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Hedge Funds
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Hedge funds are investment pools that are relatively uncon
in what they do. They are relatively unregulated (for now), cvery high fees, will not necessarily give you your money backyou want it, and will generally not tell you what they do. Thesupposed to make money all the time, and when they fail atinvestors redeem and go to someone else who has recently making money. Every three or four years they deliver a one-hundred year flood. They are generally run for rich people inSwitzerland, by rich people in Greenwich, Connecticut.
-Cliff Asness, Journal of Portfolio M
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What is a hedge fund?
Hedge Fund- A fund that can take both long and short positions
use arbitrage
buy and sell undervalued securities
trade options or bonds, and
invest in almost any opportunity in any market where it fimpressive gains at reduced risk.
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What is a hedge fund?
Opinions differ regarding the definition of the phrase HedgThe most commonly accepted definition is that a hedge funfunds which:
Have an absolute return performance objective
Allow the manager to be active on both the long and short sides o
markets
Compensate the manager with performance related fees
Allow the manager tremendous flexibility in investment style and
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What is a hedge fund?
To hedge ones bets i.e. betting on other side to limit the of loss on a speculation.
Hedge funds pool of funds of the highly influential investors,
open to limited number of investors require high investment
include high expertise based investment strategies and Risk mana
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Targeted Investments
They can invest in any type of asset class or opportunity luring in the be it
options,
derivatives,
equities,
bonds,
undervalued securities,
currencies,
Commodities
events such as mergers or bankruptcies,
domestic as well as international markets where they can expect toattractive returns in all kind of risky situations.
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Goal of the fund?
Lets break it up
The primary aim of most hedge funds is to Reduce volatility and risk
while attempting to preserve capital, and
deliver positive returns under all market conditions.
In other words Attempting to minimize the risk i.e. to hedge.
Protecting capital (i.e. the private pool of funds)
Generating superior returns in all kinds of markets (they are readybearish markets also)
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Hedging Strategies
There are approximately 14 distinct investment strategies ushedge funds
Key: All hedge funds are not the same. The investment returns, vorisk vary enormously among the different strategies
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Styles of Hedge Funds
Aggressive Growth:Invests in equities expected to experience accelegrowth of earnings per share
Hedges by shorting equities where earnings disappointment is expshorting stock indexes
Tends to be "long-biased." The long-bias hedge fund strategy essentially serves as an investment halfway house in between a m
and a long-only fund. Rather than putting on positions that cancel out as found in a market neutral fsubstantial long exposure as in a long-only fund, a long-bias fund maintains a differing ratio of long (compared to short positions) that usually exceeds 40%. With this definition in mind, a hedge fund wequity strategy could transition into a long-bias hedge fund, and vice versa, depending on how its asallocated.
this type of long/short strategy, for example, investing at a 130/30 ratio of long to short (130% longor 120/20, are known as long bias strategies. Fewer hedge funds employ a short bias over the longmarkets tend to move up over time.
Expected Volatility:High
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Styles of Hedge Funds (Contd.)
Distressed Securities:Buys equity, debt, or trade claims at deep of companies in or facing bankruptcy or reorganization
Profits from the market's lack of understanding of the true vadeeply discounted securities
Majority of institutional investors cannot own below investmsecurities.
Results generally not dependent on the direction of the mark
Expected Volatility:Low - Moderate
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Styles of Hedge Funds (Contd.)
Emerging Markets:Invests in equity or debt of emerging (lemature) markets that tend to have higher inflation and volagrowth
Short selling is not permitted in many emerging markets, and, theeffective hedging is often not available
Expected Volatility:Very High
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Styles of Hedge Funds (Contd.)
Funds of Hedge Funds:Mix and match hedge funds and other poinvestment vehicles
Blend of different strategies and asset classes aims to providelong-term return than any of the individual funds.
Returns, risk, and volatility can be controlled
Capital preservation is generally important
Volatility depends on the mix and ratio of strategies employe
Expected Volatility:Low - Moderate - High
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Styles of Hedge Funds (Contd.)
Income:Invests with primary focus on yield or current incomerasolely on capital gains
May use leverage to buy bonds or fixed income derivatives, iprofit from principal appreciation and interest income.
Expected Volatility:Low
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Styles of Hedge Funds (Contd.)
Macro:Aims to profit from changes in global economies
Typically brought about by shifts in govt. policy that impact inrates, in turn affecting currency, stock, and bond markets
Uses leverage and derivatives to accentuate the impact of mamoves
Uses hedging, but largest performance impact is from the levdirectional investments
Expected Volatility:Very High
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Styles of Hedge Funds (Contd.)
Market Neutral - Arbitrage:Attempts to hedge out most markettaking offsetting positions, often in different securities of the sam
Eg. Can be long convertible bonds and short the underlying isequity.
Focuses on obtaining returns with low or no correlation to boequity and bond markets
Relative value strategies include fixed income arbitrage, mortbacked securities, capital structure arbitrage, and closed-endarbitrage
Expected Volatility:Low
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Styles of Hedge Funds (Contd.)
Market Neutral - Securities Hedging:Invests equally in long andequity portfolios generally in the same sectors of the market
Market risk is greatly reduced
Effective stock analysis and stock picking is essential to obtainmeaningful results
Leverage may be used to enhance returns Usually low or no correlation to the market
Expected Volatility:Low
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Styles of Hedge Funds (Contd.)
Market Timing:Allocates assets among different asset classes deon the manager's view of the economic or market outlook.
Portfolio emphasis may swing widely between asset classes
Unpredictability of market movements, and the difficulty of t
entry and exit from markets increase volatility
Expected Volatility:High
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Styles of Hedge Funds (Contd.)
Opportunistic:Investment theme changes from strategy to stratopportunities arise to profit from events such as IPOs, hostile bid
May utilize several of these investing styles at a given time
Not restricted to any particular investment approach or asset
Expected Volatility:Variable
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Styles of Hedge Funds (Contd.)
Multi Strategy:Investment approach is diversified by employing vario
strategies simultaneously to realize short- and long-term gains
Other strategies: Systems trading such as trend following and varidiversified technical strategies
Allows the manager to overweight or underweight different strate
capitalize on current investment opportunities
Expected Volatility:Variable
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Styles of Hedge Funds (Contd.)
Short Selling:Sells securities short, in anticipation of being able repurchase them at a future date at a lower price
Result of anticipated overvaluation, earnings disappointmentcompetition, change of management, etc.
Often used as a hedge to offset long-only portfolios by those expect bearish cycle.
Expected Volatility:Very High
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Styles of Hedge Funds (Contd.)
Special Situations:Invests in event-driven situations such as mehostile takeovers, LBOs etc.
May involve simultaneous purchase of stock in companies beacquired, and the sale of stock in its acquirer, hoping to profispread between the current market price and the ultimate puprice of the company
Results generally not dependent on direction of market
Expected Volatility:Moderate
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Styles of Hedge Funds (Contd.)
Value:Invests in securities perceived to be selling at deep discoutheir intrinsic or potential worth
Such securities may be out of favor or under-followed by ana
Long-term holding, patience, and strong discipline are often
until the ultimate value is recognized by the market
Expected Volatility:Low - Moderate
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Various Hedge Fund Strategies
Emerging Markets Invest in emerging markets Emerging markets offer less options for short selling, so these are mostly
and employ growth or value approach to investing in equities. These can be illiquid & carry a high risk due to correlation of emerging e
Convertible Arbitrage Make profit from arbitrage of convertible securities Make money from mispricing & volatility
Usually buy a convertible bond, and take a short position in underlying e Long- Short Equity
Base strategy of the initial hedge fund formations by Jones. Hedging portfolio of longs by portfolio of shorts. Main focus on the stock picking opportunities.
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Various Hedge Fund Strategies
Global macro
Invest in developed as well as developing countries. Enough flexibility. Can invest in any security in any market where there i
opportunity.
Event Driven Focus on events of corporate life cycle like acquisitions, buybacks, deme
offs etc,.
Merger/Risk Arbitrage Focus on the companies which are going through any merger or takeove Both the acquiring company and the target. The risk is deal risk rather than a market risk.
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Various Hedge Fund Strategies
Distressed Securities Buying the bonds or securities of companies facing or approaching
bankruptcy or restructuring
Tries to benefit from the price movement of these securities.
Equity Market Neutral Market timing rather than stock picking.
Taking long and short position in the undervalued and overvalued
Has low volatility.
Some Other Strategies
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Some Other Strategies
Fixed Income Arbitrage
-Seeking arbitrage opportunities in in Fixed Income Securities
-Interest rate arbitrage
-Use of derivatives like Interest Rate futures, Caps, floors etc.
Managed Futures
-Strategic investment or arbitrage in futures(usually Commodities and C
-Spot-future arbitrage
-Contango and Backwardation arbitrage
-Calendar spread in futures
Market Directional
-Market momentum strategy
-for very short term
-example is Jobbing
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Things to Note:
FICTION:All hedge funds are volatile -- they all place large directiona
securities and commodities, while using lots of leverage FACT: Less than 5% of hedge funds are global macro funds. Most h
use derivatives only for hedging or don't use derivatives at all, andno leverage.
Some hedge funds don't actually hedge against risk. The term is appwide range of alternative funds, and encompasses funds that use highstrategies without hedging against risk of loss
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Management of Hedge funds
Most hedge funds are managed by experienced investment
professionals
Highly specialized
Trade only within their area of expertise and competitive
advantage
Remuneration heavily weighted towards performance in
Usually have their own money invested in their fund
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How is a Hedge Fund different from a MFund?
Hedge funds traditionally reserved for clients with initial
investment of $1 million. Mutual fund companies beginnoffer hedge fund products to wider client base
There are 5 key differences between them based on:1. Performance Evaluation
2. Level of regulatory control3. Basis for Remuneration of Management4. Portfolio Protection5. Dependence on Markets
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Differences (Contd.)
Performance Evaluation:
Mutual funds are measured on relative performance cto a relevant index or to other mutual funds in their se
Hedge funds are expected to deliver absolute returns ucircumstances, even when the relative indices are dow
Level of Regulation: Unlike hedge funds, mutual funds are highly regulated
restricting the use of short selling and derivatives. Makdifficult to outperform market, or protect assets in dow
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Differences (Contd.)
Remuneration for Management
Mutual Fund managers are paid based on a % of AUM. Hedge fmanagers performance-related incentive fees plus a fixed fee
Portfolio Protection
Mutual funds are not able to effectively protect portfolios again
markets other than by going into cash or by shorting a limited astock index futures
Hedge funds are often able to protect against declining marketsvarious hedging strategies, and can generate positive returns evdeclining markets.
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Differences (Contd.)
Dependence on Markets The future performance of mutual funds depends on t
direction of the equity markets.
The future performance of many hedge fund strategiesbe highly predictable and not dependent on the directequity markets.
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Fund of Funds
A fund of funds mixes the most successful hedge funds and other poo
vehicles, spreading investments among many different funds or inves
Hedge fund strategies are complex and varied in their ranges of risk/rwithin a particular style, two managers can apply different amounts oinsurance and leverage to his/her portfolio
A fund of funds blends together funds of different strategies and asseorder to accomplish:
More consistent return (than any of the individual funds) Spreading out the risks among a variety of funds Meeting a range of investor risk/return objectives
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Indian Context
Asian countries are offering many opportunities
Market in UK and US are facing huge meltdowns investors are finding hard to sustain there money making options are drying
India is offering various necessary conditions for hedge funds to with its
secondary market liquidity Futures options, etc.
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Why India?
Investment can be made through FII (Foreign Institutional In
route.
Doesnt charge anything on performance or profit of the fun
Thus giving India a plus point from others
Thus attracting more HNIs to enter India through these.
Incremental Nominal GDP (in Bi
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Incremental Nominal GDP - (in BiUS $)
0
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
China India United
States
Brazil Mexico Indonesia Russia United
Kingdom
Germany Japan
2035-2050
2020-2035
2006-2020
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Working Age Population Growth Rates (% p.a.
-1.50%
-1.00%
-0.50%
0.00%
0.50%
1.00%% p.a.
Source: PwC Report
Hedge Funds in India
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Cater toIndividualInvestors
FirstImplication
Uncorrelatedreturns
Surge inearnings
SecondImplication
Increase indemand
Increasecompetition
Reducinginvestment
fees
Essentials forHFs
Registration
Independentaudit
Transparency
Properdisclosure
Performance of Indian Hedge Funds
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Performance of Indian Hedge Funds
$44,000 million AUM (assets under management) of all Indian hedgfunds
Indias high beta market generate effective returns.2006
Bull Run
Q-India, Halbis, Baer Capital, Insynergy & FMG outperformed majorhedge fund indices.
2007
Experiment with complex strategies, resulted hard on the returns.
India index was the worst performing index with loss of around 50%2008
More cautious in year 2009 and 2010
Taking some worthwhile sectors and stock calls2009
Gloomy picture of hedge fund success
First 7 months having almost deep losses and very bleak returns
Funds which focused on inflation sensitive India gained around
15.48% according to HFRX India index
2010
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http://www.karvycapital.com/hedge.aspx
http://www.thehindubusinessline.com/markets/indian-hedoutperform-sensex-over-the-last-year/article6397094.ece
http://www.funds-europe.com/news/14240-emerging-markhedge-funds-see-positive-performance
http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-geapproval-555
http://www.karvycapital.com/hedge.aspxhttp://www.thehindubusinessline.com/markets/indian-hedge-funds-outperform-sensex-over-the-last-year/article6397094.ecehttp://www.thehindubusinessline.com/markets/indian-hedge-funds-outperform-sensex-over-the-last-year/article6397094.ecehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebi-approval-555http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebi-approval-555http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebi-approval-555http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebi-approval-555http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebi-approval-555http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebi-approval-555http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebi-approval-555http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebi-approval-555http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebi-approval-555http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebi-approval-555http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebi-approval-555http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebi-approval-555http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebi-approval-555http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebi-approval-555http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebi-approval-555http://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.funds-europe.com/news/14240-emerging-market-hedge-funds-see-positive-performancehttp://www.thehindubusinessline.com/markets/indian-hedge-funds-outperform-sensex-over-the-last-year/article6397094.ecehttp://www.thehindubusinessline.com/markets/indian-hedge-funds-outperform-sensex-over-the-last-year/article6397094.ecehttp://www.thehindubusinessline.com/markets/indian-hedge-funds-outperform-sensex-over-the-last-year/article6397094.ecehttp://www.thehindubusinessline.com/markets/indian-hedge-funds-outperform-sensex-over-the-last-year/article6397094.ecehttp://www.thehindubusinessline.com/markets/indian-hedge-funds-outperform-sensex-over-the-last-year/article6397094.ecehttp://www.thehindubusinessline.com/markets/indian-hedge-funds-outperform-sensex-over-the-last-year/article6397094.ecehttp://www.thehindubusinessline.com/markets/indian-hedge-funds-outperform-sensex-over-the-last-year/article6397094.ecehttp://www.thehindubusinessline.com/markets/indian-hedge-funds-outperform-sensex-over-the-last-year/article6397094.ecehttp://www.thehindubusinessline.com/markets/indian-hedge-funds-outperform-sensex-over-the-last-year/article6397094.ecehttp://www.thehindubusinessline.com/markets/indian-hedge-funds-outperform-sensex-over-the-last-year/article6397094.ecehttp://www.thehindubusinessline.com/markets/indian-hedge-funds-outperform-sensex-over-the-last-year/article6397094.ecehttp://www.thehindubusinessline.com/markets/indian-hedge-funds-outperform-sensex-over-the-last-year/article6397094.ecehttp://www.thehindubusinessline.com/markets/indian-hedge-funds-outperform-sensex-over-the-last-year/article6397094.ecehttp://www.thehindubusinessline.com/markets/indian-hedge-funds-outperform-sensex-over-the-last-year/article6397094.ecehttp://www.thehindubusinessline.com/markets/indian-hedge-funds-outperform-sensex-over-the-last-year/article6397094.ecehttp://www.karvycapital.com/hedge.aspxhttp://www.karvycapital.com/hedge.aspx8/10/2019 Hedge Funds - IIM Raipur
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HFRX
The Hedge Fund Research Index
Most Widely followed index for Hedge Fund Performance
It is comprised of all eligible hedge fund strategies. All strategies are eweighted.
Evaluates the performance of Hedge Funds based on Absolute ReturnRelative Risk.
As a component of the optimization process, the index selects constiwhich exhibit lower volatilities and lower correlations to standard direbenchmarks of equity market and hedge fund industry performance.
HFRX India is an index for the Indian Hedge Funds.
HFRX Returns 10 09 08 07 06 Avg Stdev Min
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Global Hedge Fund 5.19 13.4 (23.25) 9.26 2.72 1.46 14.40 (23.25)
Equal Weighted
Strategies
5.29 11.44 (21.9) 8.83 1.28 0.99 13.35 (21.9)
Absolute Return (0.12) (3.58) (13.09) 7.43 (0.03) (1.88) 7.45 (13.09)
Market Directional 9.32 29.34 (29.7) 10.45 4.2 4.72 21.48 (29.7)
Convertible
Arbitrage
8.76 42.46 (58.37) 9.57 (5.69) (0.65) 36.77 (58.37)
Distressed Securities 8.34 (5.6) (30.69) 9.56 1.21 (3.44) 16.41 (30.69)
Equity Hedge 8.92 13.14 (25.45) 9.23 4.19 2.01 15.67 (25.45)
Equity Market
Neutral
2.64 (5.56) (1.16) 4.76 0.21 0.18 3.93 (5.56)
Event Driven 1.98 16.59 (22.11) 10.32 2.81 1.92 14.70 (22.11)
Macro (1.73) (8.78) 5.61 5.61 6.67 1.48 6.64 (8.78)
Merger Arbitrage 5.69 8.14 3.69 10.73 3.72 6.39 3.03 3.69
Relative Value
Arbitrage
7.65 38.47 (37.6) 10.65 (0.97) 3.64 27.39 (37.6)
Dow Jones Credit Suisse
indices
10 9 8 7 6 Avg Stdev Min Max R
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indices
Convertible Arbitrage 0.9 3.24 -2.79 0.11 1.04 0.50 2.18 -2.79 3.24 7
Emerging Markets 0.81 2.04 -2.19 2.51 1.8 0.99 1.89 -2.19 2.51 1
Event Driven 0.6 1.6 -1.46 1.64 1.03 0.68 1.27 -1.46 1.64 6
Fixed Income Arbitrage 0.38 0.3 1.01 1.29 0.86 0.77 0.42 0.3 1.29 3
Global Macro 0.69 0.48 0.98 1.21 0.39 0.75 0.34 0.39 1.21 4
Long/Short Equity 0.58 1.47 -0.85 1.5 1.02 0.74 0.97 -0.85 1.5 5
Managed Futures 1.14 -1.08 2.29 1.39 0.99 0.95 1.24 -1.08 2.29 2
HF strategies and Systematic risk
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HF strategies and Systematic riskexposure
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Evolution of HF strategies
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Modern day HF strategies
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Empirical Findings
Returns are considerably high during a volatile market which is mean
nature
Returns during a trending market in some of the HF strategies is low anegative in some cases
Well established and High Corpus HFs give a lower returns compared relatively newer peers who have small corpus
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John Paulson(HF: Paulson and Co.)His claim to fame is his pay check for 2007: he is reported to have made $3.7 billion. Strategy: Short-selling sub prime mortgage
He made a profit of $15 billion for his investors in 2007. His flagship fundgenerated a return of 599%.
In 2010, he beat a hedge-fund record by making nearly $5 billionHis Flagship Fund (Paulson Advantage Fund) was down by 40% as on Sept. 2011
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George Soros(HF: Soros Fund Management)
Short sold 10 Billion pounds in 1992 and made 1.1 Billion $ in a singleday (Black Wednesday)
Similar speculation over the currency of Association of Southeast AsianNations (ASEAN) in 1997
As of March 2012 Soros was listed 22ndin Forbs among the richestpeople in the world
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Christopher Hohn
The hedge fund he manages reportedly lost $1 billion in a single month,June 2008. The size of his hedge fund went from $8 billion to $7billion.
Interestingly Hohn was a topper at HBS.
Other smart people who lost money through Hedge Funds are theNoble Laureates Myron S. Scholesand Robert C. Merton(The LTCMcase)
H d F d R l ti I I di
http://en.wikipedia.org/wiki/Myron_S._Scholeshttp://en.wikipedia.org/wiki/Robert_C._Mertonhttp://en.wikipedia.org/wiki/Robert_C._Mertonhttp://en.wikipedia.org/wiki/Myron_S._Scholeshttp://en.wikipedia.org/wiki/Myron_S._Scholes8/10/2019 Hedge Funds - IIM Raipur
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Hedge Fund Regulations In India
SEBI regulation seeks to cover all types of funds broadly under 3 categ
Category I AIFthose AIFs (Alternative Investment Funds) with pspillover effects on the economy
Category II AIFthose AIFs for which no specific incentives or coare given by the government or any other Regulator; which shall no
leverage other than to meet day-to-day operational requirements
Category III AIF those AIFs including hedge funds which trade wto make short term returns; which employs diverse or complex tradstrategies and may employ leverage including through investment unlisted derivatives.
R l t C t i t
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Regulatory Constraints
Restricting participation:
The Alternative Investment Fund shall not accept from an investoinvestment of value less than rupees one crore. Further, the AIF shminimum corpus of Rs. 20 crore.
Avoiding wealth concentration hazards: The fund or any scheme of the fund shall not have more than 1000
Preventing Conflict of Interest: For a Hedge Fund, the continuing interest shall be not less that 5%
corpus or rupees ten crore, whichever is lower.
Reg lator Constraints (contd )
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Regulatory Constraints (contd..)
Trading in Secondary Market:
Units of AIF may be listed on stock exchange subject to a minimumlot of rupees one crore. However, AIF shall not raise funds throughExchange mechanism
Against Concentration Alpha and Speculation: Hedge Funds shall invest not more than 10% of the corpus in one
Company.
Preventing Moral Hazard: AIF shall not invest in associates except with the approval of 75% o
by value of their investment in the Alternative Investment Fund
The Category III of AIFs (the Hedge Funds)
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The Category III of AIFs (the Hedge Funds)
Proper disclosure:
Category III Alternative Investment Funds shall enscalculation of the net asset value (NAV) shall be disthe investors at intervals not longer than a quarter foended Funds and at intervals not longer than a monopen ended funds.
Category III Alternative Investment Fund shall providquarterly reports to investors within 60 days of end oquarter.
How Hedge Fund Leverage Works (Exh
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g g (11.1)Hedge fund investor capital can be leveraged in several ways to enhance overall returns.
Direct forms of leverage:
Bank borrowingsHedge funds can take out margin loans (buying securities on margin) from banks. For exampmargin on security ABC, a hedge fund could buy $10 worth of securities by paying only $2 upbank supply the remaining $8 in the form of a loan. To protect its loan balance, the bank reqdeposit an agreed amount of securities as collateral. If the market value of the ABC securitierequire additional collateral from the hedge fund (margin call) to further protect itself.
Repossession agreements (repos)
Usually used by hedge funds to finance debt security purchases, a repo transaction involves o
sell a security to another party for a given price and then buying it back later at a higher priceImplicit forms of leverage:
Short selling
Short selling is the practice of selling securities borrowed from banks or other counterpartiessale of these borrowed securities are used to buy other securities a practice known as long
How Hedge Fund Leverage Works - Exhibit
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g gof 2)
Short selling
Short selling is the practice of selling securities borrowed from banks or other counFunds raised from the sale of these borrowed securities are used to buy other securpractice known as long/short trading.
Off-balance-sheet leverage through derivatives and structured products
Derivatives include options, swaps, and futures. Investors can gain much larger riskan asset class through the use of derivatives than from buying the assets directly. Inthe high-risk portions of structured products such as collateralized debt obligations provide implicit leverage.
Through the first half of 2008, total hedge fund industry leverage was estimated to betimes investor capital.
Source: Farrell, Diana, et al. The New Power Brokers: How Oil, Asia, Hedge Funds and Private Equity AreGlobal Capital Markets. McKinsey Global Institute Oct. 2007.
A t d t d ti t d t t l i t bl t 1 $ i t illi
Exhibit 11.2 Hedge Funds Leveraged Assets Fell from $6.6 Trillion to $2.4 Trillion in Less Than a One-YearFor recentfigures refer
Figure 11.1
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Note 1: Includes leverage from debt and off-balance sheet leverage through derivatives and other instrument
Note 2: Leverage ratio = (total leverage + AUM) / AUM
Source: McKinsey Global Institute; Global Capital Markets Survey; Dresdner Kleinwort Equity Research; Intern
Financial Services, London; Financial Risk Management, Ltd.; Financial Services Authority
Assets under management and estimated total investable assets1, $ in trillions
Implied
Leverage
Ratio2(total)
2.93.4
4.8
6.5 6.6
3.6
2.4
2.9 3.1 3.4 3.4 3.5 2.6 2.0
-64%
1.0 1.1 1.4 1.9 1.9
1.4 1.2
0.4 0.60.8
1.30.8
0.70.3
1.51.7
2.6
3.3
3.9
1.5
0.9
2004 2005 2006 2007 H1-08 H2-08 Q1-09
Leverage through derivative positions
Leverage through debt
Assets under management
g
of text book
page 222
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Estimated Total Number of Hedge FundsversusFund of Funds
1990 20008
Exhibit 11.3 (2 of 2)For recentfigures refer
Figure 11.3
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Source: Hedge Fund Research, Inc.
199020008
80 127 168 237 291 377 389 426 477 515 538 550 781
1,2321,654
1,996 2,2212,46
530 694 937
1,2771,654
2,0062,392
2,5642,848
3,102 3,335
3,904
4,5985,065
5,782
6,665
7,2417,6
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
Fund of Funds
Hedge Funds
of text book
page 223
Estimated Growth of Assets
Hedge Fund Industry 1990 2008 $ in billions
Exhibit 11.4 (1 of 2)For recentfigures refer
Figure 11.4
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Hedge Fund Industry 19902008, $ in billions
0
200
400
600
800
1,000
1,200
1,400
1,600
1,800
2,000
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
of text book
page 224
Estimated Growth of Assets
Fund of Fund Industry 1990 2008 $ in billions
Exhibit 11.4 (2 of 2)For recentfigures refer
Figure 11.5
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Source: Hedge Fund Research, Inc.
Fund of Fund Industry 1990 2008, $ in billions
0
100
200
300
400
500
600
700
800
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
of text book
page 224
Share of High Net Worth Individuals Has Fallen
Exhibit 11.5For recentfigures refer
Figure 11.6
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Source: McKinsey Global Institute; Hennessee Group LLC; International Financial Services, London estimates
5% 10% 12% 14% 15% 15% 15% 15% 12% 11% 14% 15%
9%8% 7%
7% 8% 7% 8% 8% 7% 8%12% 11%11%
10% 8% 8% 9% 9% 9% 9%
7%18%
12% 12%14%18% 20% 17%
20% 27% 24% 24% 30%
23%31% 32%
61% 54% 53% 54%
48% 42% 44% 44% 44% 40%
31% 30%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
High net-worth
individuals
Fund of hedge fu
Endowments and
foundations
Corporations and
institutions
Pension funds
of text book
page 226
Top 10 Hedge Funds by Assets Under Management at the End of 2008
Exhibit 11.6
Firm Region AUM ($bn)
For recenttable 11.1
of text book
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Note 1: As of December 31, 2008. All other figures as of January 1, 2009.
Note 2: Tied for 10thplace.
Source: Absolute Return Billion Dollar Club, March 2009 rankings
Bridgewater Associates U.S. 38.6
J.P. Morgan U.S. 32.9
Paulson & Co. U.S. 29.0
D.E. Shaw Group U.S. 28.6
Brevan Howard1 Europe 26.8Och-Ziff Capital Management U.S. 22.1
Man AHL1 Europe 22.0
Soros Fund Management U.S. 21.0
Goldman Sachs Asset Management1 U.S. 20.6
Farallon Capital Management2 U.S. 20.0
Renaissance Technologies2 U.S. 20.0
page 227
Hedge Fund Revenues are Highly Concentrated in the Top 205 Funds
Exhibit 11.7
Hedge Fund Revenue Pool for 2006
For recentfigures refer
Figure 11.7
f b k
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Source: McKinsey Global Institute; Lipper Hedge World; Merrill Lynch; McKinsey Global Institute hedge fund
interviews
43%
18%
13%
26%
Hedge Fund Revenue Pool for 2006
>$5bn (64 funds)
$3-5 bn (64 funds)
$2-3 bn (77 funds)
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Note: A bull market (denoted in green shading) is a 20% rally preceded by a 20% decline in the DJIA; a bear m
(denoted in red shading) is a 20% decline preceded by a 20% rally in the DJIA.
Source: Hedge Fund Research, Inc.; DJIA data provided by Commodity Systems Inc.
y g ,
HFRI Fund Weighted Composite Index
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
Dec-94
Jun-95
Dec-95
Jun-96
Dec-96
Jun-97
Dec-97
Jun-98
Dec-98
Jun-99
Dec-99
Jun-00
Dec-00
Jun-01
Dec-01
Jun-02
Dec-02
Jun-03
Dec-03
Jun-04
Dec-04
Jun-05
Dec-05
Jun-06
Dec-06
Jun-07
Dec-07
of text book
page 229
Since 1990, Hedge Fund Strategies Have Outperformed Both Bonds andEquities (Even Accounting for Risk)
Risk vs. return for hedge fund strategies compared to blended portfolios of bonds and equities,
Exhibit 11.9
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Source: McKinsey Global Institute; Hedge Fund Research, Inc.; Datastream
1990 - 2008
Relative Value
Event-Driven
Equity Hedge
Macro
3 4 5 6 7 8 9 10 11 12 13
7
8
9
10
11
12
13
14
15
Standard Deviation %
AverageReturn%
Portfolio composition:
100% equities, 0% bonds
Additional 5% bonds, moving to th0% equities, 100% bonds
Top Quartile Hedge Funds Outperformed U.S. Equities and Bonds1
Average annual returns (net of fees) by strategy for risk-adjusted quartiles, 20012007, %
Exhibit 11.10
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Note 1: Quartiles are defined based on risk-adjusted performance, defined using fund Sharpe ratio between 2
2007. The Sharpe ratio is given by Average (RRf) / Standard Deviation (R), where R is the return and the ben
rate Rf is the S&P 500 average between 2001 and 2007 (2.43%).
Source: McKinsey Global Institute; Hedge Fund Research, Inc.
0.2
0.4
11.2
19.4
4th
Quartile
3rd
Quartile
2nd
Quartile
1st
Quartile
Equity Hedge
4.1
12.7
15.4
31.3
Macro
-2.6
4.0
13.9
19.0
Event-Driven
2.2
7.5
9.9
13.6
Relative Value
6.12.4 6.12.4 6.12.4 6.12.4
S&
Leh
Ag
Bo
Academic Research on Hedge Fund Performance
Due to limitations in the availability of hedge fund performance data, a clear assessment of indu
Exhibit 11.11 (1 of 2)
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performance is difficult to obtain. However, based on what is available through the small but gr
number of academic papers on hedge funds, a number of observations can be made:
Hedge funds in aggregate have slightly outperformed the public equities market.
o Top-quartile hedge funds significantly out-perform equities.
Hedge funds in aggregate are slightly less volatile than the public equities market.
Absolute returns (alpha, or returns uncorrelated with the broader market) have been more
elusive:
o For many hedge fund strategies, over 70% of returns reflect returns of common market in
o Fund of funds delivered no alpha.2
o 3% of annual hedge fund returns can be attributed to alpha.3
o Top quartile hedge funds are able to achieve outsized alphas (as high as 15% annually), badata from a period of a few years.4
These findings suggest that investing in market indices can be a reasonable and less expensive
alternative to expensive hedge funds (with the exception of top performing hedge funds).
It is important to note that there are limitations to these observations as imperfect data can crea
number of biases:
Academic Research on Hedge Fund Performance
Selection bias: participation in hedge fund databases is voluntary.
Exhibit 11.11 (2 of 2)
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Survivorship bias: unsuccessful funds that have folded are not included in most hedge fund
databases.
Backfill bias: once a hedge fund registers with a database, returns from years prior to registra
are provided and incorporated into the database as well. Funds are typically included in data
after they have accumulated a good performance track record.
Liquidation bias: returns are no longer reported before a fund enters into final liquidation.
Although difficult to aggregate the effect of all of these biases, by some estimates, just survivors
and backfill bias together can inflate industry returns by as much as 4%.5
Note 1: Hasanhodzic, Jasmina and Andrew W. Lo, Can hedge -fund returns be replicated?: The linear case. JoInvestment Management, Q2 2007, Vol. 5, No. 2.
Note 2: Fung, William, et al. Hedge funds: Performance, risk, and capital formation. AFA 2007 Chicago Meetpaper, 19 Jul. 2006.
Note 3: Ibbotson, Roger G. and Peng Chen. The A,B,Cs of hedge funds: Alphas, betas and costs. Yale ICF worpaper, Sep. 2006.
Note 4: Kosowski, Robert, et al. Do hedge funds deliver alpha? A Bayesian and bootstrap analysis. Journal ofFinancial Economics, Vol. 84, No. 1, Apr. 2007, pp. 229-64.
Note 5: Fung, William and David Hsieh. Hedge funds: An industry in its adolescence. Federal Reserve Bank oAtlanta, Economic Review, Q4 2006, Vol. 91, No. 4.
Source: Farrell, Diana, et al. The New Power Brokers: How Oil, Asia, Hedge Funds and Private Equity Are ShapGlobal Capital Markets. McKinsey Global Institute Oct. 2007.
Annualized Total Return, %
Exhibit 11.12 Comparison of Hedge Fund Returns to the S&P 500 Indexs Returns, 2000
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Source: Credit Suisse/Tremont; S&P 500 data provided by Commodity Systems Inc.
4.9% 4.4% 3.0%
15.4%9.6%
7.6%
13.9%12.6%
-19
-10.1%-13.0%
-23.4%
26.4%
9.0%
3.0%
13.6%
3.5%
2000 2001 2002 2003 2004 2005 2006 2007 2
Hedge funds
S&P 500
Travails of the Hedge Fund Market in 2008
Hedge funds are supposed to thrive in rough markets.
Exhibit 11.13 (1 of 2)
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Not in 2008. A historic decline in stocks, and troubles in almost every part of the bond market, d
hedge funds their worst year on record. By the end of the year, investors were scrambling to get
bringing an end to years of industry growth and creating uncertainty about the future of major
components of the business.
Through December 2008, hedge funds globally lost 19% on average, according to Hedge FundResearch, a Chicago firm that tracks the industry. Although that's better than the 38% loss on the
Standard & Poor's 500-stock index (including dividends) over the same period, it's far from the g
most funds posted for more than a decade. The biggest fund category within hedge funds, long-
funds (where the strategy is to buy some shares while betting against others), was down 23% on
average. Funds that invest in emerging markets dropped 31%.
Assets controlled by hedge funds tumbled to $1.4 trillion from nearly $2 trillion at the start of th
according to Hedge Fund Research, and continued falling in 2009.
Fund managers and their investors are trying to figure out what went wrong. One conclusion: Tomany funds bought the same assets. As markets fell in September and October, and hedge funds
under pressure, many moved to sell investments, sending prices even lower and causing losses f
other funds that hadn't yet sold.
Stocks favored by hedge funds performed even worse than the overall market, according to data
Goldman Sachs. An index of 50 stocks "that matter most" to hedge funds lost nearly 45%, includ
dividends, compared with a loss of 38.5% on the S&P 500.
Travails of the Hedge Fund Market in 2008
One problem for many hedge funds was the amount they hold of hard-to-trade assets, such as lo
real estate holdings and stakes in small private companies These illiquid investments at one tim
Exhibit 11.13 (2 of 2)
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real-estate holdings, and stakes in small, private companies. These illiquid investments at one tim
accounted for 20% of some fund portfolios, estimated to total about $400 billion. As financial m
come under pressure, it becomes harder to get out of these investments, or even to value them
accurately.
Another problem for the industry was the fallout from December 2008s arrest of Bernard Mado
$50 billion Ponzi scheme. While Madoff wasn't a hedge-fund manager, his business of overseeing
private accounts for wealthy individuals in tight-knit social circles from Palm Beach, to Long Islan
well as for charities and private-banking clients all across Europe, rattled investor trust in private
investment managers in general.
The scandal also tainted fund of funds, the professional investment firms that raise money from
to invest in a portfolio of other investment funds. Several such firms channeled billions of dollars
Madoff through feeder funds, raising questions about how much due diligence those firms perfo
and whether clients' investments are as diversified and safe as they should be.
Source: Zuckerman, Gregory and Jenny Strasburg. For Many Hedge Funds, No Escape. Wall Street Journal 2 J
2009.
Hedge Funds Account for a Significant Share of Trading Volume
Hedge Funds Estimated Share of Trading, %
Exhibit 11.14
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Source: McKinsey Global Institute; NYSE; LSE; U.S. Bond Market Association; IMF; Greenwich Associates; Finan
News; Gartmore; Stern School of Business; British Bankers Association; ISDA; McKinsey CIB practice
32
47
45
30
6
25
30
50
Leveraged Loans
Distressed Debt
Emerging Market Bonds
Credit Derivatives - Structured
Credit Derivatives - Plain Vanilla
High-Yield Bonds
U.S. Government Bonds
Cash Equity on NYSE and LSE
Gating
The illiquidity of hedge funds often means that, even if investors realize the manager of their fun
run into trouble it could be months before they can get their money back Even then arrangeme
Exhibit 11.15
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Source: DealBook, Third Bear Stearns Fund Skids on Mortgages. New York Times 1 Aug. 2007.
run into trouble, it could be months before they can get their money back. Even then, arrangeme
called gates may restrict the proportion of an investors holdings that can be redeemed. Hedge
managers use gates to control redemptions during difficult markets. For example, in the throes o
subprime mortgage meltdown of 2007, an article in the New York Timesblog DealBook describ
how the Bear Stearns Asset-Based Securities Fund had moved to suspend investor redemptions
According to a Bear spokesman, *+ we believe by suspending redemptions we can ensure the blong term results for our investors *+ we dont believe it is prudent or in the interest of our inve
to sell assets in the current market environment. The ability of the Bear Stearns hedge fund ma
to suspend investor redemptions illustrates the power of gating. Because the fund had incurred
losses, investors in the fund likely would have pulled their money out were they not bound by ga
Thus, gating allows hedge fund managers to have greater control over their investors funds by
preventing investors from obtaining redemptions at inopportune times.
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Recent Hedge Fund IPOs Have Underperformed the Broader Market
Och-Ziff Capital Management Group LLC (NYSE:OZM) versus the S&P 500 Index
November 14 2007 (IPO date) to December 31 2008
Exhibit 11.16 (2 of 2)
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Source: Data provided by Commodity Systems Inc.
November 14, 2007 (IPO date) to December 31, 2008
-100%
-90%
-80%
-70%
-60%
-50%
-40%
-30%
-20%
-10%
0%
10%
Nov-07 Dec-07 Feb-08 Mar-08 May-08 Jun-08 Aug-08 Sep-08 Nov-08 D
OZM S&P 500
Why Use a Fund of Funds Firm?
Diversification and access
o Immediate diversification with relatively modest capital investment
Exhibit 11.17
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Source: Grosvenor Capital Management
o Immediate diversification with relatively modest capital investment
o Access to certain managers who might otherwise be closed for investment
Value-added investment process
o Fundamental knowledge of many different investment strategies
o Network of industry relationships assists in filtering manager universe
o Staffing resources and expertise necessary for manager due diligence and monitoring
o Understanding of quantitative and qualitative portfolio construction issues
o Dynamic process that requires constant attention
Operational efficiencies
o Legal due diligence and document negotiation
o Consolidated accounting, performance and financial reporting
o Cash flow management
Recommended