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Introduction to Hedge funds
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Hedge Funds
Mohammad Ali Saeed
What is hedging?
Simplistic definition to get started:
An investment made in order to reduce the risk of adverse price movements in a security, by taking an offsetting position in a related
security, such as an option or a short sale.
Trivia!
The use of the term "hedge" in the US originally was coined by the agriculture industry. Farmers were the first "hedgers" by selling crops
or cattle yet to be harvested at a price for future delivery.
In doing so, they locked in a price today and were "not exposed" to future market fluctuations.
In essence, they "hedged" their market exposure for the period of time it took them to harvest and deliver their product.
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 foresees impressive gains at reduced risk.
Goal of the fund?
Let’s 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.
Historic Hedging: Logic
Historically the hedging strategy centered around this logic: Equities on the "long side" outperformed up
markets. At the same time, the equities on the "short side" did not create a drag on performance, and possibly even added to the portfolio’s return since there are always stocks that lose value, even in a bull market.
In a market correction, the short portfolio would outperform the long portfolio, or at least "hedge" or reduce the slide in the long portfolio’s value.
Hedging Strategies
There are approximately 14 distinct investment strategies used by hedge funds
Key: All hedge funds are not the same. The investment returns, volatility, and risk vary enormously among the different strategies
“Styles” of Hedge Funds
Aggressive Growth: Invests in equities expected to experience acceleration in growth of earnings per share
Hedges by shorting equities where earnings disappointment is expected or by shorting stock indexes
Tends to be "long-biased." Expected Volatility: High
Styles of Hedge Funds (Contd.) Distressed Securities: Buys equity, debt,
or trade claims at deep discounts of companies in or facing bankruptcy or reorganization
Profits from the market's lack of understanding of the true value of the deeply discounted securities
Majority of institutional investors cannot own below investment grade securities.
Results generally not dependent on the direction of the markets.
Expected Volatility: Low - Moderate
Styles of Hedge Funds (Contd.) Emerging Markets: Invests in equity or
debt of emerging (less mature) markets that tend to have higher inflation and volatile growth
Short selling is not permitted in many emerging markets, and, therefore, effective hedging is often not available
Expected Volatility: Very High
Styles of Hedge Funds (Contd.) Funds of Hedge Funds: Mix and match hedge
funds and other pooled investment vehicles
Blend of different strategies and asset classes aims to provide stable long-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 employed Expected Volatility: Low - Moderate - High
Styles of Hedge Funds (Contd.) Income: Invests with primary focus on yield
or current income rather than solely on capital gains
May use leverage to buy bonds or fixed income derivatives, in order to profit from principal appreciation and interest income.
Expected Volatility: Low
Styles of Hedge Funds (Contd.) Macro: Aims to profit from changes in global
economies Typically brought about by shifts in govt.
policy that impact interest rates, in turn affecting currency, stock, and bond markets
Uses leverage and derivatives to accentuate the impact of market moves
Uses hedging, but largest performance impact is from the leveraged directional investments
Expected Volatility: Very High
Styles of Hedge Funds (Contd.) Market Neutral - Arbitrage: Attempts to hedge
out most market risk by taking offsetting positions, often in different securities of the same issuer
Eg. Can be long convertible bonds and short the underlying issuers equity.
Focuses on obtaining returns with low or no correlation to both the equity and bond markets
Relative value strategies include fixed income arbitrage, mortgage backed securities, capital structure arbitrage, and closed-end fund arbitrage
Expected Volatility: Low
Styles of Hedge Funds (Contd.) Market Neutral - Securities Hedging:
Invests equally in long and short equity portfolios generally in the same sectors of the market Market risk is greatly reduced Effective stock analysis and stock picking is
essential to obtaining meaningful results Leverage may be used to enhance returns Usually low or no correlation to the market Expected Volatility: Low
Styles of Hedge Funds (Contd.) Market Timing: Allocates assets among
different asset classes depending on 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 timing entry and exit from markets increase volatility
Expected Volatility: High
Styles of Hedge Funds (Contd.) Opportunistic: Investment theme changes
from strategy to strategy as opportunities arise to profit from events such as IPOs, hostile bids, etc. May utilize several of these investing styles
at a given time Not restricted to any particular investment
approach or asset class Expected Volatility: Variable
Styles of Hedge Funds (Contd.) Multi Strategy: Investment approach is
diversified by employing various strategies simultaneously to realize short- and long-term gains
Other strategies: Systems trading such as trend following and various diversified technical strategies
Allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities
Expected Volatility: Variable
Styles of Hedge Funds (Contd.) Short Selling: Sells securities short, in
anticipation of being able to repurchase them at a future date at a lower price Result of anticipated overvaluation,
earnings disappointments, new competition, change of management, etc.
Often used as a hedge to offset long-only portfolios by those who expect bearish cycle.
Expected Volatility: Very High
Styles of Hedge Funds (Contd.) Special Situations: Invests in event-driven
situations such as mergers, hostile takeovers, LBO’s etc.
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
Results generally not dependent on direction of market
Expected Volatility: Moderate
Styles of Hedge Funds (Contd.) Value: Invests in securities perceived to be
selling at deep discounts to their intrinsic or potential worth
Such 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
Expected Volatility: Low - Moderate
Things to Note:
FICTION: “All hedge funds are volatile -- they all place large directional bets on securities and commodities, while using lots of leverage” FACT: Less than 5% of hedge funds are global
macro funds. Most hedge funds use derivatives only for hedging or don't use derivatives at all, and many use no leverage.
Some “hedge funds” don't actually hedge against risk. The term is applied to a wide range of alternative funds, and encompasses funds that use high-risk strategies without hedging against risk of loss
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 incentives Usually have their own money invested in their
fund
How is a Hedge Fund different from a Mutual Fund? Hedge funds traditionally reserved for clients
with initial minimum investment of $1 million. Mutual fund companies beginning to offer hedge fund products to wider client base
There are 5 key differences between them based on:
1. Performance Evaluation2. Level of regulatory control3. Basis for Remuneration of Management4. Portfolio Protection5. Dependence on Markets
Differences (Contd.)
Performance Evaluation: Mutual funds are measured on relative performance
compared to a relevant index or to other mutual funds in their sector
Hedge funds are expected to deliver absolute returns under all circumstances, even when the relative indices are down
Level of Regulation: Unlike hedge funds, mutual funds are highly regulated,
restricting the use of short selling and derivatives. Makes it difficult to outperform market, or protect assets in downturn.
Differences (Contd.)
Remuneration for Management Mutual Fund managers are paid based on a % of
AUM. Hedge funds pay managers performance-related incentive fees plus a fixed fee
Portfolio Protection Mutual funds are not able to effectively protect
portfolios against declining markets other than by going into cash or by shorting a limited amount of stock index futures
Hedge funds are often able to protect against declining markets by using various hedging strategies, and can generate positive returns even in declining markets.
Differences (Contd.)
Dependence on Markets The future performance of mutual funds
depends on the direction of the equity markets.
The future performance of many hedge fund strategies tends to be highly predictable and not dependent on the direction of the equity markets.
Fund of Funds
A fund of funds mixes the most successful hedge funds and other pooled investment vehicles, spreading investments among many different funds or investment vehicles
Hedge fund strategies are complex and varied in their ranges of risk/return. Even within a particular style, two managers can apply different amounts of hedging or insurance and leverage to his/her portfolio
A fund of funds blends together funds of different strategies and asset classes in order 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
Questions?