What I will be talking about today
Two presentations for the price of one
Hedge Funds (& Mutual Funds)
Vs
Exchange Traded Funds
Conceptual differences
Liquid
Price transparency
Equity-like characteristics
Secondary market
Uniformity of product (although differences emerging?)
Illiquid
Pricing issues (delays)
Fund Manager NAV
Transferability?
Highly bespoke (reliance key person/ manager etc)
ETFs Mutual Funds Hedge Funds
Different documentation
Hedge Funds (and Mutual Funds): 2006 ISDA Fund Derivatives Definitions
Exchange Traded Funds: The ETF Supplement?
Characteristics of Hedge Funds
Key characteristics of hedge funds (and mutual funds)
Pricing & Liquidity
Transparency
Fund risk profile & structure A derivative on a hedge fund reflects these
characteristics
Pricing & Liquidity
When Hedge Funds Bar the Door – “If you thought getting into a hedge fund was tough, try getting out of one”
Richie Capital Management
Pardus Capital Management LP
Sandelman Partners Multi-Strategy Fund Ltd.
Drake Capital Management LLC
Russell Investments D.B. Zwirn & Co.
Transparency
Never have so many short sellers made so much money – Harbinger Capital; Paulson & Co.
Bear Sterns; HBOS; Fannie Mae and Freddie Mac
SEC moves to curb short selling FSA ruling lifts lid on hedge funds’ positions Australia takes aim at short selling Bets on HBOS rise in spite of short-sell rule
Fund Structure and Risk Profile
Lahde Capital flew high and called it a day
GLG and Greg Coffey
Peloton flew high, fell fast
As the markets throw knuckle balls, hedge-fund stars still hit home runs Paulson & Co. made money betting on the collapse of
subprime mortgages in 2007
Harbinger Capital reaps subprime profits
Characteristics of Hedge Funds
Key characteristics of hedge funds (and mutual funds)
Pricing & Liquidity
Transparency
Fund risk profile & structure
Characteristics of Hedge Funds
Key characteristics of hedge funds (and mutual funds)
“KYF” (“know your fund”) and the building block approach
Fund derivative reflects these difference- Equity Derivatives Definitions not up to the job…
2006 ISDA Fund Derivatives Definitions
2006 Fund Derivatives Definitions
Structural similarities between the Fund Definitions and the Equity Definitions
Key differences between the Fund Definitions and the Equity Definitions
Reflect key characteristics of hedge funds
2006 Fund Defs- Structural similarities to the Equity Definitions Modelled on the 2002 ISDA Equity Derivatives Definitions
Stand-alone booklet of definitions to be incorporated into short-form Confirmations for individual trades
Options, forwards and swaps covered
Single “Fund Interest” (analogous to Share) and basket trades contemplated
Knock-in and Knock-out trades contemplated
Mechanics of exercise for option transactions
Mechanics of prepayment for forward transactions
2006 Fund Defs- Structural similarities to the Equity Definitions Fund swap mechanics
Valuation provisions
Cash and physical settlement provisions
Dividends
Adjustments and modifications
Extraordinary Events
Miscellaneous representations, agreements and acknowledgement
Key differences between the Fund Definitions and the Equity Definitions Key characteristics of hedge funds (and mutual
funds)
Pricing & Liquidity
Transparency
Fund risk profile & structure A derivative on a hedge fund reflects these
characteristics
1/ Differences- pricing & liquidity
KYF- how do you value an interest in the fund?
Many funds, especially hedge funds, set up, administered and valued in “off-shore” jurisdictions
Primarily concerned with funds not traded on a public exchange. No liquid secondary market
Less transparency in terms of regulatory disclosure requirements
Meaning of NAV
Fees, incentive fees, trail fees
Hold back/ claw back
1/ Differences- pricing & liquidity
KYF- how do you buy and sell interests in the fund?
Primarily concerned with funds not traded on a public exchange. No liquid secondary market
Transfer restrictions
Timing of subscription and redemption
Gating
Use of side letters
1/ Differences- pricing & liquidity
Valuation methodologies based on subscriptions and redemptions (not secondary market)
Reported Value Method and Deemed Payout Method
1/ Differences- pricing & liquidity: Deemed Payout Method of Valuation Deemed Payout Method, Observation Dates & subscription/ redemption
cycles measures redemption payments
Redemption Proceeds per Fund Interest Unit “that would be received by the Hypothetical Investor … in connection with a redemption of all Fund Interest Units that are subject to valuation during the period from, and including, the Initial Observation Date to, and including, the Final Observation Date” (Section 1.18 Relevant Price, Section 5.9 Final Price, Section 7.3 Settlement Price)
Redemption Proceeds (Section 1.43) - the redemption proceeds “that would be paid by the related Reference Fund to a Hypothetical Investor who, as of the relevant Redemption Valuation Date, redeems such amount of such Fund Interest”
Provided that proceeds that would or could be paid in property other than cash shall be valued or treated as payable in cash
1/ Differences- pricing & liquidity: Deemed Payout Method of Valuation
“Final Observation Date” (Section 1.50) – with respect to a Valuation Date, specified date, failing which the Valuation Date itself, subject to Sections 6.6 and 6.7 (Disruption), 11.1 (Adjustments) and 11.2 (Correction)
Section 11.2(ii) - where Redemption Proceeds that would have been paid to Hypothetical Investor adjusted to reflect additional payment or claim for repayment (clawback), and adjustment made by end of Cut-off Period starting on Final Observation Date, Calculation Agent to adjust to account for correction
“Cut-off Period” (Section 1.51) - unless specified, one year (or up to earlier specified Final Cut-off Date)
1/ Differences- pricing & liquidity: Deemed Payout Method of Valuation
“Fund Disruption Event” where “Fund Settlement Disruption” on the relevant Valuation Date (Section 6.3)
“Fund Settlement Disruption” where failure by the Reference Fund to pay the full amount of the Redemption Proceeds by the scheduled payment date
Consequence is to postpone the relevant Valuation Date (and therefore the Final Observation Date) to next undisrupted day or last day of Cut-off Period (Section 6.6)
1/ Differences- pricing & liquidity: Reported Value Method of Valuation
Reported Value Method Reported Fund Interest Value … as of the Valuation Date … subject to the
applicable Reported Value Convention” (Section 1.18 Relevant Price, Section 5.9 Final Price, Section 7.3 Settlement Price)
If Confirmation specifies Calculation Agent Adjustment, Calculation Agent to adjust to reflect: fees that would be charged Redemption Proceeds that would have been received by the Hypothetical Investor
If Calculation Agent determines no adjustment will produce a commercially reasonable result, Deemed Payout Method shall apply
Calculation Agent Adjustment makes outcome similar to Deemed Payout Method, but involves more discretion
1/ Differences- pricing & liquidity: Reported Value Method of Valuation
“Reported Value Convention (Section1.42) – the method to be used for determining Reported Fund Interest Value where Valuation Date is not a Scheduled Fund Valuation Date:
“Prior Redemption Valuation Date” – immediately preceding Scheduled Redemption Valuation Date value (this is the fallback if no Convention is specified)
“Following Redemption Valuation Date” – next following Scheduled Redemption Valuation Date value
“Prior Fund Valuation Date” – immediately preceding Scheduled Fund Valuation Date value
“Last Reported Value Date” – most recently available Reported Fund Interest Value
“Following Fund Valuation Date” – next following Scheduled Fund Valuation Date value
1/ Differences- pricing & liquidity: Reported Value Method of Valuation
“Fund Disruption Event” where “Fund Valuation Disruption” on the relevant Valuation Date (Section 6.3)
“Fund Valuation Disruption” occurs where Reported Value Convention is Prior Redemption Valuation Date or
Following Redemption Valuation Date, if Reference Fund fails to determine redemption value on scheduled redemption valuation date
where any other Reported Value Convention applies, if Reference Fund fails to determine the fund value on scheduled fund valuation date
Consequence is to postpone the relevant Valuation Date to next undisrupted day or last day of Cut-off Period (Section 6.6)
2/ Differences- Transparency
KYF- how do you know what is going on with the fund?
Many funds, especially hedge funds, set up have less transparency in terms of regulatory disclosure requirements
Personalised investment (fees, subscription and redemption date etc)
2/ Differences- Transparency
Hypothetical Investor” (Section 1.33) Introduces a measure of objectivity and separation between
reference investor and the actual hedging investor that may be important for some analysis, but also introduces a potential basis risk
Related Definition: “Hypothetical Investor Jurisdiction” (Section 1.34) - as specified or if not specified, the jurisdiction of the Equity Amount Payer or Seller
For subscription, deemed to have submitted a duly completed notice requesting subscription on the relevant Subscription Notice Date
For redemption, deemed to have submitted a duly completed notice of redemption on the relevant Redemption Notice Date
Role of Calculation Agent
3/ Differences- Risk profile & Structure
KYF- What is the fund about?
Fund focuses on particular investment strategy or strategies in contrast to general business of the issuer of an equity share
Investment restrictions
Service providers
Legal nature and status of fund (often not in corporate form - for example trust, partnership), domicile
3/ Differences- Risk profile & Structure
Extraordinary Fund Events: Fund Modification & Strategy Breach
Extraordinary Fund Events: Adviser Resignation Event
Fund Service Provider concept
3/ Differences- Risk profile & Structure
“Fund Interest” (Section 1.8) and “Fund Interest Unit” (Section 1.9) – “interest issued to or held by an investor in a fund, pooled investment vehicle or any other interest identified as such …”
“Reference Fund” (Section 1.11) – “the issuer of, or other legal arrangement giving rise to, the relevant Fund Interests”
“Fund Documents” (Section 1.29) – “the constitutive and governing documents, subscription agreements and other agreements of the related Reference Fund specifying the terms and conditions relating to such Fund Interest and any Additional Fund Documents, in each case, as amended from time to time”
Exchange traded funds
Two presentations for the price of one
Hedge Funds (& Mutual Funds)
Vs
Exchange Traded Funds
Exchange Traded Funds- key characteristics What is an ETF?
Strategy
Exchange traded
Creation Units
Pricing & liquidity, transparency and risk profile
Key players
Developments in the market
ETF Supplement
Ignores Creation Units (probably) Index equity ETFs only Share trade Share and index trade
Valuation disruption (level of index) Index Disruption Events Underlying exchanges
Share and index and fund trade Extraordinary Fund Events