what are hedge funds by marcusbuggs

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									                               HEDGE FUNDS

“All these countries have spent 40 years trying to build up their economies and a moron like
Soros comes along with a lot of money to speculate and ruin things.”

                                  --Mahathir Mohamad, Prime Minister of Malaysia, 1998
                                                                  (from ‘The Color of Hot Money’)

‘To hedge’ means to minimize risk or insulate oneself. Conventionally the term 'hedge fund'
is used to refer to a type of private investment vehicle that invests all or most of its assets in
publicly traded securities and hedges the investors’ risk from market exposure. These
investment vehicles are commonly structured as limited partnerships in which the
investment manager, or the investment manager's capital management company, acts as the
general partner while the investors act as the limited partners. These funds are alternative
investment vehicles and are generally available to high net worth individuals and institutional
investors. For the investors who make up the fund, there is usually little or no market
liquidity. In fact they usually have a minimum lock in period ranging from one to three years.

Albert Willson Jones formed the first hedge fund in 1949. The unique feature of the fund
was that it offered operational flexibility and use of unconventional strategies to the
managers. It took both long and short positions (see strategies below) in securities to increase
returns while reducing net market exposure and used leverage to further enhance the
performance. This fund earned substantially higher and more regular than the normal mutual

Today the term ‘hedge funds’ takes on a much broader connotation, as many of the hedge
funds control risk by hedging one or more methods. Moreover hedge funds are broadly
defined by their structural characteristics, rather than their ‘hedged’ nature. They are
considered to be an asset class that aims in producing absolute (not relative) returns,
irrespective of how the markets perform. The best of these funds offer greater
diversification, less risk and more stable returns than conventional equity investments
moreover some offshore hedge funds can offer plan sponsors a third advantage: tax-free
hedge fund investing.

The conventional equity and bond manager’s performance is largely related to the
performance of the underlying markets. On the other hand, performance of hedge funds
depends on the skills of the fund manager, who risk his own as well as his clients’ capital.
The manager receives a fee for managing the fund, only if it is productive. This is called an
“incentive based fee” or a “performance based fee”. Some funds also add a “watermark” or
“hurdle” (a benchmark), which the fund must outperform in order for the General Manager
to earn his fee. The General Manager's fee is typically 1-2% of the total assets of the fund
and 20-30% of the profits. The general manager may use any investment strategy or style he
chooses, no matter how risky or "volatile", to manage the fund's assets for greater return.
        Projected and historical growth rates, assets: Global Hedge Funds

                 Hedge Fund Performance CAGR
                 1984-1994                          26%
                 1990-1996                          40%
                 1996-2006 (Expected)               26%

                                                                Source: Bekier, RRCM, KPMG

An excellent overview of the industry by Business Week characterized the pattern more
pointedly. "Bankers, security industry professionals, mutual fund managers — all are beating
the drum…It’s no secret that Wall Street hates hedge funds." But why? "It’s not just jealousy
or scapegoat that makes the hedge funds anathema to the powers on Wall Street. Fear is
another possibility—fear that the public may demand incentive-based compensation
for their funds as well." The concept of performance-based compensation may well be
unsettling to an industry that charges according to the volume of transactions made or the
total assets under management, regardless of whether the customers earn profits or not.

                                                                       Source: Bekier, Cottier, ICI

Looking at these curves, it appears that the rapid growth of mutual funds began some ten
years prior to that of hedge funds; approximately 1980 for mutual funds and 1990 for hedge
funds. The rapid growth stage for mutual funds has lasted more than 15 years (1980-1997).
Granted, that some of the underlying drivers of growth may be different for mutual funds
than for hedge funds. However, if one assumes that the growth cycles will parallel each other
to some extent, then one can conclude that hedge funds are at the beginning of their journey
and the growth cycle for hedge funds could last another ten years taking us well into the next


Hedgers use the futures market to protect themselves from risk. Similarly the portfolio
managers hedge stock fund risk. Commonly, prices in the cash markets have a fundamental
relationship to the futures prices. When the forces of demand and supply change the prices
in the cash market, the future prices are supposed to move in a parallel fashion. But in reality
they do not move in exact amounts. Hedgers take advantage of this relationship between
cash and futures prices. Analysts attempt to classify them into a number of different
strategies and sectors, but each set of managers is essentially looking to exploit pricing
anomalies through trading, rather than through simply buying and holding assets. In each
case, hedge fund managers aim to exploit price differentials, remaining market-neutral but
buying one asset and selling another. Price convergence will lead to profit irrespective of the
overall price movements in the sector. The successful funds with good track records make
money and prosper, although limits to the size of trades and the need to stay nimble do limit
a manager's size.
There are approximately 14 distinct investment strategies used by hedge funds, each offering
different degrees of risk and return.

Very high risk strategies

       Emerging Markets: Invests in equity or debt of emerging (less mature) markets that
       tend to have higher inflation, volatile growth and the potential for significant future
       growth. Examples include Brazil, China, India, and Russia. Short selling is not
       permitted in many emerging markets, and, therefore, effective hedging is often not
       available. This strategy is defined purely by geography; the manager may invest in any
       asset class (e.g., equities, bonds, currencies) and may construct his portfolio on any
       basis (e.g. value, growth, arbitrage)

       Short Selling: In order to short sell, the manager borrows securities from a prime
       broker and immediately sells them on the market. The manager later repurchases
       these securities, ideally at a lower price than he sold them for, and returns them to
       the broker. In this way, the manager is able to profit from a fall in a security's value.
       Short selling managers typically target overvalued stocks, characterized by prices they
       believe are too high given the fundamentals of the underlying companies. It is often
       used as a hedge to offset long-only portfolios and by those who feel the market is
       approaching a bearish cycle.

                         ARBITRAGE USING SHORT SALES

       Macro: Aims to profit from changes in global economies, typically brought about by
       shifts in government policy that impact interest rates, in turn affecting currency,
       stock, and bond markets. Rather than considering how individual corporate
       securities may fare, the manager constructs his portfolio based on a top-down view
       of global economic trends, considering factors such as interest rates, economic
       policies, inflation, etc and seeks to profit from changes in the value of entire asset
       classes. For example, the manager may hold long positions in the U.S. dollar and
       Japanese equity indices while shorting the euro and U.S. treasury bills. Uses leverage
       and derivatives to accentuate the impact of market moves. The leveraged directional
       investments tend to make the largest impact on performance

High risk strategies

       Aggressive Growth: A primarily equity-based strategy whereby the manager invests
       in companies, with smaller or micro capitalization stocks, characterized by low or no
       dividends, but experiencing or expected to experience strong growth in earnings per
       share. The manager may consider a company's business fundamentals when investing
       and/or may invest in stocks on the basis of technical factors, such as stock price
       momentum. Managers employing this strategy generally utilize short selling to some
       degree, although a substantial long bias is common. This includes sector specialist
       funds such as technology, banking, or biotechnology.

       Market Timing: The manager attempts to predict the short-term movements of
       various markets (or market segments) and based on those predictions, moves capital
       from one asset class to another in order to capture market gains and avoid market
       losses. While a variety of asset classes may be used, the most typical ones are mutual
       funds and money market funds. Market timing managers focusing on these asset
       classes are sometimes referred to as mutual fund switchers. Unpredictability of
       market movements and the difficulty of timing entry and exit from markets add to
       the volatility of this strategy.

Moderate risk strategies

       Special Situations: The manager invests, both long and short, in stocks and/or
       bonds which are expected to change in price over a short period of time due to an
       unusual event. Examples of event-driven situations are mergers, hostile takeovers,
       reorganizations, or leveraged buyouts. It may involve simultaneous purchase of stock
       in companies being acquired, and the sale of stock in its acquirer, hoping to profit
       from the spread between the current market price and the ultimate purchase price of
       the company.

       Value: A primarily equity-based strategy whereby the manager invests in securities
       perceived to be selling at deep discounts to their intrinsic or potential worth. The
       manager takes long positions in stocks that he believes are undervalued, i.e. the stock
       price is low given company fundamentals such as high earnings per share, good cash
       flow, strong management, etc. Possible reasons that a stock may sell at a perceived
       discount could be that the company is out of favor with investors or that its future
       prospects are not correctly judged by Wall Street analysts. Securities may be out of
       favor or under-followed by analysts. Long-term holding, patience, and strong
       discipline are often required, until the ultimate value is recognized by the market.
       The manager can take short positions in stocks he believes are overvalued.
       Funds of Hedge Funds: The manager invests in other hedge funds (or managed
       accounts programs) rather than directly investing in securities such as stocks, bonds,
       etc. These underlying hedge funds may follow a variety of investment strategies or
       may all employ similar approaches. Because investor capital is diversified among a
       number of different hedge fund managers, funds of funds generally exhibit lower
       risk than do single-manager hedge funds. Funds of funds are also referred to as
       multi-manager funds. It’s a diversified portfolio of generally uncorrelated hedge
       funds and it’s a preferred investment of choice for many pension funds,
       endowments, insurance companies, private banks and high-net-worth families and

Variable risk strategies

       Opportunistic: Rather than consistently selecting securities according to the same
       strategy, the manager's investment theme changes from strategy to strategy as
       opportunities arise to profit from events such as IPOs, sudden price changes often
       caused by an interim earnings disappointment, hostile bids, and other event-driven
       opportunities. Characteristics of the portfolio, such as asset classes, market
       capitalization, etc., are likely to vary significantly from time to time. The manager
       may also employ a combination of different approaches at a given time

       Multi Strategy: The manager typically utilizes many specific, pre-determined
       investment strategies, e.g., Value, Aggressive Growth, and Special Situations in order
       to better diversify their portfolio and/or to more fully use their range of portfolio
       management skills and philosophies and also in order to realize short or long term
       gains. This style of investing allows the manager to overweight or underweight
       different strategies to best capitalize on current investment opportunities. Although
       the relative weighting of the chosen strategies may vary over time, each strategy plays
       a significant role in portfolio construction.

Low risk strategies

   Distressed Securities: The manager invests in the debt and/or equity of companies
   having financial difficulty. Such companies are generally in bankruptcy reorganization or
   are emerging from bankruptcy or appear likely to declare bankruptcy in the near future.
   Because of their distressed situations, the manager can buy such companies' securities at
   deeply discounted prices. The manager stands to make money on such a position should
   the company successfully reorganize and return to profitability. Also, the manager could
realize a profit if the company is liquidated, provided that the manager had bought senior
debt in the company for less than its liquidation value. "Orphan equity" issued by newly
reorganized companies emerging from bankruptcy may be included in the manager's
portfolio. The manager may take short positions in companies whose situations he
deems will worsen, rather than improve, in the short term.

Income: Invests with primary focus on yield or current income rather than solely on
capital gains, though it may also utilize leverage to buy bonds and (sometimes) fixed
income derivatives in order to profit from principal appreciation and interest income.
Other strategies (e.g. distressed securities, market neutral arbitrage, macro) may heavily
involve fixed-income securities trading as well.

Market Neutral - Securities Hedging: The manager invests similar amounts of capital
in securities both long and short, generally in the same sectors of the market, maintaining
a portfolio with low net market exposure. Long positions are taken in securities expected
to rise in value while short positions are taken in securities expected to fall in value. Due
to the portfolio's low net market exposure, performance is insulated from market
volatility. Market risk is greatly reduced, but effective stock analysis and stock picking is
essential to obtaining meaningful results. Leverage may be used to enhance returns. It
sometimes uses market index futures to hedge out systematic (market) risk. It uses T-
bills as a relative benchmark index.

Market Neutral - Arbitrage: The manager seeks to exploit specific inefficiencies in the
market by trading a carefully hedged portfolio of offsetting long and short positions. By
pairing individual long positions with related short positions, market-level risk is greatly
reduced, resulting in a portfolio that bears a low correlation to the market. For example,
long convertible bonds and short underlying issuer’s equity. For example, can be long
convertible bonds and short the underlying issuers equity. It may also use futures to
hedge out interest rate risk. These relative value strategies include fixed income arbitrage,
mortgage backed securities, capital structure arbitrage, and closed-end fund arbitrage.
Are all hedge funds speculative and risky?

A majority of the funds stress on returns. At the other extreme, for the highly risk-averse
investor, there is a whole group of funds that emphasizes low volatility. Some managers do
an excellent job of keeping volatility down close to government-bond level but handily
beating bond returns. E.g.: Relative benchmark index used for Market neutral security
hedging is usually T-bills.

 Risk & Reward Comparisons Hedge Funds vs. Traditional Assets (1986-1995)

Various studies indicate that hedge funds as a group provide higher absolute returns on average compared to
the S&P 500.

The normal view is that hedge funds are highly risky - that they all use global macro
strategies and place large directional bets on stocks, currencies, bonds, commodities, and
gold, while using lots of leverage. Even though the inference of gambling is not usually
correct, it is easily made when viewed in the context of tools used- like leverage and short
selling. These are perceived by most investors as purely speculative tools. But many hedge
funds successfully employ them to increase performance while actively managing risk. Most
hedge funds use derivatives only for hedging or don't use derivatives at all, and many use no
leverage. The reality is that less than 5% of hedge funds are global macro funds causing
speculative waves and contagions, like Quantum, Tiger, and Strome.

Estimated to be growing at about 20% per year, there are between 4,000 and 5,000 active
hedge funds in this industry. Measured against major equity and bond indices, global hedge
fund indices do indeed appear more attractive, with lower volatility and higher return. But
there is a wide range of outcomes, and history is full of people who thought they had found
the alchemist's stone - some magical ingredient that turns dross into gold.
Indeed, in 1998, John Meriwether, the anti-hero of Michael Lewis' book Liars Poker, bet his
firm, Long Term Capital Management (LTCM), on the theories espoused by his partners, the
Nobel prize-winning economists, Robert Merton and Myron Scholes, and lost. LTCM was a
hedge fund, founded by Meriwether in 1994, engaged in arbitraging pricing differentials in
the bond markets, through betting on convergence in the prices of similar assets. The theory
worked very well - for a time - but when differentials blew out, the firm's highly leveraged
positions quickly lost money, necessitating an eventual bail-out by a group of banks. LTCM
had nearly $1 trillion in bad investments, but only $2 billion in assets that it could sell to pay
off its debts. Its borrowing in the 1997 alone averaged between 50 and 100 times its asset
base, and it borrowed from the biggest of banks and brokerage houses in the world, thereby
endangering a banking system already rocked by losses in Russia and the Far East.

Quantum Funds: A brief history
Hedge funds became (in)famous in 1992 with George Soros’s Quantum Funds. At that time,
UK was a part of the European Union, because of which it was following the highly
conservative monetary policy of the German Central Bank - Deutsche Bundesbank. The
British economy was suffering from a recession despite of which, it had to keep its interest
rates high, making the pound sterling very strong. Because of this conflict faced by UK, it
was widely believed that the country would soon let the pound go. This is where Quantum
Funds stepped in. George Soros borrowed 15 billion pounds and short sold the currency
intensifying the pressure on the pound and what would have happened over 4-5 months,
was made to happen immediately. UK pulled out of the EU, lowered its interest rates and let
the sterling fall (it depreciated by 15%). Soros made a quick profit of 2 billion pounds. For a
common man, he became a villain overnight, who twisted the market conditions to make a
quick profit. However it must be noted that Quantum Funds did not lead to UK pulling out
the EU. It just hastened the whole process.

Note: The average annual return of Quantum Funds for the past 5 years has been 41%


The size of the hedge fund industry, relative to the markets in which the funds operate, is
too small for hedge funds alone to move the market. The total net assets of the industry are
estimated to be around $800 to $1000 billion; therefore, hedge funds represent only about 4
percent of the $25 trillion in investments held by institutional investors. However, it is
possible that they may move the market because other investors follow their lead—an effect
referred to as “herding.” But studies of the role of hedge funds in the currency crises find
little evidence that hedge funds were the market leader— or even the lead bull in the herd.
Hedge funds managers and marketers are reluctant to entertain comparisons between the
LTCM debacle and their own activities. But, says Damien Hatfield, the chairman of the
Australian chapter of AIMA, the hedge fund's industry body, hedge funds are not wholly
different from other businesses. LTCM was highly geared, but so are most banks and
investment banks. And although some hedge funds do gear internally, only a fifth of them
have debt-to-asset ratios above 50 per cent, on a par with many industrial companies. Hedge
funds can only play a limited role in the sense, they do not create conditions themselves, they
only capitalize on the sometimes warped fundamentals of the markets.

•   “The Return of Depression Economics”, by Paul Krugman
•   “The Truth about Hedge Funds”, by P. Osterberg and James B. Thomson
•   “Risk Management Lessons from Long Term Capital Management”, Philippe
    Jorion, June 1999.
•   “Alternative Software Development - Hedge-Funds - Finance Software - Free
•   “A Primer on Hedge Funds”, William Fung and David A. Hsieh, August 1999.
•   “The Coming Evolution of the Hedge Fund Industry: A Case for Growth and
    Restructuring”, RR Capital Management Corporation, KPMG Peat Marwick LLP,
    March 1998
•   “The Eve of Destruction”, by David Shirreff
•   Webliography
            o www.fraternityfunds.com
            o www.E-Hedge.com
            o www.hedgefundresources.com

                                                             Anoop Goplani
                                                             Neha Agarwal
                                                             Vaibhav Kalia

                                                  Students 1st year PGDM

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