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An introduction to hedge funds Man


									An introduction
to hedge funds

History and definition                  3

Hedge fund styles                       4

The myths and facts about hedge funds   6

Funds of hedge funds                    8

Glossary of terms                       10
History and
The first hedge fund was developed in                                Jones’ dramatic outperformance of                            The term ‘hedge fund’ was initially used
the US in 1949 by doctor of sociology,                               mutual funds in the early-to-mid 1960s                       to describe a private investment fund
Alfred Winslow Jones. His pioneering                                 sparked a wave of interest and by 1968,                      which followed Alfred Jones’ original
insight came from his appreciation of                                there were 200 hedge funds in operation                      strategy of using leverage to enhance
the complementary nature of leverage1                                in the US. However, it was not until the                     returns and short selling to limit risk.
(investing borrowed money) and short                                 early 1990s that the industry began to                       However, such a narrow definition is no
selling1 (borrowing stock to trade). Both                            grow in earnest. The real boom period                        longer appropriate due to the evolutionary
of these concepts were used widely in                                for hedge funds followed the bursting of                     nature of the industry. Trading techniques
isolation, often for speculative purposes.                           the technology bubble and the ensuing                        are constantly being redefined and
However, Jones discovered that they                                  bear market. Investors were impressed                        enhanced and the number of sub-
could be effectively combined to produce                             by the ability of hedge fund managers to                     strategies is steadily expanding.
a conservative investment portfolio.                                 preserve capital in such stark conditions
This strategy is known today as ‘equity                              and the number of hedge funds
                                                                                                                                      Distinct characteristics of
long/short’.                                                         subsequently doubled between 2002
                                                                                                                                      hedge funds:
Jones stepped down from fund                                         and 2007.
                                                                                                                                      •	 Key performance driver is manager
management in the early 1980s. His track                             In recent years, the growth and
                                                                                                                                         skill rather than market returns
record demonstrated that he lost money                               contraction of the industry has been
in only three years out of 34, while the                             driven by hedge fund performance.                                •	 Target consistent returns rather than
S&P 500 index recorded nine years of                                 Although 2008 was a poor year for hedge                             outperformance of a benchmark
negative returns during the same period.                             funds in terms of meeting absolute return                           index
Significantly, Jones’ fund substantially                             objectives, the exceptionally difficult                          •	 Managers are unrestricted in their
outperformed the market during the                                   trading conditions acted as a form of                               choice of investment strategies
boom years of the early 1960s and also                               quality control with many low-calibre                            •	 The ability to invest in any asset
provided resilience during the sharp                                 hedge funds folding.                                                class or instrument
downturn of 1973-74.

Growth of the hedge fund industry2
Number of funds

                                                                                                                                                   Index value USD

                  12000                                                                                                                     3500

                  10000                                                                                                                     3000

                  8000                                                                                                                      2500

                                    HFRI Fund of Funds Composite Index
                  6000                                                                                                                      2000

                  4000                                                                                                                      1500

                  2000                                                                                                                      1000

                      0                                                                                                                     500
                          94   95   96   97   98    99    00    01    02   03   04     05     06     07     08     09     10     11

1. A more comprehensive definition of both techniques is provided in the glossary. 2. Source: Bloomberg and ‘HFR Global Hedge Fund Industry Report’, Q4, 2011. Hedge Fund Research, Inc.
There is no guarantee of trading performance and past performance is not necessarily a guide to future results. Please note that the HFRI Index data over the last four months may be subject
to change. Date range: 1 January 1994 to 31 December 2011.

     Hedge fund

      Relative value
      Global macro
      Event driven
      Managed futures
      Equity hedge

         Hedge fund managers employ a diverse and
         constantly evolving range of trading strategies to
         generate returns. These can be grouped into five
         broad investment styles as illustrated below1.

                                                                                Event driven
                                                                                Buying and short                                                   Equity hedged
                                                                                selling of securities
                                                                                of companies                                                       Pro ts from taking up
                                               Global macro                     experiencing or                                                    long and offsetting
                                               Analysis of shifts               involved in substantial                                            short positions in
             Relative value                    in macroeconomic                 corporate changes                                                  undervalued and
                                               trends to capitalise             (merger, arbitrage,                                                overvalued stocks
             Exploitation of                                                    distressed securities                                              with a xed or variable
             mispricings and                   on upward
                                                                                and special situations)
                                                                                                                 Managed futures
                                               and downward                                                                                        underlying net long
             changing price                                                                                                                        or short exposure
                                               directional                                                       Global trading in futures
             relationships between
                                               opportunities across                                              and derivatives on
             related securities
                                               various markets,                                                    nancial instruments and
             (convertible bond
                                               asset classes and                                                 goods (systematic,
             arbitrage, xed income
                                                 nancial Instruments                                             long-term trend-following
             arbitrage, statistical
                                                                                                                 models, discretionary
                                                                                                                 strategies and short-term,
                                                                                                                 active trading strategies)


         The equity hedged style incorporates                             describe the exploitation of anomalies                              Global macro and managed futures
         equity long/short which, as discussed, is                        stemming from the mispricing of related                             disciplines are based on the development
         the founding strategy of the hedge fund                          assets and the potential convergence of                             of views on economic and market
         industry. Equity hedged also constitutes                         prices. Relative value managers are able                            themes. They use highly liquid financial
         the largest segment of the industry,                             to exploit such opportunities by taking a                           instruments such as futures contracts
         accounting for approximately 30% of                              short position in the overvalued asset and                          to implement a strategy to reflect these
         total assets. Similar to equity hedged,                          a long position in the undervalued asset.                           observations. The major difference
         both the relative value and event driven                         Profits are generated if the prices of the                          between the two styles is that global
         styles are concerned with the appraisal of                       two assets converge, regardless of the                              macro is a more discretionary discipline
         underlying asset values. However, global                         overall direction of the market.                                    which tends to produce portfolios that are
         macro and managed futures disciplines                            Event driven managers identify specific                             quite concentrated. Conversely, managed
         are based on the observation of market                           events with the capacity to trigger                                 futures is almost completely systematic
         trends and are therefore more tactical                           significant changes in the price of                                 and typically takes a much larger number
         than fundamental in their orientation.                           securities and seek to exploit the resulting                        of small positions.
         Arbitrage can be an important                                    investment opportunity. Consequently,
         component of both the event driven                               these strategies are focused on corporate
         and equity long/short investment                                 actions, such as bankruptcies, mergers
         philosophies, but it is the foundation of                        or takeovers.
         relative value strategies, as the name
         implies. Arbitrage is a term used to

         Source: Bloomberg. Styles represented by HFRI Relative Value (Total) Index, HFRI Macro (Total) Index, HFRI Event Driven (Total) Index, Barclay BTOP 50 Index, HFRI Equity Hedge (Total) Index.
         There is no guarantee of trading performance and past or projected performance is not a reliable indicator of future performance. Returns may increase or decrease as a result of currency
         fluctuation. Please note that the HFRI index data over the last 4 months may be subject to change. Please note that the Barclay BTOP 50 Index data over the last 12 months may be subject
         to change. 1. Schematic illustration adapted from Bloomberg data covering period 1 January 1994 to 31 December 2011.

  The myths
  and facts about
  hedge funds
  Traditional asset managers typically                      that hedge funds (in general) are riskier             delivered. Conversely, a substantial
  allocate capital to equities, bonds and                   than traditional investment strategies is             proportion of hedge fund manager
  cash on a ‘long-only’ basis. Although they                misguided, especially considering that                remuneration comes from performance
  employ skill-based security selection,                    the long-only approach fails to make any              fees which can only be charged when
  they manage their portfolios against a                    provision against the fundamental risk of             positive investment returns are generated.
  passive benchmark (usually a familiar and                 market downturns.                                     Furthermore, many hedge fund managers
  established index which is representative                 The underlying philosophy of the                      invest their own capital in their funds,
  of the markets and assets they invest                     hedge fund industry is that, the skill of             meaning that their interests are aligned
  in). Consequently, their scope is limited                 the manager (‘alpha’), rather than the                with those of their investors.
  to outperforming a benchmark index                        performance of a market or asset class
  by an amount sufficient to justify their                  (‘beta’), should principally determine
  management fees. If they diverge too far                  the success of the strategy. This
  from the index the relative risk carried will             key difference is also reflected in the
  be considered unacceptably high. This                     remuneration of managers and the
  makes it virtually impossible for traditional             freedom that they are given to invest
  managers to produce positive returns                      in a much broader range of financial
  when markets are declining.                               instruments and assets.
  In a financial context, the term ‘hedge’                  Traditional investment funds typically
  can be defined as ‘guarding against                       levy a flat fee for active management
  risk of loss’. As such, any inference                     regardless of the level of performance

     Hedge fund misconceptions               Reality

     They are unregulated                Established providers are regulated at the manager level
     They are very risky                 Provide superior diversification/downside protection
     They are highly leveraged           Leverage is typically low; many banks use significantly more leverage
     They charge excessive fees          Performance fees only levied when ‘earned’
     They have long ‘lock-up’ periods    Range of liquidity profiles available according to strategy
     They lack transparency              Disclosure is improving but data interpretation is complex

Consequently, hedge funds provide investors with a number of advantages relative to
traditional funds.

 Traditional investments                                        Hedge funds

 Restricted opportunity set                                     9      Can exploit wide range of price distortions

 Mainly dependent on beta                                       9      Focused on alpha generation

 Relative return objectives                                     9      Target consistent performance

 Flat fee structure                                             9      Alignment of manager/investor interests

 Limited diversification sources                                9      Large number of strategies

 Inefficient dispersion of risk                                 9      Enhanced risk/reward trade-off

Hedge funds are normally used in a                                   The illustration below demonstrates how
portfolio context rather than being                                  a 30% allocation to a fund of hedge funds
considered as stand-alone investments.                               can enhance the risk and return dynamics
As the performance of hedge funds is                                 of a traditional investment portfolio
not closely correlated with traditional                              comprising equities, bonds and cash1.
asset classes – especially in declining
markets when correlations tend to be
low – they offer a tremendous source
of diversification for most investment

Traditional portfolio                                                Enhanced portfolio
          Cash       10%

                                                                       Fund of
             World              World
                                                         Fund of      hedge fund
  World      bonds              stocks
                      World                             hedge fund      index
  bonds      30%                 60%
                      stocks                              index          30%
  30%                  60%                                 30%                                 portfolio
                                                                             portfolio           70%

 Traditional portfolio                                                Enhanced portfolio

 Total return                   142.5%                                Total return                          150.1%    Improvement of                  7.6%

 Annualised return                 5.0%                               Annualised return                      5.2%     Improvement of                  0.2%

 Annualised volatility             8.7%                               Annualised volatility                  7.5%     Lowered by                      1.2%

 Worst drawdown                   -32.7%                              Worst drawdown                        -29.6%    Improvement of                  3.1%

 Sharpe ratio    2
                                     0.15                             Sharpe ratio        2
                                                                                                              0.20    Improvement of                   0.05

1. Source: Bloomberg and MSCI. Date range 1 January 1994 to 29 February 2012. There is no guarantee of trading performance and past or projected performance is not a reliable indicator
of future performance. Please note that the HFRI Index data over the last four months may be subject to change. Hedge fund index: HFRI Fund of Funds Composite Index. World stocks:
MSCI World Net Total Return Index hedged to USD. World bonds: Citigroup World Government Bond Index hedged to USD (total return). Cash: 3 month USD LIBOR rate. 2. Sharpe ratio is
calculated using the risk-free rate in the appropriate currency over the period analysed. Because the Sharpe ratio is an absolute measure of risk-adjusted return, negative Sharpe ratios are
shown as n/a as they can be misleading.

  Funds of
  hedge funds
  The significance of the five hedge                                A low correlation coefficient between                      Funds of hedge funds allocate capital to a
  fund styles is that they have different                           two elements of an investment portfolio                    number of different hedge fund managers
  drivers of performance and therefore                              is highly desirable as it implies that one                 and strategies creating diversified
  different return dynamics. This leads to                          component is an excellent diversifier for                  portfolios that can potentially deliver more
  comparatively low correlation coefficients                        the other. Blending the two components                     consistent investment returns than stand
  between different styles and traditional                          together in one portfolio provides a                       alone hedge funds. They can also be
  assets (as illustrated below) and means                           superior risk-adjusted return than                         individually structured to meet specific
  that portfolios composed of different                             either could provide as stand-alone                        risk, return and liquidity requirements and
  hedge funds (funds of hedge funds) can                            investments.                                               so offer widespread appeal to a broad
  constitute a very attractive investment                           Notably, the correlation between                           range of investors.
  proposition.                                                      managed futures and world stocks is                        The construction of a fund of hedge
  Although global macro and managed                                 slightly negative which signifies that an                  funds requires expertise and experience
  futures have similar investment styles,                           allocation to managed futures could help                   in hedge fund research, manager
  as discussed previously, the table                                counteract the negative performance                        selection, risk monitoring and quantitative
  demonstrates that the correlation                                 of world stocks in a bear market, rather                   analysis. A study published in September
  between their returns is only 0.52. This                          than merely cushion the impact. This was                   20061 found that larger funds of hedge
  effectively means that only half of their                         the case in 2008 when managed futures                      funds tended to perform better than
  performance can be attributed to their                            delivered positive returns while capital                   their smaller counterparts. This can be
  similarities.                                                     markets collapsed.                                         attributed to superior research and better

     Correlation matrix2

                                   World               World               Equity               Event              Global      Managed              Relative
                                  stocks               bonds               hedge                driven             macro        futures               value

     Relative value                  0.62               -0.15                 0.72                 0.82              0.32           -0.11               1.00

     Managed futures                -0.14                0.31                -0.02                -0.04              0.52            1.00

     Global macro                    0.38                0.21                 0.56                 0.52              1.00

     Event driven                    0.77               -0.19                 0.87                 1.00

     Equity hedge                    0.79               -0.17                 1.00
                                                                                                                                     1.0 = perfect correlation
     World bonds                    -0.18                1.00                                                                               0 = no correlation
                                                                                                                            -1.0 = perfect inverse correlation
     World stocks                    1.00

  1. Source: ‘The ABCs of Hedge Funds: Alphas, Betas and Costs’ published by Ibbotson Associates.
  2. Source: Bloomberg, MSCI and Barclays BTOP 50 Index. There is no guarantee of trading performance
  and past or projected performance is not a reliable indicator of future performance. Please note that the HFRI
  Index data over the last four months may be subject to change. Please note that the Barclay BTOP 50 Index
  data over the last twelve months may be subject to change. World stocks: MSCI World Net Total Return Index
  hedged to USD. World bonds: Citigroup World Government Bond Index hedged to USD (total return). Equity
  hedge: HFRI Equity Hedge (Total) Index. Event driven: HFRI Event Driven (Total) Index. Global macro: HFRI
  Macro (Total) Index. Managed futures: Barclays BTOP 50 Index. Relative value: HFRI Relative Value (Total)
  Index. Date range: 1 January 1994 to 29 February 2012.

access to the scarce capacity of the most
talented hedge fund managers. These are
                                            Advantages of funds of hedge funds
two of the major reasons why investors      With one single transaction, funds of hedge funds can provide:
should consider fund of hedge funds
rather than making direct allocations to    • Professional portfolio construction
single managers.

                                            • Optimal diversification
                                              and efficiency
                                            • Ongoing due diligence and
                                              performance monitoring
                                            • Superior risk management
                                            • Access to ‘closed’ funds
                                            • Enhanced liquidity
                                            • Low minimum investments

  of terms
  Alpha            The component of investment return that can be attributed to the skill of the fund manager(s).
  Beta             The component of investment return provided by (positive or negative) market movements
                   (alpha +/- beta = total return).
  Correlation      A measure of the interdependence or strength of the relationship between two investments.
                   A correlation of 1 means that the two investments are perfectly synchronised, while a
                   correlation of -1 implies that they move in symmetrically opposite directions.
  Derivative       A financial instrument that offers synthetic access to the properties of an underlying asset,
                   typically a commodity, bond, equity or currency. Examples of derivatives include futures and
                   options. Derivatives can be used to manage the risk associated with the underlying security,
                   to protect against fluctuations in value, or to profit from periods of inactivity or decline.
  Drawdown         A term used to describe the extent of a decline in asset value from peak to trough in any given
                   cycle. The worst or maximum drawdown constitutes the greatest peak to trough fall since
                   inception of the fund. In this context, the worst drawdown for any comparison index relates to
                   the period being analysed rather than the full history of the index.
  Leverage         A term used to describe the degree to which an investor utilises borrowed money or
                   speculative derivative positions to enhance investment returns.
  Liquidity        A relative term describing the speed at which an asset or assets can be converted into cash
                   (liquidated) and vice versa.
  Lock-up period   Indicates how liquid a hedge fund is through the specification of a notice period which
                   investors must provide prior to making a withdrawal. This is typically 30 days although certain
                   hedge fund styles such as event driven and relative value may be less liquid to enable the
                   manager to avoid having to sell assets cheaply to fund redemptions.
  Risk-adjusted    Describes the investment return achieved for each unit of risk absorbed, typically measured
  performance      using the Sharpe ratio.
  Sharpe ratio     The original measure of risk-adjusted performance. It is calculated by dividing the sum of the
                   return on an investment less a risk-free (cash) rate by the annualised volatility of the
                   investment. If one investment is similar to another in composition but has a higher Sharpe
                   ratio, it can be considered to offer greater efficiency.
  Short selling    A trading technique whereby an investment manager arranges to borrow stock
                   from a stock lender with a view to selling it and buying it back at a lower price in
                   the future.
  Transparency     A term that relates to the level of disclosure that a hedge fund manager is willing to provide.
                   Hedge funds have traditionally been seen as opaque but levels of transparency have improved
                   in the aftermath of 2008. Fund of hedge fund managers are usually able to negotiate
                   enhanced transparency terms in return for a guarantee of confidentiality, which enables them
                   to provide superior risk management.
  Volatility       A measure of the relative rate at which the price of an investment moves up and down.
                   Volatility is found by calculating the annualised standard deviation of daily change in price. If
                   the price changes rapidly over short time periods, it has high volatility and is therefore riskier
                   than investments with lower volatility. (Please note that volatility is an absolute measure of the
                   total range of prices and does not convey any information about price direction).

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