Hedge Funds-Avinash and Sham

Defining Hedge Funds

Opinions differ regarding the definition of the phrase “Hedge Fund”. The most commonly accepted definition is that a hedge funds are the funds which:

• Have an absolute return performance objective

• Allow the manager to be active on both the long and short sides of the markets

• Compensate the manager with performance related fees

• Allow the manager tremendous flexibility in investment style and approach

What are HFs?

• “To hedge one’s bets” i.e. betting on other side to limit the possibility 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 management

Targeted InvestmentsThey can invest in any type of asset class or opportunity luring in the any market, 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

to receive attractive returns in all kind of risky situations.

Motive of Hedge Funds

• Protecting capital (i.e. the private pool of funds)

• Generating superior returns in all kinds of markets (they are ready to take bearish markets also)

• Attempting to minimize the risk i.e. to hedge.

Past Returns

2000 2001 2002 2003 2004 2005 2006 2007 2008-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

MSCI All- Country World IndexHedge Fund Research Index Fund Weighted Composite Index

Bear Market Achievers Riding Asset Growth Crisis

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 explore with its– secondary market liquidity– Futures– options, etc.

Why India?

• Investment can be made through FII (Foreign Institutional Investors) route.

• Doesn’t charge anything on performance or profit of the fund

• Thus giving India a plus point from others• Thus attracting more HNIs to enter India

through these.

Incremental Nominal GDP (in Billion US $)

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

2035-20502020-20352006-2020

Working Age Population Growth Rates (% p.a.)

India

Turke

yBraz

il US

Indonesia

Australi

a

Mexico

Canad

a UKFra

nceChina

Spain Ita

ly

German

yKorea

Japan

Russia

-1.50%

-1.00%

-0.50%

0.00%

0.50%

1.00%% p.a.

Source: PwC Report

Hedge Funds in India

Cater to Individual Investors

First ImplicationUncorrela

ted returns

Surge in earnings

Second Implication

Increase in

demand

Increase competiti

on

Reducing investme

nt fees

Essentials for HFs

Registration

Independent audit

Transparency

Proper disclosure

Performance of Indian Hedge Funds• $44,000 million AUM (assets under management) of all

Indian hedge funds• India’s high beta market generate effective returns.

2006

• Bull Run• Q-India, Halbis, Baer Capital, Insynergy & FMG

outperformed major hedge 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

Various Hedge Fund Strategies

• Emerging Markets– Invest in emerging markets – Emerging markets offer less options for short selling, so these are mostly

long biased and employ growth or value approach to investing in equities. – These can be illiquid & carry a high risk due to correlation of emerging

economies.• 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

equity. • 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.

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 is

an opportunity.

• Event Driven– Focus on events of corporate life cycle like acquisitions, buybacks,

demerger, spin-offs etc,.

• Merger/Risk Arbitrage– Focus on the companies which are going through any merger or takeover– Both the acquiring company and the target. – The risk is deal risk rather than a market risk.

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

securities – Has low volatility.

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 Currency)-Spot-future arbitrage-Contango and Backwardation arbitrage-Calendar spread in futures

• Market Directional-Market momentum strategy-for very short term-example is Jobbing

HFRX Returns

10 09 08 07 06 Avg Stdev Min Max Rank

Global Hedge Fund

5.19 13.4 (23.25) 9.26 2.72 1.46 14.40 (23.25) 13.4 7

Equal Weighted Strategies

5.29 11.44 (21.9) 8.83 1.28 0.99 13.35 (21.9) 11.44 8

Absolute Return (0.12) (3.58) (13.09) 7.43 (0.03) (1.88) 7.45 (13.09) 7.43 11

Market Directional

9.32 29.34 (29.7) 10.45 4.2 4.72 21.48 (29.7) 29.34 2

Convertible Arbitrage

8.76 42.46 (58.37) 9.57 (5.69) (0.65) 36.77 (58.37) 42.46 10

Distressed Securities

8.34 (5.6) (30.69) 9.56 1.21 (3.44) 16.41 (30.69) 9.56 12

Equity Hedge 8.92 13.14 (25.45) 9.23 4.19 2.01 15.67 (25.45) 13.14 4

Equity Market Neutral

2.64 (5.56) (1.16) 4.76 0.21 0.18 3.93 (5.56) 4.76 9

Event Driven 1.98 16.59 (22.11) 10.32 2.81 1.92 14.70 (22.11) 16.59 5

Macro (1.73) (8.78) 5.61 5.61 6.67 1.48 6.64 (8.78) 6.67 6

Merger Arbitrage

5.69 8.14 3.69 10.73 3.72 6.39 3.03 3.69 10.73 1

Relative Value Arbitrage

7.65 38.47 (37.6) 10.65 (0.97) 3.64 27.39 (37.6) 38.47 3

Dow Jones Credit Suisse indices

10 9 8 7 6 Avg Stdev Min Max Rank

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 exposure

Evolution of HF strategies

Modern day HF strategies

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 equally weighted.• Evaluates the performance of Hedge Funds based on Absolute

Return and the Relative Risk. • As a component of the optimization process, the index

selects constituents which exhibit lower volatilities and lower correlations to standard directional benchmarks of equity market and hedge fund industry performance.

• “HFRX India” is an index for the Indian Hedge Funds.

Empirical Findings

• Returns are considerably high during a volatile market which is mean reverting in nature

• Returns during a trending market in some of the HF strategies is low and even negative in some cases

• Well established and High Corpus HFs give a lower returns compared to the relatively newer peers who have small corpus

How does size matter?

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 fund generated 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

George Soros(HF: Soros Fund Management)

Short sold 10 Billion pounds in 1992 and made 1.1 Billion $ in a single day (Black Wednesday)

Similar speculation over the currency of Association of Southeast Asian Nations (ASEAN) in 1997

As of March 2012 Soros was listed 22nd in Forbs among the richest people in the world

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 the Noble Laureates Myron S. Scholes and Robert C. Merton (The LTCM case)

Hedge Fund Regulations In India

• SEBI regulation seeks to cover all types of funds broadly under 3 categories

• Category I AIF – those AIFs with positive spillover effects on the economy

• Category II AIF – those AIFs for which no specific incentives or concessions are given by the government or any other Regulator; which shall not undertake leverage other than to meet day-to-day

operational requirements • Category III AIF – those AIFs including hedge funds which trade with a

view to make short term returns; which employs diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. 

Regulatory Constraints

• Restricting participation: The Alternative Investment Fund shall not accept from an

investor an investment of value less than rupees one crore. Further, the AIF shall have a minimum corpus of Rs. 20 crore.

• Avoiding wealth concentration hazards: The fund or any scheme of the fund shall not have more than

1000 investors

• Preventing Conflict of Interest: For a Hedge Fund, the continuing interest shall be not less that

5% of the corpus or rupees ten crore, whichever is lower.

Regulatory Constraints (contd..)

• Trading in Secondary Market: Units of AIF may be listed on stock exchange subject to a minimum

tradable lot of rupees one crore. However, AIF shall not raise funds through Stock Exchange mechanism

• Against Concentration Alpha and Speculation: Hedge Funds shall invest not more than 10% of the corpus in one

Investee Company.

• Preventing Moral Hazard: AIF shall not invest in associates except with the approval of 75% of

investors by value of their investment in the Alternative Investment Fund

The Category III of AIFs (the Hedge Funds)

• Proper disclosure: Category III Alternative Investment Funds shall ensure that

calculation of the net asset value (NAV) shall be disclosed to the investors at intervals not longer than a quarter for close ended Funds and at intervals not longer than a month for open ended funds.

Category III Alternative Investment Fund shall provide quarterly reports to investors within 60 days of end of the quarter.

Thank You