HEDGE FUNDS

Hedge funds are alternative investments using pooled funds that employ numerous
different strategies to earn active return, or alpha, for their investors. Hedge funds may be
aggressively managed or make use of derivatives and leverage in both domestic and
international markets with the goal of generating high returns (either in an absolute sense or
over a specified market benchmark). It is important to note that hedge funds are generally only
accessible to accredited investors as they require less SEC regulations than other funds. One
aspect that has set the hedge fund industry apart is the fact that hedge funds face less regulation
than mutual funds and other investment vehicles.

Hedge Funds VS Mutual Funds

Hedge Funds Mutual Funds
Transparency Usually are set up as limited Mutual funds are subject to
liability partnerships, and the Securities Act of 1933 and
provide minimal information the Investment
about portfolio composition Company Act of 1940
and (designed to protect
strategy to their investors unsophisticated investors),
only. which require
transparency and
predictability of strategy.
They periodically must
provide the public with
information on portfolio
composition.
Investors Hedge funds traditionally Generally open with
have no more than 100 the public
“sophisticated” investors,
in practice usually defined by
minimum net worth and
income requirements. They
generally
do not advertise to the
general public, and minimum
investments usually are
between
$250,000 and $1 million.
Investments Strategies Hedge funds by design are Mutual funds lay out their
empowered to invest in a general investment approach
wide range of (e.g.,
 investments, with various large, value stock orientation
funds focusing on derivatives,
versus small-cap growth
distressed firms, currency orientation) in their
speculation, prospectus. They
convertible bonds, emerging face pressure to avoid style
markets, merger arbitrage, drift (departures from their
and so on. Other funds may stated investment
jump from one asset class to orientation), especially
another as perceived given the importance of
investment opportunitiesretirement funds such as
shift. 401(k) plans to the industry,
and the
demand of such plans for
predictable strategies.
Liquidity Hedge funds often impose generally can be withdrawn
lock-up periods, that is, or redeem by the investors
periods as long as several
years in which investments
cannot be withdrawn. Many
also employ redemption
notices
that require investors to
provide notice weeks or
months in advance of their
desire to
redeem funds.
Compensation Structure hedge funds charge mutual funds assess
a management fee, usually management fees equal to a
between 1% and 2% of assets, fixed percentage of assets,
plus a substantial incentive for example, between .5%
fee and 1.5% annually for typical
equity funds

HEDGE FUND STRATEGIES

Hedge Fund Styles
DIRECTIONAL STRATEGIES – They are simply bets that one sector or another will outperform
other sectors of the market.
NON DIRECTIONAL STRATEGIES – usually designed to exploit temporary misalignments in
security valuations. For example, if the yield on corporate bonds seems abnormally high
compared to that on Treasury bonds, the hedge fund would buy corporates and short sell.
Convertible arbitrage Hedged investing in convertible securities, typically long
A trading strategy that typically involves taking a long strategy in a convertible
security and a short position in the underlying common stock, in order to capitalize on
pricing inefficiencies between the convertible and the stock. Convertible arbitrage is a
long-short strategy that is favored by hedge funds and big traders.

Dedicated short bias Net short position, usually in equities, as opposed to pure short
exposure.
A hedge fund strategy that maintains a net short exposure to the market through
a combination of short and long positions. A dedicated short bias investment
strategy attempts to capture profits when the market declines, by holding investments
that are overall biased to the short side.

Emerging markets Goal is to exploit market inefficiencies in emerging markets. Typically

long-only because short-selling is not feasible in many of these markets.
Equity market neutral Commonly uses long/short hedges. Typically controls for industry,
sector, size, and other exposures, and establishes market-neutral positions designed to
exploit some market inefficiency. Commonly involves leverage.
A hedge fund strategy that seeks to exploit differences in stock prices by being
long and short in stocks within the same sector, industry, market capitalization, country,
etc. This strategy creates a hedge against market factors.

Event driven Attempts to profit from situations such as mergers, acquisitions,

restructuring, bankruptcy, or reorganization.
Fixed-income arbitrage Attempts to profit from price anomalies in related interest rate
securities. Includes interest rate swap arbitrage, U.S. versus non-U.S. government bond
arbitrage, yield-curve arbitrage, and mortgage-backed arbitrage.An investment
strategy that attempts to profit from arbitrage opportunities in interest rate securities.
When using a fixed-income arbitrage strategy, the investor assumes opposing positions
in the market to take advantage of small price discrepancies while limiting interest rate
risk.

Global macro Involves long and short positions in capital or derivative markets across the
world. Portfoliopositions reflect views on broad market conditions and major economic
trends.
Long/short equity hedge Equity-oriented positions on either side of the market (i.e., long
or short), dependingon outlook. Not meant to be market neutral. May establish a
concentrated focusregionally (e.g., U.S. or Europe) or on a specific sector (e.g., tech or
health carestocks). Derivatives may be used to hedge positions.
Managed futures Uses financial, currency, or commodity futures.May make use of
technicaltrading rules or a less structured judgmental approach.
 Multistrategy Opportunistic choice of strategy depending on outlook.
Fund of funds Fund allocates its cash to several other hedge funds to be managed.
Statistical Arbitrage
A version of a market-neutral strategy, but one that merits its own discussion. It differs
from pure arbitrage in that it does not exploit risk-free positions based on unambiguous
mispricing (such as index arbitrage). Instead, it uses quantitative and often automated trading
systems that seek out many temporary and modest misalignments in prices among securities.

Pair Trading that matches a long position with a short position in a pair of highly
correlated instruments such as two stocks, exchange-traded funds (ETFs), currencies,
commodities or options. Pairs traders wait for weakness in the correlation, and then go
long on the under-performer while simultaneously going short on the over-performer,
closing the positions as the relationship returns to its statistical norm. The strategy’s profit
is derived from the difference in price change between the two instruments, rather than
from the direction in which each moves. Therefore, a profit can be realized if the long
position goes up more than the short, or the short position goes down more than the long
(in a perfect situation, the long position will rise and the short position will fall, but this is
not a requirement for making a profit)

Data mining is a process used by companies to turn raw data into useful information. By
using software to look for patterns in large batches of data, businesses can learn more
about their customers and develop more effective marketing strategies as well as
increase sales and decrease costs. Data mining depends on effective data collection
and warehousing as well as computer processing.

PORTABLE ALPHA

A strategy in which portfolio managers separate alpha from beta by investing in

securities that differ from the market index from which their beta is derived. Alpha is the return
achieved over and above the return that results from the correlation between the portfolio and
the market (beta). In simple terms, portable alpha is a strategy that involves investing in areas
that have little to no correlation with the market.

Alpha- often considered the active return on an investment, gauges the

performance of an investment against a market index used as a benchmark, since they
are often considered to represent the market’s movement as a whole. The excess
returns of a fund relative to the return of a benchmark index is the fund's alpha.

Beta-a measure of the volatility, or systematic risk, of a security or a portfolio in

comparison to the market as a whole. Beta is used in the capital asset pricing
model (CAPM), which calculates the expected return of an asset based on its beta and
expected market returns. Beta is also known as the beta coefficient.
 Alpha Transfer
rportfolio = rf +1 β(rM -rf) +e + α

PURE PLAY
An investment that is concentrated in a particular industry or operation. An investor wh
o believes that snowmobilesare the wave of the future will search for a pure play in sno
wmobiles. In other words, the investor seeks out acompany that does nothing other tha
n manufacture and sell snowmobiles. Likewise, Maytag Corporation is more of apure pla
y in household appliances than is General Electric, even though General Electric has a lar
ger share of theappliance market than Maytag. Reason: General Electric generates much
of its revenues from its other operation

HEDGE RATIO

The hedge ratio compares the value of a position protected through the use of a hedge
with the size of the entire position itself. A hedge ratio may also be a comparison of the value of
futures contracts purchased or sold to the value of the cash commodity being hedged.

Hedge Ratio
Investment portfolio X β
Index value X Price
FEATURES OF HEDGE FUNDS
1. Privately owned and privately managed
 Most often set up as private investment fund that markets itself almost exclusively to
wealthy/sophisticated investors.
2. Secretive
 Hedge fund managers know that each hedge fund is formed to take advantage of certain
identifiable market opportunity that is why all their theories, strategies and the like are
not known to the public.
3. Unregulated
 Hedge funds have less regulations than other standard funds because it was done by only
few investors.
4. Illiquid
 It is mostly illiquid because investments are locked up for some period of time.
5. Absolute Return
 Focus on generating positive ROI regardless of the direction of the market which makes
hedge funds attractive to the investors.
 6. High Fees
 Mostly, hedge funds have a fee structure of TWO and TWENTY.

HEDGE FUND STYLES ANALYSIS

Hedge funds use different investment strategies that is why they are classified according to their
styles. Hedge funds are mostly traditional assets managed in non-traditional ways. There are many ways
to classify hedge funds, each with its own particular nuances and the analysis of it thus measure the
implicit asset class exposure of a portfolio.

The general idea of Style Analysis is to attempt to explain, or understand, the return stream of a
given fund in terms of a set of asset classes (or style factors).

Styles of Hedge Funds

1. Long/Short Positions
 Long position is investors are just buying a stock.
 Short position is borrowing or selling which allows you to make money as things (prices)
go down.
 Shorting is selling stock hoping to buy the stock back at a low price.
 Shorting is riskier than long positions because when you get it wrong and the prices rise,
the investors will lose a lot of money.
 Example is the 130/30 fund.
2. Relative Values (Arbitrage)
 Identifying an opportunity to something that’s expensive and buy something that is
cheap.
 Exploiting inefficiencies between prices in the market by trading a portfolio of carefully
selected long and short positions.
3. Event Driven
 These are profits made by major events which includes mergers and acquisitions,
takeovers, bankruptcy, etc.
 Examples:
i. Short selling debt in distressed companies
ii. Profiting from the difference between the stock price and acquisition price.
4. Macro
 These are funds that see the “BIG” picture – the overall economic outlook.
 These are also funds that take big bets on the direction of currencies, government bonds,
etc.
 Example: the September 16, 1992 which is called the “Black Wednesday” wherein George
Soros short sell British currency and made £ 1 Billion out of it.

PERFORMANCE OF HEDGE FUNDS

 Hedge fund performance is measured by comparing their returns to an estimate of their risk. It
also may reflect a high degree of skill among hedge fund managers. Unlike mutual funds, hedge funds
promise – and are intended – to provide absolute returns regardless of the market condition. That being
said, there are always market movements that affect hedge fund performance, either directly or
indirectly.

Liquidity
 Hedge funds tend to hold more illiquid asset because it is locked up for some period of
time. In hedge funds, liquidity is the key concern for investors because invested funds
may be difficult to withdraw “at will”. Therefore, it is important to control for liquidity
when evaluating performance.

Survivorship Bias
 Backfill Bias is a variation of survivorship bias that result from inclusion of a new hedge
fund into a given index and its past performance of a fund is added into the database
months or even years after the fund’s inception.
 This type of bias may make hedge funds appear to be a better performing asset type
than they really are because hedge fund managers can choose whether to report the
performance of their funds.

FEE STRUCTURE IN HEDGE FUNDS

 Management fee
o It is for the same service that management fee covers in mutual funds. The difference
is that they typically charge 2% of asset managed – and in some cases even higher.
 Incentive fee
o It is given to reward the hedge fund manager for good performance of the
investment.
o It is between 10% - 20% of the investment’s profit.
o High water mark
 If a fund experiences losses, it may not be able to charge an incentive fee
unless and until it recovers to its previous higher value.

Two and Twenty Fee Structure

 It is a type of compensation structure that hedge fund managers typically employ.
 Two percent (2%) for management fee and Twenty percent (20%) profit fee
o Profit fee or Incentive fee of 20% is only given once the fund achieves a level of
performance that exceed its threshold.

REFERENCES:
BOOK:
Bodie, Z., Kane, A., & Marcus, A. J. (2014). Investments (Tenth ed.). 2 Penn Plaza, New York, NY 10121:
McGraw-Hill Education.
OTHER WORK:
Chopra, P. (2002). Hedge Funds. MII Presentation [8-20]. Retrieved from https://collab.itc.virginia.edu/
access/content/.../Fundamentals/Hedge%20Funds.ppt

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