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Hedge Funds

Hedge Funds. Definition. A subset of alternative investments that incorporate all investment strategies run with an orientation to producing primariloy absolute returns using largely marketable securities

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Hedge Funds

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  1. Hedge Funds

  2. Definition • A subset of alternative investments that incorporate all investment strategies run with an orientation to producing primariloy absolute returns using largely marketable securities • A private and unregisterd investment pool that employs sophisticated hedging and arbitrage techniques to trade in the corporate equity markets

  3. Definition • “Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their inestors redeem and go to someone else who has recently been making money. Every three or four years, they deliver a one-in-a-hundred-year flood.”

  4. History • The first hedge fund was set up by Alfred W. Jones • 1949 • Used short sales, leverage and fees • Converted from general partnership to limited partnership in 1952 • Publicized in 1966 in article in Fortune magazine • Growth from 1986-1993 and following collapse of tech bubble in 2002 • Hedge funds did relatively well in 2000 - 2002

  5. Currently • Size has been doubling almost every two years • One measurement of 11,000 active funds in 2008 • $2.4 Trillion under management (various measurements) • Account for 30% of all U.S. fixed-income trading • 80% for distressed debt and high-yield derivatives

  6. (Lack of) Regulation • Do not fall under the Investment Company Act • No public offerings • Limited number of investors • Do not fall under Securities Act of 1933 • Only “accredited investors consisting of institutional investors, companies, or high net worth individuals who can ‘fend for themselves’”

  7. (Lack of) Regulation • Not required to disclose their holdings to investors • Not required to report investment results • May not advertise • Limited partners must have already formed a relationship with the general partner • Allowed to use leverage • Usually 2:1 to 10:1 • LTCM was 500:1 by one report

  8. Structure • Limited Partnership or Offshore Corporation • Collection of funds (feeder funds) • Each fund designed to optimize taxes for a group of investors • Offshore fund for foreign investors and onshore fund for U.S.-taxed investors

  9. Hedge Fund Location

  10. Features • Manager usually has high percentage of his/her assets invested in fund • Current trend towards more institutions investsing in hedge funds • Proportion of institutions to individuals is increasing

  11. Asset Class Allocation by Institutional Investors Source: NACUBO Endowment Study

  12. Investment Strategies • Convertbile Arbitrage • Merger Arbitrage • Long/Short • Dedicated Short Strategy • Statistical Arbitrage • Market Neutral Strategy • Event Driven • Fixed Income Abritrage (High Yield or Mortgage Backed) • Managed Futures • Emerging Markets • Sector Funds • Relative Value Arbitrage

  13. Strategy Allocation Source: Lipper/Tass

  14. Investment Performance • Very difficult to gauge for certain • Voluntary disclosure • Survivorship bias • Backfill bias • Must be Risk-Adjusted • Normal risk adjustments don’t always apply • Often a strong systemic (sector) risk

  15. Investment Performance • January 1995 – April 2006 Study • Pre-fee annualized return of 12.72% • Fee of 3.74% • Alpha of 3.04% • Excess returns shared roughly equally between hedge fund managers and their investors

  16. Strategy Performance

  17. Fees and Compensation • Management Fee of 1% - 2% of assets under management (median is 1.5%) • Incentive Fee of 20% of profits above a benchmark • May be T-bill rate • May be zero • No incentive fees in mutual funds

  18. Liquidity Issues • Mutual Funds must redeem shares on demand • Mutual Funds must calculate NAV daily • Hedge Funds often invest in illiquid assets that cannot be easily priced due to infrequent trading • Models (estimates) are often used to value assets • Mark-to-Model • Leads to positive serial correlation in returns

  19. Liquidity Issues • Hedge Funds will not necessarily allow withdrawls on demand • Usually specific times (quarterly) when investors can withdraw funds • Often a lock-up period of up to two years • Minimum Investment of $200,000 or more • Limited number of investors and dollars • Diseconomies of scale • Managers want long-term investors

  20. Fund of Funds • Allows for diversification among Hedge Funds • Fund manager is responsible for due dilligence of various hedge funds • Allows for smaller investments and greater liquidity • Additional fee of approx. 1% • About 15% of all hedge fund assets managed through fund of funds • About 25% of hedge funds are actually funds of funds

  21. Risks • “Fat Tails” – High positive returns, but also a possibility to lose everything like LTCM • Extremely unlikely in mutual fund • Lack of liquidity • Lack of information for investors • High Leverage • Difficult to evaluate performance

  22. Style Correlations 1/1994-6/2005

  23. Top Hedge Funds as of 10/07 • Ranked by Average Annual Return for prior 3 years • RAB Special Situations Fund 47.69% • The Children’s Investment Fund 44.27% • Highland CDO Opportunity Fund 43.98% • BTR Global Opportunity Fund, Class D 43.42% • SR Phoenicia Fund 43.10% • Atticus European Fund 40.76% • Gradient European Fund A 39.18%

  24. Highest-earning Hedge Fund Managers in 2007 • John Paulson, Paulson & Co. $3 billion+ • Philip Falcone, Harbinger Capital Partners $1.5-$2 billion • Jim Simons, Renaissance Technologies $1 billion • Steven A. Cohen, SAC Capital Advisors $1 billion • Ken Griffin, Citadel Investment Group $1-$1.5 billion • Chris Hohn, The Children’s Investment Fund $800-$900 million • Noam Gottesman, GLG Partners $700-$800 million

  25. Capturing Positive Alpha • You think a stock (or portfolio) is underpriced • But you also think the market might drop • You want to capture the underpricing without subjecting yourself to the risk of your position losing value along with the market • You need to separate the stock-specific bet from the effects of the market

  26. Capturing Positive Alpha • This is called any of the following: • Pure Play • Alpha Transfer • Portable Alpha • Creating a market-neutral portfolio • The key is to eliminate the market (systematic) risk

  27. Capturing Positive Alpha • Example: • You have put together a portfolio which you believe will outperform the market by 2% next month. • Your portfolio has a beta of 1.0 and you suspect that the overall market will fall next month • The risk-free rate is 1% per month • E(R) = Rf + β(Rm – Rf) + α + e • You must create a portfolio with a beta of -1.0 which will offset the suspected market drop

  28. Capturing Positive Alpha • You can create a portfolio with a negative beta by: • Selling S&P 500 futures contracts • Purchasing puts on S&P 500 contracts • Shorting a SPDR ETF • Each of these creates a beta of -1.0. • You can adjust this beta by borrowing or lending at Rf

  29. Capturing Positive Alpha • You now have a total position with a beta of zero • E(R) = Rf + β(Rm – Rf) + α + e • Your return will be the 1% risk-free rate, the 2% alpha (if you were correct) and any undiversified unique risk that remains (expected value of zero)

  30. Capturing Positive Alpha

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