
US (mainly from New York and Connecticut). It is estimated, that in 2008, about
7000 investment funds managers were based in the US http://sec.gov/rules/final/ia2333.htm#IA. A dominant European place of hedge funds management is London.
Offshore hedge funds usually are organized as corporations in countries like: the
Cayman Islands, British Virgin Islands, the Bahamas, Panama, Netherlands Antilles or Bermuda. Commonly, these attract tax-exempt entities, such as pension
funds, charity foundations, as well as the investors outside the United States. US
tax-exempt investors prefer investments in the onshore funds, because they could
be subjected to a tax, if they invest in a domestic hedge fund set up in the form of a
limited partnership.4
According to the US tax law, income tax exempt organizations, such as ERISA or charities which
take up investment strategies requiring debt, loose that privilege. In such cases, entities are
subjects to an income tax on unrelated business taxable income (UBTI). It is possible to avoid
this tax by investing in offshore funds. More on: http://www.greencompany.com/HedgeFunds/
OffDocOffshore.shtml [accessed: October 20, 2014].
32
2 Hedge Funds
Offshore hedge funds can be organized by foreign financial institutions or by US

institutions and their branches. Hedge funds operating in the so-called tax heavens,
usually enter into an agreement with an investment advisor, who can be employed
by an entity located in the US. Often these funds have an independent administrator
of a fund located offshore, who can assist in the tasks related to valuation of the
securities and in calculating the funds net value. The sponsor of a fund located on
an offshore territory usually is assigned by the Board, which controls this entitys
activity.
Domestic hedge funds can employ brokers, accountants, attorneys, or administrators. In general, however, these entities do not hire employees and are not
engaged in management of any other assets / cash other than those, which constitute
the funds investment portfolio. These entities often use outsourcing, that is, they
distribute (outsource) the responsibilities associated with the fund to external
entities. This reduces employment within the fund. The fund incurs some fees for
the services provided to it according with concluded contracts. The use of external
specialist advisory services is, on one hand, meant to limit the costs and on the
other, to supply specialized high quality service.
Moreover, distribution of the responsibility to a larger number of entities is
supposed to reduce the likelihood of embezzlement and of using dishonest practices. Such approach, however, is dangerous due to a possible lack of effective
coordination of individual activities within the fund. Involvement of the managers
own financial assets, though, results in their much greater responsibility for the
decisions made as well as for the results performed. Entities, which are usually
involved in the funds activities are going to be characterized in Diagram 2.5.
A so-called sponsor is an initiator of a hedge fund. The sponsors, also called the
general partners of hedge funds, are former businessmen, investment advisors or
financial analysts. Often they are the people, who have successfully served managerial functions in the financial sector. A sponsor, generally, deposits some assets
during the phase of setting up a fund. He/she usually possesses non-transferable
shares in the fund, with voting rights and the right to participate in majority of
decision-making of the companys Board. If the fund is created in the form of a
limited partnership, the funds sponsor becomes its limited partner. If a different
Diagram 2.5 Classic
structure of a hedge fund
(http://www.harcourt.ch
2014)
Investor
Auditor
Administrator
Hedge fund
Manager/Sponsor
Main broker
Assets
Clearing brokers
Investment advisor
2.5 The Structure of Hedge Funds
33
legal form is chosen, e.g. a limited liability company, the sponsor is an entity
controlling the funds management. As such, he/she receives an income depending
on performance of the fund controlled by him/her. Frequently, the sponsor contributes his/her own capital (owners equity) to the hedge fund. The remaining shareholders of hedge funds, that is all other entities, which bring in the capital, are the
investors. They receive shares proportionally to the capital contributed in the fund.
Issuance of the shares occurs as a private placement. Majority of hedge funds is
supervised by the Boards designated for that purpose. Actions taken up by the
management are intended to supervise compliance of the undertaken activities with
the funds investment policy. Members of the Board are independent persons, who
are not related to and not involved in the funds activity. Frequently, the entities
engaged in the funds activity are the investment advisors assistants. Independent
members, on the other hand, cannot have any relations with the funds advisor, who
is supposed to guarantee objectivity of the decisions made. Generally, these persons
are recruited from among prominent individuals with extensive experience in
management.
Hedge funds advisor is one of the most important entities influencing performance
of a fund. He/she can influence the alpha indexadditional return rate achieved by the
hedge fund. Its development depends on the advisors competence and professionalism. The funds advisor is expected to closely cooperate with its sponsor. Usually, the
advisor also manages all marketing activities and distribution of the fund shares, as
well as supplies the investors with periodical reports on the funds performance. An
advisor can also act as the funds partner. The scope of the investment advisors
activities varies depending on the funds organizational structure.
The funds managers are professionals hired to manage the money in accordance
with the funds investment goals. Main tasks for the person managing the securities,
from an organizational perspective, involve managing the funds portfolio and
compliance with recommendations of the investment advisor. Expenses of the
person managing the securities usually are covered by the management fee. In
case of the hedge funds operating offshore, an investment manager usually operates
in the form of a company which is affiliated with the funds sponsor. This form
limits the responsibility and is more beneficial in terms of taxation. In case of an
offshore fund, the manager can act as the funds sponsor and its manager at the
same time.
Usually, hedge fund brokers are large investment banks. Hedge funds typically
use services of numerous brokers, in order to guarantee themselves access to most
favorable buying and selling offers. The so-called main broker, also called a prime
broker, has a different function; he/she provides comprehensive services connected
with carrying out the operations and their settlement. Main responsibilities of a
funds broker are:
Transaction settlement,
Acting as the funds depositary,
Settlement of the profit margin,
Lending the securities for the purpose of short-selling,
34
2 Hedge Funds
Table 2.3 The largest hedge

funds administrators in 2012
Administrators name
State Street
CITCO
SS&C GlobeOp
HSBC
Citibank
Others
Administered assets (%)

12.8
12.8
7.6
6.8
6.1
53.9
Reporting on the risks,

Conducting market research,
Management of security deposits,
Valuation of securities.
The prime broker often becomes a guarantor during taking up risky positions on
the market, which involves additional charges for him/her.
The main role of the funds administrator is to provide support by taking the
responsibility for valuation of the assets as well as for all operational, administrative and accounting services. The level and the scope of the fund administrators
work varies depending on the level of the administered funds complexity as well as
on the activities performed by the prime broker. Hedge funds administrator deals
with problem description, calculates the net value of the funds assets and performs
all administrative activities related to that. In some hedge funds, especially in the
US, some of these functions are performed by the hedge funds manager. The
largest entity administering hedge funds was Citco Fund Services, and State Street.
Each of them managed 12.8 % funds. Table 2.3 lists the largest entities administering hedge funds in 2012, according to the percentage of the net assets administered by those funds.
Hedge funds also use legal advisors, who deal with tax law and ensure the funds
functioning in compliance with the laws in force. The role of an auditor is to ensure
compliance of the funds activities with applicable accounting standards, as well as
to control the funds financial statements. In general, an audit takes place once a
year, and it results in a report that is sent out to the investors. In addition to the audit,
periodical reports on the valuation of the funds assets and on the funds performance
are prepared. They are held periodically, that is weekly, monthly or quarterly.
A transfer agent is an entity managing the records of the funds participants.
Within the scope of activities associated with such registry, a transfer agent
performs current updates of the registrys balance, accepts and executes dispositions of the funds participants (e.g. data conversion, acceptance of powers of
attorney), organizes and conducts circulation of documents and cash, as well as
provides accounting services. Keeping registry of the hedge funds share-holders is
also the transfer agents task. The recorder undertakes the actions associated with
subscription and withdrawal of the funds shares from the market. The funds other
activities include allocation and distribution of the profit. If the fund does not have
its own transfer agent, this function is performed by its administrator.
2.6 Hedge Fund Databases
35
The entity entitled by the fund to carry out instructions and orders made by the
funds participants is the distributor. As a rule, it is a brokerage office or selected
bank branches. Some hedge funds distribute their shares internally, that is without
participation of a distributor. The funds investors buy its shares directly from the
fund, through a registrar or a transfer agent. Sometimes, however, distribution of
the shares within the fund is done by a distributor, who can affiliated with the fund
or operates autonomously. A distributor can be, for instance, an independent
brokerage firm, an insurance agent or a bank representative. Such entity is engaged
in contacting the funds potential clients directly in their jurisdictions (where it is
legal, in accordance with the law). In both cases, the investor pays 25 % of the
invested amount for distribution of the funds shares. Often, a distributor is also the
entity responsible for delivering the offer to potential investors.
Many institutional investors are also prohibited from investing in the stocks or
shares which are not listed or recognized on a regulated stock market. Issuance on a
well-known and regulated stock market is therefore an important marketing power
for the promoters of hedge funds and/or funds of funds. What is more, several stock
exchanges dedicated to hedge funds were founded, such as: the Irish Stock
Exchange, the Channel Island Stock Exchange or the Bermuda Stock Exchange.
Although these stock exchanges do not offer attractive conditions associated with a
high levels of liquidity and trade, they facilitate marketing activities of the stocks/
shares directed to selected groups of investors. Each fund which intends to make
issuance on a stock market, usually is obliged to obtain approval and permission of
a traded sponsor listed on a given stock exchange.
2.6
Hedge Fund Databases
Hedge funds belong to private investments, therefore it is difficult to obtain precise

information regarding their functioning and investment performance.
Some hedge funds, however, practice monthly reporting on their results and
share information about their business with specialized databases. These databases
collect information on functioning of funds and sell such information to those
interested in the results achieved by the funds. Information about such results is
bought by investors, banks, funds of funds as well as by scientific institutions
conducting research on a given sector.
There is no single complete database containing information about activities of
all hedge funds. The databases being created are not representative of the entire
sector either. There are various reasons for this. The first is related to the aforementioned lack of obligation to provide information on funds activity. Due to a
novelty nature of this sector, it is should be noted, that the earliest historical data
comes the 90s of the twentieth century. Each of the databases already created
contains different criteria for classification of funds, as well as uses different data
collection and processing methods. There are two organizations which have
attempted clearing their database of errors: Hedge Fund Research (HFR) and
CSFB/Tremont (CT) (Table 2.4).
36
2 Hedge Funds
Table 2.4 Characterization of the largest hedge fund databases and of Commodity Trading
Advisors (CTAs) (Lhabitant 2007, 2011)
Database name
Altvest/Investor
Force
Barclays Hedge Fund

and CTA Database
CISDM/Zurich/MAR
Daniel B. Stark&Co.
Eureka Hedge
Investhedge
AsiaHedge
Financial Risk
Management (FRM)
Hedge Fund Research
Hennessee
Morgan Stanley Capital Indices (MSCI)

Tass/Tremont
Tuna/Hedgefund.net
Characterization of the database

Founded by Altvest, taken over by Investor
Force. This database provides information
about alternative investments, as well as prepares analyses and reports.
The Barclays database belongs to most modern
and extremely precise ones, with a high growth
potential.
Databases created by Manager Account Report
(MAR), sold in March 2001 to Zurich Capital
Market, then donated to University of Massachusetts Center for International Securities and
Derivatives Markets (CISDM) in August 2002.
Daniel B. Stark&Co.s CTA& Futures Fund
Manager Database contains information on
CTAs and on future funds from the last
16 years.
EurekaHedge is an advisory institution registered by Securities and Futures Commission of
Hong Kong.
Database managed by HedgeFund Intelligence
an independent institution cooperating with
the Bank of Bermuda, collecting information
about the results of European funds and on
funds of funds.
Database owned by FRM, an independent
management group. Information in the database
is subject to research in academic centers.
HFR is an advisory group registered by SEC,
specialized in constructing and managing funds
of funds and various portfolios. It is one of
leading databases of information on hedge
funds.
Hennessee is an advisory institution registered
by SEC, which provides advisory services
solely connected with the alternative investments sector.
Founded in 2002, offers indexes of hedge
funds.
Tass/Tremont was founded in London in 1990,
one of leading providers of data and information about the hedge funds sector. It is also one
of the oldest organizations researching the
market.
Hedgefund.net is a free database of information
on alternative investments, used by over 35,000
accredited investors worldwide.
Number reporting of
hedge funds/CTA
Around 2600
Around 2200
Around 2500
Around 420 CTAs,

around 200 future
funds
Over 330 in Asia
Over 500 in Europe
734 of funds of funds
Over 650 in Europe
700 of funds of funds
Around 8000
Over 2500
Around 3000
Over 1300
Over 3000
Around 4000
(continued)
2.7 Database Errors
37
Table 2.4 (continued)

Database name
US Offshore Funds
Directory
Van Hedge Fund
Advisors
2.7
Characterization of the database

US Offshore Funds Directory publishes information about the hedge funds sector annually
An institution providing advisory services and
researching the alternative investments sector.
Number reporting of
hedge funds/CTA
Around 1000
Over 5000
Database Errors
Any measurements comes with possible errors, which can be divided into two
categories: random errors, that is coincidental ones, and systematic errors (biased
errors) (Wisniewski 2009, 2013). Random errors mainly result from imperfections
of measuring devices and due to imperfections of the person conducting the
measurement. This kind of errors is unavoidable during any measuring process.
Random errors are characterized by a normal distribution with a zero mathematical
expectation.
The so-called systematic errors are different in nature. This type of errors occurs
when a test conductor deliberately tries to get a different result than the actual one
(that is, higher or lower). It can therefore be assumed, that this type of errors could
be eliminated through reliable measurements.
These types of errors should be considered when using databases, since they also
contain random and systematic errors. Moreover, one should be aware, that even
the data collected by the most prestigious databases is not representative for the
entire sector of alternative investments. Random errors originate during the process
of gathering information. Databases also bear errors that are systematic in nature.
While analyzing the hedge funds results available in databases, occurrence of the
following errors should be taken into consideration (Fung and Hsieh 2004)
Survivorship bias,
Self-selection bias,
Instant history bias,
Database/sample selection bias.
Short time series presenting performance of hedge funds can indicate a process
of continuous formation of new funds and liquidation of the funds which have not
reached satisfactory results. This creates a type of errors called survivorship bias.
Performance analysis of those hedge funds which have survived on the market until
the present, can also cause some errors associated with overestimation of those
funds historical results. Many of the least profitable funds become decommissioned during the course of achieving unsatisfactory results. These funds obviously
stop reporting to databases. Analysis of the relation between the number of new
funds and their results can suggest that this type of errors is of significance. Most
hedge funds are closed before the end of 6 years.
38
2 Hedge Funds
The funds which begin to generate losses, very often stop reporting on their
results.5 For instance, Long-Term Capital Management, during the period from
October 1997 to October 1998, had lost up to 92 % of its capital. None of the
negative results achieved by the fund had been reported to the databases.
The motives related to liquidation of a fund or to its discontinuation of reporting
to a given database can be various. Among the most important causes, we can list
the following:
Liquidation of a fund after a period of severe losses,
Liquidation of a fund after a long period of achieving results below expectations,
which decrease the net value of its assets, below the high-water mark,
Fusion of a fund with another hedge fund. Such situation most frequently occurs
when small hedge funds, achieving least satisfactory investment results, are
absorbed by larger hedge funds,
Cessation of reporting by a hedge fund, despite continuing its activity. Such
funds are called defunct funds, while the term dead fund is used for the hedge
funds which disappear from databases and at the same time cease their activity.
It is also possible that funds achieve such satisfactory results, that they stop using
the services of institutions creating databases (Ackermann et al., 1999). Those
hedge funds which achieve very good investment results, have reached their
targeted volume and do not seek to expand their investment group, do not report
to databases.
The estimates relating to the magnitude of those errors vary, depending on the
measurement method. Fung and Hsieh have estimated their error magnitude at the
level of 3 %, while Park, Brown and Goetzman have estimated their error level at
the rate of 2.6 %.6
Self-selection bias mainly results from the nature of the hedge funds reporting to
databases. Due to the private nature of those investments, reporting is selective in
character. As such, it can be concluded, that those funds will be more likely to share
information, which achieve favorable investment results, while hedge funds incurring losses are omitted.
Database/sample selection bias is the main source of errors related to hedge
funds performance. They result from the lack of complete databases as well as
from some specific criteria the hedge funds must meet in order to be included in a
given database (Lhabitant 2011). Such criteria, for instance, can be: a minimal
value of the funds assets, the funds measurable performance, minimal time of the
funds operation. Although, they can seem rational, they do influence selection of a
given fund from a particular segment of the market.
5
The studies on dependencies between cessation of reporting by the funds and their results was
conducted by Posthuma and Van der Sluis 2003, A Reality Check on Hedge Fund Returns,
Working Paper.
6
See also: Fung and Hsieh (2001) Park et al. (1999). Other works in which survivorship error
measurement was attempted are: Brown et al. (1999), Liang (2000, 2001), Amin and Kat (2002).
2.8 Hedge Fund Indices
39
The funds, which are being added to a database for the first time, also provide their
historical data, which is registered in the database as ex post results. It is likely, that
funds will only provide favorable results of their investments, in this way, overstating
their average return rate. This kind of results is called an instant history bias.
Despite the fact that database bear some errors, they still are extremely useful
and are an important source of information on the activity of the hedge fund sector.
Increasing reporting activity regarding hedge funds strategies and their results
indicates that these entities are willing to be perceived as transparent. The growth
rate of this sector, also reflected by database statistics, indicates that alternative
funds are ceasing to be a marginal sector of the capital market.
2.8
Hedge Fund Indices
Most database suppliers offer additional services, such as e.g. assistance in

selecting a fund or in selecting securities for a portfolio. The information accumulated in databases is also used to create hedge fund indices, which are a common
assessment measure of funds activity.
Indices belong to descriptive measures expressing relative time-changes in
measurement series (Aczel 2000). Hedge fund indices allow a comparative analysis
within the hedge fund sector as well as between other forms of capital investments.
Activity of hedge funds can be described using various indices. Within the sector of
alternative funds, we can distinguish the following indices (Niedzioka 2009):
Investment indices (investment vehicles),
Non-investment indices (non-investment vehicles),
Cloned indices (clone vehicles).
Generally, indices are a synthetic measure of the changes in certain units of
value making up a given index (Wisniewska 2007a, b). Investment indices are
based on the results of hedge funds. Alternative indices can be created on the basis
of the results as well as based on the risk profile of a group of funds which are
obliged systematically disclose certain data to a given indexs creator. Using
indices for the hedge fund sector brings similar benefits as for any other class of
assets. Thus, many potential benefits of using indices can be noted. Such index
provides important information about the condition, the results and the risk of the
hedge fund sector during a particular time interval, as well as allows assessment of
the links between the price changes and the assets. From the perspective of a
strategic allocation of assets, it provides crucial information which facilitates
proper construction of a diversified investment portfolio. It also allows evaluation
of the hedge funds results, depending on the investment strategies used by them. It
should be noted, that there are large discrepancies between the skills of hedge fund
managers, which often develop over time. In this situation, an index provides a
pattern which allows evaluation of the managers skills.
An index also constitutes the base for constructing a passive investment product,
e.g. a fund index. Such a tool can be an interesting option for those investors, who
40
2 Hedge Funds
seek an effective diversified form of an investment. Possible benefits associated

with a particular investment style are another advantage of creating investment
indices. What is more, an index provides standardized data which is needed to
measure a risk profile of a given fund, in comparison with the index.
Investment indices of hedge funds can be described as investment portfolios
designed to present the results of selected hedge funds. The characteristics associated with distribution of hedge funds results have been extensively described in
the literature concerning the subject. For instance, Brooks and Kat stated that the
results of hedge fund indices are characterized by a relatively low skewness and a
high kurtosis (Kat and Lu 2002).
Indices are constructed using the same methodology that is used while constructing
traditional financial indices. Investment indices are not representative, since they are
created based on a selected group of hedge funds which permit reporting on their
performance. A financial institution undertaking creation of an index selects the funds,
the structured products and the derivatives which will constitute the basis for calculating its results. Investment indices allow the investors to invest, via the created index,
in a certain group of hedge funds, according to an assumed risk profile. Those indices
consider only those hedge funds, which agree to invest under the terms proposed by
the constructor of an index. Often, investment indices do not consider the results of
those large and profitable hedge funds, which do not accept the conditions proposed by
the creators of a given index. That may be a drawback for those indices. Among
recognizable investment indices the following should be mentioned: Hedge Fund
Research, Eurekahedge Indices, CSFB Tremont or FTSE Hedge.
Non-investable indices, on the other hand, are representative in nature. They are
used for assessment of particular hedge fund segments. At the same time, they use
such statistical categories as the mean, the weighted average, or the median.
Calculation of non-investable indices is based on information from the databases
created on the basis of various criteria regarding selection and construction of hedge
funds. This leads to significant differences between the indices being calculated.
Clone indices belong to the most innovative ones in the hedge fund sector. They
seek to replicate some of the statistical properties of hedge funds. They do not
reflect the results of hedge funds, but they use those hedge funds historical results
in order to construct a model, which is meant to determine the sensitivity of a given
funds return rate to the price changes of various investment assets. This model then
allows construction of an investment portfolio. These indices, however, are based
on rather short time series, which makes it difficult to determine whether this
method is effective. Such indices are offered by Goldman Sachs and Merril Lynch.
2.9
Selected Hedge Fund Indices
Despite a very large number of currently existing hedge fund indices, only selected
indices are reputable and are recognized among investors. The following hedge
fund indices belong to a category of non-investable indexes.
2.9 Selected Hedge Fund Indices
41
Eurekahedge indices are created by AMB Amro and Eurekahedge Fund Advisors. These institutions create balanced indices, which represent the condition of
Asian investment funds. They include such indices as: ABN EH Index, ABN EH
Japa Indeks, ABN EH Asia ex-Japan index. The funds comprising those indices
manage the assets of a minimum value of $40 million.
Altvest is a subsidiary company of InvestorForce Inc., involved in acquisition
and provision of information about institutional investors, consultants and financial
managers. Since 2000, Altvest has created 14 indices that are based on information
from a group of over 2000 hedge funds. Altvest has constructed a base index,
composed of 13 subindices. The information, that the largest pension system in the
USCalpers is going to use Altvest data for management of the positions on the
market of alternative investments in total value of $1 billion (Lhabitant 2007), has
greatly contributed to popularity of indices created by Altvest.
CSFB/Tremont Index LLC is a joint venture company founded by Credit Suisse
First Boston and Tremont Advisors Inc. CSFB/Tremont Index LLC is a leading
investment firm, while Credit Suisse First Boston and Tremont Advisors Inc. is a
company specialized in financial services. Indices created by this company have
been created since 1998 and are based on time series beginning in 1994 Selection of
the funds, based on which CSFB/Tremont indices are being created, is done
quarterly. The most important criteria to be met by hedge funds are as follows
http://www.hedgeindex.com:
Assets value in the amount of at least $10 million,
Publication of financial statements,
Meeting the requirements of CSFB/Tremont regarding the release of the data
and the firms transparency. Moreover, since August 2003 the company has been
creating a series of investment indices, which are based on a sample of 60 funds.
Evaluation Associates Capital Market (EACM) is an advisory company, specialized in hedge funds and in investment programs for institutional investors and
wealthy individual investors http://www.eacm.com. In January 1996, EACM introduced a new benchmark for alternative investment strategies, called EACM100Index, as well as some other indices for 5 strategies and 13 substrategies that are
based on information dating back to 1990. EACM indices are calculated based on
information provided by a set composed of around 100 hedge funds. Based on the
information obtained from hedge funds, advisory firm selects those funds, which
are representative for a particular investment style. Correction of the indices is done
at the beginning of the following calendar year.
Hedge Fund Research is one of the oldest hedge fund databases. This entity
publishes a series of 37 indices, the value of which is based on the condition of the
onshore and offshore funds reporting to the database. Since 2003, HFR has also
been the founder of the HFRX index series, which reflect the changes of the
following investment styles: convertible arbitration, distressed securities, eventdriven, equity hedge, equity market neutral, macro, relative value and merger
arbitrage. The indices created by the company have been cleared of survivorship
bias errors since 1994.
42
2 Hedge Funds
Hennesse Group LLC is a company providing advisory services. The database

created by Hennesse contains information on 3000 hedge funds http://www.
hennesseegroup.com. Based on this information, 23 balanced indices and 4 complex
indices are being created. Complex indices are based on a sample of 500 funds
selected from 3000 of all reporting hedge funds. Majority of indices had been
created in 1987, but they were published in 1992. The hedge funds contained in this
database must fulfill certain qualification criteria. The assets managed by a given
fund must have the value of at least $100 million, alternatively the value not less
than $10 million, and over a year long period of operation. The next criterion is
related to information that the funds are obliged to disclose to a reporting firm.
HedgeFund Intelligence is an independent publishing group which is concentrated on collecting information on the hedge fund sector and on organizing
conferences. The companys independence and lack of its advisory activity or
assets management are its characteristic features. Moreover, the group in owned,
in 100 %, by its manager and employees. HedgeFund Intelligence also creates a
series of global, European and Asian indices. European indices include the data
since 2000, Asian indices since 2001 http://www.hedgefundintelligence.com.
Morgan Stanley Capital Indices (MSCI) is a leading institution creating indices
based on the prices of the instruments that are listed on the international financial
market, inter alia stocks and securities with a fixed income. In 2001 MSCI teamed
up with the group Financial Risk Management and formed a new database, which
collects information on about 1500 hedge funds. In addition, MSCI created the most
comprehensive and most detailed criteria for classification of hedge funds, the
so-called MSCI Hedge Fund Classification Standard, which allows detailed classification and grouping of hedge funds on various dimensions.
2.10
Hedge Funds and Their Impact on the

Financial Market
The issue of hedge funds raises a lot of controversy. On one hand, hedge funds have
a number of features that positively impact the financial market. They contribute to
the growth of its liquidity and to efficiency of its functioning. Arbitrage strategies
used by the managers allow effective valuation of instruments and eliminate the
price imperfections prevailing on the market. Hedge funds also play a significant
role in the financial system by allowing distribution of the risk onto various entities.
Active participation of hedge funds on the market of derivatives contributes to a
more effective transfer of the risk, among the investors operating on the market.
Thus, hedge funds contribute to lowering the transaction costs. Absence of these
funds on the market could result in fewer possibilities of risk management and in an
increase of the cost of raising capital.
Activity of hedge funds, however, raises many disturbing questions, mostly
regarding the consequences of their activity from the perspective of the entire
2.11
The Global Hedge Fund Market
43
financial system. Hedge funds are often characterized by very high investment risk,
while the strategies used by them often are speculative. The problem of too little
transparency in functioning of these collective investment institutions also raises
disputes. Lack of clear regulations referring to the activities of those entities, on a
domestic level as well as internationally, raises additional controversies. Main
controversies are raised by the following problems:
Creation of volatility on the market, due to high transaction turnovers;
Using leverages, which multiply the value of the rotated capital and may
endanger stability of the financial system.
There are many studies connecting hedge funds with their impact on increasing
market volatility. The OECD research suggests, that hedge funds serve a positive
function on the financial market by ensuring its liquidity. Their activity, therefore,
influences reduction of volatility Blundell-Wignall (2007).
2.11
Data on the sizes of the hedge fund sector vary due to the lack of official statistical
data, the lack of clear definition of hedge funds, as well as due to a very dynamic
development of this segment of the market. Currently, the number of hedge funds
operating worldwide is estimated at about 11,000, while the value of the assets
managed by those funds increased within 10 years (20022011) from 550 billion
USD to 2 trillion USD.
The global hedge fund market has also been characterized by very high growth
dynamics since the moment of its emergence. While analyzing the data on the
hedge fund sector, collected by Hedge Funds Research, it can be seen that the value
of the hedge funds assets increased from 39 million USD in 1990 to 1 trillion USD
in 2004. The world economic crisis in 2007 led to withdrawal of the investors from
investing in hedge funds, to accumulation of losses incurred by individual funds,
and consequently, a to a rapid decrease in the value of the assets managed by those
funds. The assets of investment funds in 2008 fell down by almost 30 % to the level
of 1.5 trillion USD. Figure 2.1 represents the estimated value of the hedge funds
net assets during the years 20022012.
Analyzing the number of hedge funds, it can be seen, that according to Hedge
Funds Research data, the number of hedge funds increased from 610 in 1990 to an
estimated 1070 in 2007.7 In 2008, the number of hedge funds decreased by around
6 % to an estimated number of 9600 funds. It was the first year during which a
decrease in the number of operating funds was reported. Despite a further systematic decrease in the number of hedge funds during the years 20082011, the value of
the assets being managed was increasing. This signifies a progressive concentration
This data does not include funds of funds.
44
2 Hedge Funds
Fig. 2.1 The estimated value of the hedge funds assets during the years 20022011 ($ billion
assets) (The CityUK estimates 2014)
Fig. 2.2 The number of hedge funds during the years 20022011
of the capital being managed by the largest hedge funds. The number of hedge
funds again began to increase starting in 2011, reaching a record amount in 2014,
that is 11,000. The changes in the number of hedge funds during the years 2002
2012 are presented on Fig. 2.2.
Table 2.5 presents return rates of the hedge funds represented in comparison
with stocks and bonds indices. The average losses of hedge funds in 2008 were
around 21.3 %. It can be noted, that as much as 85 % of hedge funds reported
financial losses. To compare, in 2008 the S&P 500 Index lost as much as 38 %.
Hedge funds experienced heavy losses also due to closures of many banks in the US
2.11
45
Table 2.5 Return rates of the hedge funds represented by GV Global Hedge Fund Index, in
comparison with stocks and bonds indices (Hennessee Hedge Fund Indices, . . .)
Year
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
S&P 500 (%)

22.1
28.7
10.9
4.9
15.8
5.5
37.0
26.5
15.1 %
2.1
16.0
Barclays Aggregate Bond Index (%)

10.3
4.1
4.3
2.5
4.33
7.0
5.2
5.9
6.5
7.8
4.2
Global hedge fund returns

2.8
23.5
10.0
6.7
13.5
9.3
21.3
18.2
9.7
4.6
6.1
and in Europe. Other causes included rapid declines on the stock market and
pressure for rapid liquidation of the positions on the market due to investors
withdrawals.
It can be seen, that the hedge funds assets are concentrated. Around 390 hedge
funds manage over 1 billion UDS, thus control over 70 % of the global net hedge
funds assets.8 Funds such as: Bridgewater Associates (assets valued at 76.1 billion
UDS), JP Morgan Asset Management (assets valued at 53.6 billion USD) and Man
Group (36.5 billion USD) manage lions share of the assets in this sector. Table 2.6
represents the largest hedge funds according to their net assets in 2012.
While analyzing the structure of the hedge funds assets according to the place of
their management, it can be noticed, that the main place of hedge funds management is the United States of America. In 2012 as much as 70 % of the hedge funds
assets were managed in the US. Analysis of the data from Table 2.7 indicates that
during the years 20022008 US participation in management of those assets
decreaseddown to 15 %, while importance of European countries another places
is increasing. Table 2.7 presents the structure of hedge funds according to the place
of their management.
New York and London are the main locations of those managing hedge funds.9
Analyzing the data from Table 2.8 it can be noticed, that while New York holds a
stable position as a location for hedge fund management, by managing with
participation about 40 % of the hedge funds, during the past years the position of
London as the place of management has been decreasing. While during the years
20062008 London managed over one fifth of the hedge fund market, in 2012
participation of the funds managed there fell down to 18 %. Other important US
hedge fund management centers include: California, Connecticut, Illinois and
8
9
On the basis of the Hedge Funds Research data from December 20th, 2009.
Estimates by International Financial Services London.
46
2 Hedge Funds
Table 2.6 The largest hedge funds according to their net assets in 2012 (Institutional Investor
2014)
Largest hedge funds, 2012
Assets under management
Bridgewater Associates
JP Morgan Asset Man.
Man Group
Brevan Howard Asset Man.
Och-Ziff Capital Man. Group
BlackRock Advisors
BlueCrest Capital Management
Baupost Group
AQR Capital Management
Paulson & Co
Angelo, Gordon & Co.
Renaissance Technologies Corp.
DE Shaw & Co.
Ellion Management Corp.
Table 2.7 The structure of

hedge funds according to the
place of their management
(in %) (TheCityUK estimates)
Place
$ billion
Westport CT, US
New York NY, US
London, UK
London, UK
London, UK
New York NY, US
New York NY, US
London, UK
Boston MA, US
Greenwich CT, US
New York NY, US
New York NY, US
East Setauket NY, US
New York NY, US
76.1
53.6
36.5
34.2
30
28.8
28.8
28.6
25.2
23.2
22.6
22.1
20
19.5
Management location of global hedge fund assets (% share)

Year
Americas
Europe
Asia
Other
2002
82
13
4
1
2003
76
22
1
1
2004
72
25
2
1
2005
67
23
7
3
2006
66
27
5
2
2007
67
26
5
2
2008
67
25
6
2
2009
67
21
9
3
2010
68
22
7
3
2011
69
22
6
3
2012
70
21
6
3
Florida. The second largest hedge fund management center and at the same time the
largest management center in Europe is London. Other important hedge fund
management centers include: France, Spain and Switzerland.
The nature of the entities directing the assets into high risk funds has also been
changing. Significant changes in the structure of different groups of investors can be
noticed during the past yearsan increasing significance of institutional investors
on the hedge fund market. While in 1999 their participation in the structure of the
assets was 47 %, in 2008 it increased by almost 49 %up to the level of 70 %.
2.12
The Forecasts of the Hedge Funds Market
Table 2.8 London versus

New Yorkshare of total
assets under management (%)
(The CityUK estimates)
Year
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
47
London
11.9
16.8
20.7
20.5
22.3
22.7
22.6
19.1
18.4
18.7
18
New York
50
46
44
41
40
41
41
41
41
42
42
Fig. 2.3 Global hedge

funds by source of capital in
2012 (%) (Hennessee Group
LLC; FSA; TheCityUK
estimates)
Figure 2.3 presents the share of selected groups of investors on the hedge fund
market in 2012. It can be noticed, that institutional investors are the main group of
investors on the hedge fund market. Their share in the structure of investors is as
high as 80 %. The share of individual investors in the structure of investors in 2012
was around 20 %.
2.12
Alternative investments are intended for wealthy investors. It can be hypothesized,

that an increase in the level of wealth of potential investors will increase the value
of the hedge funds assets. At the same time, it can be expected that these funds
stand a chance of existing on the market after the financial assets at the disposal of
citizens exceed a certain amount. Therefore, the impact of the value of the financial
assets per one adult world citizen (bfinadt) on the average annual value of the assets
48
2 Hedge Funds
in each of the existing hedge funds10 (akt1ht) during the years 20002013 was
examined. As a result, the following empirical equation (2.1) was obtained11:
akt1ht 163:67 12:101bfinad t uakt1ht ;
6:81
11:92
2:1
R2akt1h 0:922, Suakt1h 15:84, V akt1h 10:3 %:

Equation (2.1) has very good stochastic characteristics. The value of the financial
assets per one adult world citizen (bfinadt) explains 92.2 % of the volatility of each
existing hedge funds average annual asset value (akt1ht). An increase in the value
of the financial assets per one adult world citizen by a 1000 USD caused an increase
in the value of the assets of each hedge fund, averagely, by 12.101 million USD.
At the same time, the absolute term of Eq. (2.1), equal to 163.67 million USD,
indicates that the funds assets are formed only after reaching a relatively high value
of the financial assets at the disposal of the so-called average investor.
This amount is (163.67/12.101 13.525) and it means, that only after exceeding
a certain value of the financial assets per one adult world citizen (bfinadt), that is,
13.525 thousands USD, hedge funds assets could be formed.
Equation (2.1) can be used to estimate the forecasts of the value of the average
assets per 1 hedge fund (akt1hTp) during the years 20142016. Estimation of these
forecasts will be possible, if forecasts of the variable bfinadt are known.
An empirical equation describing a volatility mechanism of bfinadt was
constructed. As such, an autoregressive-trend equation, with a first order
autoregression, emerged:
bfinad t 13:103 0:509t 0:364bfinad t1 ubfinadt ;
2:041
1:275
1:044
2:2
R2bfinad 0:717, Subfinad 2:416, V bfinad 9:07 %:

Forecasts (bfinadTp) for the years 20142016 were estimated, which are the
extrapolants of Eq. (2.2). The results are presented in Table 2.9 and on Fig. 2.4.
These forecasts indicate, that worldwide, during the upcoming years, an increase
of the financial assets per one adult citizen can be expected. These values can range
from a little over 31,000 USD in 2014, through 32,563 USD in 2015, up to 33,610
USD in 2015. These increments, thus, will result in an increase of the hedge funds
assets.
10
First and second order autoregression of the variable akt1ht and a linear trend were also
analyzed. They turned out to be statistically insignificant at the significance level not exceeding
0.1.
11 2
R is the value of determination coefficient, Vis the random volatility coefficient being a
percentage of the standard residual error (Su) in the average arithmetic value of the equations
explanatory variable.
2.12
49
Table 2.9 Forecast of the values of the financial assets, worldwide, per one adult citizen
(bfinadTp) for the years 20142016
Forecasted
period (T )
2014
2015
2016
Forecast of bfinadTp
(thousands USD)
31.086
32.563
33.610
Average prediction
error (VT)
2.4157
2.5708
2.5906
95 % confidence
interval
25.70336.468
26.83538.291
27.8389.382
40
bfinad
Forecast
95% interval
38
36
34
32
30
28
26
24
2008
2009
2010
2011
2012
2013
2014
2015
2016
Fig. 2.4 Forecast of the values of the financial assets, worldwide, per one adult citizen (bfinadTp)
for the years 20142016 (Table 2.9)
The forecast values of bfinadTp presented in Table 2.9 were used to estimate the
forecasts of the values of the average assets per 1 hedge fund (akt1hTp) for the years
20142016.
The results of the calculations are presented in Table 2.10 and on Fig. 2.5 The
forecasts obtained indicate that further increases in the value of the hedge funds
assets can be expected. In 2014, the average value of a hedge finds assets can be
equal to a little over 212 million USD, in 2015 it can exceed the level of 230 million
USD, while in 2016 it can reach the value of over 243 million USD.
The next research question is whether global the wealth of the world (bglcurt)
has impact on the global value of the hedge funds assets (akthedt)?
The impact of the global wealth on the variable akthedt, occurrence of a trend in this
variable as well as autoregressions up to and including the second order were examined. Finally, only world wealth (bglcurt) turned out to be statistically significant.
An empirical equation (2.3) describing the variable akthedt has the following
form:
50
2 Hedge Funds
Table 2.10 Forecasts of the average value of the assets per 1 hedge fund (akt1hTp) for the years
20142016
Forecasted
period (T )
2014
Forecast of akt1hTp
(million $)
212.485031
Average prediction
error (VT)
17.132084
2015
230.357540
17.625007
2016
243.026814
18.041808
95 % confidence
interval
175.157428
249.812635
191.955949
268.759132
203.717091
282.336537
300
akt1h
Forecast
95% interval
280
260
240
220
200
180
160
140
2008
2009
2010
2011
2012
2013
2014
2015
2016
Fig. 2.5 Forecasts of the average value of the assets per 1 hedge fund (akt1hTp) for the years
20142016 (Table 2.10)
akthed t 1273:44 14:923bglcur t uakthedt ;

7:639
16:49
2:3
R2akthed 0:958, Suakthed 144:89, V akthed 10:3 %:

Equation (2.3) indicates, that the global wealth (bglcurt) explains almost 96 % of
the total volatility of the hedge funds assets. The variable bglcurt is statistically
significant at the significance level of < 0.01.
An increase in the value of the variable bglcurt by 1 trillion USD caused an
increase in the hedge funds assets on average by 14.923 billion USD.
At the same time, a negative value of the equations absolute term (1273.33)
indicates, that the hedge funds assets were created after exceeding a threshold of
the global wealth.
2.12
51
Table 2.11 Forecasts of the value of the global wealth in the world (bglcurTp) for the years 2014
2016 in trillion $
Forecasted
period (T )
2014
2015
2016
Forecast of bglcurTp
(billion $)
255.3
265.5
275.6
Average prediction
error (VT)
15.56
15.97
16.41
95 % confidence
interval
221.4289.2
230.7300.3
239.9311.4
The threshold is equal to 1273.44/14.923 85.334 trillion USD. Above this

value the global wealth (bglcurt), that is, above over 85 trillion USD, the hedge
funds assets emerged. An increase of this global wealth entailed an increase of the
hedge funds assets which was revealed in Eq (2.3).
Equation (2.3) can be used to estimate the forecasts of the hedge funds assets for
the next 3 years. It requires, however, a description of the global wealths volatility
mechanism (bglcurt). As such, autoregressive-trend structure of this variable was
examined. It turned out, that autoregression in the variable bglcurt is statistically
insignificant. The linear trend is significantat a low significance level of < 0.01.
An empirical equation of the trend in the variables bglcurt has the following form:
bglcurt 103:07 10:150t ubglcurt ;
13:48
11:30
2:4
R2bglcur 0:914, Subglcur 13:547, V bglcur 7:56 %:

The trend explains 91.4 % of the global wealths volatility. Equation (2.4) indicates
that an average annual increase in the global wealth during the years 20002013
was above 10 trillion USD.
Equation (2.4) has good stochastic properties, which allows its application for a
trend extrapolation. Estimated forecasts of bglcurTp are presented in Table 2.11 and
on Fig. 2.6.
Forecasts of the value of the hedge funds assets (akthedTp) for the years 2014
2016 are presented in Table 2.12 and on Fig. 2.6
These forecast estimations indicate,12 that further increases in the value of the
hedge funds assets can be expected. In 2014, the value of those funds should
exceed the amount of 2.5 trillion USD. During the following years, increases in the
hedge finds assets, up to the level of 2688.7 billion USD in 2015 and up to 2839.43
billion USD in 2016, can be expected. Hedge funds, thus, are facing good perspectives for development in the nearest future.
12
Rationality of the forecasts depends on realization of the global wealths forecasts and on
stability of the description mechanism of generating the hedge funds assets, provided by Eq. (2.3).
52
2 Hedge Funds
3400
akthed
Forecast
95 % interval
3200
3000
2800
2600
2400
2200
2000
1800
1600
1400
2008
2009
2010
2011
2012
2013
2014
2015
2016
Fig. 2.6 Forecasts of the value of the hedge funds assets (akthedTp) for the years 20142016
(Table 2.12)
Table 2.12 Forecasts of the hedge funds value (akthedTp) for the years 20142016 in trillion $
Forecasted
period (T )
2014
2015
2016
Forecast of akthedTp
(million $)
2536.49
2688.70
2839.43
Average prediction
error (VT)
165.033
169.092
173.503
95 % confidence
interval
2176.912896.06
2320.283057.13
2461.403217.46
References
Ackermann, C., Mcnally, R., & Ravenscraft, D. (1999). The performance of hedge funds:
Risks, return and incentives. Journal of Finance, 54, 833874.
Aczel, A. D. (2000). Statystyka w zarzadzaniu. Warszawa: Wydawnictwo Naukowe PWN.
Amin, G., & Kat, H. M. (2002). Stocks, Bond and Hedge Funds: Not a Free Lunch (No. icmadp2002-11). Henley Business School, Reading University.
Blundell-Wignall, A. (2007). An overview of hedge funds and structured products.
Financial Market Trends, 2007(1), 3757.
Brown, S. J., Goetzmann, W. N., & Ibbotson, R. G. (1999). Offshore hedge funds: Survival and
performance, 198995. Journal of Business, 72(1).
Connor, G., & Woo, M. (2004). An introduction to hedge funds. Working Paper,
Financial Markets Group, London School of Economics 2003, pp. 139.
Fung, W., & Hsieh, D. A. (2001). Benchmarks of hedge fund performance: Information content
and measurement biases. Available at SSRN 278744.
Fung, W., & Hsieh, D. A. (2004). Hedge fund benchmarks: A risk-based approach.
Financial Analysts Journal, 60(5), 6580.
References
53
Goetzmann, W. N., Ingersoll Jr, J., & Ross, S. A. (1998). High water marks (No. w6413). National
Bureau of Economic Research.
Ineichen, A. (2000). In search of alpha: Investing in hedge funds. UBS Investment Bank.
Jaeger, L. (2002). Managing risk in alternative investment strategies: Successful investing in
hedge funds and managed futures. Pearson Education.
Jobman, D. (Ed.). (2002). The handbook of alternative investments (Vol. 157). Chichester: Wiley.
Kat, H. M., & Lu, S. (2002). An excursion into the statistical properties of hedge fund returns.
Cass Business School Research Paper.
Lhabitant, F. S. (2007). Handbook of hedge funds. Chichester: Wiley.
Lhabitant, F. S. (2011). Handbook of hedge funds (Vol. 579). London: Wiley.
Liang, B. (2000). Hedge funds: The living and the dead. Journal of Financial and Quantitative
Analysis, 35(03), 309326.
Liang, B. (2001). Hedge fund performance: 1990-1999. Financial Analysts Journal, 57(1), 1118.
Lins, G. T. (2002). Hedge fund organization. Special Issues, 2002(1), 98102.
Niedzioka, P. (2009). Fundusze hedgingowe: A stabilnosc finansowa. Warszawa: Difin.
Park, J., Brown, S., & Goetzmann, W. (1999). Performance benchmarks and survivorship bias for
hedge funds and commodity trading advisors. Hedge Fund News.
Posthuma, N., & Van der Sluis, P. J. (2003). A reality check on hedge fund returns, Working Paper.
Schneeweis, T., Kazemi, H., & Martin, G. (2001). Understanding hedge fund performance.
Lehman brothers report, November.
Securities, U. S. (1934). Securities exchange act of 1934. Retrieved May, 23, 2012.
Sokoowska, E. (2014). Alternative investments in wealth management: A comprehensive study of
the central and east European market. Springer.
Stefanini, F. (2010). Investment strategies of hedge funds (Vol. 577). Wiley.
Stracca, L. (2006). Delegated portfolio management: A survey of the theoretical literature.
Journal of Economic Surveys, 20(5), 823848.
Wisniewska, E. (2007). Wpyw rozwoju sektora funduszy hedgingowych na stabilnosc systemu
finansowego. W: Harmonizacja rynk
ow finansowych i finans
ow przedsiebiorstw w skali
narodowej i europejskiej. red. A. Bogus, M. Wypych. Difin, Warszawa.
Wisniewska, E. (2007). Giedowe instrumenty pochodne. CeDeWu. PL Wydawnictwa Fachowe.
Wisniewski, J. W. (2009). Mikroekonometria. Wydawnictwo Naukowe Uniwersytetu Mikoaja
Kopernika.
Wisniewski, J. W. (2013). Correlation and regression of economic qualitative features, 63 s.
Saarbrucken: LAP LAMBERT Academic Publishing.
Chapter 3
Investment Strategies of Hedge Funds
3.1
The Concept of Investment Strategies and Their Risk
Investment strategies, narrowly speaking, encompass and describe the behaviors

and decisional assumptions of the entities investing on the market. An investment
strategy is a set of rules and patterns of behavior, through which an investor intends
to pursue his/her orders of buying and selling on a given market. Alternative
investments are characterized by a very broad range of investment opportunities,
while offering multiple risk and the return rate combinations, which generally are
unavailable through application of traditional investment methods. Understanding
the possibilities of shaping the risk profile and the return rate by the managers
working under alternative strategies is one of key aspects of alternative
investments.
Jaeger (2002) states, that the subcategory of alternative investments, which
encompasses all investments except those of traditional nature, has been created
owing to alternative investment strategies. The strategies of conducting activity on
the financial market are very diverse, depending on the group of investors applying
them. The main difference lies in the intensity of the undertaken actions and in
the degree of the risk incurred. Application of the strategies characterized by
various risk profiles and different return rates is possible, inter alia, due to the use
of such tools as: financial leverages, short-selling and derivatives.
Investment strategies used by alternative funds should enable the investors to
achieve attractive return rates, regardless the direction of the price changes on the
market, and a low correlation with traditional classes of assets (Ineichen 2000). The
variety of the instruments and techniques used for constructing investment strategies characterized by various risk levels and different potential return rates, goes far
beyond traditional instruments such as stocks or bonds. Knowledge of applicable
strategies is the foundation enabling creation of a coherent long-term investment
plan. Inappropriate application of investment strategies is connected with the
probability of incurring significant losses.
DOI 10.1007/978-3-319-13215-0_3
55
56
3 Investment Strategies of Hedge Funds
Analysis of hedge funds performance should be closely linked with analysis of

the risks associated with those funds. In fact, risk management is one of fundamental issues associated with alternative investing. Complexity of the investment
strategies used by hedge funds generates many kinds of risk. Three types of risk,
which are particularly important for hedge funds activity, can be distinguished:
The market risk,
Credit risk,
Liquidity risk.
These three classes of risk have different impact, depending on the investment
strategy used by the fund. In addition to these risk types, it is evident, that each of
the applied investment strategies bears other types of risk that are characteristic for
a given strategy. For instance, the following can be indicated:
The funds using a distressed securities strategy, that is, those investing in
companies with serious financial problems, are particularly exposed to a liquidity risk and a risk associated with not fulfilling the obligations (default risk);
The funds using merger arbitrage strategies are exposed to the risk of a failure of
the merger;
The funds specializing in investing on the developing markets are exposed to a
credit risk, with respect to a particular country (country risk);
The funds using long/short equity strategies are exposed to the risk of a forced
purchase/sale of stocks (short-squeeze risk);
The funds using fixed-income arbitrage) strategies are exposed to the risk of a
changing credit spread (credit spread widening).
Using leverages in transactions, in turn, exposes hedge funds to the risk of a
rapid withdrawal of the financial assets, which often results in a necessary closure
of the positions at unfavorable prices. Improper application of investment strategies
can result in huge losses on the part of the entities using those strategies. It has been
confirmed by some examples of huge losses incurred due to improper application of
certain investment styles. Table 3.1 presents examples of such financial disasters,
with respect to an investment strategy used by a given entity.
Despite an extremely diverse spectrum of applicable investment styles, some of
them have gained special recognition by the managers and the investors. Investors
preferences vary according to the risk profile and the level of the expected income.
Figure 3.1 presents the structure of hedge fund assets according to an investment
strategy used, for the year 2012. It can be noticed, that long/short equity was the
most popular strategy type used by hedge funds. The multi strategy, which is a
combination of many various investment styles, also had a quite high share in the
structure of the assets. The relative value strategy and distressed debt had the lowest
share in the structure of the assets.
3.2 Classification of Investment Strategies
57
Table 3.1 Selected examples of financial disasters on the hedge fund market and the levels of
their losses (UBS Warburg)
The fund
Askin Capital Management
Argonaut Capital
Management
Vairocana Limited
Fenchurch Capital
Management
Global Systems Fund
(Victor Niederhoffer)
LTCM
Manhattan Investment
Fund
Tiger Management
Soros Fund
Ballybunion Capital
Partners
Investment strategy used

Fixed income arbitrage
(mortgage-backed securities)
Macro
Year of
bankruptcy
1994
The losses
(millions USD)
420
1994
110

1994
1995
700
NA
Macro
1997
NA

Long/short equity
1998
1999
3600
300
Macro
Macro
Long/short equity
2000
2000
2000
NA
NA
7
Fig. 3.1 The structure of

hedge fund assets according
to an investment strategy
used, for the year 2012
(Eurekahedge)
3.2
Classification of Investment Strategies
Systematization of the investment styles used by hedge funds is a complex issue.

Multitude of the investment styles applied by alternative funds as well as the
number of the constructions achievable through using innovative techniques and
instruments make it extremely difficult to create a uniform classification. What is
more, dynamic development of the financial market results in a systematic expansion of the catalogue of possible strategies. It can be assumed, that common
elements of the investment strategies currently applied include:
Application of arbitrage techniques,
Application of a financial leverage,
58
Hedge funds
Relative Value
Convertible arbitrage
Equity market neutral
Return rate
Volatility
Sharpes coefficient
Leverage level
Liquidity
Fat tails
~ 9 12%
~ 2 5%
~0,7 2,0
High
Medium
yes
Event Driven
Merger arbitrage
Distressed securities
~10 14%
~ 4 7%
~1,3 1,7
Medium or low
Medium or low
yes
Directional
Equity long/short
Discretionary trading
Systematic trading
Emerging markets
~ 13 16%
~ 8 14%
~ 0,8 1,4
Low
Medium or high
yes
Diagram 3.1 Hedge fund classification according to their strategies and substrategies (Ineichen
2000)
The use of a short-selling technique, which allows profiting from the price drops
on the market,
The use of derivatives and active investing in the futures markets,
The use of a very wide spectrum of the base instruments constituting the subject
of an investment (financial instruments, commodities, precious metals, real
estate),
Investing on the markets characterized by high price volatility,
Participation in merger and acquisition transactions.
Diagram 3.1 shows a general hedge fund classification, which considers such
characteristics as the return rate, liquidity or the leverage level. Calculations carried
out by Ineichen are based on the historical data from the years 19901999. They
can, however, constitute a reference point for further discussion on investment
strategies.
Fung and Hsieh have classified hedge funds according to the investment style
used by a given fund and to its investment aim (Fung and Hsieh 1997). The term
investment style refers to the nature of an approach and to the stand taken by the
funds managers, while the concept of location refers to the class of the assets in
which a fund invests.
Amenc et al. (2003) have divided investment strategies into those allowing
increases of the return rate and of the risk, and into the strategies allowing reduction
of the risk. The strategies allowing an increase of the return rate at a high risk
include: distressed securities, event-driven and macro funds. On the other hand, the
strategies allowing risk reduction include: convertible arbitrage, fixed income
arbitrage, long/short and short selling funds.
59
Investment strategies can be classified based on various criteria. Given the

investment horizon, we can distinguish the following: positional trade (where the
time horizon ranges from few hours to few days), as well as short-term, mediumterm, long- term strategies.
Another important division of investment strategies takes into account the level
of exposure to the risk. Given the classification criterion, we can distinguish: firstly,
the strategies of low exposure to the risk, that is e.g. those using the inefficiencies
arisen on the market (arbitrage strategies), secondly, the strategies of moderate
exposure to the risk, which include event-group strategies (event driven strategies),
and thirdly, the strategies of high exposure to the risk, which include opportunistic
strategies (global macro, short sellers, emerging markets).
Another possible classification criterion is division of investment strategies
according to the use of information. Such strategies include those, which attempt
inadequate valuation by using analytical tools. The following strategies can be
mentioned here: short-selling/long-selling of shares (long/short equity), discretionary trading and aggressive growth/market timing. Yet another criterion of strategy
division involves the degree of application of advanced quantitative methods. Such
strategies attempt to detect inaccuracies in valuation or awarding for the risk,
through the use of the relative value models. The strategies based on models
include: convertible arbitrage, merger and acquisition arbitrage, relative valuation
models and macro based market timing models.
We can also indicate the strategies which attempt detection of inaccuracies in
valuation or the risk through the use of technical analysis. Such strategies include:
the trend following strategies and the statistical arbitrage.
Another possible criterion of investment strategies division considers the process of making investment decisions and divides those strategies into: systematic
strategies and discretional strategies. Systematic strategies establish trading based
on the decisions made by complex computer programs. Discretional strategies base
their actions on the decisions of the managers. Some hedge fund strategies bear the
characteristics of both of these categories.
The literature on the subject often divides investment strategies into primary
groups which are further divided into sub-categories. This division is based on the
investment-technique criterion and distinguishes the following (Stefanini 2010):
Short-selling/long-selling strategies (long/short equity strategies),

The relative value strategies,
Event driven strategies,
Directional/trading strategies,
Other strategies.
A study on a group of investors, conducted by Alternative Investment Management Association in 2003 (Lhabitant 2011), has provided interesting information on
the investors views on selected investment styles. According to the study, half of
the respondents admitted to using their own classification of investment strategies.
About 47 % of the respondents stated, that they use at least one investment strategy
that has been described in the literature on the subject. The remaining 3 % of the
60
respondents answered that it is not possible to classify the investment strategies

within the sector of alternative investments (www.aima.org). The group of those
respondents who admitted to using at least one investment strategy that has been
already classified, pointed to the systematizations used by: CS/Tremont (27 %
indications), Hedge Fund Research (27 % indications), MSCI (23 % indications),
and also to classifications of CISDM, Eurekahedge or Cogent Hedge. Some wellknown systematizations used by prestigious institutions e.g. by USB Warburg, was
not mentioned by the respondents at all. Systematizations created by institutions
involved in data collection on the sector of alternative investments, can constitute a
starting point in the division of investment strategies. According to the CS/Tremont
classification, the following 10 basic investment styles can be distinguished (www.
hedgeindex.com):
Long/short equity, which involves acquisition of the shares and a simultaneous
short-selling of the shares;
Dedicated short strategy, in which hedge funds use short positions only and
profit on the price drops on the market;
Equity market neutral strategy, whose aims is to seek possibilities of using
market ineffectiveness for valuation of the shares;
Distressed securities strategy, which is based on searching for companies in a
difficult financial situation;
Merger arbitrage, which involves investing in the companies being the subject
of mergers and acquisitions;
Convertible bond arbitrage strategy, focused on finding the anomalies emerging
on the market between convertible bonds and the shares;
Fixed income arbitrage, which involves searching for price anomalies on the
global market of the securities with a fixed income level, e.g. fixed rate bonds;
Emerging market fund, which involves investing in various kinds of securities on
the developing markets with a high growth potential;
Global macro strategy, focused on accurate forecasting of global economic
trends and macroeconomic indicators;
Managed futures, covering a broad spectrum of the strategies implemented on
the derivative markets.
VAN Hedge Fund Advisors, LLC from Nashville, USA distinguish four basic
groups of hedge fund investment strategies, which are adequately divided into
18 more specific investment styles. These four basic categories are:
1.
2.
3.
4.
Neutral market strategies group

Long and short equities group.
Directional trading group.
Special strategies group.
Systematization by UBS Warburg was created based on the criterion of hedge

funds openness to the market risk. Under this classification, strategies have been
divided into those characterized by low exposure to the market risk and the more
61
HEDGE FUND STRATEGIES
Relative-Value
Event-Driven
Opportunistic
Convertible arbitrage
Risk arbitrage
Macro
Distressed securities
Short sellers
Equity market neutral
Long region, industry

or style
Emerging markets
Long/short equity
LOW
Exposure to the
market risk
HIGH
Fig. 3.2 The UBS Warburgs systematization of investment styles
risky ones.1 The UBS Warburgs categories of investment strategies are presented
by Fig. 3.2.
The above examples of investment strategies division provided by different
financial institutions indicate the lack of a consensus on the formal system of
classifying investment strategies. Hedge Funds Research company divides hedging
strategies into 30 different investment styles, while TASS Research distinguishes
17 basic investment styles. Each of these classifications exhibits some common
characteristics. Table 3.2 presents a classification summary, taking into account
some characteristic features of investment strategies.
Lack of a uniform classification of hedge funds has caused the financial institutions involved in collecting information, in researching the market as well as in
publishing information on the results of selected investment strategies to introduce
their own classifications. As a result, there may be significant discrepancies in
publications of the results achieved through given investment style. Comparison of
1
A similar systematization of investment strategies, which takes into account the level of sensitivity to changes in the market trend was adapted by Jaeger (2002).
62
Table 3.2 Compilation of characteristic features of the investment strategies used by hedge funds,
according to a chosen criterion
Criterion
Investment
style
Investment
market
Instruments
used
Exposure to
risk
Investment
field
Diversification
Investment
method
Characteristic features of a strategy

Global macro, event driven, long-short equity, statistical arbitrage
Resources, precious metals, commodities, currency, real estate
Shares, bonds, contacts forward, futures, options, options on contacts futures,
swaps
Directional, neutral in respect to the market
Technology, health care, developing markets
Multi manager, multi-strategy, multi-market, of multiple funds
Discretionary/qualitative (individual investments are selected by the managers), systematic/quantitative, Quant (individual investments are selected
using numerical methods and computer transaction systems)
classifications of the investment strategies used by the four largest, reputable

financial institutions, which publish the results of indices, is presented in Table 3.3.
3.3
The Relative Value Strategies
The strategies based on a relative value involve the use of arbitrage, in order to
profit from the price differences on particular markets. The group of investment
strategies, called relative value, entails profiting from inaccurate valuation of
financial instruments. Generally, taking directional positions is avoided in relative
value and the market neutral strategies. This kind of strategy is suitable for those
investors who expect stable return rates. Emergence of those strategies should not
be directly related to the changes on the market. Relative value and market neutral
strategies are based on identifying valuation errors occurring on financial markets.
The term arbitrage, according to its classic definition, means a risk-free transaction which generates profit from price differences in of the same instrument on
various markets.2 Arbitrage deals become available when technical, geographical,
legal and administrative barriers are restricting proper interaction between two
particular markets on which the same instrument is handled. Ideally, in a perfect,
highly effective world the option of arbitrage would not exist. Relative value
strategies can be based on application of an appropriate formula, on the use of
statistical methods or a on fundamental analysis. They generate income, if the value
of a given instrument returns to its market value.
2
This term was created by Ross (1976), who used this concept as the basis for the APT Theory
(Arbitrage Pricing Theory).
3.3 The Relative Value Strategies
63
Table 3.3 Comparison of classification of the investment strategies used by alternative funds,
according to four largest index creators
Strategy
group
Event
Driven
Sub-category
Event Driven
Event Driven MultiStrategy
Merger/
RiskArbitrage
Distressed
Special Situation
Relative
Value
Long/Short
Long/Short equity
Dedicated Short
sellers
Equity Market
Neutral
Equity Hedge
Long bias
No bias
Short bias
Variable Bias
Tactical
Global Macro
Managed Futures
Equity/Long
Location
Standard and
Poors
+
Hedge Fund
Research
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
Developed Markets
Emerging Markets
Global
MSCI
+
+
+
+
Arbitrage
Statistical Arbitrage
Specialist Credit
Convertible
Arbitrage
Fixed Income
Arbitrage
Relative Value
Arbitrage
Multiple
Strategy
CSFB/
tremont
+
+
+
+
+
+
+
+
+
+
+
+
+
64
Table 3.4 Summary of selected characteristics of relative value strategy (UBC Warburg 2000)
Strategy
Convertible
arbitrage
Fixed income
arbitrage
Equity
market
neutral
Income
level
Medium
Volatility
Low
Sharpes
coefficient
Medium
Correlation
with shares
Medium
Leverage
Medium
Investment
horizon
Medium
Low
Low
Low
Low
High
Medium
Medium
Low
High
Low
Medium
Medium
As part of a relative value investment strategy, attempts are made to use the
exchange rate differences between financial instruments that are similar or dependant on each other. Financial instruments, which are priced above the market value,
are sold through short-selling. Instruments priced below their market value, that is,
underpriced instruments, are bought successively. Purchasing of an instrument at a
lower price and its immediate sale at a higher price generates an instant income.
Arbitrage strategies used by hedge funds also can seek opportunities to use the
so-called spread. If the spread is expanding or narrowing (accordingly to the
investors expectations), income is realized. If the investor makes incorrect assessment of the spreads future formation, he/she will incur losses.
Arbitrage strategies are quite commonly used in hedge fund operation. In fact,
arbitrage deals disappear quickly. The higher the number of entities engaged in
arbitrage transactions, the bigger the competition on the market and, at the same
time, the lower the potential income from an arbitrage.
As part of the relative value strategy, the following more specific strategies can
be distinguished:
Convertible arbitrage,
Fixed income arbitrage,
Market neutral equity.
More elaborate classifications contain such strategies as: mortgage-backed arbitrage or capital structure arbitrage. Table 3.4 presents selected characteristics of
relative value strategy.
3.3.1
The Convertible Bond Arbitrage Strategy
The convertible bond arbitrage strategy, that is, an arbitrage of convertible instruments, entails the use of an inadequate relative valuation of a convertible instrument
and/or of the shares of a particular company. This strategy is based on the use of
hybrid instruments, that is, bonds or preference shares exchanged for ordinary
shares. Usually, convertible instruments are convertible bonds or convertible preferred stocks, which are exchanged for ordinary stocks of a company that had issued
3.3 The Relative Value Strategies
65
convertible instruments. Generally, the manager takes a long position on the

convertible instrument and enters into a short-sale deal. Leverage is also applied
in this strategy and it usually falls between 2 and 10 the capital.
3.3.2
The Fixed Income Arbitrage Strategy
The fixed income arbitrage strategy also involves seeking income possibilities
resulting from market inefficiencies. This strategy includes a number of strategies
that are focused on searching for price anomalies on the global market of the
securities characterized by a fixed return rate. The differences in valuation of the
same or similar instruments generate possibilities of a risk-free income. Relative
value strategies involve constructing such a portfolio, which will allow a positive
return rate resultant from valuation irregularities between at least two fixed-income
instruments composing that portfolio. The main purpose of this strategy is to
maximize the income, while controlling the risk. The following factors have
disseminated applicability of this strategy:
Lack of a single model allowing pricing of instruments,
Existence of many relative relations between the prices of financial instruments
that are characterized by a fixed level of income,
Complex construction of the instruments characterized by a fixed interest rate.
The fixed income arbitrage strategy, similar in its construction to a fixed income
directional strategy which applies to fixed interest securities, however, does not
only apply to bonds. The securities being traded are government bonds, corporate
bonds, securities issued by federal agencies, local government securities, or treasury securities of developing countries. During arbitration, opposite positions on
related markets are taken with an attempt to profit from the price anomalies of
similar instruments. In general, portfolio managers open arbitrage positions in those
securities, the prices of which are positively correlated. Because they operate on the
differences in interest, ranging from few to several base points, they often use a high
leverage of about 20 the net asset value.
The strategy is relatively neutral towards the market, therefore volatility of the
return rates achieved by this type of funds is low. Using arbitrage on related
instruments, e.g. on a given primary instrument and on a futures contract of that
instrument, is a common practice within this strategys framework. The possibility
of earnings emerges, when futures contracts on the bonds are inaccurately priced.3
It should also be indicated, that the fixed income arbitrage strategy belongs to
complicated ones and requires highly skilled managers.
Multiple ways of applying the fixed income arbitrage strategy allow distinction
of its more specific uses, which, inter alia, include the following (Stefanini 2010):
More on the method of pricing the forward/futures contracts can be found in Hull.
66
1. Issuance driven arbitragesnap trade. Arbitrageurs predict, that the prices of

recently issued treasury bonds (on-the-run4) and the prices of the penultimately
issued bonds, which have very similar maturities, will be getting closer, due to
a decrease in the demand for those recently issued bonds, as a result of planning
next issuance;
2. Yield curve arbitrage. This strategy is based on an expectation of changes in the
slope of a specific interest rate curve. A typical income curve arbitrage is called
a butterfly trade;
3. A spread within the market (intermarket spread trading). This strategy is based
on trading two income curves in two different currencies;
4. Trading based on the futures contracts ( futures basis trading). This strategy
allows income, due to incorrect valuation of the futures contracts of a primary
instrument and due to the primary instrument at the moment of delivery.
Obtaining an income is possible because of the base effect;
5. Swap spread trading;
6. Other kinds of trading associated with the spread;
7. Capital structure trade;
8. Pair trading (short/long position on the securities with similar characteristics);
9. Carry trade, which involves financing of a purchase of high interest bonds,
loans contracted in low interest currencies;
10. Breakeven inflation trade;
11. Trading of fixed-income securities on the developing markets (emerging market fixed income);
12. Cross-currency trade on the relative value of a given currency (cross-currency
relative value trade).
3.3.3
The Equity Market Neutral Strategy
Equity market neutral strategies, in their methodology, are similar to a relative

value strategy. The funds seek possibilities to use market inefficiencies between
related stocks, while neutralizing their exposure to the market risk. The main
difference between those strategies results from systematic securing of the positions
along with interest rate changes. The strategy involves taking opposite stands
(buying/selling) on two securities/values representing the same segment on the
market. Users of this strategy try to identify small, but statistically significant,
opportunities for a return, often making a choice from among a very large number
of stocks. Selection of the stocks constituting an investment objective is performed
using a fundamental or technical analysis. Broadly speaking, the managers adjust
long and short positions on the market in order to eliminate other types of risk.
Usually, managers of such funds protect themselves against the exchange rate risk
4
A term used in the US in reference to treasury securities with a specified maturity, which are
characterized by high level of liquidity.
3.4 Event Driven or Specialist Credit Strategies
67
as well. This strategy results in different price behaviors of both instruments; this
difference in price behavior is highly independent on the price changes on the
market. This means, that positive returns are possible even when the prices on the
exchange market are declining. Equity market neutral strategies have been
designed to allow stable return rates, not only in case of price declines, but in
conditions of low volatility as well. An exemplary application of market equity
neutral strategy involves using the price differences between two types of equal
stocks of the same enterprise, in case of a fusion.
3.4
Event Driven or Specialist Credit Strategies
The event driven strategy, or otherwise called a specialist credit strategy, involves
seeking investment opportunities and obtaining profiting from extraordinary events.
In practice, however, few areas that will encourage investment activity through an
event driven strategy can be indicated. Events of this nature include, e.g.:
A bankruptcy of a company;
Restructuring, consolidation, or a change of the companys profile;
Events affecting the companys credit rating and its assessment;
Mergers and acquisitions;
Bankruptcies;
Buyouts and amortization of the companys own shares by that company (sharebuy-back);
Other possible events having significant influence on the companys valuation.
Event driven strategies are chosen by those investors, who prefer to concentrate
on the value of an enterprise. This means, searching for the companies of inestimable asset value, which function in the underestimated value sector. Such companies, generally, have a stable financial foundation. The search for such companies
primarily should be focused on the price, as one of the components of P/E (price/
earnings) and a P/BV (price/book value) ratio while assuming that the share price is
too low in term of these indicators, and comparing it to its fair value (Reilly and
Brown 2006). Moreover, it seems reasonable to search for companies whose P/E or
P/BV indicators are at a very low level, while there is a belief in an imminent
correction of the stock prices, in the absence of any changes in the companys
income.
Extraordinary situations generally lead to establishment of new stock prices. The
actions undertaken usually tend to be focused on the events already known.
Therefore, forecasting of those events is of a little significance. However, it is
important to accurately predict the direction of the changes and their potential
consequences for the company. That uncertainty associated with the final result of
an extraordinary incident provides the investors, who will accurately diagnose its
consequences, with ample opportunities of making a profit. As part of event driven
strategy, we can distinguish the so-called sub-strategies, which include: merger
68
Table 3.5 Summary of selected characteristics of event-driven strategies (UBS Warburg)

Strategy
Risk (merger)
arbitrage
Distressed
securities
Income
level
High
Volatility
Medium
Sharpes
coefficient
High
Correlation
with stocks
Medium
Leverage
Medium
Investment
horizon
Medium
Medium
Medium
Medium
Medium
Low
Long
arbitrage and distressed securities. A more detailed division of event driven

strategies also includes e.g.: special situations strategies, multi-strategy, or activism
investors strategy (Table 3.5).
3.4.1
The Merger Arbitrage Strategy
The merger and acquisition arbitrage strategy (risk arbitrage), also known as the
merger arbitrage, is one of the oldest strategies in the group of event driven
strategies. Its emergence dates back to 1940, when Gustave Levy had officially
created the department of arbitration in the Goldman Sachs bank. Robert Rubin,
later a secretary in the US Ministry of Treasure, was his successor. In the 80s of the
twentieth century, the merger arbitrage strategy involved seeking opportunities for
earnings resultant from such events as mergers and acquisitions (M&A) as well as
from leveraged buyouts. Some basic types of mergers and acquisitions also can be
specified, which include the following:
Cash mergers and tendering sales of securities (tender offers),
Multiple auctions (multiple bidder situations),
Exchange of the shares connected with a collar (stock swap mergers with a
collar),
A shares exchange merger (stock swap mergers) or shares for shares mergers
(stock-for-stock mergers),
Separation of an enterprise (spin-off),
Leveraged buyouts and hostile takeovers
Brealey et al. (2004) have found, that events like mergers and acquisitions, in US
history, had occurred at a specific time. Many merger and acquisition events
resulted from the industrial changes, technological changes, from deregulation,
from the changes in the prices of raw materials as well as from a progressive
globalization processes. The authors, therefore, have attempted to isolate those
historical times, during which the events of mergers and acquisitions occurred
relatively most often. In their study, they also have concentrated on identifying
those factors, which had significant impact on the mergers and acquisitions.
3.4 Event Driven or Specialist Credit Strategies
69
Information on a planned merger or an acquisition of a given company is an

important signal for speculators. The most common consequence of an acquisition
announcement is a drop in the share price of the company being acquired. The
capital of the company being acquired is treated as a kind of the capital reducing the
value of the company planning a takeover. In the long term, if the merger process is
successful, the synergy process is started and the price of the acquired companys
shares increases.
The managers of hedge funds can use this information and take direct positions
in the spread:
In case of an acquisition, between the value of a proposed acquisition and the
current market value of the acquired company;
In case of a merger, between the theoretical exchange rate for the shares of the
merging companies and the current rate expressed by the market.
At the same time, the higher the probability of an unsuccessful merger or
acquisition, the higher the value of the spread. All mergers and acquisitions bear
the risk of not meeting the deadline announced originally. If acquisition is not
implemented, generally, the value of the acquired company decreases rapidly. The
managers supervising an arbitrage of a merger and acquisition can use two
approaches alternatively:
Opening positions in the acquired and in the acquiring companies, after
announcing a planned arbitrage of merger and acquisition;
Attempting to forecast merger or acquisition events and taking the positions
before announcing a planned merger and acquisition transaction.
Generally, the merger arbitrage strategy is used after the announcement of a
planned transaction. Merger and acquisition transactions are complex, therefore
their application should be preceded by a profitability analysis, which takes into
account the following:
The financial and strategic terms of the transaction;

The number of potential candidates willing to submit a higher price bid;
The potential level of a loss, in case of transaction failure;
Profitability of the transaction, assuming its success as well as the expected
duration of its implementation.
3.4.2
The Distressed Securities Strategy
The origins of the distressed securities strategy and its application date back to the
nineteenth century. The industrial revolution in England accelerated the development of innovative, as for those times, transportation means. The British railway
70
network is the oldest one in the world. In 1926, the law had been passed to build a
railroad, which begun to be constructed in 1930. Unlike in most countries, construction of the railway solely relied on private companies. As such, a problem
emerged regarding technical unification of individual railroads, specified in the
agreements on the so-called running powers, which formed a complicated and
operationally linked structure that was exploiting the routes managed by other
parties. Difficulties associated with competition from other transportation means
began during World War I. The government, therefore, took the initiative of
restructuring the railway. In 1923, consolidation of 123 railway companies into
4 large managements, still private, begun (railway grouping). The reform, however,
did not lead to improvement of the railways economic position.
The distressed securities strategy is speculative in character. It involves
investing in securities of the companies facing financial difficulties. Investing in
companies that are on the verge of bankruptcy, or in which restructuring is being
carried out, is associated with many types of risk, such as:
The risk of the companys bankruptcy,
The risk of not fulfilling the terms.
The distressed securities strategy involves taking long or short positions on the
shares or bonds of the companies at a risk of bankruptcy. Experts also invest in the
securities issued by the companies, which have applied for protection against
insolvency, or in the securities of the companies involved in negotiations with
their creditors about their non-judicial restructuring. These companies, generally,
can be purchased at attractive prices. Successful restructuring of a company is
connected with an increase of its value and a simultaneous profit on the part of the
investor who took a long position. A strategy involving taking short positions on the
shares of a company in a difficult financial situation, in case of a further deterioration of its condition and a price decrease, means the funds profit. It is possible to
profit from a purchase of a non-subordinated debt of a bankrupting company at a
price lower than its liquidation value.
The distressed securities strategy also allows purchasing a difficult debt and then
a short-selling of the companys shares. The price of such a debt usually is
undervalued. Therefore, in this variant, profit can be achieved regardless the change
of the companys financial status. Improvement of the companys condition means
an increase of its debts price and simultaneously of its share price. As a result,
profit will be generated from the interest on the deposit from short-selling and from
the debt. If the companys financial situation deteriorates, a decline in the share
price below the price of the debt will be the consequence, due to a higher priority of
this debt in the bankruptcy process. Table 3.6 presents examples of publicly listed
companies, which experienced the biggest bankruptcies during the period between
1980 and 2012.
3.5 Opportunistic Strategies (Directional-Trading)
71
Table 3.6 The biggest bankruptcies of the companies listed publicly, during the years 19802012
(www.bankruptcy.com)
Company
Lehman Brothers
Holdings Inc.
Washington Mutual, Inc.
WorldCom, Inc.
General Motors
Corporation
Enron Corp.
Conseco, Inc.
Date of
bankruptcy
09/15/08
Industry
Investment Bank
Value of assets
(billion USD)
691.063
09/26/08
07/21/02
06/01/09
Savings & Loan Holding Co.

Telecommunications
Manufactures & Sells Cars
327.913
103.914
91.047
12/02/01
12/17/02
Energy Trading, Natural Gas

Financial Services
Holding Co.
Manufactures & Sells Cars
Residential Mortgage
Lending Company
Electricity & Natural Gas
65.503
61.392
34.940
33.864
12/20/05
04/02/07
Petroleum & Petrochemicals

Financial Services &
Savings and Loans
Brokerage Services
Bank Holding Company
Global Telecommunications
Carrier
Interstate Bank Holding
Company
Real Estate Investment
Company
Global Manufacturer of
Chemicals
Integrated Power Company
Real Estate Investment Trust
12/09/02
Passenger Air Carrier
25.197
Chrysler LLC
Thornburg Mortgage,
Inc.
Pacific Gas and Electric
Company
Texaco, Inc.
Financial Corp. of
America
Refco Inc.
IndyMac Bancorp, Inc.
Global Crossing, Ltd.
04/30/09
05/01/09
Bank of New
England Corp.
General Growth
Properties, Inc.
Lyondell Chemical
Company
Calpine Corporation
New Century Financial
Corporation
UAL Corporation
01/07/91
3.5
04/06/01
04/12/87
09/09/88
10/17/05
07/31/08
01/28/02
04/16/09
01/06/09
39.300
36.521
36.152
33.333
32.734
30.185
29.773
29.557
27.392
27.216
26.147
Opportunistic Strategies (Directional-Trading)
Opportunistic strategies, also called directional trading strategies, allow profiting

from a changing market trend. This category of strategies mainly includes such
sub-strategies as: global macro, managed futures or short sellers (Table 3.7).
72
Table 3.7 Summary of selected characteristics of directional trading strategies (UBS Warburg)
Strategy
Macro
Long
shellers
Long/short
equity
Emerging
markets
Income
level
High
Low
Volatility
High
High
Sharpes
indicator
Medium
Low
Correlation
with stocks
Medium
Negative
Leverage
Medium
Low
Investment
horizon
Short
Medium
High
High
Low
High
Low
Short
High
High
Low
High
Low
Medium
Source: UBS Warburg
3.5.1
The Global Macro Strategy
Hedge funds using a global macro strategy had constituted one of the largest group
of funds for quite long time. Application of this strategy also allowed achievement
of the best investment results. Due to severe consequences of using a global macro
strategy, from the perspective of financial systems of individual countries, it is
going to be discussed in more detail.
Popularity of this investment strategy is owed to people like George Soros
(Quantum Fund), Julian Robertson, Lewis Bacon or Bruce Kovner. One of most
famous applications of the global macro strategy was a speculative attack carried
out by George Soros, who was also called the man, who broke the bank of
England. It involved the sale of British pounds obtained from bank loans, which
led to devaluation of the British currency. Soros had assumed, that Great Britain
would be forced out of the European Exchange Rate Mechanism (ERM) in 1992.
Thus, he decided to short-sellbesides the British poundsalso the Italian lira,
and then instead to purchase German marks and French francs. On the 16th of
September 1992, on Black Wednesday, Soros purchased back the pounds on the
day the exchange rate was the lowest.
Application of this strategy revealed some possible consequences of operations
on the alternative investment market. Speculative sale of the Italian lira and the
British pound done by Soros, as well as his use of a leverage, on one hand, had
caused devaluation of these currencies and huge profits for the Quantum fund, on
the other, had threatened operational stability of the Central Bank of England and
the Central Bank of Italy. The exit of the British pound and the Italian lira from the
Monetary System in September 1992, enabled Soros to earn over 2 billion USD.
The 90s of the twentieth century were characterized by large popularity of the
global macro strategy. However, some events, that were unforeseen by the managers, had caused severe losses for some well-known hedge funds using the global
macro strategy. On the 4th of February 1994, an unexpected increase of interest
rates by 25 base points caused great financial losses for the Steinhard Partners fund.
Another fund, which recorded heavy losses due to improper anticipation of the
market behavior was the Tiger fund. At the beginning of 1998, this entity was
73
managing assets of over 4 billion USD. In October 1998, Robertson, the funds
founder, lost over 2 billion UNS due to appreciation of the yen to the US dollar. In
March 2000, Julian Robertson announced closing of the Tiger fund, blaming
irrational markets for the funds huge losses.
Despite a huge popularity of the global macro strategy in the 90s, over the next
years its significance decreased noticeably. This is confirmed by the following
facts. In April 1990, up to 71 % of hedge funds was using the global macro strategy,
while by the end of 2004 only 10 % of those funds admitted to using this strategy
(www.lipperweb.com).
The decrease of this strategys significance may have contributed to its perception as one of the riskiest.
The global macro strategy belongs to investment strategies, which are characterized by an extremely wide spectrum of activities, a wide range of the instruments
used by it and the techniques applied, as well as by variety of the markets on which
investments are done. The direction of the actions undertaken within the scope of
global a macro strategy is determined using analyses of macroeconomic variables.
Forecasts are often done on the basis of econometric models. The models are meant
to enable detection of inconsistencies between statistical analyses done on the basis
of such macroeconomic variables as: the gross domestic product, trade balance,
budget deficit, interest rates of the bonds, the demographic data, the average return
rate of the stock market, commodity prices, exchange rates, etc. Fund managers
formulate their conclusions about the results obtained and using that information
they construct a portfolio based on assessment of global economic trends.
Selection of the companies for a portfolio does not involve finding single
companies, but consists in finding opportunities to obtain profits resultant from
price changes of a particular class of assets, usually those with most liquidity.
Managers of global macro funds use two basic methods:
Basing investment decisions on the human factor (the discretionary approach),
which means that they are mostly based on the managers decisions;
Basing decisions on computer programs (systematic approach), which are based
on quantitative models.
Each of the above mentioned methods of operation can be divided according to
the following categories:
Directional, in which the manager clearly assumes an increase of the prices by
taking long positions, or assumes a decrease in the prices by taking short
positions;
Relative value, in which the manager simultaneously takes a long and a short
position in the same or similar groups of assets, in order to profit from emerging
price differences.
In general, the global macro strategy does not involve any predetermined
geographical restrictions regarding the area of investment, therefore the managers
make investments worldwide. The managers of global macro funds try to predict
price changes on the capital markets and thus take directional positions, often
74
without securing them. They attempt to use the exchange rate fluctuations induced
by macroeconomic events, such as: wars, natural disasters or political decisions of
crucial importance for national economy.
Each investment decision should be consistent not only with macroeconomic
assessments, but also with the risk profile of the whole investment portfolio. The
main purpose of the hedge funds using the global macro strategy is to protect the
funds capital. A relatively low investment transparency for the investors is a
characteristic feature of global macro funds. Effectiveness of using this strategy
is highly dependent on the competence, the skills and experience of the managers,
who make the key investment decisions. The managers of those funds construct
their positions gradually, simultaneously with several transaction parties, which
makes it difficult to assess transaction scales, as well as to determine the direction of
an investment.
Managers of global macro funds also openly trade on currency markets, taking
into consideration the relative value of currency positions. The following exemplary positions can be indicated (Stefanini 2010):
A long position of PLN in terms of a short position of Euro,
A long position of the Swedish crown in terms of a short position of Euro,
A long position in the Australian dollar in terms of a short one in the
New Zealand dollar,
A long position in the Korean won in terms of a Japanese yen,
A long position in the Korean won in terms of a short one in Euro.
3.5.2
The Strategy of Short-Selling
History of short-selling dates back to 1609. Edward Chancellor (1999) in his work
titled Devil Take the Hindmost: A History of Financial Speculation suggests, that
the first short-sale transaction was carried out on the Amsterdam Stock Exchange
by a Dutch merchantIsaac Le Marie. He short-sold the Dutch East Indie Company (VOC) listed on the same stock exchange. In 1610 the managers of VOC
convinced the Dutch States-General to consider short-selling as an illegal operation, which resulted in the Dutch governments decision of taxing the profits from
short-selling.
Short-selling was also considered illegal in the eighteenth and nineteenth centuries in Great Britain, France and in Germany. Currently we are dealing with very
different regulations on the use of short-selling in selected countries worldwide.5
Summary of the regulations regarding using short-selling in selected countries is
presented in Table 3.8.
5
Analysis of effects associated with short-selling and their impact on informational efficiency of
the market was analyzed by Diamond and Verrecchia (1987).
75
Table 3.8 Summary of the practices related to short-selling in selected countries worldwide
(International Encyclopedia of the Stock Market 2000 as well as based on the websites of global
stock exchanges)
Country
South Africa
Albania
Argentina
Australia
Austria
Belgium
Brazil
Bulgaria
Chile
China
Chech Republic
Denmark
Egypt
Ecuador
Estonia
Philippines
Finland
France
Gerece
Spain
The Netherlands
Hong Kong
India
Indonesia
Ireland
Israel
Japan
Jordan
Canada
Colombia
South Corea
Lithuania
Luxembourg
Malaysia
Marocco
Mexico
Germany
Norway
New Zealand
Pakistan
Peru
Possibility of short-selling
Yes
No
Yes
Yes
Yes
Yes
Yes
No
Yes
No
Yes
Yes
No
Yes
No
Yes
Yes
Yes
Yes
Yes
Yes
Yes
No
Yes
Yes
Yes
Yes
No
Yes
No
Yes
No
Yes
No
No
Yes
Yes
Yes
Yes
No
Yes
Short-selling practice
Yes
No
No
Yes
Yes
No
Yes
No
No
No
Yes
Yes
No
No
No
No
No
Yes
Yes
No
No
Yes
No
No
No
No
Yes
No
Yes
No
No
No
Yes
No
No
Yes
Yes
Yes
No
No
No
(continued)
76
Table 3.8 (continued)

Country
Poland
Portugal
Russia
Singapore
Slovkia
Sri Lanka
Switzerland
Sweeden
Thiland
Taiwan
Turkey
USA
Venezuela
Hungary
Great Britain
Italy
Zimbabwe
Possibility of short-selling
Yes
No
Yes
Yes
No
No
Yes
Yes
Yes
No
Yes
Yes
No
No
Yes
Yes
No
Short-selling practice
No
No
No
No
No
No
Yes
Yes
No
No
No
Yes
No
No
Yes
Yes
No
The strategy of short-selling is based on anticipation of future price declines of

various financial instruments. Thus, the securities on the market are borrowed in
order to be sold at a relatively high price and then bought back at a lower price. The
difference between the sale price of a security and its purchase price is the
investors profit. The strategy is directed at borrowing the securities which are
considered as overvalued. Most commonly, the entities which are the subject of a
short-sale exhibit the following characteristics:
A weak financial condition and high quotations. This class includes
non-profitable companies or those characterized by a high level of a financial
leverage;
A changing structure of the shares;
Affiliations with the distressed securities sector;
High valuation on the market at a simultaneous low level of the cash inflows or a
high level of the applied leverage;
Systematic loss of the value e.g. with a low level of dividend yield, a high level
of price/earnings ratio;
Regular changes of an auditor and delays in submission of financial statements;
Involvement in industries characterized by high risk;
Involvement in unsuccessful mergers;
A high level of confidential sales (insider selling), characterized by a high level
of share sales by the managing company.
The strategy of short-selling belongs to category of much riskier transactions
than those of a long position in securities. Borrowing the shares from another
77
investor for the purpose of their short-selling always involves a risk of the investor
being called to return the shares at any time. The need for an immediate return of
the assets (short squeeze) can be associated with severe losses, if their price
drastically increases. Moreover, it is not always possible to borrow particular shares
on the market. Hedge funds using short-selling must account for specific types of
risk which are associated with this kind of activity. While in the case of taking a
long position the potential profit, theoretically, is unlimited, in short-selling, the
price of the shares cannot drop below zero. The entity is also obliged to a dividend
payout to the borrower, who is the legal owner of the securities.
3.5.3
The Long/Short Equity Strategy
The long/short equity strategy involves profiting by taking long and short positions
on the market. Short positions are taken, if the investor is expecting future price
declines of the purchased instruments. Long positions are taken when expecting
increases in their price. The long/short equity strategy often is called a classic hedge
fund strategy, which has been most commonly used by hedge funds during the past
few years. Alfred Winslow Jones was first to use a strategy, which today is called a
long/short equity. As the founder of the Jones & Co LLC fund, he noticed that
during recession, when share prices are dropping, it does not make sense to sell
some of the shares and loose on those remaining in the portfolio. He thus decided to
use short-selling in order to profit on the dropping share prices. It allowed him to
secure the investors money during a bear market period. In 1966, the Fortune
magazine described the investment phenomenon of the A.W. Jones & Co. LLC,
which had reached a return rate of around 670 % (www.finanseosobiste.pl).
Long/short equity funds nowadays constitute a very heterogeneous group, with
different exposure to the market risk and different levels of the leverages applied by
them. Some managers mainly rely on long positions, others on short positions, or
they stay neutral towards the market. In the latter case, they get close to the above
discussed equity market neutral category of funds, with a low exposure to market
risk. The choice of the securities depends on the expectations regarding price
formation in the future. A Deutsche Bank (2004) report titled The role of long/
short equity hedge funds in investment portfolios presents the results of a S&P500
Index and a TUNA Long/Short Equity Index.6 During the years 19902003, the
average return rate from the TUNA Long/Short Equity Index was 20.3 %, while the
S&P500 Index, during the same period, increased by 10 %. It is also worth noticing,
that in the same period, the funds risk, measured by a standard deviation, was
significantly lower for the Tuna index (9 %), than for the S&P500 index (15 %). The
Deutsche Bank report, therefore, indicates, that minimizing the risk is another
The Tuna Index is created based on information made available by long/short funds at
HedgeFund.net.
78
important advantage of the funds using long/short strategy, besides a higher return
rate. According to the Deutsche Banks data, the asset value of the hedge funds
using this strategy, has increased by over 20 % annually http://www.deutsche-bank.
de. The long/short equity strategy can be classified according to the investment
techniques used to achieve a desired result. Therefore, the following can be
distinguished:
1. The long biased strategy, the portfolio of which is dominated by long positions
and which gamble on increasing markets;
2. Market neutral strategy, which maintains market neutral positions and attempts
using short-term inefficiencies occurring in valuation. At the same time, emphasis is placed on compensating these valuation inefficiencies on the market;
3. The short biased or short sellers strategies, in which short positions are dominant. Emphasis is, therefore, placed on a more probable decline of the share
price. Short-selling of own financial instruments or those acquired through
borrowing transactions is performed, in order to later buy them out at more
favorable terms.
The long/short equity strategy provides an opportunity to use futures and
options. Hedge funds, which use a strategy of a long/short type, are such funds
whose managers take long positions in the shares simultaneously with short positions balancing them. Simultaneous combination of a long position in the stocks
with their short-selling is aimed at securing the position. Such combination is meant
to minimize the risk, but not reducing it to none. The investor therefore is slightly
exposed to a market risk. Taking short positions is supposed to serve two purposes.
First, it is to protect against the price declines occurring on the market, second, it is
to provide opportunities of profiting on those declines. For the strategy to be
effective, undervalued shares ought to be purchased at a simultaneous short-sale
of the securities of the overvalued companies, preferably from the same sector.
The main motive for constructing a strategy of a long/short equity type is the
possibility to earn through short-selling the stocks at reasonable prices. Selection of
a right brokerage firm, which is able to negotiate the value of the deposit to be paid
for an opportunity to borrow the shares, has high impact on the transaction.
3.5.4
The Emerging Markets Strategy
The emerging markets strategy involves investing on the emerging markets characterized by a high growth potential. The term emerging markets most commonly is
used in reference to certain regions of the world, in reference to their characteristics
of economic growth and financial market activity. For example, such countries like:
China, India, Malaysia, as well as Middle-Eastern Europe countries are considered
as emerging markets.
This strategy, thus concentrates on a geographic criterion, which constitutes the
basis for selection of the territory and the subject of an investment. These countries
References
79
generally are characterized by a dynamic economic growth as well as by a high

level of investments. Such features make those countries attractive places for
capital allocation.
Investments on emerging markets practically entail all kinds of securities on the
emerging markets, including shares, bonds, and the so-called sovereign loans. This
investment style is characterized by high volatility of return rates, which results
from fundamentals of the markets called emerging markets.
References
Amenc, N., Martellini, L., & Vaissie, M. (2003). Benefits and risks of alternative investment
strategies. Journal of Asset Management, 4(2), 96118.
Brealey, R. A., Myers, S. C., & Marcus, A. J. (2004). Essentials of coporate finance. McGraw-Hill.
Chancellor, E. (1999) Devil take the hindmost: A history of financial speculation. Basingstoke:
Macmillan.
Diamond, D. W., & Verrecchia, R. E. (1987). Constraints on short-selling and asset price
adjustment to private information. Journal of Financial Economics, 18(2), 277311.
Fung, W., & Hsieh, D. A. (1997). Empirical characteristics of dynamic trading strategies: The case
of hedge funds. Review of Financial Studies, 10(2), 275302.
Ineichen, A. (2000). In search of alpha: Investing in hedge funds. UBS Investment Bank.
International Encyclopedia of the Stock Market. Reference Reviews, 2000, 14.2: 18-18.
Jaeger, L. (2002). Managing risk in alternative investment strategies: Successful investing in
hedge funds and managed futures. Edinbourgh Gate: Pearson Education.
Lhabitant, F. S. (2011). Handbook of hedge funds (Vol. 579). London: Wiley.
Reilly, F. K., & Brown, K. C. (2006). Investment analysis and portfolio management. Mason, OH:
Thomson South-Western.
Ross, S. A. (1976). The arbitrage theory of capital asset pricing. Journal of Economic Theory,
13(3), 341360.
Stefanini, F. (2010). Investment strategies of hedge funds (Vol. 577). Wiley.
www.bankruptcydata.com
Chapter 4
Funds of Funds
4.1
The Genesis of Funds of Funds
Over the past few year, interest in investing through funds of funds has been
increasing. Funds of funds are entities investing financial assets in the shares,
units or in certificates of other investment funds. Funds of funds play a significant
role on the market of alternative investments. According to the statistical data
published, the value of the assets in funds of funds currently constitutes about
30 % of the assets of all hedge funds (http://www.ifsl.org.uk). This means that, from
the hedge funds perspective, those entities constitute a very important aspect of the
demand.
The first hedge fund was created in Geneva in 1969 (Ineichen 2002; Gregoriou
2008). The Leverage Capital Holdings fund was formed by George Karlweis of the
Banque Privee Edmund de Rothschild. This fund was also the first hedge fund in
Europe. Less than 2 years later, that is in 1971, the fund was opened in the US by the
Grosvenor Partners fund of funds. In 1973, Permal Group had introduced on the
market the first fund which used multi-manager and multi-strategy strategies,
calling it the Haussmann Holdings N.V.
In 1980, Julian Robertson and Thorpe McKenzie formed the Tiger Management
Corporation and introduced on the market a new fund of funds, called Tiger. The
funds initial capital amounted to 8.8 million USD. The first company specializing
in management was created in 1983. Several years later, it was overtaken by the
USB AG (in 1999). Less than 5 years later, the company was managing assets worth
38 million USD. Currently, the funds of funds sector is developing rapidly. More
importantly, due to lower capital entry barriers, a much wider group of investors has
access to this form of investment.

DOI 10.1007/978-3-319-13215-0_4
81
82
4.2
Funds of Funds
The Definition of Funds of Funds
Most countries lack a formal definition of funds of funds. The legal acts established
only specify certain criteria, which ought to be met for a given entity to be classified
as a fund of funds. For instance, German investment law allows a possibility of
investing in hedge funds, however, it prohibits the use of leverages and short-selling
methods.1 In Spain, on the other hand, regulations require funds of funds to invest
at least 60 % of its assets in domestic hedge funds or in foreign ones that have their
headquarters or their Boards in the OECD countries. French regulations require
funds of funds to be created in accordance with strictly applicable regulations. The
term funds of funds defines such funds, which buy shares of a value exceeding
10 % of the portfolio, in hedge funds or in other alternative forms of investment. In
turn, according to Brazilian law, hedge funds are a category of funds of funds,
which are described as investment funds investing at least 95 % of their own assets
in other investment funds. The funds which are the subject of an investment can
belong to any category of investment funds. The above presented examples of
regulatory solutions applied in different countries indicate, that despite the lack of a
formal definition, activity of those entities on the global financial market has been
noticed. These exemplary solutions also indicate, that attempts are being made to
regulate their activity.
According to the classification used by the Polish Chamber of Fund and Asset
Management, funds of funds and the funds investing a substantial part of its assets
in participation entitlements (investment fund shares) of a single institution of a
joint investment, should be classified based on assessment of the overall composition of investment portfolios of those joint investment institutions, whose shares a
given fund invests in (i.e. based on the funds model exposition onto the market of
equity securities and fixed income securities or on the markets of alternative
investments) (http://www.izfa.pl). This means, that the portfolios composition
determines the nature of a given investment fund.
4.3
The Types of Funds of Funds
Different types of funds can be specified, depending on their investment purpose.

Funds of funds, similarly to hedge funds, can be created under various legal forms.
Their legal form is mainly determined by the place of their origin and the applicable
law. In practice, funds of funds can function as a category of investment funds
(e.g. in Ontario Canada, Hong Kong, Ireland, Japan), as a limited liability company
(e.g. in Ontario Canada, Switzerland, USA), as an investment company (e.g. in
1
Investmentgesetz (InvG), vom 15 Dezember 2003, Kapitel 4, Sonderverm
ogen mit Zusatzlichen
Risiken (Hedgefons) Paragraf 113, 114.
4.3 The Types of Funds of Funds
83
France, Hong Kong, Ireland, Japan, Luxemburg, Spain, Switzerland), or in another

legal form.
If a fund of funds is formed as an investment fund, it may be of an open
investment fund character (France, Switzerland) or of a closed investment fund
character (Ontario Canada, Quebec Canada, Switzerland, Greta Britain, USA). As a
rule, however, funds of funds function as private companies, which enables them to
avoid the restrictions of regulatory nature. Despite their significantly lower entrance
barriers, in comparison to hedge funds, funds of funds often are run by accredited
investors.
Funds of funds can also be classified according to the investment purpose. Such
basic division distinguishes the following:
The funds of investment funds,
The funds of hedge funds,
The funds of private equity funds.
The term funds of funds most frequently is used in the context of an investment
in hedge funds and in private equity funds. Construction of funds of funds is
particularly important while investing in those funds.
Funds of funds, which invest financial assets in the newly created private equity/
venture capital funds, are the so-called primary funds of funds. Funds of funds,
which are oriented on investing in the already existing private equity/venture
capital funds, are called the funds of secondary funds.
Another division of funds of funds takes into account the financial instruments
which an investment is based on. Considering various possible ways of constructing
a portfolio of funds of funds, the following funds can be distinguished:
Fraction funds,
Hybrid funds (sustainable ones and those of stable growth),
Debt securities,
Cash and money market funds.
Classification of funds of funds according to their construction type distinguishes the following:
Closed funds of funds,
Open funds of funds.
Depending on the management concepts used by funds of funds, the following
variants can be distinguished (Fabozzi et al. 2008):
Index funds,
Qualitative funds,
Quantitative funds.
The index concept involves investing in a maximum of a 100 hedge funds and its
investment objective is to achieve a return rate from a given sector of the hedge
fund market. Depending on the nature of an investment and on the intended
investment objective, the managers select those funds, whose activity falls within
the scope of their investment strategy. The managers using this approach assume
84
Funds of Funds
that their skills will allow selection of such hedge funds for the portfolio, which will
enable achievement of high return rates, while minimizing the investment risk in
the long term.
The qualitative concept is based on an assumption, that the investment portfolio
of funds of funds should include a maximum of 50 funds. The funds for the
portfolio are chosen on the basis of econometric models, which allow selection of
the shares of particular funds in the portfolio. Selection of a category of funds,
depending on the investment strategies used, is also performed using the models.
Using a qualitative concept involves investing in a strictly selected group of
maximum 20 funds. Moreover, selection of funds for the portfolio is held through a
very strict quality control of the strategies used by the funds. This concept,
however, is associated with incurring additional, high costs.
Funds of funds also can be classified according to the investment objective. Four
basic strategies used by the managers of funds of funds (FOF) can be distinguished
here (Hedge funds: Approaches to diversification 2002):
The strategy of a target return rate, which involves allocating the funds assets in
other funds, with assumption of a target return rate at the level of 1015 %, while
reducing risk;
Maximum return rate strategy, which involves allocating the funds assets in
other funds, assuming achievement of a maximum possible return rate and a
simultaneous acceptance of the investment risk;
A dedicated strategy, which involves investing the funds assets in the funds
using a specific type of an investment strategy, or in the funds investing on
specific markets;
A combined strategy, which takes into account a combination of the investment
styles which allow achievement of a particular result.
4.4
The Constructions of Funds of Funds
Construction of funds of funds involves creation of a single investment portfolio

comprised solely of participation units and investment certificates of other funds,
not necessarily of the same company. Classification of a fund of funds as a
separate category, makes it an investment entity, whose basic strategy involves
buying the shares of other investment funds, instead of investing directly in stocks,
bonds or other financial instruments. Often, the category of funds of funds is treated
as a subcategory of hedge funds, which uses a multi-manager strategy. Such
understanding of the term, although correct, does not reflect the essence of this
investment category and its developmental perspectives as a separate class of
alternative investments. Therefore, in this work, funds of funds are treated as a
separate category.
4.5 Advantages of Investing in Funds of Funds

Diagram 4.1 Construction
of funds of funds
85
Funds of funds
Investment fund
A
TFI A
Investment fund
B
TFI B
Investment fund
C
TFI C
Investment fund
D
TFI D
Allocation of financial assets in a fund of funds generally means buying a

portfolio reflecting the changes in the values of the units of 3060 selected primary
funds. Diagram 4.1 presents a typical construction of funds of funds.
4.5
Advantages of Investing in Funds of Funds
There are many advantages to be had by investing through funds of funds. The most
frequently mentioned one is their double diversification of the risk. It is performed
at the level of the primary fund, then at the level of the fund of funds. This form of
investment also is more accessible to a wider group of investors, due to a much
lower entrance barrier, in comparison to hedge funds or private equity funds. At the
same time, the form of funds of funds enables the investors to access the instruments and the markets that are unattainable through unassisted investing.
Summarizing the benefits of investing in funds of funds, it can be concluded, that
this type of collective investment institutions also allows diversification of the risk
and professional portfolio management of the funds selected. Professional management of a portfolio of funds of funds allows avoidance of the costs associated
with monitoring and analysis of various data, which in the case of own portfolios
are necessary for effective investment management. Another benefit of investing in
FOF is the possibility of using specialized databases, which collect and store
information from a variety of sources, that is banks and financial institutions.
This type of data is only accessible to the managers.
An important argument for advisability of investing in funds of funds is a
successful selection of funds from among the many primary funds functioning on
the market. The large number of the funds operating on the market often prevents
the investors from an efficient selection of an appropriate investment level. The
so-called information range, which allows selection of the object of an investment,
is an important parameter in selection of funds. It can be expressed using an
information ratio, which is described using the following formula (Ineichen 2000;
Lee 2000):
86
IR
ER
BR
Funds of Funds
4:1
where:
IRinformation ratio,
ERaverage positive return rate,
BRstandard deviation of the additional return rate.
The information ratio allows assessment of whether taking a risk in order to
achieve a higher return rate is justified. Another option is to adopt a passive
strategy, which faithfully copies the index. The numerator of the ratio is the average
positive return rate, which is related to the return rate achieved by a given model
portfolio. The equations numerator is compared with the positive return rate, that is
the excess return rate from the portfolio, above the model portfolios return rate.
The equations denominator represents the risk. Standard deviation of the excess
return rate is referred to as a tracking error. The more the manager differs in his/her
portfolio from the composition of the benchmark constituting a reference model,
the greater the tracking error.
Summarizing the discussion on the benefits of investing in funds of funds, it can
be concluded, that its most important advantages are the following:
Reduction of the risk associated with investing in a single fund,

Possibility of investing in various classes of assets,
Access to investing on various markets,
Using a wide range of investment strategies,
Using the knowledge and the experience of many managers from different
regions of the world,
Elimination of the need to conduct time-consuming and costly analyses, which
are necessary to make investment decisions in numerous individual funds,
Lower operating costs than those in traditional funds; as opposed to a fund
investing in traditional instruments such as stocks and bonds, a fund constructed
as a fund of funds does not need to incur the costs associated with a detailed
analysis of the securities and financial instruments, as well as it does not need to
incur the costs associated with their purchase,
Access to a wider spectrum of leading funds, which may be difficult to access
due to high capital barriers or their location.
Funds of funds often cooperate with hedge funds, which in this way secure
themselves in case of a potential gain of the capital. In addition, funds of funds often
become engaged in investors educational activities, which are associated with
explaining basic the forms of traditional and alternative investments, the role of
the risk in investing, or possible applications of investment strategies. Often,
educating the investors is part of the sales strategy of funds of funds. The above
advantages comprise important presumptions for investors to invest in funds of
funds, which is reflected by the data evidencing development of this sector of
alternative forms of investment.
4.6 Disadvantages of Investing in Funds of Funds
4.6
87
Disadvantages of Investing in Funds of Funds
Investing in funds of funds, however, is not without drawbacks. Their low availability to the investors is one of primary disadvantages associated with investing in
funds of funds. Due to a relatively recent development of this sector and the lack of
adequate regulations, this form of investment is not widely available for entities
investing on the market. Funds of funds are not well recognized by the investors,
who often are not familiar with this form of investing or cannot indicate any specific
funds of funds that are currently operating on the market. Along with the development of this sector of alternative investments, as well as due to the increasing
investors knowledge, it is believed, that such state of the matters should soon
change.
High transaction costs are a drawback of investing in funds of funds and thus its
shortcoming as well. Investing in those funds involves incurring a double fee. The
funds charge fees to those managing investment funds and to the distributor or to
the investor. This double fee structure is considered a negative aspect of investing in
funds of funds. Management fees, in case of funds of funds, usually are higher than
those charged by traditional investment funds, because they include part of the
management fee collected by the funds which are direct subjects of a given
investment. These charges also include cumulated management fees.
Funds of hedge funds usually collect fees for their services. Generally these are
management and performance fees, respectively 1.5 % and 1530 %. In management of funds of funds the fee structures often are 1 plus 10, that is, a fixed
management fee equal to 1 % and a commission of 10 %. There can also be a
structure of 1 plus 15 or a 1 plus 20. These charges can decrease the investors
profits and potentially reduce the overall income, below the potential income to be
achieved by cheaper investment funds or by the ETFs (Exchange Traded Funds).
Lack of transparency in funds of funds activity is another drawback. The level
of their transparency is lower than in case of traditional investment funds. Lack of
clarity often results from the lack of information and, on the part of the managers,
from not disclosing the names of the funds composing the portfolio. Such situation
is referred to as a black-box syndrome (Ineichen 2001).
Moreover, while investing in funds of funds, attention should be paid to the
following issues (Kaiser 2004):
Possible difficulties with optimal capital allocation in case of a high value of the
assets being managed,
Difficulties associated with selection of the managers in accordance with the
funds warranty capacity,
Possible tendencies associated with too wide diversification of the portfolio,
Possible difficulties associated with capital allocation using specific investment
strategies,
Difficulties with applying niche or quasi-closed strategies.
88
4.7
Funds of Funds
The Global Funds of Funds Market
The subject of the analysis is going to be the market of the funds investing in hedge
funds. The number of these funds does not correspond with the number of all funds
functioning globally. The number of hedge funds has increased since 1999, so just
in 10 years it has increased from 800 to more than 3000. This means that the
average annual increase rate of the funds of funds was almost 28 %. This period was
characterized by an apparent increase in the number of funds of funds as well as by
an icrease in the values of the investment assets that were managed by those funds.
The number of functioning funds of funds was highest in 2007. It is estimated, that
around 3250 funds of hedge funds functioned globally in this year. A decrease in the
number of funds of funds in 2008 was related to the financial crisis and to outflow of
the capital from this sector of the market. Outflow of the capital from the funds of
funds sector directly contributed to the decrease in the number of funds of funds
globally. The number of funds of funds during the years 20022012 is presented on
Fig. 4.1.
The increase in the number of funds of funds in recent years has been associated
with a rapid growth of the value of the net assets being managed by funds of funds.
While in 1999 the value of the assets being managed by funds of funds was
estimated at 58 billion USD, in 2008 this amount was 600 billion USD. Also,
with regard to the value of investments, it can be noticed that the funds of funds
market reached the highest value in 2007 (860 billion USD). As a consequence of
the global economic crisis, the number of the funds of funds as well as the value of
the assets managed by them decreased. According to the estimations by the Hedge
Fund Research (HFR), the fund of hedge funds industry suffered net outflows
totaling 221 billion dollars (162 billion euros) between 2008 and 2013, including
net outflows of 8.1 billion USD in fourth quarter 2013 alone. The value of the assets
Fig. 4.1 The number of funds of hedge funds worldwide during the years 20022012
4.7 The Global Funds of Funds Market
89
being managed by funds of funds during the years 200220012 is presented on

Fig. 4.2.
Analysis of the emergence process of funds of hedge funds seems to be interesting. It can be noticed that the most funds of funds were created in 2007. A
downward trend in creation of new funds of funds can be observed, with the
exception of the year 2010. The number of new funds introduced on the market
in the years 20022012 is presented on Fig. 4.3.
Fig. 4.2 The value of the assets being managed by funds of funds in the years 20022012
Fig. 4.3 Fund of hedge funds launches 20022013 (Prequin 2015)
90
4.8
Funds of Funds
The Forecasts of Funds of Funds Market
An attempt was made to examine the structure of an autoregressive-trend variable:

funds of funds assets (afft) in billion. It turned out, that autoregression does not
occurs in this variable, while a linear trend does. Thus, impacts of the simultaneous
worlds wealth (bglcurt) as well as a delayed by 1 year worlds wealth (bglcurt1)
and a delayed by 2 years worlds wealth (bglcurt2) were examined. An empirical
equation describing a formation mechanism of the funds of funds assets has the
following form:
a f f t 1245:84 9:053bglcur t 5:920bglcur t1 124:4t uafft ;
6:313
5:841
3:637
5:826
4:2
R2aff 0:912, Suaff 70:99, Vaff 15:3 %:

Equation (4.2) highly accurately describes volatility of the funds of funds assets.
The linear trend, as well as the current and the delayed by 1 year values of the
worlds wealth explain 91.2 % of the total volatility of the variable afft. The trend
mechanism indicates an autonomous decrease in the annual value of the considered
assets on average by 124.4 billion USD. An increase of the current wealth by
1 trillion USD causes an increase in the value of the funds of funds assets, one
average, by 9 billion USD. An increase of the wealth delayed by 1 year (bglcurt1)
results in an increase of the current funds of funds assets, on average, by close to
6 billion USD. Each explanatory variable in Eq. (4.2) is statistically significant at a
very low significance level ( < 0.01). A negative value of the absolute term
(1245.84) indicates that funds of funds emerge only at a high level of the wealth.
Equation (4.2) can be used to estimate the forecasts of the funds of funds assets
(affTp). As such, it will be necessary to use the forecasts of the wealth, which are
presented in Table 2.2. Forecasts of the global funds of funds assets are presented
in Table 4.1 and on Fig. 4.4.
The calculations indicate, that during the upcoming years increases in the value
of those assets up to the level over 577 billion USD in 2014, over 678 billion USD
in 2015 and almost 706 billion USD in 2015 can be expected. Of course, realism of
the estimated forecasts depends on accuracy of the forecasts of the worlds wealth
(affTp).
Table 4.1 Forecasts of the global funds of funds assets (affTp) for the years 20142016 (billion
USD)
Forecasted
period (T)
2014
2015
2016
Forecast of affTp
(billion $)
577.44
678.58
705.99
Average
prediction
error (VT)
86.700
85.201
87.982
95 % confidence
interval
381.31773.57
485.84871.32
506.96905.02
4.8 The Forecasts of Funds of Funds Market

280
91
aff1f
Forecast
95%interval
260
240
220
200
180
160
140
120
2008
2009
2010
2011
2012
2013
2014
2015
2016
Fig. 4.4 Forecasts of the global funds of funds assets (affTp) for the years 20142016 (billion
USD) (Table 4.1)
Another issue needing explanation is the mechanism of fluctuations in the funds

of funds assets per 1 fund (aff1ft). Analysis of an autoregressive-trend structure of
the variable aff1ft revealed existence of a negative linear trend only and a lack of
autoregression. As such, impact of the values of global financial funds per 1 adult,
the current value as well as the delayed by 1 and 2 years values, were examined. As
a result, the following empirical equation emerged:
aff1f t 281:69 12:93bfinadt 6:935bfinadt1 9:401t uaff1ft ;
5:196
5:761
2:606
3:078
4:3
R2aff1f 0:922, Suaff1f 17:139, Vaff1f 10:2 %:

The structure of Eq. (4.3) is similar to that of Eq. (4.2). The trend and the values of
global financial assets per 1 adult, both the current one and the one delayed by
1 year, explain 92.2 % of the total volatility of the average assets per 1 fund of
funds. An autonomous decrease of the average value of the asset per one fund of
funds, annually, by around 9.4 million USD, is observed. An increase in the value of
global financial assets per 1 adult by a 1000 USD entailed an increase in the value of
the assets per 1 fund of funds, averagely by 12.93 million USD. At the same time,
an increase in the value of global financial assets per 1 adult by a 1000 USD,
delayed by 1 year, resulted in an increase in the value of the assets per 1 fund of
funds, averagely by 6.935 million USD.
Assessment of the forecasts of the average funds of funds assets per 1 fund
(aff1fTp) for the years 20142016 was attempted. The forecasts of global financial
92
Funds of Funds
Table 4.2 Forecast of the average global funds of funds assets per 1 fund (aff1fTp) for the year
2014 (million USD)
Forecasted
period (T)
2014
2015
2016
Forecast of aff1fTp
(millions $)
176.269
204.408
218.785
1000
Average prediction
error (VT)
23.1046
21.8886
22.1466
95 % confidence
interval
(124.003; 228.535)
(154.893; 253.924)
(168.686; 268.884)
aff
Forecast
95 % interval
900
800
700
600
500
400
300
2008
2009
2010
2011
2012
2013
2014
2015
2016
Fig. 4.5 Forecast of the average global funds of funds assets per 1 fund (aff1fTp) for the year
2014 (million USD) (Table 4.2)
assets per 1 adult (bglcurTp), presented in Table 2.11, were used for this estimation.
The forecasts (aff1fTp) turned out to be not significant enough, in the statistical
sense. Therefore, we present a forecast for the years 20142016 (aff1f2014p), which
is characterized by a relatively high relative prediction error V *2014 13:11 %. The
results are presented in Table 4.2 and on Fig. 4.5.
A decrease of the average global funds of funds assets per 1 fund in 2014, down
to the level of a little over 176 million USD, can be expected. It results from the
changes in legal regulations associated with funds of funds.
References
Fabozzi, F. J., Fuss, R., & Kaiser, D. G. (2008). The handbook of commodity investing (Vol. 156).
Hoboken, NJ: Wiley.
References
93
Gregoriou, G. N. (Ed.). (2008). Encyclopedia of alternative investments. Boca Raton, FL: CRC
Press.
Hedge funds: Approaches to diversification, Kellog School of Management, Working Paper, June
2002, p. 14.
Ineichen, A. M. (2000). Risks of hedge funds. Managing hedge fund riskfrom the seat of the
practitioner. London: Risk Books.
Ineichen, A., & Warburg, U. B. S. (2001). The myth of hedge funds. Journal of Global Financial
Markets, 2(4), 3446.
Ineichen, A. M. (2002). Absolute returns: The risk and opportunities of hedge fund investing (Vol.
195). New York: Wiley.
Kaiser, D. G. (2004). Hedgefonds: Entmystifizierung einer Anlageklasse; Strukturen, Chancen,
Risiken. Springer.
Lee, T. R. (2000). Active Management. Journal of Portfolio Management, 26(2), 2532.
Prequin. (2015). Preqin global hedge fund report. Available at https://www.preqin.com/
Chapter 5
Managed Futures Investments
5.1
The Genesis of Managed Futures Investments
Analysis of a type of investments called managed futures should begin with

introduction of the derivatives to the subject of the matter, particularly of the
futures contracts, which constitute a direct object of this type of investments.
Derivatives are the futures markets tools, the value of which depends on the
value of the so-called primary instrument constituting the base of a futures transaction. These innovative instruments of the financial market can be used both for
hedging, arbitrage as well as for speculation that allows profiting on the changes in
the basic instruments price.
Analysis of the Bible revealed some references to the contracts, construction of
which corresponds with todays derivative instruments (Wisniewska 2007). The
Book of Genesis, chapter XXIX, mentions a contract, which was to guarantee the
marriage of Labam with Jacobs daughterRachel, in exchange for 7 years of
work. The nature of that contract, depending on its interpretation, bore characteristics of both modern optionsthe swaps and forward/futures contracts. Records
on derivatives can also be found in the works of Aristotle and in many other
writings on the history of humanity. The first contracts on food products were
meant to protect both the producers and the buyers against the risks arising from
infertile crop harvests. Crop changes could have caused significant price fluctuations and unfavorable changes in the prices of agricultural and food products.
The first futures contracts on agricultural products were introduced in 1848 on
the Chicago Board of Trade stock exchange. They were called the to arrive
contracts, that is, contracts to delivery, and they applied to such food products as
flour or hay. Successive derivatives stock exchange markets emerged very rapidly.
In 1898 the Chicago Mercantile Exchange, initially known as the Chicago Butter
and Egg Board, was created. On the New York Mercantile Exchange (NYMEX)
contracts on energy products were traded, while on the New York Cotton Exchange
contracts on cotton and orange juice were traded. Introduction of the first financial
DOI 10.1007/978-3-319-13215-0_5
95
96
futures contract on mortgage-secured certificates (Government National Mortgage

Association mortgage-backed certificates) in 1975 was the next step in development of the futures contracts. Less than 2 years ago, futures contracts on the US
Treasury bonds were introduced. As a consequence of the derivatives markets
development, increasingly sophisticated strategies, which correspond with different
risk profiles and potential return rates, were created (Sokoowska 2009a, b, c).
An important figure in the history of the managed futures transactions development was Richard Donchian, known as the father of contemporary theory of trendfollowing (Stefanini 2006). The original Donchian method involved the use of the
moving averages as entrance/exit indicators in the sale/purchase transactions. In
1948, the systems constructor created the first public commodity fund dedicated to
investing in commodities (Commodity Fund Future, Inc.) (Anson 2006). Installation of electronic displays showing real-time price changes was another important
event that affected the development of managed futures investments.
Along with a rapid development of transactions using derivatives, the need to
create some regulatory frameworks for the market was recognized. In 1974, the
Commodity Exchange Act was passed and a commission supervising the derivatives
marketCommodity Trading CommissionCFTCwas created. The Act of
Commodity Exchange has defined the concepts of a commodity pool operator and
a commodity trading advisor.1 It can therefore be assumed, that the events described
here had significant impact on development of the managed futures investments.
Managed futures transactions, as an alternative form of investment, emerged on
the market as early as the 60s (Chance 1994; FoxAndrews and Meaden, 1995;
Peters and Warwick 1997). Currently, transactions of this type are managed by
professional investment advisors called the commodities trading advisors (CTAs),
who conclude transactions on the global derivatives market. They enable the
investors to release their cash funds within 3 months. A hedge fund, which engages
its own assets in a transaction on the futures market is called a commodity pool and
is required to be registered with the CFTC. An advisor once specified as a CPO or a
CTA undergoes continuous registration with the CFTC.2 Some well-known hedge
funds and funds of funds, which are registered as CTAs or CPOs, entail the
following (Schneeweis and Gupta 2006):
Caxton Associates, LLC;

Kingdom Capital Management LLC;
Moore Capital Management, LLC;
Renaissance Technologies Corp.;
1
Section 1a(5) CEA contains the definition of a CPO; Section 1a(6)(A) contains the definition of a
CTA. An advisor in hedge funds does not fall under those descriptions, provided that he/she
invests in swaps and in forward contracts of synthetic futures contracts only.
2
See: Section 4m(1) of the CEA. A person generally registers with the CFTC as a CPO or a CTA
by filing a completed Form 7-R and certain supporting materials with the National Futures
Association (NFA), the self-regulatory organization governing the commodities markets.
17 C.F.R. Section 3.10.
5.2 The Concept of Managed Futures Investments
97
SAC Capital Advisors, LLC;

Tudor Investment Corporation;
Pacific Alternative Basset Management Co.; LLC.
Initially, the primary object of investments realized under the managed futures
mostly involved the futures contracts on commodities. Currently, however, the
futures contracts on various types of primary instruments constitute the subject of
trade. Four basic classes of managed futures investments can be distinguished:
Goods and commodities,

Financial instruments and metals,
Currencies,
A diversified portfolio of the above mentioned classes of assets.
5.2
The Concept of Managed Futures Investments
The term managed futures signifies a manner of operating on the futures market,
through authorizing the advisors to manage money on the futures market, on behalf
of the client. The term Commodity Trading Advisor literally means an advisor on
the commodities market, therefore it can be somehow misleading. Commodities,
that is goods/products, are associated, for instance, with agricultural products,
precious metals, petroleum and many other physical assets, which can constitute
a base for a transaction on the futures market.
In financial terminology, the term Commodity Trading Advisor (CTA) signifies
a professional, whose activities are also related to currency markets, the futures
markets, financial instruments, and to stock indices. Managers are supervised by the
National Futures AssociationNFAan American institution regulating the
futures markets. A CTA license is issued by the Commodity Futures Trading
Commission (CFTC). It is worth to emphasize the fact, that CTAs also undergo a
thorough check by the FBI and are obliged to carry out financial audits, which are
then evaluated by appropriate authorities supervising the futures markets.
The term managed futures often is translated into other languages as managed
accounts and investment programs. In fact, this term entails the whole industry
based on advisory of specialized consultants, who use the derivatives as profit
developing tools (Schneeweis 1998). This activity is therefore associated with
active investing on the futures market. The purpose of investing assets on the
derivatives market is diversification of the investment portfolio and an ongoing
speculation, which allows profiting from future the price changes of financial
instruments.
The first managed accounts, as an alternative type of investment, appeared at the
end of the 60s, however, interest in this type of investments increased at the end of
70s of the twentieth century. Increasing demand for derivatives was mainly related
to increasing risk on the international financial market and to possibilities of
transferring that risk, which the futures transactions offered. Rapid development
98
Fig. 5.1 Structure of the
options and futures market,
according to the primary
instrument, in 2013 (Futures
Industry Association 2015)
5
2%
2%
Individual Equity
4%
Equity Index
5%
30%
6%
Interest
Currency
10%
Agriculture
Energy
Non-Precious Metals
15%
27%
Precious Metals
Other
on the derivatives market became a stimulus for development of managed futures

investments. According to Barclay Hedge Ltd, which monitors the market of
alternative investments, the value of the assets invested in managed accounts
worldwide was 330 billion USD at the end of the 3rd quarter of 2013, while
10 years earlier it had reached 75 billion USD (www.barclayshedge.com, accessed:
July 27, 2014).
Derivatives encompass the following: forward contracts, futures, options, warrants and swaps. The futures contracts offered on many stock exchanges constitute
primary subjects of investments in managed futures transactions. As such, they are
standardized instruments. Daily marking-to-market allows minimization of the
credit risk associated with transaction counterpartys insolvency. Currently, the
futures market offers a wide range of primary instruments, which constitute the
basis for futures transactions. It should be underlined, however, that the futures
contracts are symmetrical instruments, which oblige both parties to honor the
contract at the transactions maturity. These instruments use a leverage, which
multiplies potential profits or losses of those participating in a transaction.
Figure 5.1 shows the structure of futures and options contracts, in terms of the
primary instrument. It can be seen, that the futures and options contracts on
individual equity (30 %) and on equity indexes (24 %) had the biggest share in
the derivatives market. The futures and option contracts on interest rates constitute
about 9 % of the futures markets value.
While analysing the market of alternative investment according to the place of
transaction conclusion, it can be noticed, that 38 % of the transactions were
concluded in North America, more than one third on Asia Pacific, and Europe
constitutes one fifth of the entire market. Figure 5.2 presents global futures and
options volume by region in 2013.
Very rapid growth of trading the derivatives as well as the expanding range of
these products offered globally, have created a wide spectrum of portfolio diversification possibilities, both geographically as well as based on the primary assets
constituting the subject of a transaction. Table 5.1 presents the selected top
5.3 Forms of Managed Futures Investments

Fig. 5.2 Structure of the
options and futures market
by region in 2013 (Futures
Industry Association 2015)
99
2%
7%
North America
38%
20%
Asia Pacic
Europe
Lan America
Other
33%
20 Futures and options contracts in 2013 traded on global exchanges worldwide

which were the subject of most intensive trading continentally.
5.3
Forms of Managed Futures Investments
A decision about investing through the accounts managed by order alternatively

means: entrusting own capital to be managed by a professional CTA on an individual account, or joint investment using managed futures funds specializing in
such transactions. Based on this information, three basic forms of managed futures
investments can be distinguished (Anson 2006):
1. Investing through public institutions of collective investment (public commodity
tools).
2. Investing through private institutions of collective investment (private commodity tools).
3. Investing through individual managed accounts.
Managed futures funds are similar to hedge funds in their construction and their
manner of operating. Such a fund is managed by the so-called general partner. An
entity functioning as a manager, in general, is obliged to obtain permits from the
Commodity Futures Trading Commission and the National Futures Association. An
entity obtaining authorization is called a commodity pool operator. Operators of
funds generally employ at least one investment advisor (CTA), who invests the
capital entrusted him/her.
Under a Lungarella and Harcourts (2002) classification, investments can be
divided according to four basic criteria:
The nature of an investment,

The type of analyses used,
The source of a return rate,
The time horizon of an investment.
S&P Sensex Options, BSE
E-mini S&P 500 Futures,

CME
Euro Stoxx 50 Futures,

Eurex
RTS Futures, Moscow

Exchange
Euro Stoxx 50 Options,

Eurex
S&P 500 Options, CBOE
CSI 300 Futures, CFFEX
10
SPDR S&P 500 ETF

Options*
Kospi 200 Options, Korea
Exchange
Equity
CNX Nifty Options, NSE
India
U.S. Dollar Futures, Korea

Exchange
U.S. Dollar/Russian Ruble
Options, Moscow
Exchange
Euro FX Futures, CME
U.S. Dollar Futures, Rofex
U.S. Dollar Futures,

BM&F
U.S. Dollar/Indian Rupee

Futures, mSXI
Options, NSE India
Currency
U.S. Dollar/Russian Ruble
Futures, Moscow
Exchange
Futures, NSE
Futures, BSE*
Soybean Futures,
CBOT
Egg Futures,
DCE*
Cotton
No. 1 Futures,
ZCE
Soy Oil Futures,

DCE
Corn Futures,
CBOT
Rubber Futures,
SHFE
Palm Oil Futures,
DCE
Soy Meal
Futures, DCE
White Sugar
Futures, ZCE
Agricultural
Rapeseed Meal
Futures, ZCE
NY Harbor RBOB
Gasoline Futures,
Nymex
No. 2 Heating Oil
Futures, Nymex
WTI Crude Futures,
ICE Futures Europe
Crude Oil
(LO) Options, Nymex
Gasoil Futures, ICE

Futures Europe
Coking Coal Futures,

DCE
Coke Futures, DCE
Light, Sweet Crude

Oil Futures, Nymex
Henry Hub Natural
Gas Futures, Nymex
Energy
Brent Crude Futures,
ICE Futures Europe
Copper Grade A
Futures, LME
Special High Grade
Zinc Futures, LME
SPDR Gold Shares
ETF Options*
Zinc Futures
Copper Futures,
SHFE
High Grade Primary
Aluminum Futures,
LME
Comex Gold Futures,
Nymex
Iron Ore Futures,

DCE
Silver Futures, SHFE
Metals
Steel Rebar Futures,
SHFE
Euribor Futures, ICE

Futures Europe
Euro-Bobl Futures,
Eurex
10 Year TreasuryNote Options, CBOT
Eurodollar
Mid-Curve Options,
CME
7 Sterling Futures,
ICE Futures Europe
10 Year Treasury
Note Futures, CBOT
One Day Inter-Bank
Deposit Futures,
BM&F
5 Year Treasury Note
Futures, CBOT
Euro-Bund Futures,
Eurex
Interest rate
Eurodollar Futures,
CME
Table 5.1 Selected Top 20 Futures and options contracts in 2013 traded on global exchanges worldwide
100
VIX Options, CBOE
Taiex Options, Taifex 50
Powershares QQQ ETF

Options*
iPath S&P 500 VIX Short
Term Futures ETN
Options*
iShares MSCI Emerging
Markets ETF Options*
13
14
15
Long Gilt Futures,

ICE Futures Europe
Euro-Bund Options,
Eurex
Options, CBOT
IDI Index Options,

BM&F
Euro-Schatz Futures,
Eurex
DI x US Dollar FRA
Futures, BM&F
Eurodollar Options,
CME
3 Year Treasury
Bonds Futures, SFE

Futures, CBOT
30 Year Treasury
Bond Futures, CBOT
*Traded on multiple U.S. options exchanges
20
19
18
17
Bank Nifty Options, NSE

India
S&P BSE 100 Options,
BSE
E-mini Nasdaq
100 Futures, CME
iShares Russell 2000 ETF

Options*
12
16
Nikkei 225 Mini Futures,

OSE
11
Euro/Russian Ruble
Futures, Moscow
Exchange
Options, USE
Mexican Peso/U.S. Dollar
Futures, Mexder
Canadian Dollar Futures,
CME
U.S. Dollar/Rand Futures,

JSE
Euro/U.S. Dollar Futures,
Moscow Exchange
British Pound Futures,
CME
Australian Dollar Futures,
CME

Options, BSE*
Japanese Yen Futures,

CME
Rapeseed Oil
Futures, ZCE
Live Cattle
Futures, CME
Lean Hogs
Futures, CME
Soybean
Options, CBOT
Sugar #11
Futures, ICE
Futures U.S.
No. 1 Soybean
Futures, DCE
Soybean Oil
Futures, CBOT
Corn Options,
CBOT
Soybean Meal
Futures, CBOT
Wheat Futures,
CBOT
Brent Oil Futures,

Moscow Exchange
EUA Futures, ICE
Futures Europe
Henry Hub Swap
(NN) Futures, Nymex
Brent Crude Oil Last

Day Futures, Nymex
U.S. Oil Fund ETF
Options*
Natural Gas Futures,
MCX
Brent Crude Opt. on
Fut., ICE Futures
Europe
U.S. Natural Gas
Fund ETF Options*
Natural Gas
European-Style
Options, Nymex
Crude Oil Futures,
MCX
Standard Lead
Futures, LME
Gold Futures, Moscow Exchange
Silver M Futures,
MCX
Comex Silver
Futures, Nymex
Silver MIC Futures,

MCX
Primary Nickel
Futures, LME
Comex Copper
Futures, Nymex
Aluminum Futures,
SHFE
iShares Silver Trust

ETF Options*
Gold Futures, SHFE

101
102
Investment approach
Systematically
According to the
manager
A combination of
systematic approach
and one based on the
managers
knowledge
Type of analyses
Technical analysis
Source of return-rate
Based on the
trend-theory
Fundamental
analysis
A combination of
technical and
fundamental
analyses
Investment Horizon
Short-term
Medium-term
Not based on the

trend-theory
Long-term
Diagram 5.1 Classification of managed futures investments (Lungarella and Harcourt 2002)
A more detailed classification considering the above mentioned criteria is

Currently, managed futures transactions include methodical and mature industry
entailing different variations of the investment strategies used. Barclay indicates
that the value of the assets in CTA management can be equal to around 312.6 billion
USD (2014) (www.barclays.co.uk, accessed: July 10, 2014).
Public managed futures funds (Public Commodity Pools) are presented to
investors through a public offer, therefore access to this type of investments is
open for all those potentially interested, who have an appropriate amount of capital.
Before their release into public trade, these funds are obliged to register their
business activity. This means, that they need to apply for a registration with the
Securities Exchange Commission. Lower entry levels, compared to the ones in
private funds, undoubtedly are an advantage of investing in public funds. A
relatively high liquidity of fund units allows a fast withdrawal of the cash assets
from the investment.
Private funds (Private Commodity Pools) are mainly sold to wealthy individual
investors (High-Net-Worth Investors) and to institutional investors. Private funds
are not obliged to register their business activity with the SEC. They also are not
obliged to report on their business activity to the CFTC. A lower margin of the
brokers profit and greater flexibility in implementation of sophisticated investment
strategies are advantages of private funds.
It is also possible to invest in futures contracts through individual managed
accounts. Managed account is a simple form of investment, which involves an
investor openingin his/her own namea broker account at one of licensed
brokerage firms and signing a contract granting the power of attorney for a
specialized advisor (CTA) to manage that account. Such transactions are carried
103
out as assessment management services. Investing accordingly with the investors

profile, high transparency of transactions and high liquidity are advantages of
this form of money allocation. Undoubtedly however, high entrance levels,
which means that such services are available only for wealthy investors, are its
disadvantage.
The discussed above classification of managed futures investments ignores the
option of investing in managed futures indices. Schneeweis and Gupta (2006)
provide a more extensive classification of the Managed Futures investments,
which distinguishes the following:
Investing in CTAs using managed accounts,

Investing in private or public investment funds,
Investing in active managed futures indices,
Investing in managed futures indices.
Investing through managed accounts and through investment funds has also been
discussed on the basis of the above classification. Investing in indices, described as
active, is a flexible management strategy involving a smooth and frequent use of
long and short positions, depending on the expectations associated with the price
changes. Profitability of such operations highly depends on the abilities and competency of the people responsible for the management process.
Most recognized active indices are: S&P Managed Futures Index created by
Standard&Poors, the BTOP50 index created by Barclay Group, as well as indices
created by Credit Suisse First Boston (CSFB)/Tremont Partner. They are built
based on the data obtained from those, who voluntarily report to the databases
managing managed futures investments. Each index has a different construction.
The Barclay CTA index is a reference index for the managed futures industry. This
index is calculated based on information obtained from 429 investment programs
with at least 4-year history of business activity.
Passive investing makes profitability of indices dependent on long-term return
rates from the markets constituting the subject of an investment. Passive management, also called passive investment, is a financial strategy where the funds
manager makes as little as possible investment decisions regarding the portfolio.
Lack of activity is meant to minimize the transaction costs.
Primary Commodity Managed Future indices are divided into three categories.
First category includes commodity indices based on the return rates of the future
contracts and the return rates of the spot market. This group includes such indices
as: CRB, Goldman Sachs, Chale Manhattan, Commodity Index, Dow Jones-AIG
Commodity Index, JPMorgan. The second group entails indices based on current
CTA condition. This group includes such indices as: MAR, Barclay, TASS and
EACM Global Basset Allocators. The third group of indices guarantees return rates
comparable with the results achieved from passive long/short positions on listed
future contracts. Exemplary managed futures investment indices are presented in
Table 5.2.
104
Table 5.2 Selected managed future indices

Active indices
Passive indices
5.4
S&P Managed Futures Index

BTOP50
CSFB Managed Futures Investable Index
CSFB Sector Invest Index
Barclay CTA Index
MAR (Managed Account Reports) Indexes
MLM (Mount Lucas Management) Index
Dow Jones-AIG Commodity IndexSM (DJ AIG CISM)
Commodity Research Bureau Index (CRB Index)
Goldman Sachs Commodity Index (GSCI)
Reuters-CRB Total Return Index
Application of Managed Futures Transactions
Managed futures investments, similarly to other alternative forms of investment,

should be treated as complementary to the investment portfolio. Numerous benefits
associated with incorporation of the managed futures transactions into the investment portfolio can be indicated. Most commonly these advantages include:
Possibilities to reduce the investment portfolios risk,

An opportunity to increase the total return rate of the portfolio,
Ample opportunities of diversifying the portfolio,
Possibility of profiting during a period of increases as well as during declines of
the prices on the market, due to the possibility of taking both long and short
positions.
Primary advantage resulting from complementing a portfolio with managed

futures investments is a limited portfolio volatility. Reduction of the risk is possible
due to transactions carried out within the portfolio, in various areas of international
financial market, which are strongly positively correlated with traditional instruments. According to Markowitzs (1952) theory, an investment portfolio composed
of uncorrelated investment instruments leads to a lower risk and higher return rates
than the average for these investments. Lack of correlation between the managed
futures transactions and the stocks and bonds has been recognized in numerous
scientific studies (Lintner 1983; Edwards and Liew 1999; Edwards and Caglayan
2001; Fung and Hsieh 2001).
Many examples of the studies focused on the benefits of incorporating managed
futures investments in the portfolio of assets can be specified.3 Numerous studies
indicate, that the contracts on commodities, which allow particularly effective
The following studies should be mentioned: S. Irwin, W. Brorsen, (1985); S. Irwin, D. Landa,
(1987); G. R. Jensen, J. M. Mercel (2001); C. M Conover, G. R., Jensen, R. R., Johnson, & J. M.
Mercer, (2010).
5.4 Application of Managed Futures Transactions
105
Table 5.3 Correlation coefficient of return rates from selected classes of assets (BarclayHedge
2014)
Class of assets
Managed futures
U.S. stock
Bonds
Real estate
Managed futures
1.00
0.01
0.02
0.01
U.S. Stock
0.01
1.00
0.19
0.58
Bonds (3)
0.02
0.19
1.00
0.2
Real Estate (4)

0.01
0.58
0.2
1
Correlation coefficients calculated on the basis of the data from the period of 1980 to 2012
portfolio diversification4 or even protection against inflation,5 carry specific

benefits.
Table 5.3 shows a correlation dependency between the managed futures investments and two other selected classes of assets, that is, American stocks bonds and
real estate. This dependency was measured using a coefficient of Pearsons linear
correlation, based on the data from 1980 to 2012. Indices are treated as a substitute
of the market portfolio.
Managed futures have compared favorably with stocks and bonds over the past
30 years and has the potential to profit in various economic environments. Since
managed futures have the ability to use the prive trends in different markets to its
advantage, they can profits during the periods of losses for other investments
(e.g. stocks and bonds). The managed futures performance during the worst
peak-to-valley declines of stocks, long-only physical commodities, bonds, and
real estate is illustrated by Table 5.3.
The results of the calculations indicate, that the managed futures transactions
expressed by the Barclay CTA Index were positively correlated with American
stocks, however, the value of the correlation coefficient was low. Empirical observations thus confirm, that addition of the managed futures investments to a classic
stocks portfolio allows reduction of the overall risk of the portfolio; keeping in
mind though, that the so-called total risk is a sum of two components: a systematic
risk, also called the market risk, and a specific risk, nonsystematic risk. Skillful
diversification of a portfolio allows almost complete elimination of the specific risk,
without impacting the systematic risk.
Table 5.4 shows selected statistics for the managed futures transactions, calculated on the basis of the data form 1990 to 2005. Managed futures transactions have
been expressed using the CISDM indices. The CISDM database, also known as
MAR/Hedge, is one of the oldest, most comprehensive and highly reputable among
market participants databases. It was created in 1979, while CISDM indices were
developed and constructed in 1980. Since then, it has been collecting information
4
The following studies should be mentioned: B. Bjornson, C. Carter, 1997. G. Jehnsen ,
R. Johnson, J. Mercel, 2000; Conover, C. M., Jensen, G. R., Johnson, R. R., & Mercer, J. M.
(2010).
5
The following studie should be mentioned: Z. Bodie, Spring 1983, Bodie, Z., & Rosansky, V. I.
(1980). Spierdijk, L., & Umar, Z. (2013).
106
Table 5.4 Selected statistics of indices, during the years 19902005 (Schneeweis et al. 2008)
Index
CISDM CTA
Asset
Weighted
Index
CISDM CTA
Equal
Weighted
Index
CISDM CTA
Asset
Weighted
Currency
Index
CISDM CTA
Asset
Weighted
Diversified
Index
CISDM CTA
Asset
Weighted
Financials
Index
CISDM CPO
Asset
Weighted
Index
S&P 500 Total
Return
Lehman Govt/
Corp
Average
annual
return rate
(in %)
10.47
Standard
deviation
(in %)
9.77
Tendency
0.71
Curtosis
2.28
Correlation
with the
S&P Index
0.08
Correlation
with the
Lehman
Govt/Corp.
Index
0.28
8.89
9.43
0.52
0.66
0.14
0.26
8.87
11.53
1.55
5.34
0.06
0.15
8.86
11.26
0.44
0.63
0.12
0.27
11.94
12.62
1.02
3.63
0.08
0.33
8.23
9.42
0.73
2.81
0.12
0.30
10.55
14.32
0.45
0.73
0.13
0.31
7.42
4.42
0.44
0.77
0.13
1.00
on managed futures transactions. Currently, over 700 CTAs and CPOs advisors are
reporting to it.
The results presented in Table 5.4 constitute research material, which allows
drawing many interesting conclusions. All managed futures indices were characterized by a volatility level lower than that of S&P Index. It may also be noticed, that
the average annual return rate from the S&P Index, during the research period, was
10.55 % and was comparable or slightly higher than most return rates from the
managed futures indices. The table also includes correlation coefficients of the
CTA and CPO indices with S&P 500 stocks index. Almost all managed futures
indices were weakly negatively correlated with the S&P 500 Total Return Index.
5.5 Automated Transaction Systems in the Activity of Commodity Trading Advisors
107
Analysis of managed futures investments would be incomplete without indicating their limitations. First of all, it should be underlined, that these investments
are characterized by a high investment risk, similarly to majority of investments in
derivatives. Leveraging has a significant impact on the risk level. A high leverage
level can mean high profits, but also, in case of price changes it can go in the
opposite directionvery heavy losses. What is more, managers do not guarantee
that the investor will achieve the desired financial results. Often, simulations carried
out on the models, which work well on historical quotations, may prove to be
inadequate for future analysis of the data. This means, that investors should be
prepared for different variants of final financial results. The drawndown ratio,
which allows calculation of the highest cumulated loss in the history of the analyzed
CTA, is an analytical tool which can be very practical for investors. The indicator
shows the level of the investors potential loss, in case of a payout of the capital at
the worst moment in the CTAs operation period. An investor planning to invest
using managed futures should also be prepared to incur high transaction costs.
Standard fees reach about 2 % of the value of the invested funds, and additionally,
the fees charged from the profit reach 2035 %. Investing in CTAs who have been
active for less than 5 years is also risky.
5.5
Automated Transaction Systems in the Activity

of Commodity Trading Advisors
Investing in managed accounts and in investment programs is equivalent to using

managed futures strategies. This strategy is very similar to the macro-type strategy.
Both strategies are directed at investing in the futures contracts listed on global
exchange markets. Managed futures investments most often use the so-called
automatic transaction systems, which are meant to make decisions with exclusion
of the human factor and human emotions.
A transaction system defines the rules of concluding transactions on the financial
market. Automatic investment systems operate within a specially developed investment strategy, often based on the trend following theory. The strategy, in its
assumptions, implies that there is a possibility of generating income during the
bull and bear market. As such, the models programmed are meant to follow the trend
are. Comparison of the global macro and CTAs strategies is presented in Table 5.5.
Moreover, they are to ensure security of a transaction through programming a
maximum level of risk for a given market position. The mans role comes down to
designing and controlling the activities undertaken within the framework of the
developed system. Such approach is aimed at eliminating emotions being the factor
influencing subjective assessment of the situation on the market. All open positions
are monitored on an ongoing basis, thus preventing an increase of the risk above a
predetermined level. Continuous updating the stop-loss limits allows adaptation to
the price changes on the markets. Based on the analysis of historical data conducted
within the framework of the programmed system, buy and sell signals are sent out.
108
Table 5.5 Comparison of the global macro and CTAs strategies

Global macro
This strategy uses a very broad spectrum of
instruments, beginning with stocks and bonds,
currencies, and ending with complex
derivatives
It is mainly based on analysis of a fundamental
nature
It is often characterized by decisions made by
people, not by computer transaction systems
and are based on subjective assessment of the
market
Decisions are made in teams specializing in the
financial instruments being traded
5.6
CTAs
The strategies used by CTAs use derivatives
only
Decisions made within those managed futures

investments often result from immediate
decisions, not from those backed by analysis
The managed futures strategy most
commonly is based on automatic transaction
systems, in which the human factor is eliminated, such decisions are based on the market
models
CTAs generally base their actions on one or
two persons managing the portfolio
The Forecasts of Managed Futures Investments
The value of managed accounts (CTAt) during the period between 2000 and 2013
increased over eightfold. We examined how did the wealth level per one adult, the
current one as well as the delayed by 1 and 2 years impact this variable. A
possibility of occurrence of an autoregressive-trend process in the variable CTAt
was checked. It turned out, that autoregression did not occur, while a linear trend
did. An empirical equation describing the variable CTAt has the following form:
CTAt 11:832 3:596bfinad t 4:834bfinad t2 28:375t uCTAt ;
0:338
3:045
3:468
14:09
5:1
R2CTA 0:993, SuCTA 8:924, V CTA 4:39 %:

Each explanatory variable of the above equation is statistically significant at a low
level of significance ( < 0.01). A trend, as well as the current and the delayed by
2 years level of the financial assets value per one adult citizen of the world explain
99.3 % of the volatility of managed accounts.
The average annual increase in the value of managed accounts during the years
20002013 was equal to 28.375 billion USD. An increase of the variable bfinadt by
1000 USD entailed an increase in the value of the managed accounts, on average, by
3.596 billion USD. An increase in the value of the financial assets, which are
represented by the variable bfinadt, prior to 2 years, by 1000 USD, resulted in a
decrease in the value of managed accounts, on average, by 4.834 billion USD. This
means that the owners of the financial assets make financial corrections of their
financial investments generally every 2 years.
Equation (5.1) has a very high stochastic characteristics, which allows its use for
estimation of the forecasts of the variable CTAt. The condition for this estimation is
having the forecasts of the values of the financial assets per one adult. These
5.6 The Forecasts of Managed Futures Investments
109
Table 5.6 Forecasts of the values of global financial assets per one adult citizen (bfinadTp) for the
years 20142016
Forecasted
period
2014
2015
2016
Average prediction
error
2.4157
2.5708
2.5906
Forecast of bfinadTp
(thousands $)
31.086
32.563
33.610
95 % confidence
interval
25.70336.468
26.83538.291
27.83839.382
Table 5.7 Forecasts of the values of managed accounts (CTATp) for the years 20142016
Forecasted
period
2014
2015
2016
Forecast of CTATp
(billion $)
380.8
421.9
441.1
Average prediction
error
11.44
13.48
12.66
95 % confidence
interval
354.5407.2
390.8452.9
411.9470.3
500
CTA
Forecast
95% interval
450
400
350
300
250
200
150
2008
2009
2010
2011
2012
2013
2014
2015
2016
Fig. 5.3 Forecasts of the values of managed accounts (CTATp) for the years 20142016
(Table 5.7)
forecasts were estimated earlier, during forecasting of the hedge funds, and are
presented in Table 5.6.
Forecast estimations of managed accounts (CTATp) are presented in Table 5.7
and on Fig. 5.3.
The calculations indicate, that if the values of the financial assets per one adult
will increase up to an adequate level, further increases in the values of managed
accounts can be expected. The expected value of managed accounts in the year
110
2014 can reach the level of 380.8 billion USD. In 2015, the value of managed
accounts can exceed the amount of 420 billion USD, while in 2016 it can be
expected to exceed the value of 440 billion USD.
References
Anson, M. J. (2006). Handbook of alternative investments. New York: Willey.
Bjornson, B., & Carter, C. A. (1997). New evidence on agricultural commodity return performance under time-varying risk. American Journal of Agricultural Economics, 79(3), 918930.
Bodie, Z. (1983). Commodity futures as a hedge against inflation. The Journal of
Portfolio Management, 9(3), 1217.
Bodie, Z., & Rosansky, V. I. (1980). Risk and return in commodity futures. Financial Analysts
Journal, 36(3), 2739.
Chance, D. M. (1994). Managed futures and their role in investment portfolios. Charlottesville,
VA: The Research Foundation of the Institute of Chartered Financial Analysts.
Conover, C. M., Jensen, G. R., Johnson, R. R., & Mercer, J. M. (2010). Is now the time to
add commodities to your portfolio? The Journal of Investing, 19(3), 1019.
Edwards, F. R., & Liew, J. (1999). Hedge funds versus managed futures as asset classes. The
Journal of Derivatives, 6(4), 4564.
Edwards, F. R., & Caglayan, M. O. (2001). Hedge funds and commodity fund investments in
bull and bear markets. Available at SSRN 281522.
FoxAndrews, M., & Meaden, N. (1995). Derivatives, markets and investment management.
London: PrenticeHall.
Fung, W., & Hsieh, D. A. (2001). The risk in hedge fund strategies: Theory and evidence from
trend followers. Review of Financial studies, 14(2), 313341.
https://fia.org. Accessed March, 2015.
Irwin, S. H., & Landa, D. (1987). Real estate, futures, and gold as portfolio assets. The Journal of
Irwin, S. H., & Wade Brorsen, B. (1985). Public futures funds. Journal of Futures Markets, 5(2),
149171.
Lintner, J. V. (1983). The potential role of managed commodity-financial futures accounts
(and/or Funds) in portfolios of stocks and bonds. Division of Research, Graduate School of
Business Administration, Harvard University.
Lungarella, G., & Harcourt, A. G. (2002). Managed futures: A real alternative. White Paper.
Markowitz, H. (1952). Portfolio selection. The Journal of Finance, 7(1), 7791.
Peters, C. C., & Warwick, B. (Eds.). (1997). The handbook of managed futures: Performance,
evaluation and analysis. New York: McGraw Hill.
Schneeweis, T. (1998). Dealing with myths of hedge fund investment. The Journal of
Alternative Investments, 1(3), 1115.
Schneeweis, T., & Gupta, B. (2006). Diversification benefits of managed futures. Journal of
Investment Consulting, 8(1), 5362.
Schneeweis, T., Gupta, R., & Szado, E. (2008). The benefits of commodity investing. Investment &
Wealth Monitor.
Sokoowska, E. (2009a). Alternative investments: Managed futures. Acta Universitatis Nicolai
Copernici, Ekonomia, 40, 215226.
Sokoowska, E. (2009). Pochodne instrumenty pogodowe w zarzadzaniu ryzykiem. Prace
Naukowe Uniwersytetu Ekonomicznego we Wrocawiu, Zarzadzanie finansami firm: teoria i
praktyka, (48), 736743.
Sokoowska, E. (2009c). Managed futures jako inwestycja alternatywna. Acta Universitatis
Nicolai Copernici Ekonomia, 40, 215226.
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Spierdijk, L., & Umar, Z. (2013, April 25). Are commodity futures a good hedge against inflation?
(Netspar Discussion Paper No. 11/2010-078). Available at SSRN: ttp://ssrn.com/abstract=
1730243orhttp://dx.doi.org/10.2139/ssrn.1730243.
Wisniewska, E. (2007). Giedowe instrumenty pochodne. Warszawa: CeDeWu.
Chapter 6
Structured Products
6.1
The Concept of Structured Products
Structured products are a combination of traditional investments into stocks and

bonds with investments in derivatives. A combination of traditional instruments
with more innovative ones allows the investors to generate higher return rates. A
traditional instrument is meant to protect the capital invested in an investment. A
derivative is meant to multiply an income. Creation of asymmetrical payout profiles
is possible by using e.g. options. Such financial vehicles are designed to better fit
the changing conditions on the financial market. Development of the market of
structured instruments is an answer to the changing investor demand. The current
low interest rates environment and a simultaneous decrease in attractiveness of
bank deposits has motivated individual investors to become interested in structured
products, which offer potentially higher return rates. The demand for structured
products is also linked to the exposure to risk of those assets, which are not
necessarily available to the investors on the base market. Structured products,
similarly to other alternative investments, also allow the possibility of diversifying
the investment portfolio, thus allow reduction of the investment risk and provide
access to various investment structures. Some of these structures also enable tax
savings (unit-linked products).
Currently, there are many structured products offered on the stock market and
over the counter market (OTC). Often, various names are used to describe the same
structures. A classic structured product consists of two elements: a traditional debt
instrument and a derivative.1 Exemplary market databases, which can constitute the
basis for calculating the amount of the interest paid out, include i.e.: short-term and
long-term interest rates, exchange rates, stock exchange indices (global and local),
stock prices or commodity prices (for example the prices of precious metals, energy
carriers, agricultural commodities, etc.).
1
In structured products, an option often is a derivative.

DOI 10.1007/978-3-319-13215-0_6
113
114
6 Structured Products
Although structured products have been present on the market for almost
10 years, they have not been defined in a uniform manner. Also, there is no single,
official definition in most legislations either. The financial market has adopted a
description of structured products as complex instruments composed of at least two
elements.
According to the definition used on the Warsaw Stock Exchange, structured
products should be understood as financial instruments, whose price depends on a
specific market index (e.g. stock rate or the rate of the baskets of shares, the value of
stock exchange indices, the price of resources, currency exchange rates) (http://
www.gpw.pl). By investing in a particular security, the investor gains an opportunity of a relatively simple participation in the changes of foreign indices, share
baskets and/or resource prices, such as gold or oil.
According to a different definition taken from foreign literature, structured
products are hybrid products often composed of the assets bringing a fixed income
(e.g. bonds) and of at least one derivative. Issuer of a structured product, in relation
to the buyer (investor), covenants to pay him/her a settlement amount calculated
according to a specific formula, at the maturity of a given investment. The formula
defining payout rules allows the owners of those instruments to calculate the current
value of a given instrument. Drawing on literature, many more various formulated
definitions of structured products can be found. Swedroe and Kizer (2010) define
structured products as packaged synthetic investment products designed to meet
those expectations of investors, which are not met by available financial instruments. Another definition states that structured products are combinations of
derivatives with traditional instruments, such as stocks or bonds.
The definition provided by the Securities Exchange Commission emphasizes the
fact, that structured products are instruments, in which cash flows depend on one or
more various indices. What is more, they have a built-in derivative or another
instrument. The attached instrument determines the investors potential income, as
well as defines the issuers obligations resultant from the changes of that instruments value. A definition used on the Pacific Stock Exchange describes structured
products as products based on specific assets or on a basket of assets, such
as. shares, indices, commodities, currencies, debt instruments, and many other
instruments.
The above facts show, that the multitude of structured products is sort of a barrier
on the path to creation of a universal definition of those instruments. Due to an
extremely dynamic development of the structured products market, especially in
the EU countries, it is important that a proposed definition should not prevent
further development of various constructions of those instruments. Despite the
lack of a universal definition of structured products, it is possible to distinguish
some characteristic features most of those instruments exhibit. Structured products
are characterized by the following features:
Possibility to preserve the capital, which can be fully or partially secured,
A specific duration of the investment,
6.2 The Types of Structured Products
115
Possibility to obtain a return rate, the amount of which is calculated based on a

specific formula,
An embedded derivative instrument.
According to Wallmeier (2011), this can be caused by the complexity of the
products sold, by lack of financial education for individual investors, as well as by
behavioral factors. Hens and Rieger (2009) in their study indicate, that for rational
investors the benefits arising from using structured products are scant. On the other
hand, Henderson and Pearson (2011) present a hypothesis, that issuance of structured products, which belong to innovative and very complex instruments, seeks to
exploit information asymmetries. Since assessment of structured products profitability is not easy, the investors who are unaware of the risk associated with those
instruments can incur unexpected losses, which may reduce their confidence in
financial markets and institutions.
Good knowledge of the possible constructions of structured products has positive impact on the investors investment decisions and facilitates management of
investment portfolios.
6.2
The Types of Structured Products
Generally, structured products have a defined minimum level of capital warranty or

are characterized by a guaranteed minimum return rate. Under this classification,
they can be divided into:
The products characterized by a full capital protection, where investment risk is
limited to the amount of a potential return rate,
The products characterized by partial protection of the capital, where a
percentual value of the protected capital is predetermined,
The products without capital protection, which are characterized by high investment risk, but allow achievement of higher profit.
Structured products characterized by capital guarantee often have a defined limit
of a possible return rate (the so-called cap). Typically, before purchasing structured
products, one can become familiar with the mathematical formula on which the
profit will depend, according to the changes of the base instrument, at the moment
of their expiry. Payouts from structured instruments commonly occur once, usually
at the maturity of an instrument.
According to their construction, structured products can be divided into (http://
www.barclaysstructuredproducts.com):
Structured certificates,
Products enabling a maximum return rate,
Products ensuring capital protection.
116
Structured certificates replicate the price changes of the primary instrument

constituting the basis of a transaction. They enable investors to operate on a
particular market, in a specific sector, or to use a defined scheme by a single
transaction.
The products allowing a maximum return rate usually are formed by a combination of a primary instrument with an option. They are directed to those investors,
who are willing to take a higher risk.
Products ensuring capital protection also are a combination of items in a primary
instrument with an item in an option. The main difference between the products
allowing a maximum return rate and the products ensuring capital protection is a
different profile of the risk option. Possible items allowing construction of the
structured products that are characterized by certain parameters will be presented,
in detail, further in this chapter.
As already mentioned, a whole set of derivatives can be used to construct
structured products. While classifying structured products according to a reference
base, they can be divided into the following categories:
The products and the deposits based on interest rates (interest rate-linked notes
and deposits),
The products and the deposits based on shares (equity-linked notes and deposits),
The products and the deposits based on currencies and on commodities (FX and
commodity-linked notes and deposits),
Hybrid products and deposits (hybrid-linked notes and deposits),
Credit products and deposits (credit-linked notes and deposits),
The products and the deposits connected with the market (market-linked notes
and deposits).
It is worth noting, that the range of the products which can form a reference base
for structured products, is currently expanding. It is possible to construct structured
products connected with e.g. investment funds, funds of funds, hedge funds as well
as with the ratings (of companies, countries), inflation level, with the weather
conditions or with mortality level.
Depending on the time of maturity, structured products can be divided into:
Short-term ones,
Medium-termed ones,
Long-term ones.
Structured products also can be divided according to the nature of investment.
Considering such criterion, we can distinguish the following:
Investment products characterized by a longer, few-year lifetime; investors
expect a profit after a longer period of time; those for example include structured
bonds,
Speculative products based on indices or on stocks of a relatively short time
horizon, from few months up to 1.5 years; they include e.g. certificates.
6.2 The Types of Structured Products
117
Raiffesen Research classification of structured products takes into account the

amount of the invested capital and divides them into two main groups:
Leveraged products,
Investment products.
Leveraged products are instruments, which in their construction use a financial
leverage. For those products, basic assumption is to allow realization of a specific
investment goal through a relatively low amount of capital. This is possible by
using a leverage effect. Such strategies, however, are subject to higher risk.
Exemplary types of leverage products, according to Raifaissen Research, are
Diagram 6.2 shows selected examples of structured products, in which leverage
is not applied.
Diagram 6.1 Selected

structured leveraged
products (Hirsch and Reindl
2006)
Leveraged products
Warrant Options
Diagram 6.2 Selected

structured products (Hirsch
and Reindl 2006)
Options with an exit

barrier, certificates
Turbo, mini-future
certificates
Exotic products
(special warrants)
Investment products
Investment certificates
Index certificates
Discount certificates
Open-end certificates
Cash-or-Shares certificates
Bonus certificates / with partial capital security warrants
Express certificates
Guaranteed certificates
Basket certificates / sector-type /
Strategy-type certificates / Sprint certificates
Outperformance
and others
118
6.3
The Construction of Structured Products
An important advantage of structured products is the possibility to fit their offers

to various expectations of investors in connection with future price changes.
Diagram 6.3 shows possible payout profiles of structured products, depending on
their construction. Appropriate constructions of structured products can be fitted to
both, the anticipated rising prices on the market to the anticipated price declines.
The constructions of structured products used in anticipation of future rising prices
are presented in Diagram 6.3.
The graph on the left side of the diagram presenting possible constructions of
investment products shows a payout profile of an investor, who expects a future
increase in the price of the primary instrument.
The middle chart, where a final payout profile is composed of a combination of
an option with a primary instrument, is characterized by a risk profile of the sale
options issuer. Such position is used when an investor expects a future increase of
the price of a primary instrument. The investor sells the sales options and accepts a
higher risk, while receiving a bonus for the option and takes a long position in the
base instrument. Diagram 6.4, on the other hand, shows the constructions of
structured products, which are possible to be used while waiting for future price
declines.
Depending on the situation on the market, the types of structured products can be
attributed to appropriate degrees of risk acceptance on a two-dimension matrix.
Table 6.1 shows selected types of structured products, which meet the investors
expectations during a given market situation, and take into account the investors
attitude to the risk.
Diagram 6.3 The

constructions of structured
products used in
anticipation of future price
increases
Constructions of structured products
6.4 Structured Certificates
119
Diagram 6.4 The

constructions of structured
products used while
awaiting future price
decline
Constructions of structured products
Table 6.1 Risk matrix/the matrix of market trends

The
market
state
Growth
market
The degree of risk acceptance by an investor

High
Certificate
Turbo long purchase
warrants
Medium
Bonus certificate
Index certificate
Side
market
Corridor certificate
Declining
market
Turbo certificate
short warrants of the
sale
Bonus certificate
with an upper limit
Discount certificate
Cash-or-share
certificate
Reverse index certificate
Reverse bonus
certificate
6.4
Low
A certificate with capital protection
Warrants, with participation in the
profits from the market growth
Bonus certificate
Certificate with a large discount
A certificate with a capital protection

Warrants, with participation in the
profits from a declining market
Structured Certificates
Structured certificates are a type of a structured products, which replicates a return

rate of the primary instrument constituting the basis of the transaction. Shares,
baskets of shares, stock indices, interest rates, commodities or other combinations
of financial instrumentsall those can be the primary instrument. Structured
certificates are designed for those investors, who locate their capital on the markets,
in anticipation for a price increase, without using the financial leverage effect. This
means, that a 1 % increase of the base instrument will also cause a 1 % increase of
its value. A more extensive classification of structured certificates involves the
following certificates:
120
Index certificates,
Basket certificates,
Guaranteed certificates,
Bonus certificates,
Discount certificates,
Turbo-type certificates (using a leverage effect).
The demand for each of the above mentioned types of certificates depends on the
investors expectations regarding future price changes of primary instruments.
6.4.1
Index Certificates
Index certificates are instruments based on share indices (index certificates) or on a

basket of shares (basket certificates). An index certificate is a simple form of an
investment in a basket of shares comprising the index. The certificates value is
directly related to the value of the base index. Those instruments allow a purchase
of an index for those base instruments, the purchase of which, under normal
conditions, is not available for an average investor. They are often based on:
Price indices (price indices),
Total indices of return rates (total return indices).
Main global stock indices or the indices reflecting exchange quotes of the
companies coming from a given region are the base instrument of the certificates
based on price indices (Fig. 6.1).
Profit
Withdraw profile for an
index certificate
+10%
+10%
Loss
Fig. 6.1 Payout profile for structured index certificates
The value of a DAX index, in

Euro
6.4 Structured Certificates
6.4.2
121
Bonus Certificates
Structured bonus certificates are instruments directed to those investors, who are
anticipating a sideway trend of the market in the nearest future. Those instruments, similarly to discount certificates, are formed by a primary instrument and
an expiring option, which helps to protect against a risk of a decline of the base
instruments price to a certain level (a barrier). While constructing a particular
bonus certificate, the bonus level, the barrier level and a possible price limit are
determined. Those parameters are determined depending on the time of purchase,
volatility of the base instruments price, as well as on the predictions of a
dividend level. Those parameters remain constant throughout the duration of a
certificate. At the time of certificates issue, its price corresponds to the price of
the primary instrument. Protection of a bonus certificate through an expiring sales
option is active until the primary instruments price decline to the barrier level.
At this point the option automatically expires. The level of the primary instruments price, which will not reach the level of the fixed price barrier nor a price
below that level, is the condition to withdraw the bonus. The bonus is paid out
at the time of the certificates maturity. The amount of the resulting bonus
depends on two basic factors: the primary instruments price at the time of
maturity as well as at the time of the primary instruments price formation during
the duration of the transaction. If the base instruments value is above the bonus
level, the investor will be able to fully participate in price increases (100 %
participation). A bonus certificate allows unlimited participation in the price
increase of the primary instrument, if there is no upper boundary in the form of
an upper limit (cap).
A graphic representation of a payout profile, in respect to ownership of a bonus
certificate, is a Fig. 6.2. The maximum level of a payout from a bonus certificate
depends on the base instruments value at the time of calculating the final settlement
price.
6.4.3
Basket Certificates
Basket certificates are based on a basket of shares, which is a reference base for
structured products. One of the advantages of those certificates is enabling the
investors to replicate the return rate of a selected segment of the market, using one
transaction. The owner of a certificate does not receive an interest payment, but
receives a payout based on a discount formula. Price indices can be the base
instrument for structured products as well. Owner of such a certificate does not
receive an interest payment, but receives an investors profit calculated on the basis
of the discount.
122
Profit
Withdraw profile for a bonus certificate
Exit barrier
(knock-out)
15% bonus
Loss
The value of an S&P index
Fig. 6.2 Payout profile of structured bonus certificates
6.5
6.5.1
Structured Maximum Return Rate Products

Discount Certificates
Construction of discount certificates is based on application an option strategies

called a sales strategy of a covered call option. Discount certificates involve a
purchase of a base instrument and a simultaneous sale of the call option. Due to the
built-in option, the value curve of a certificate can deviate from the value curve of
its base instrument during the period of the certificates duration. Such construction
of discount certificates allows income in case of a price increase of the instrument
constituting the transaction basis as well as during a stagnation period or during
slight declines. Discount certificates are sold with a discount, that is, below their
nominal price. This means, that investment in a discount certificate is cheaper than
investment in a corresponding base instrument. Such construction of a certificate
provides the investors with a possibility of profiting on the markets remaining in a
sideways trend as well as on slightly declining or slightly growing markets.
Purchase of a discount certificate allows the investors to participate in the price
changes of the base instrument constituting the basis of the certificates construction. At the same time, sale of the call option with a strike price (the price of
implementation), at the level of the interest rates upper limit (cap), generates a
bonus for its issuer, which is used to finance the discount. Certificates price can
only increase up to a certain limit, referred to as cap (upper limit of the interest
rate). If the price of the base instrument increases above this limit, the certificate
6.6 Structured Products with Capital Protection
123
Fig. 6.3 Payout profile of structured discount certificates
holder will not be able to profit from the increase of the base instruments price,
above this limit. The value of the discount depends primarily on the strike price of
the option, on the volatility of the base instruments price, and on the maturity of the
certificate. The bigger the volatility of the base instruments price and the longer the
time to maturity, the higher the value of the discount (Fig. 6.3).
6.6
Structured Products with Capital Protection
The third primary group of structured products are the instruments guaranteeing
capital protection. The products guaranteeing capital protection, among others,
include guaranteed certificates and structured bonds. Those instruments are an
alternative to traditional instruments, such as e.g. treasury bills or bonds. The profit
from investments in structured products with capital warranty depends on the
instruments duration, on the issuers credibility and solvency, as well as on
efficiency of primary instruments.
6.6.1
Guaranteed Certificates
Guaranteed certificates are composed of two elements: a bond, which allows capital
warranty at the time of the certificates maturity, and an option. Usually a zerocoupon bond or a bond characterized by a low-interest coupon are used to construct
124
this certificate. The option used to build a certificate usually is exotic in nature.
Guaranteed certificates can be divided into two general categories:
Guaranteed coupon certificates,
Guaranteed participation certificates.
Guaranteed coupon certificates allow a voucher payout, the value of which
depends on the basket of shares included in the primary instrument. There is also
an option of receiving a voucher with a guaranteed fixed interest rate. The certificates value, in this option, depends on the pricing of the primary instrument at the
time of its purchase. Capital protection can mean, that on the day of transactions
maturity, the investor receives the amount, which was defined at the time of a
purchase of the structured product. It is also possible to guarantee various capital
levels. The lower the level of guaranteed capital, the higher the possibility of
obtaining higher profits. The amount guaranteed also can be slightly higher than
the amount initially invested (e.g. by 105 %). Usually, however, the guaranteed
profit is symbolic and rarely exceeds a possible profit from secure instruments.
Structured products plain vanilla (plain vanilla capital protection products) are the
simplest form in this category of structured products. This type of structured
products guarantees a predetermined payout at the time of transactions maturity.
At the same time, those instruments allow participation in the profits arising from
the changes of the primary instrument. The level of participation in the profits is
determined by the so-called participation rate (Fig. 6.4).
Fig. 6.4 Payout profile of the structured products with capital protection
6.6 Structured Products with Capital Protection
6.6.2
125
Structured Bonds
Structured bonds are structured instruments enabling capital warranty. Structured

bonds are financial instruments, which are a combination of two elements:
1. A security of a fixed income (bond) with maturity ranging from few months to a
dozen or so years. Payout from a security is obtained periodically during the
bonds life or on the day of its maturity;
2. A financial instrument influencing the value of the capital during the investment
or on the day of its maturity. It can include other bonds, shares, indices of various
markets (of shares, commodities, real estate), interest rates of investment funds,
currencies, resources or other financial assets.
The design of structured bonds, by definition, is identical with the design of the
certificates guaranteeing capital. The difference results from terminology and from
construction details. Table 6.2 summarizes the above considerations of possible
constructions and types of the structured products available on the market. It also
presents classification of the risk associated with the structured products listed.
Products which can be used by investors in case of rising prices on the market are
also included in Table 6.2
Table 6.2 Classification of the risk of structured certificates (materials from the II Forum of
Structured Products, presentation Raiffeisen Centrobank A.G., Warsaw)
Products characterized by a risk

under the market value

identical to market risk

higher than the market
Type of a
certificate
Guaranteed
certificates
Bonus
certificates
Discount
certificate
Index
certificates
Basket
certificates
Turbo long
certificates
Turbo short
certificates
Callwarranties
The market
(a predicted trend)
Growing, stable
Putwarranties
Declining
Growing, stable
The risk
100 % capital
warranty
Partial capital
guarantee
Risk buffer
Growing
Market
Growing
Market
Growing
Higher than
the market
Higher than
the market
Higher tha the
market
Higher than
the market
Growing, stable
Declining
Growing
126
6.7
The Market of Structured Products in Europe
The bonds guaranteeing capital had been offered by insurance companies as early
as the 70s of the twentieth century. The sale of structured products began in the 80s,
however, for several years, mainly institutional investors were interested in those
products.
Paradoxically, the market of structured products currently is much more developed in the European Union countries than in the United States, due to the fact, that
structured products are an alternative and relatively safe form of investing. Moreover, these products are offered not only on the stock markets, but often by banks as
well. In case of certain complex structured products there is no access to any
statistical data reflecting the state of the markets development. The www.Structur
edRetailProducts.com database currently contains information on the structured
product markets in 19 European countries.2 The database contains sales figures for
most of the products, based on the country of the investors rather than the country of
the issuer. It means that a product issued in UK but sold in Germany will appear in
the German database.
The value of the assets of the structured products on the European retail market
in 2006 exceeded 803 billion euros. The market of structured products, despite its
rapid development, also was the subject to impact of the financial crisis during the
years 20082009. After reaching a maximum volume of the sales in 2007, in the
amount of 250 billion euros, the volume of structured products sales dropped down
to 110 billion euros (StructuredRetailProducts.com 2015).
In 2012, over one million structured products were issued and sold to retail
investors. According to the data, most of the products were equity linked (60 % of
total volumes in 2012) and interest-rate linked (25 % of total volumes in 2012). In
addition, lowering of the interest rates, in most countries, led to a search for
products, which would be characterized by a higher profitability than bank deposits.
One of the observed behaviors among the investors on the market of structured
products is moving away from the products characterized by 100 % capital guarantee. The share of the products with capital protection lower than 100 % increased
from 30 % in 2009 to 48 % in 2012 (StructuredRetailProducts.com). Still, most of
the products being sold is characterized by a certain level of capital protection
(around two thirds of the products sold during the years 20072012). Among those
products, capped and uncapped call represent around 40 % of the volumes sold,
followed by yield enhancement products (12 %) and participation products (7 %)
(ESMA Economic Report 2013).
These countries include: Belgium, Czech Republic, Denmark, Finland, France Germany, Ireland,
Italy, Norway, Slovenia, Spain, Sweden, Switzerland, The Netherlands and Great Britain, while in
2008 Poland and Austria joined the list. As far as Europe is concerned, the database covers over
2,000,000 retail structured products issued in all the major markets: AT, BE, CZ, DK, FI, FR, HU,
DE, IE, IT, NL, NO, PL, PT, SK, ES, SE, SW, and UK.
6.7 The Market of Structured Products in Europe
127
With regards to wrapper types, most structured products are issued as securities
(63 % of volumes sold in 20072012), funds (9 %), deposits (8 %) and life
insurance products (5 %), with the remaining representing a wide range of wrappers
(tax efficient schemes or pension products etc.).
In December 2012, the volume of the structured products in Europe reached the
value of 770 billion euros. An extremely dynamic development of structured
products, especially in Italy and in Germanythe largest retail structured products
market in the worldcontributed to that. This tendency mainly results from
development of such trends like an increasing market competition, low costs of
auctions, and cross-border sales in Austria and Switzerland, which led to a rapid
increase of issued instruments. During the years 20072012, issuance of over one
million new products for the retail investors on new markets was reported. The
growth rate of new products issuance, thus was extremely rapid, given that in 2007
around 175,000 structured products were issued. Development of the European
structured products market, however, was not even, since a decrease in issuance of
structured products as well as their sale on individual markets were observed.
Table 6.3 presents structured products sales volumes in selected European
countries in 2012. The presented data confirms that Italy and Germany constitute
as much as 44 % of the structure of the European structured products market.
In 2012, over one million structured products were issued and sold to retail
investors, in the value of 110 euros. After reaching a maximum of 250 billion euros
in 2007, the volume of the sales in 2012 did not return to its level from 2004. Most
of the products were capital-related (60 % of the total volume in 2012) and interest
rate (25 %) (StructuredRetailProducts.com).
Structured products, although represent a relatively safe form of alternative
investments, also can pose many risks for financial markets. Purchase of structured
products is also associated with a risk and can cause financial losses for retail
investors. This is especially true for the products not offering 100 % capital
protection, which can cause not only a lack of income, but also partial or total
loss of the invested capital.
Due to the complexity of structured products, retail investors often are not able
to assess the actual value of those products, the factors impacting the potential
return rate, nor the potential credit risk associated with structured products. These
Table 6.3 The European structured products market (StructuredRetailProducts.com)
Country
IT
DE
FR
BE
UK
ES
Others
Total
Outstanding amounts (end-2012, EUR billion)

204
134
81
79
59
42
170
769
Market share
27 %
17 %
11 %
10 %
8%
5%
22 %
100 %
128
elements, however, should be considered during selection and management of

structured products. Bouveret and Burkhart (2012) show, that a systemic risk
resultant from negative financial effects of investing in structured products is
relatively low. Structured products, in fact, constitute less than 4 % of the financial
wealth of households in Europe. As a result, a 20 % decrease in the value of
structured products in the portfolios of individual investors will lead to a small
decrease in GDP by 0.002 %, even when considering the highest wealth estimates
(ESMA 2013). This information is extremely valuable, also from the perspective of
the financial sectors stability.
References
Bouveret, A., & Burkhart, O. (2012). Systemic risk due to retailisation?. ESRB Macro-prudential
Commentaries No. 3, July 2012.
Henderson, B., & Pearson, N. (2011). The dark side of financial innovation: A case study of the
pricing of a retail financial product. Journal of Financial Economics, 100(2), 227247.
Hens, T., & Rieger, M. (2009) Why do investors buy structured products?. EFA 2009 Bergen
Meetings Paper.
Hirsch, T., & Reindl, J. (2006). Assets allocation, ABC of Certificates, Raiffeisen Research.
Swedroe, L. E., & Kizer, J. (2010). The only guide to alternative investments youll ever need: The
good, the flawed, the bad, and the ugly (Vol. 42). Wiley.
Wallmeier, M. (2011). Beyond payoff diagrams: How to present risk and return characteristics of
structured products. Financial Markets and Portfolio Management, 25(3), 313338.
Chapter 7
Private Equity/Venture Capital Investments
7.1
Private Equity/Venture Capital: The Controversy

Surrounding the Concepts and Their Possible
Interpretations
The sector of venture capital investments is assumed to date back to the year 1946,
when Georges Doriot, R. Flanders, K. Comptone, M. Griswold and other partners
founded the American Research and Development Corporation. Their goal was to
invest in the stocks characterized by a low level of liquidity or in the securities of
newly established companies (Swedroe and Kizer 2010).
Most studies on private equity/venture capital investments aim at presenting
these investments by pointing to numerous advantages of a private capital in the
process of financing business projects. Increased-risk capital (venture capital)
primarily serves as a source of financing prospective long-range projects. It also
points to a positive impact of the private equity and venture capital sectors
development on the process of stimulating innovations, on promoting small and
medium enterprises, on combating unemployment, and consequently on supporting
economic development of many countries. High-risk capital (venture capital) is
closely related to financing new and innovative enterprises, which bear high risk
much higher than in already existing entities having more capital, more market
experience, and better protection of their business.
One of the most important issues for investors on the financial market is the
potential return rate from an investment and its relation to the risk incurred. Private
equity investors, while analyzing potential projects, do consider an additional,
increased investment risk, which is associated, among others, with low liquidity
of an investment, lack of security, a possibility of losing control due to malfunction
of the law, lack of informational transparency, characteristic of non-public markets,
as well as with restricted options of exiting an investment, etc.

DOI 10.1007/978-3-319-13215-0_7
129
130
7 Private Equity/Venture Capital Investments
Therefore, investors seek such projects, the required return rate of which would
include a premium for an increased risk. Often, such projects are rejected by banks
as too risky.
Private equity/venture capital investments, at the same time, are forms of
alternative investment on the securities market. This conceptualization points to a
possibility of achieving superior return rates resultant from financial participation in
projects of a high growth potential. Specificity of those investments lies in operating on the niche market segments, which on one hand are associated with a
possibility of earning high incomes, and on the other bear high risk.
Definitions of the terms private equity and private capital, as well as their further
interpretations differ significantly, depending on where they are applied. According
to a definition published by the European Venture Capital Association (EVCA) in
1995, private equity funds entail investments in the companies at various stages of
development, from the moment of their establishment and start-up, through their
expansion stages, until they are sold (White Paper 2001).
While defining the term private equity, in the most general sense, it can be said it
encompasses all investments on the private capital market, which are aimed at
obtaining a medium-term and a long-term profit from an increase in the value of the
capital. The term venture capital also refers to private investments in early stages of
development. As such, it can be inferred, that venture capital is a type of private
equity. The term venture capital most often is interpreted as an investment into a
completely new project, while private equity is an investment in an already existing
entity, financing of which is aimed at its further, more dynamic development.
Venture capital is a private equity capital invested in the companies, which are at
an early stage of development. Such investments can, for instance, include fund
investments in an idea (seed capital), that is, in a business concept, in start-up, postcreation companies initiating their business, or investing in rapid development of
the companies with a high expansion and development potential.
Particular individual stages: the seed stage, the companys start-up stage and its
post-creation stage, by the investors are called early development stages, and are
characterized by lack of profit during the initial stage of the companys financing.
The earlier the phase of the companys development, the higher the risk of the
project; thus, the highest expected return rate. Financing a company at these stages
is called the initial funding. The EVCA reports and data regarding private equity
market also provide the notion of the later stage venture, which signifies a
development and expansion stage, up until the moment of the companys market
maturity.
Venture capital investments are characterized by a substantially higher risk
compared to private equity investments, which entail investing in mature companies as well. In addition, the concept of a venture capital entails all the elements
contained in the definition of a private equity. Application of these two concepts is
still quite common.
The importance of financing the projects which are at the beginning of their
capital venture pathnot only for the development of innovation in various sectors
of the economy and for creation of entirely new industriesis confirmed by
7.1 Private Equity/Venture Capital: The Controversy Surrounding the. . .
131
Table 7.1 Interpretations of the terms: Private Equity and Venture Capital (Arundale 2007)
Private
equity
Venture
capital
Venture capital + management buyouts, management buy-ins), replacement

capital/secondary purchases
Seeding stage (seed), start-up stage (start-up), expansion stages
specific data from a more developed and market, which has been applying such
solutions much longer. The example of the North American market reveals quantifiable benefits of this for the entire economyduring the difficult years of 2008
2012, when sales in the US decreased by 1.5 %, the companies which used venture
financing in the years prior to that (since 1970) recorded their incomes increased by
1.6 % (Gabriel 2013; Golec & Gabriel 2014). For every dollar invested in the form
of a venture capital during the years 19702010, a sales income of 6.27 USD was
generated in 2010 (Venture Impact 2011).
The term private equity, although often used interchangeably with the term
venture capital, is a much broader term (Sokoowska 2010). It should also be
underlined, that there are significant differences between the definitions of private
equity and venture capital functioning in the US and in Europe. In the US the term
venture capital is used to describe projects in early stages of their development,
while in Europe this term can also entail further stages of project development
(Table 7.1).
Private equity refers to the process of acquiring stocks and shares in the
companies not listed on regulated public markets, with an intent of a future resale
of those shares at a profit (http://www.privateequity.pl). Investment of a the capital
can be also done through the funds especially appointed for this purpose. Each fund
has its own investment policy, often with a preference of selected industries,
regions, or development stages of the company invested in.
Swedroe and Kizer (2010) distinguish three basic private equity investment
subcategories:
Venture capital
Leveraged buyouts (buyouts capital),
Mixed financing (mezzanine financing).
A similar classification of private equity investments has been proposed by
Jobman (2002), Gladstone and Gladstone (2002), who also include venture capital,
leveraged buyouts and mezzanine debt. A definition by Executive Encyclopedia
describes venture capital as capital of high risk (Friedman 1987).
Another category distinguished within private equity investmentsbuyout capital transactionsinvolves buying out by a fund a part or the entire company, in
cooperation with the current management (Management Buy-Out MBO) or with
the new management (Management Buy-In). These transactions use debt capital.
Buy-outs are a specific type of private equity. European Private Equity and
Venture Capital Association (EVCA) describes the funds specializing in
conducting buy-outs as the funds directed at purchasing a larger part or even
132
majority of a given companys stocks/shares from its owners, which usually is

accompanied by a change in the ownership structure as well. Buy-out funds
generally invest in the companies at advanced stages of development, in order to
finance and support a given companys expansion. It can be in the form of a merger,
restructuring, a sale, or extraction of some parts of the assets from the company
structures (venture management).
There are several types of buy-outs involving private equity funds. Their common feature is conducting transactions when current company owners decide to sell
all or part of their shares, with intention to withdraw from active participation in the
companys business or with intention to extract part of the companys assets for
strategic reasons. A decision to focus the companys business on its main object of
activity can be such a reason. Generally, divestment by venture capital/private
equity funds can take various forms. The methods currently used include the
following:
Introduction of the company on the stock exchange (IPO),
Sale of the shares to a given industry investor or a strategic investor (trade sale),
Sale of the shares to a financial investor or to another venture capital/private
equity fund (secondary purchases),
Sale of the shares to the remaining companys owners (buy back),
Managerial buy-out by the companys managers (MBOManagement
Buy-Out) or by managers outside the company (MBIManagement Buy-In),
Purchase of the company by another investor in return for his shares (Reverse
Takeover),
Companys liquidation and amortization of the shares (write off),
Other buy-out transactions.
Other buy-out transactions can include:
Purchase by the companys managers and by those outside it (BIMBO),

Managerial-employee buy-out (MEBOManagement Employee Buy Out),
Employee leasing (EBOEmployee Buy Out),
Assisted buy-out also called a leveraged buy-out (LBOLeverage Buy Out),
Public Buy Out.
Furthermore, additional methods of divestment can be distinguished, however,

most commonly they are a combination of those mentioned above.
Mixed financing, also called the mezzanine capital, can occur in the form of a
venture capital or financing an MBO transaction. The term mezzanine comes from
French and signifies an element connecting two floors. Mezzanine is a term most
commonly used in finances to describe an innovative method of financing the
companies. Another description of mezzanine is the term subordinated debt (subordinated loan). The nature of this source of financing predestines this instrument to
be treated as an indirect form of financing between a debt financing (e.g. a credit)
and an equity financing (e.g. the issue of shares). One of main applications of
mezzanine financing is financial support of mergers and acquisitions.
7.2 Classification of Venture Capital/Private Equity Investments
7.2
133
Classification of Venture Capital/Private Equity

Investments
Venture capital/private equity investments can be divided considering various

classification criteria. Taking into account the subject of investment, the funds of
private equitytype can be divided into single funds, that is funds investing
directly in companies, and funds of funds, that is funds investing in other private
equity funds.
These investments can also be divided according to the industries, which the
assets are invested in. Considering this criterion, the following can be
distinguished:
Defense industry,
Telecommunications,
Computer science,
Biotechnology,
Food production, etc.
Another classification divides funds according to the development stage of the

companies in which they invest, where the following can be distinguished:
Venture capital (investments in new projects and in companies at an early stage
of development),
Development funds (investments in flourishing companies, in relatively young
ones as well as in new ones),
Buyout funds (investments in mature companies that usually are in the manager
buyout phase (MBO), in leveraged buyout (LBO), or before a market debut IPO
(initial public offering),
Balanced funds (investments in each of the above mentioned categories),
Special situation funds (investments in the companies being in specific situations
e.g. fusion, division, liquidation, etc.).
Tamowicz (1995) proposed classification of venture capital/private equity funds
according to the value of the funds entrusted in them. Taking this criterion into
account, first of all, we can distinguish mega funds, generally independent, with
capital not less than 100 million UDS. Activation of investment projects is done
both on the domestic market and on a foreign market. Involvement of these funds in
one project generally ranges from 1 to 3 million UDS. Additionally, they specialize
in financing the expansion phase as well as in assisted buyouts.
The second group consists of mainstream funds, which operate with capital
ranging from 25 to 99 million USD. These funds, in one project, usually engage a
sum of up to approximately 1 million USD. Second tier funds have capital of around
25 million USD, at an average investment magnitude ranging from 500,000 to
750,000 USD. The last group includes niche funds, which operate with capital
under 25 million USD. They specialize in financing the start-up phase and in
134
financing specific industries. Average magnitude of an investment fluctuates around

the amount ranging from 50,000 to 250,000 USD.
Some of private equity funds specialize in providing a mezzanine-type capital.
Mezzanine financing is a specific kind of raising capital, in which most often used
instruments include the following (http://www.mezzanine.com.pl/KPK):
A loan with the right to participate in the capital,

A loan with the right to participate in the income,
Warrant bonds,
Convertible bonds,
Exchangeable bonds,
Zero-coupon bonds/discount bonds,
Bonds or preferred PIK bonds (pay-in-kind) securities,
Increasing coupon bonds (increasing rate bonds),
Bonds with extended maturity (extendible bonds).
A loan with the right to participate in the capital is a specific form of financing, in
which the owners bear the costs, if the project ends with a planned financial result.
Interest costs are incurred by the company. An entity financing a mezzanine is
entitled to buy a certain amount of stocks or shares at a pre-estimated price and at a
predetermined time in the future. This right is in the form of a warrant and most
often it comprises a small package of the companys stocks or shares, which usually
does not exceed few percent of the capital. Before financing using a mezzanine
instrument begins, the number and the price of the stocks available from the warrant
are specified.
A loan with the right to participate in the income entitles the lender to partial
participation in the profits from the investment.
Warrant bonds are a type of financing, in which the company bears the cost of
financing a given enterprise, in the form of a coupon. All other financing costs are
incurred by the companys owners. The company issuing convertible bonds, which
is another financing possibility, is the entity incurring the costs of interest coupons.
The entity financing a mezzanine, in turn, is entitled to later on convert the bonds
issued by the company into its stocks or shares, accordingly with predefined rules.
Exchangeable bonds are a type of an instrument very similar to convertible
bonds. These instruments, however, differ in the possibility of exchanging the
bonds for stocks or shares of an issuer other than the original issuer of the bonds.
Zero-coupon bonds/discount bonds are a type of debt instruments, in which the
issuer pays off the entire amount at one time, along with the interest, at the time of
the bonds maturity.
Bonds or stocks called the PIK (pay-in-kind) securities are privileged securities.
Alternatively, interest on the bonds or on the dividends from the stocks are paid out
without using cash, in the form of securities. Usually, only a form of non-cash debt
payment is possible in the first periods. The form of the payment is specified by the
issuer.
7.3 Legal Forms of Venture Capital/Private Equity Funds
135
A bond with an increasing coupon (increasing rate bond) is a debt instrument, in

which the issuer specifies the value of the coupon in the initial period as well as sets
the rules of this coupons increase in the following periods.
Bonds with extended maturity (extendible bond) are an instrument containing a
clause permitting extension of its maturity time by certain periods (e.g. by 1, 2,
3 years), noting that the total cannot exceed the maximum specified value.
7.3
Legal Forms of Venture Capital/Private Equity Funds
Venture capital/private equity funds can be formed using various legal forms. Vc/pe
funds can exist in the following legal forms (Kornasiewicz 2004):
Contractual private companies (private limited partnership),

Funds listed on a public market (publicly traded funds),
Corporate venture capital funds,
Investments by private persons (angel investors).
Contractual private company (Private Limited Partnership) is an organizational

and legal form frequently used to form a venture capital fund. This form was first
used in the US by such companies like Silikon Valley, Kleiner Perkins, Sequoila
and Accel, and subsequently has been popularized in Europe by such companies as
Amadeus, Apax Partners and Adwent Venture Partners in Great Britain, Sofinnova
Partners in France, Capricorn Ventures in Belgium and Wellington Partners in
Germany. Those investing in a private limited partnership company are obliged to
provide, the capital necessary for financing their investment plans,1 over the
following few years. Repayment of the capital usually takes much longer, even
up to 810 years. The policy statement of the European Private Equity and Venture
Capital Association defines the concept of an investor acting as a venture capitalist.
Organized entities or private persons, whose primary objective is to obtain profit
from the invested capital can act as a Venture Capitalist entity. Furthermore, these
entities help in management of the project constituting the subject of investment.
Venture capitalists should have effective capital or quasi-capital management skills
within the scope of newly established or developing subjects of high developmental
perspectives.
Another legal form allowing creation of a private equity fund is a limited liability
partnership. It is based on a conclusion of an agreement between the funds
manager (general partner) and the funds investors (limited partners). This organizational form seems to be beneficial from the tax and legal perspective. Similarly
as in the case of the hedge funds using this form of operating, the responsibility of
paying tax is at the level of the investor. Basic rules of the funds operation are
1
General partner is also an investor. Similarly as in hedge funds, financial involvement of
managers is meant to motivate them and help them identify with the funds politics.
136
regulated by a contract called a partnership agreement, which specifies basic rights

and responsibilities of the funds managers and investors. Investment funds and
other institutions invest the capital as limited investors.
Public venture capital/private equity funds (publicly traded funds) are formed as
public companies, subjected to reporting and informative requirements. Because of
the nature of venture capital/private equity projects, this form is not attractive. It is
used by the companies, which gather capital in order to start business activity, or by
the entities providing capital for bridge financing.
Venture capital funds formed as corporations (corporate venture capital funds)
can be formed as separate projects (similar in character to private limited partnership) or in the form of organizationally separate units of the company. The goals of
a fund created within a corporation must be consistent with its strategy and
generally ought to serve its extension onto new markets.
Investments by private persons (angel investors, business angels) involve individual wealthy investors searching attractive projects, which can provide opportunities for future high return rates. They are long-term investments, which take place
at early stages of investments development.
Business angels are private persons supporting entrepreneurs both financially
and substantively. Most commonly, they are subjects who have managed to successfully develop their own companies, managers, stock exchange investors, who
want to have influence on investments.
7.4
The Stages of Venture Capital/Private Equity

Investments
On the private equity market the following can be distinguished: institutional

entities (formal ones), and informal entities. Numerous entities, varying not only
in their legal form but also in the subject of their activity, can become providers of
private equity capital. They invest in various companies operating on the private
market. Leading investors on the venture capital/private equity market are: banks,
pension funds, insurance companies, family offices, government agencies, public
institutions, scientific institutions and private entities.
Sometimes other private equity funds and funds investing in private equity
exclusively through other funds (funds of funds) can become providers of the
capital for private equity funds.
Among the largest private equity investors are banks. Through provision of
capital for private equity funds, banks seek to expand their investment activities
and to achieve high profits, as well as hope to attract new customers. In addition to
bringing capital for the funds, banks often become lenders, specializing in financing
the transactions associated with private equity, including management buy-outs.
Banks are among the biggest European investors in private equity funds.
7.4 The Stages of Venture Capital/Private Equity Investments
137
Pension funds are also one of the major investors on the market of private equity
funds. These entities, although theoretically characterized by an aversion towards
incurring risk, manage large amounts of assets, have a long investment horizon and
use very advanced risk management methods. The main objective of placing
private equity investments in the investment portfolios of pension funds (as long
as the law in a given country allows it) is to diversify this portfolio. The amount of
the capital managed by pension funds is so high, that it determines their significant
position among the providers of capital.
Another group of investors are insurance companies, which seek attractive, longterm investment options for their assets.
Companies and corporations are also important feeding investors for private
equity funds. This group of investors, as well as other entities in the financial sector,
can invest their surplus assets as long-term investments, taking maximization of the
profits and minimization of the risk as the criteria for selecting investments. Another
group of capital providers uses private equity activity for restructuring or development of particular technologies and the solutions later on used in their production
activities. This type of private equity investment often is called venture management.
Institutions operating as family office emerged as a separate category of providers of the capital for private equity in recent years. They are companies offering
comprehensive management of the assets for wealthy clients. These solutions are
included in the family office service and they mainly combine management and
investing of the capital with tax and legal advisory, as well as with intergenerational transfer of the assets.
Wealthy individual investors often act as business angels, by supplying innovative and promising companies with capital, thus expecting future extraordinary
return rates. Entities on the increased risk capital market can also be divided into
formal and informal ones. A detailed classification of the entities according with
this criterion is presented in Diagram 7.1.
Diagram 7.1 Entities on
the private equity market
(Private Equity Consulting
2004)
Formal entities (institutional )

Private equity funds
Informal entities
Bussiness angels
Commercial domestic
Cross-regional domestic
Legal persons
(e.g. enterprises)
Special domestic
PE quasi funds
Informal capital groups
138
After accumulating the capital, it is time for selecting an investment. The

selection procedure is very detailed, in order to select entities with the highest
growth potential as compared to the risk incurred. In the first stage, negative
selection is made, during which about 90 % of the initially analyzed entities are
discarded based on a document called an elevator brief, which contains basic
information about the company (its financial results, product information, and
information about the company and its owners). For the companies, a more detailed
analysis is then made, which is meant to explore such aspects as the products, the
markets and competition, the clients, development strategies, the companies fixed
assets, as well as to prepare, along with the companys board, reliable financial
forecasts. These forecasts are to realistically present the companies predicted
growth, which would be possible with an investment from a fund.
The next step is a due diligence analysis conducted over several weeks. It
involves mediation with the funds representatives and outside specialists, mainly
lawyers, auditors and experts from the industry in which a given company operates.
The purpose of this analysis is to verify the financial projection estimated previously, the companys valuation and finding any shortcomings in the areas of risk.
For a fund, it is also very important to find a method for obtaining profits from an
investment. Obviously, besides the profits from a high growth potential and favorable perspectives, a fund can also earn by buying a company that requires
restructuring and cost reduction, but is much cheaper than other similar entities.
It may also be useful to apply a leverage, that is, to purchase using much cheaper
foreign capital (e.g. a bank loan). As a result, the funds expected return rate from
the entire investment automatically decreases, which allows the fund to achieve a
better return rate from own capital measured by the ROE (return on equity).
Investors can finance venture capital/private equity projects at various stages of
their development. Classifications of venture capital/private equity investment
stages vary depending on the location of an investment. Main terminological
differences occur between the US and European countries. Private equity investments, in general, tend to be long-term in nature. A specific life cycle is also their
characteristic trait. The following stages of venture capital/private equity activity
can be distinguished:
Activation of the capital,
Exploration, analysis and selection of potential investment projects, and the
investment undertake,
Duration of the investment (increase in the value of the portfolio companies),
Realization of portfolio profit (divestment from the companies).
The above mentioned stages are not disjoint successive in character. Some of
them can occur simultaneously. There also is a possibility of reacquisition of the
capital during the term of the financial investment, using the assets obtained during
the first acquisition of the capital (the first closing). Private equity/venture capital
funds adopt a certain strategy and decide to enter an investment during one of the
stages: seed capital, start-up, expansion, or a buyout.
7.4 The Stages of Venture Capital/Private Equity Investments
139
The seed phase, associated with the first stage of the development, is characterized
by a relatively high investment risk. This phase is often called the seed-up phase. One
way to reduce the risk on the part of the investor is to engage relatively small financial
assets. The phase related to provision of the so-called incubation capital is associated
with a possibility to develop the concept of the companys project and with qualifying
for start-up capital financing. The following funds can be specified on the developed
markets: seed capital funds, start-up funds, and early stage funds.
The seed stage occurs when the fund invests less in a company, and more in the
people who begin to run it. At this stage, what counts is a genius idea, which can
bring a very high rate of return. However, the risk is very high, which makes
investing at such an early stage very uncommon.
At an early stage, the so-called early development, which is associated with
activation of the capital, assessments are carried out in order to determine whether a
given prototype justifies taking the risk of its further financing (Kornasiewicz
2004). The start-up stage is related to smaller risk, because there already is a
concept of a product which can generate profit.
Investments in the expansion phase are designed to provide a given commodity
to the final purchaser and to check the reaction to that product. The initial phase is
associated with the companys further development and with conducting investments. Small profits for the company can emerge at this stage. We can speak of the
start-up stage when the capital is supplied at an early stage of a project, most
commonly for launching production or service provision. Investing at this stage
also entails a considerable risk and a high growth potential, yet a less one than at the
previous stage. Most of investments at both mentioned here stages apply to the
companies affiliated with high-tech industry, often those introducing entirely new
products and services to the market, which are meant to become market pioneers
bringing high profits.
The next two stages concern less risky, yet still financially very attractive,
companies, which already are operating on the market, have a stable position, but
their development is inhibited by a lack of capital. In such case, the fund investing
in a company at the expansion stage provides not only the capital needed, but also
the know-how of the managers (sometimes helping in e.g. developing a new
strategy or in restructuring). At this stage, the company should begin to make
profits. Although the profit will not be as high as in case of investments in
companies at early stages of development, it will be characterized by lower risk
and the investment period will be shorter.
Expansion phase is associated with the companys development. An enterprise
at further stages of its development is characterized by a stabilized market position
and by lack of difficulties with financing its current activity. Such entities carry out
activities related to expansion of their recipients. McKinsey studies conducted
among eleven leading American private equity funds have indicated five most
important projects, used by the managers of those funds, in order to create the
value of the portfolio companies (Panfil 2006).
The last investment method involves the funds participation in purchasing of a
companys shares (stocks) from its owners by this companys managers (management buyout) or by an outside group of managers (management buy in).
140
Average time of investment in one company ranges from 3 to 7 years. Much

depends on the type of the company, the stage of its development during which the
investment was made, as well as on the prospects for exiting the investment. Two
most common solutions are: a sale of the company to an investor form its industry
who is willing to contribute a certain premium, thus increase the companys value,
due to potential synergy to be possibly achieved; or an IPO, that is, introduction of
the company to the public market.
Other, less commonly used methods of exiting an investment involve a sale of
the shares/stocks to those managing the company or to another venture capital/
private equity fund. A possibility of failure should also be accounted for, with an
option of writing a given companys shares off the funds assets.
First of all, venture capital/private equity funds analyze the investments in detail
before engaging capital. They use the boards knowledge of and the data acquired
from external trusted sources of information. Secondly, these funds introduce an
incentive program concentrated on management of the companys value.
Encouraging the CEO to purchase stocks/shares, or motivating him/her by
facilitating a purchase of the options for stocks/shares at an attractive price, is a
common practice. Usually, plans to maximize the companys value are also incorporated. A resale of the stocks/shares acquired previously, also called an exit from
the investment or divestment, is the last stage of a private equity fund. This exit can
occur once, at several stages.
A summary of these considerations is presented on Fig. 7.1, which shows
dependencies between the risk and the expected return rate in particular forms of
venture capital/investments. It can be noticed, that the most important risk is related
to the investments in their initial stages. Relatively lower risk characterizes buyouts
and indirect mezzanine financing forms (Graph 7.1).
120
100
80
60
40
20
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Fig. 7.1 Overview-all private equity-fundraising (billion euro) Thomson Reuters/EVCA (2000
2006) & EVCA/PEREP analytics (20072013)
7.5 Alternative Investments Markets in Europe
141
Graph 7.1 The risk and

the expected return rate in
selected types of venture
capital/private equity
investment
7.5
Alternative Investments Markets in Europe
It is quite impossible not to notice the growing importance the capital markets play
in the process of capital raising by companies. The changes were the beginning of
institutional innovations, including trade of financial instruments, which caused
legislative changes. One such change was emergence of alternative trade systems.
Introduction of a company on the stock exchange (IPOinitial public offering)
also is a classic exemplary manner of financing using the capital of an
increased risk.
Due to a lack of a developed stock market for venture capital/private equity
investments in Europe, many companies in the 80s tried to gain capital on American stock exchanges. The problem had been noticed by the European Committee,
which in consequence took initiatives in the 90s to support development of stock
exchange markets in the EU countries. As a result, stock exchange markets for
small and medium-sized companies characterized by high growth potential
emerged.
The main focus in this chapter will be on analysis of alternative trading systems
in Europe. Since the subject of the analysis in this book entails various alternative
investments, it is worth to indicate, that European requirements for issuers are much
less restrictive than in the US. It can also be noted, that the base markets in Europe
are also less restrictive with future issuers compared to the US. In the US,
NASDAQ is the alternative market, which is entirely different from its European
counterparts. While considering alternative investments as institutions functioning
142
on the verge of the regulated market, it seems that such an approach reflects the
nature of the matter. Other global alternative markets were omitted in this chapter,
due to their differing characteristics resulting from the various roles capital markets
play in individual countries.
The legal regulations, which determine the different specificity of alternative
trade systems around the world, are diverse. Most of the alternative trade systems in
Europe function as multilateral trading facilitiesthe MTF, accordingly with the
intra-European Union law. Their definition stems from European directives and
regulations (The Directive 2004/39/WE 2004; The Commission Directive 2006/73/
WE 2006; The Commission Regulation WE NR 1287/2006 2006). These markets
can be regarded as young, since majority of them emerged during the first decade of
the twenty-first century. Comparing those to alternative trade systems in the US,
which are the home to the capital market, it can be noticed that the period of their
functioning is much longer. The origins of the NASDAQ market date back to 1971,
when a platform for trading on the OTC market had emerged.
Currently, alternative trading systems also function if Asia. At the beginning of
2009, the Tokyo AIM market was launched within a joint venture of the Tokyo
Stock Exchange and London Stock Exchange (Tokyo AIM 2011). Previous to that,
such markets as the Catalyst in Singapore (earlier called SESDAQ) KOSDAQ in
Korea or GEM in Hong Kong. In Africa, there are markets dedicated to smaller and
more risky companies, for example, the AltX organized by the stock exchange in
Johannesburg.
According to a definition by Federation of European Securities Exchanges,
alternative markets or segments are defined as those having other rules and regulations, compared to main markets (FESE 2015). Majority of European stock
markets has alternative markets of segments. In Europe, Hungary and Bulgaria
are exceptions. Some institutions are the owners and the operators of few alternative trade systems, differing in the instruments being traded within those markets
(e.g. Weiner Borse) or in their business model and in satisfaction of their need
(e.g. AIM Italia and Mercato Alternativo del Capitale). The main features
distinguishing alternative trade systems from regulated markets are the criteria of
admission to trading and informational requirements. In addition, various entities
conduct administrative and organizational as well as supervising functions on both
market models. Among those less restrictive criteria of admission to trading within
the alternative trade systems (ASO), lack of a requirement to produce a prospectus
under certain conditions, lack of restrictions or lower requirements for minimum
capitalization and free float. In terms of informational requirements, liberal information policy applies to both, current reports, through a shorter catalogue of
required information, and periodical reports. What is more, the penalties for
breaching these requirements are defined market regulations, not a law or decrees,
non-compliance of which can also result in criminal responsibility.
The data in Table 7.2 confirms, that the market organized within the alternative
trade system currently is run by majority of the stock markets in Europe. Most of
them emerged in the first decade of the twenty-first century. Main factors stimulating development of alternative markets of capital acquisition are lesser formal
7.5 Alternative Investments Markets in Europe
143
Table 7.2 Classification of selected alternative markets in the world (FESE 2014)
Exchange
Athens
BME
Borsa
Italiana
Bratislava SE
Cyprus SE
Deutsche
B
orse
Irish SE
Ljubljana SE
London stock
exchange
Luxembourg
SE
NYSE
Euronext
NASDAQ
OMX
Oslo Brs
SWX
Warsaw SE
Wiener
Borse
Market
EN.A
MAB (Segment 1 collective
investment companies)
MAB (segment 2 private
equity)
MAB (segment 3 SMEs)
STAR
Mercato expandi
Mercato alternativo del
capitale
New listed market
CSE alternative market
Entry standard
Kind of the market (alternative trading

system-MTF/ regulated market RM)
MTF
MTF
Date
2007
2006
MTF
2007
MTF
RM
RM
MTF
2008
2001
1997
2007
RM
RM
2008
2004
2005
Irish enterprise exchange

Semi-official
AIM
MTF
RM
MTF
2005
2005
Euro MTF
MTF
2005
NextPrime
NextEconomy
Alternext
First north
RM
RM
MTF
MTF
2002
2002
2005
2005
Oslo axess
Alternative bond market
Local caps
NewConnect
Second regulated market
Third market
RM
MTF
RM
MTF
RM
MTF
2005
2005
2005
2007
1989
2002
and informational restrictions placed on issuers. European platforms organized in

terms of alternative trade systems offer many incentives designed to attract potential issuers, including e.g.
No requirement to submit a prospectusAthens SE;

No requirement to submit quarterly reportsMercato Expandi;
No requirement to define the companys minimum market capitalizationAIM;
Lower acceptable share pricesOslo Axess;
Possibility to issue shares by new companies with no documented credit historyNew Listed Market.
144
The most important markets in Europe are the London AIM in the European
Union and the Alternext in the Euro area.
7.6
Alternative Investment Market in London
Alternative Investment Market is the largest OTC market in Europe. It is a segment

of an international stock exchangethe London Stock Exchangecreated in order
to issue stocks of small, innovative companies. AIM was initiated in 1995. Since
then, the market collected almost 24 billion for over 300 companies (http://www.
londonstockexchange.com/companies-and-advisors/aim/aim/aim.htm. The companies listed include both, small companies at the start-up stage, which are financed
by high-risk capital, as well as mature companies with an established position on
the market. Transfer of the shares from the AIM segment to the main market can be
a consequence of strengthening a companys capital. Three other indices, which
illustrate the changes in innovative companies, are listed on the market: FTSE AIM
UK 50 Index, FTSE AIM 100 Index, and FTSE AIM All-Share Index.
The AIM market is attractive for small and medium-sized enterprises, enabling
acquisition of relatively small assets for financing a company. The companies listed
on the AIM can be divided into two categories.
The first category includes developed companies with a well-established market
position. For those companies, the AIM is an expansion path allowing a decrease of
the capital costs. At the same time, those companies often move onto the main
market, after a certain period of time. The second group includes venture companies operating in innovative or niche industries, for which the AIM is one of the
phases in financing their development.
The London ASO allows the use of tax benefits in the form exemption from the
tax on the gains from capital donations, in the form of the shares listed on the AIM.
In addition, the Enterprise Investment Scheme (EIS) allows individuals to benefit
from the exempt from the income tax. Each investor who, during the fiscal year,
invests up to 500,000 Pounds into emission of shares of a company in the AIM and
does not sell it within 3 years, will benefit from an income tax exempt in the amount
of 20 % of the invested assets (London Stock Exchange 2009). A similar program
has been developed for institutional investors. The above mentioned actions could
have a significant impact on rapid development of the market.
Despite the fact that the companies listed on the AIM are companies operating in
increased-risk conditions, the number of bankrupting companies is small. The AIM
market operated by the London Stock Exchange is supervised by the United
Kingdom Financial Services Authority. This institution oversees activity of both,
the London stock exchange and the AIM. The institution itself aims to promote
knowledge about the financial market. The AIM regulatory system is based on
entities called Nominated Advisers, who can be referred to as authorized advisors.
A nominated advisor guarantees emission of the companys shares on the AIM and
monitors fulfillment of the criteria set by the stock market. Evolution of an
7.7 The European Venture Capital/Private Equity Market
145
alternative trade system in London has made it simple and homogeneous, which has
guaranteed its international success. In 2005, the AIM gained two European
competitors: the Alternext managed by the Euronext and Entry Standard managed
by the Deutsche Borse in Frankfurt.
7.7
The European Venture Capital/Private Equity Market
The private equity market has developed very intensively during the past 25 years,
which has been indicated by the statistics reflecting the state of the venture capital/
private equity market in numbers.
While activity in Northern Europe is satisfactory, activity in the South has
significantly decreased. It results from the problems with public debt and from
the savings measures undertaken. As such, the available assets directed at the
emerging markets exceeds Western Europe. The private equity industry in Europe
developed at the same rate as in North America. Traditionally, the UK is the largest
and most attractive private equity market in Europe. The UK suffered one of the
hardest hits by the financial crisis, but it also has recovered as one of the first. The
data on private equity fundraising, investment and divestment across the industry
sectors is regularly published by the EVCA. The atmosphere in the European
private equity sector indicates an optimistic perception of the future. The total
funds raised in 2013, that is 53.6 billion euros, was more than twice its volume in
2013 (2013 European Private Equity Activity). This increase was caused by buyout
funds, 12 of which accumulated more than 1 billion euros each, representing 66 %
of the total funds raised. The financing for creating the funds mainly came from
pension funds. It can be noticed, that 40 % of financing for this phase came from
pension funds, 16 % from funds of funds, 11 % from sovereign wealth funds (11 %)
and from insurance companies (11 %) (EVCA 2013). Around half of the funds
financing came from the assets of institutional investors outside Europe. Private
equity investments constituted around 8 % of the total fundraising. The structure of
the private equity market, in terms of fundraising, according to the financing
sources is presented on Fig. 7.2. The 2013 statistics cover 90 % of the 555 billion
euros, constituting the capital being managed on the European market, including
the data on more than 1200 European private equity companies.
While analyzing the volumes of private equity investments in Europe, it can be
noticed, that during the years 20002013 a dominant share of private equity
investments in the venture capital/private equity market occurred. The largest
investment amounts of the assets accumulated by the venture capital/private equity
funds in Europe, equal to over 70 billion euros, were in the years 20062007. In
2008, the upward trend collapsed and fully revealed the effect of the financial crisis
in 2009by shrinking the market to the smallest size during the analyzed period
(around 24 billion euros). As for Middle-Eastern Europe, the amounts during the
period of investing by the venture capital/private equity industry ranged from
around half a billion (during the years 20042005) to as little as 2.5 billion euros
146
80
70
60
50
40
30
20
10
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Fig. 7.2 Overview-all private equity-investments (billion euro) Thomson Reuters/EVCA (2000
2006) & EVCA/PEREP analytics (20072013)
(the years 20072009), and for the majority of the study period they constituted
from one to few percent of the entire market of venture capital/private equity
investments in Europe (the median was 2.87 %, the average share was 3.59 %).
During the years 20092010, the effects of the crisis in the Middle-Eastern Europe
were recorded with a certain delay. A significant collapse in the investments was
observed only in 2010 and 2011.
During the following years, the value of the venture capital/private equity
investments stabilized. In 2013, more than 5000 companies were supported by
this capital (EVCA 2013). Over 40 % of the companies which received investments
in 2013 were supported for the first time. The total amount of the venture capital
invested increased by 5 %, to the amount of 3.4 billion euros. It is also worth to note
the tendency on the part of the investors to buyout. In 2013, over 800 companies
received buyout investments. Most of the venture capital investments in involved
such sectors as: life sciences, computer and consumer electronics, communications
and energy and environment. It is estimated, that these sectors constitutes around
70 % of the entire venture capital investments. Just as in 2012, over 1000 companies
attracted developmental investments. They constituted a 6 % increase in the
number of the companies and a decrease by 10 % in the amount of the capital
invested. Around 50 % of those enterprises investments targeted the companies
operating in the sector of business and industrial services. Figure 7.2 presents the
values of private equity investments in Europe during the years 20002013.
The number of the companies that exited was 2290, which represent former
equity investments in the amount of 33.2 billion euros (EVCA 2013). The number
of the companies increased by 10 %, while the amount divested increased by 54 %.
Most significant, in terms of the amounts, exit routes included trade sales (27 %),
sales to another private equity company (26 %) and sale of quoted equity (14 %).
Almost 40 % of the divested companies used these exit routes (EVCA 2013).
7.7 The European Venture Capital/Private Equity Market
147
40
35
30
25
20
15
10
5
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Fig. 7.3 Overview-all private equity-divestments (in billion euro) Thomson Reuters/EVCA
(20002006) & EVCA/PEREP analytics (20072013)
The value of the buyouts related to the exits increased by 53 %, up to 28 billion

euros. The value of divestments at cost increased by 54 %, up to the amount of 1.8
billion euros. The potency of public markets in 2013 was displayed by a rapid
increase in the divestments through floatation (IPO). Application of this exit route
increased over sevenfold in its amount (2.2 billion euros) and almost four times in
term of the number of the companies (23). The value of divestments from venture
capital increased by 21 %, up to the amount of 2.2 billion euros. The overview of all
private equity divestments presents Fig. 7.3.
In 2007, due to the banks policies, credit financing that was cheaper began to
displace mezzanine. As a result, the value of the mezzanine market decreased. The
rapid decrease in the number of leveraged transactions in 2008 also caused a
decrease in the value of the European mezzanine market. Among current
European mezzanine financing providers the following can be indicated: the
banks, investment funds and pension funds as well as hedge funds. According to
Fitch Ratings, in 2007 an average 78 % of the acquisition values were financed by
debt, 74 % of which usually constituted crediting, while the remaining 26 % was
other forms of debt financing http://www.fitchratings.com. During the years 2010
2012, the value of mezzanine financing decreased further. Due to numerous advantages of this form of financing, it is expected, that further development of the
mezzanine market is possible, despite the difficulties.
148
7.8
The Forecasts of Venture Capital/Private Equity

Market in Europe
A study of an autoregressive-trend structure of the value of the funds created in

Europe (frt) was done for the years 2000 012. It turned out that this variable does
not have a trend nor autoregression. In addition, there is an effect of a crisis
speculative bubble during the period between 2006 and 2008. Therefore, further
considerations include the dummy variable identifying the years 20062008,
defined as follows:

crist
up
f or
to
2006,
2005
2007,
and
2008,
after
2008:
An econometric model describing impact of the variable crist and of the following
explanatory variables on the value of the funds created (frt) was constructed:
bglcurtthe value of wealth in Europe, in trillion Euro;
desinvtthe value of divestments in Europe, in billion Euro.
The empirical model has the following form:
f r t 36:726 58:505crist 0:478bglcur t 1:771de sin vt u f rt ;
4:294
8:446
4:097
4:540
7:1
R2f r 0:923, Su f r 9:34, V f r 19:5%:

Equation (7.1) describes the volatility of the variable frt with sufficient accuracy,
since the explanatory variables included in this equation explain 92.3 % of the total
volatility of the explanatory variable. Equation (7.1) indicates that during the peak
of the crisis (20062008), the values of the funds created (frt) in Europe were
averagely higher in comparison to the so-called systematic component by over 58.5
billion euros. Along with an increase in the wealth of Europeans by 1 trillion euros,
a decrease of the value of the variable frt by around 478 million euros followed.
Along with an increase of divestments (desinvt) by 1 billion euros, there was an
increase in investments, averagely, by 1.771 billion euros. This means that capital
holders generally transferred their assets to other investment areas after achieving
profits from current investments, thus increased those amounts, on average, by
771 million euros. The actual and theoretical values of the variable frt are presented
in Fig. 7.4.
Forecast estimation for the variable frt based in the statistical information
available is very risky. Specification of the changes in the funds created (frt) in
Europe only allows an assumption, that during the next 34 years their value will
oscillate around the value of the equations (7.1) absolute term, that is, around
37 billion euros.
Similarly, as before, a study of the autoregressive-trend structure of the values of
the investments in Europe (invt) was done for the years 20002012. It turned out
that the variable invt does not have a trend nor autoregression. An empirical
7.8 The Forecasts of Venture Capital/Private Equity Market in Europe
149
120
Actual
Fitted
100
fr
80
60
40
20
0
2000
2002
2004
2006
2008
2010
2012
Fig. 7.4 Actual and fitted value of variable: fr (billion euro)
econometric model describing the volatility mechanism of the investments has the
following form:
invt 18:027 25:032crist 0:944de sin vt uinvt ;
5:314
7:831
5:594
7:2
R2inv 0:933, Suinv 4:564, V inv 10:77 %:

Equation (7.2) indicates that 93.3 % of the total volatility of investments (invt) is a
reaction to fluctuations of divestments and it results from crisis period between
2006 and 2008. During the years 20062008 the value of the variable invt was
higher than the so-called systematic component, on average, by over 25 billion
euros. In turn, an increase in divestment in Europe by 1 billion euros caused an
increase in the value of new investments, on average, by 944 million euros. The
actual and theoretical values of the variable invt, calculated on the basis of Eq. (7.2),
are presented in Fig. 7.5.
Equation (7.2)due to a large irregularity of the volatility of investments
valuescannot be used for forecast estimation of the variable invt. It can be
expected, that the values of investments during the upcoming 34 years will
oscillate around 45 billion euros. It results from a visual assessment of the dispersion of the empirical values in Fig. 7.5, after elimination of sudden increases during
the peak crisis.
150
80
Actual
Fitted
70
invest
60
50
40
30
20
2000
2002
2004
2006
2008
2010
2012
Fig. 7.5 Empirical and fitted values of variable: invest
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Conclusion
Every investment is inherently connected with risk. Its existence and diversity
among various types of investments is one of the driving forces behind the development of the capital market. The risk has also caused emergence and development
of alternative investments. Flourishment of this segment of the market has also been
influenced by periodical financial crises, which have been the driving force behind
the search for investments that would allow investment portfolio diversification and
would provide opportunities for profiting, even during price declines on the market.
Alternative investments constitute an effective tool for risk diversification, however, they are not suitable for all investors.
Institutional investors, including the banks, pension funds, large companies as
well as individual investors within the wealth management sector, constitute a
dominant group of the investors on the alternative investments market. Investors
considering such investments should rely on their own preferences regarding the
acceptable risk as well as on the entities acting as the trustees of the investors
assets. Often, it is the experience gained during management of own alternative
investment portfolio, which allows verification and assessment of the acceptable
level of the risk, definition of the maximum loss tolerance, and designation of
achievable financial targets.
This book aims to present alternative investments in management of the investors assets. Analysis of this sector of the global financial market is not possible
without determining which alternative investment categories can be qualified
within this group. There is still no universal definition of alternative investments
which would be agreed on in the financial world and which would indicate a set of
homogenous characteristics that are relatively stable over time. As a result, many
individual and institutional investors are not fully convinced that alternative
investments constitute a separate category of investments. Multitude of various
definitions raises the need for creation of some universal patterns, which would
allow correct classification of individual investments and at, the same time, would
make it easier to manage them.

DOI 10.1007/978-3-319-13215-0
151
152
Conclusion
The book attempts to analyze and evaluate the following types of investments:
hedge funds, funds of funds, managed futures, structured products and private
equity/venture capital. While the hedge funds and funds of funds market is, by
far, most developed in North America, the structured products are an attractive
subject of investment on the European market. On the other hand, the definitions
and the development stages of the private equity and venture capital market vary
across different areas of the world.
The attempt to evaluate and forecast the alternative investments market was
conducted with caution. A different specificity, not only of the investments themselves, but of the market on which these investments are made, have been considered as well. Undoubtedly, the lack of access to crucial statistical data has hindered
the inference considerably.
Despite these difficulties, an attempt has been made to verify the study hypothesis that globalization and international integration of the financial market will
cause the alternative forms of investing on the securities market to penetrate into
new areas, including the European Union. The dynamics of this penetration and its
development depends on the pace of the citizens enrichment and on their knowledge about financial innovations. Diversification of the specificity of alternative
investments around the world, resultant from cultural and historical predispositions
as well as from differences in economic development can be expected.
The estimated forecasts of development of individual categories of alternative
investments allow indication of the priorities in their management. The forecasts
also allow measurement of additional types of risk these investments may bear.
The models constructed in this book have confirmed, that evolution of this
segment of alternative investments leads to development of those categories,
which meet the expectations of the market participants and leads to expiration of
those investments, which do not find customers and cease to be accepted by them.
This monograph is meant to extend the knowledge segment, which will contribute to a better understanding of alternative investments within the category of
modern, contemporary financial innovations.
It is, however, necessary to further continue the studies on the development of
innovative instruments and the institutions permanently developing on the financial
market. Given the huge capital amounts involved in this market, the directions of
development of these investments have impact on the economies of countries
around the world as well as on all participants of the financial market. What is
more, it means that proper understanding of the risk, of management and transparency is essential.
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The Principles of Altern at IV Investments Management

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EwelinaSokoowska

The Principles of Alternative Investments

ThiS is a FM Blank Page

The Principles of Alternative

Library of Congress Control Number: 2015943397

A theory should be made as simple as possible, but not simpler.

The beginning of the twenty-first century was characterized by a rapid increase in

framework for this market. It allows indication of the priorities in management of

Chapter 7 presents PE/VC (private equity/venture capital) investments, which

Alternative Investments on Contemporary Financial Market . . . . .

Investment Strategies of Hedge Funds . . . . . . . . . . . . . . . . . . . . . .

Opportunistic Strategies (Directional-Trading) . . . . . . . . . . . . .

Managed Futures Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Private Equity/Venture Capital Investments . . . . . . . . . . . . . . . . . . .

Alternative Investments on Contemporary

The Concept and the Essence of Alternative

Investing constitutes an essential factor in economic growth and development.

1 Alternative Investments on Contemporary Financial Market

investments.html, Accessed 20 July 2009). Thereby, this term encompasses all

1.1 The Concept and the Essence of Alternative Investments

Cash and cash equivalents

Alternave Investments (a)

Other Alternave Investments

or traditional instruments offered by banks, such as e.g. deposit certificates

1 Alternative Investments on Contemporary Financial Market

1.1 The Concept and the Essence of Alternative Investments

1 Alternative Investments on Contemporary Financial Market

The focus on achievement of absolute return rates, without referring to any

Classification of Alternative Investments

1.2 Classification of Alternative Investments

Hedge funds are currently most well-known alternative investment institutions.

1 Alternative Investments on Contemporary Financial Market

1.2 Classification of Alternative Investments

1 Alternative Investments on Contemporary Financial Market

Fig. 1.3 Classification of alternative investments

1.3 The Risk Associated with Alternative Investments

Anson (2006), while classifying alternative investments, listed the following:

Alternative investments are often interpreted through the prism of applicable

The Risk Associated with Alternative Investments

Positive returns can be earned in bull markets

To a limited extent; not always

Regulated, subject to public supervision, very liquid

Table 1.1 Comparison of traditional and alternative investments

Management remuneration system that aligns managers

Manager often invests substantial sums

1.3 The Risk Associated with Alternative Investments

Another remarkable concept was developed by the Commission for Insurance

1 Alternative Investments on Contemporary Financial Market

1.3 The Risk Associated with Alternative Investments

1 Alternative Investments on Contemporary Financial Market

The risk of unfavorable investment results,

Emergence and development of financial innovations, including alternative

Table 1.2 Examples of risk identification, measurement and its management

1.3 The Risk Associated with Alternative Investments

1 Alternative Investments on Contemporary Financial Market

determining the methods of its measurement and by designation of an adequate risk

1.3 The Risk Associated with Alternative Investments

international financial market, interest in alternative investment strategies has

1 Alternative Investments on Contemporary Financial Market

Specificity of Hedge Funds