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Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
Hedging funds & its impact on capital market
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Hedging funds & its impact on capital market

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  • 1. “Hedging Fund & Its Impact On Capital Market” CONTENTS Sr.No. Particulars Page No. 1. Introduction 1. 2. Characteristics Of Hedge Funds 7. 3. Growth Of Hedge Funds 9. 4. Hedge Fund Data 12. 5. Benefits Of Hedge Funds 21. 6. Workings Of Hedge Funds 27. 7. Risks Involved In Hedge Funds 32. 8. Impact Of Hedge Funds In Capital Market 45. 9. Role Of Hedge Funds In Capital System 48. 10. Investor Protection 50. 11. The Federal Reserve & Hedge Funds 52. Hemant Palav / MBA / Semester II 1.
  • 2. “Hedging Fund & Its Impact On Capital Market” INTRODUCTION The term 'hedge fund' is used to describe a wide variety of institutional investors employing a diverse set of investment strategies. Although there is no formal definition of 'hedge fund,' hedge funds are largely defined by what they are not and by the regulations to which they are not subject. As a general matter, the term 'hedge fund' refers to unregistered, private investment partnerships for wealthy sophisticated investors (both natural persons and institutions) that use some form of leverage to carry out their investment strategies. The term 'hedge fund' is undefined, including in the federal securities laws. Indeed, there is no commonly accepted universal meaning. As hedge funds have gained stature and prominence, though, 'hedge fund' has developed into a catch-all classification for many unregistered privately managed pools of capital. These pools of capital may or may not utilize the sophisticated hedging and arbitrage strategies that traditional hedge funds employ, and many appear to engage in relatively simple equity strategies. Basically, many 'hedge funds' are not actually hedged, and the term has become a misnomer in many cases. Hedge funds engage in a variety of investment activities. They cater to sophisticated investors and are not subject to the regulations that apply to mutual funds geared toward the general public. Fund managers are compensated on the basis of performance rather than as a fixed percentage of assets. 'Performance funds' would be a more accurate description. Hemant Palav / MBA / Semester II 2.
  • 3. “Hedging Fund & Its Impact On Capital Market” SeleCTeD DefINITIONS Of "HeDge fUND" "Hedge fund" is an expression believed to have been first applied in 1949 to a fund managed by Alfred Winslow Jones.1 Mr. Jones's private investment fund combined both long and short equity positions to "hedge" the portfolio's exposure to movements in the market. Today, hedge funds are no longer defined by a particular strategy and often do not "hedge" in the economic sense. The following is a selection of definitions and descriptions of the term "hedge fund" showing the diversity of views among commentators. "The term 'hedge fund' is commonly used to describe a variety of different types of investment vehicles that share some common characteristics. Although it is not statutorily defined, the term encompasses any pooled investment vehicle that is privately organized, administered by professional money managers, and not widely available to the public." --THe PReSIDeNT'S WORKINg gROUP ON fINANCIAl MARKeTS, HeDge fUNDS, leVeRAge, AND THe leSSONS Of lONg-TeRM CAPITAl MANAgeMeNT 1 (1999). "The term 'hedge fund' refers generally to a privately offered investment vehicle that pools the contributions of its investors in order to invest in a variety of asset classes, such as securities, futures contracts, options, bonds, and currencies." --THe SeCReTARY Of THe TReASURY, THe BOARD Of gOVeRNORS Of THe feDeRAl ReSeRVe SYSTeM, THe SeCURITIeS AND eXCHANge COMMISSION, A RePORT TO CONgReSS IN ACCORDANCe WITH § 356(C) Of THe USA PATRIOT ACT Of 2001 (2002). Hemant Palav / MBA / Semester II 3.
  • 4. “Hedging Fund & Its Impact On Capital Market” "A hedge fund can be broadly defined as a privately offered fund that is administered by a professional investment management firm (or 'hedge fund manager'). The word 'hedge' refers to a hedge fund's ability to hedge the value of the assets it holds (e.g., through the use of options or the simultaneous use of long positions and short sales). However, some hedge funds engage only in 'buy and hold' strategies or other strategies that do not involve hedging in the traditional sense. In fact, the term 'hedge fund' is used to refer to funds engaging in over 25 different types of investment strategies .…" --MANAgeD fUNDS ASSOCIATION, HeDge fUND fAQS 1 (2003). "There is no universally accepted meaning of the expression 'hedge fund'; indeed, many competing (and sometimes partially contradicting) definitions exist. The term first came into use in the 1950s to describe any investment fund that used incentive fees, short-selling, and leverage. A summary definition frequently used in official sector reports is 'any pooled investment vehicle that is privately organised, administered by professional investment managers, and not widely available to the public'. The term can also be defined by considering the characteristics most commonly associated with hedge funds. Usually, hedge funds: • are organised as private investment partnerships or offshore investment corporations; • use a wide variety of trading strategies involving position-taking in a range of markets; • employ an assortment of trading techniques and instruments, often including short- selling, derivatives and leverage; • pay performance fees to their managers; and • Have an investor base comprising wealthy individuals and institutions and a relatively high minimum investment limit (set at US$100,000 or higher for most funds)." Hemant Palav / MBA / Semester II 4.
  • 5. “Hedging Fund & Its Impact On Capital Market” --FINANCIAL SERVICES AUTHORITY (UNITED KINGDOM), HEDGE FUNDS AND THE FSA, DISCUSSION PAPER 16, at 8 (2002). "Originally set up to 'hedge bets' or insure against currency or interest rate risks, hedge funds have since taken on a much wider remit, investing in assets ranging from equities and fixed interest stocks to derivatives and commodities. Their aim is to make absolute returns, that is to make performance returns irrespective of which way the markets are going. Rather like derivative funds, hedge funds use derivative instruments or gearing (borrowing against the fund's assets) to gain greater exposure to their investments or to protect against losses." --ROBeRT B. MIlROY, STANDARD & POOR'S gUIDe TO OffSHORe INVeSTMeNT fUNDS 28 (2000). "The term 'hedge fund' was in use as early as the 1960s to describe a new speculative investment vehicle that used sophisticated hedging and arbitrage techniques in the corporate equities market. In the late 1960s, former Securities and Exchange Commissioner Hugh Owens described 'hedge funds' as 'private investment partnerships which employ the investment techniques of leveraging and hedging.' In the 1970s and 1980s, the activities of similar types of funds broadened into a range of financial instruments and activities .… The term 'hedge fund' does not have a precise definition, but it has been used to refer generally to a cadre of private investment partnerships that are engaged in active trading and arbitrage of a range of different securities and commodities." --DePARTMeNT Of THe TReASURY, SeCURITIeS AND eXCHANge COMMISSION, BOARD Of gOVeRNORS Of THe feDeRAl ReSeRVe SYSTeM, JOINT RePORT ON THe gOVeRNMeNT SeCURITIeS MARKeT, AT B-64 (1992) Hemant Palav / MBA / Semester II 5.
  • 6. “Hedging Fund & Its Impact On Capital Market” (CITINg HUgH OWeNS, SeCURITIeS AND eXCHANge COMMISSIONeR, A RegUlATOR lOOKS AT SOMe UNRegUlATeD INVeSTMeNT COMPANIeS: THe eXOTIC fUNDS, ReMARKS BefORe THe NORTH AMeRICAN SeCURITIeS ADMINISTRATORS ASSOCIATION (OCT. 21, 1969)). A hedge fund is a "private investment partnership (for U.S. investors) or an off-shore investment corporation (for non-U.S. or tax-exempt investors) in which the general partner has made a substantial personal investment, and whose offering memorandum allows for the fund to take both long and short positions, use leverage and derivatives, and investment in many markets. Hedge funds often take large risks on speculative strategies, including [program trading, selling short, swap, and arbitrage]. A fund need not employ all of these tools all of the time; it must merely have them at its disposal." --JOHN DOWNeS AND JORDAN ellIOTT gOODMAN, BARRON'S, fINANCe & INVeSTMeNT HANDBOOK 358 (5TH eD. 1998). "There is no precise definition of the term 'hedge fund,' and one will not be found in the federal or state securities laws. The term was first used to describe private investment funds that combine both long and short equity positions within a single leveraged portfolio. It is generally believed that the first such fund to employ this approach was an investment partnership organized in 1949 by Alfred Winslow Jones … Hedge funds are no longer defined by the strategy they pursue. While a number of today's funds pursue the hedged equity strategy of Jones, numerous different investment styles are embraced by hedge funds .… Hedge funds are defined Hemant Palav / MBA / Semester II 6.
  • 7. “Hedging Fund & Its Impact On Capital Market” more by their form of organization and manner of operation than by the substance of their financial strategies." --SCOTT J. leDeRMAN, HeDge fUNDS, IN fINANCIAl PRODUCT fUNDAMeNTAlS: A gUIDe fOR lAWYeRS 11-3, 11-4, 11-5 (ClIffORD e. KIRSCH eD., 2000). "Like mutual funds, hedge funds pool investors' money and invest those funds in financial instruments in an effort to make a positive return. However, unlike mutual funds, hedge funds are not registered with the SEC. This means that hedge funds are subject to very few regulatory controls. In addition, many hedge fund managers are not required to register with the SEC and therefore are not subject to regular SEC oversight. Because of this lack of regulatory oversight, hedge funds historically have been available to accredited investors and large institutions, and have limited their investors through high investment minimums (e.g., $1 million). Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other speculative investment practices that may increase the risk of investment loss." --SeCURITIeS AND eXCHANge COMMISSION, HeDgINg YOUR BeTS: A HeADS UP ON HeDge fUNDS AND fUNDS Of HeDge fUNDS, AVAIlABle AT HTTP://WWW.SeC.gOV/ANSWeRS/HeDge.HTM. "'Hedge fund' is a general, non-legal term used to describe private, unregistered investment pools that traditionally have been limited to sophisticated, wealthy investors. Hedge funds are not mutual funds and, as such, are not subject to the numerous regulations that apply to mutual funds for the protection of investors - including regulations requiring a certain degree of liquidity, regulations requiring that mutual fund shares be redeemable at any time, regulations protecting against conflicts of interest, regulations to assure fairness in the pricing of fund shares, disclosure regulations, regulations limiting the use of leverage, and more." Hemant Palav / MBA / Semester II 7.
  • 8. “Hedging Fund & Its Impact On Capital Market” --SeCURITIeS AND eXCHANge COMMISSION, INVeST WISelY: AN INTRODUCTION TO MUTUAl fUNDS, AVAIlABle AT HTTP://WWW.SeC.gOV/INVeSTOR/PUBS/INWSMf.HTM. "A hedge fund is an actively managed investment fund that seeks attractive absolute return. In pursuit of their absolute return objective, hedge funds use a wide variety of investment strategies and tools. Hedge funds are designed for a small number of large investors, and the manager of the fund receives a percentage of the profits earned by the fund. Hedge fund managers are active managers seeking absolute return." --ROBeRT A. JAegeR, All ABOUT HeDge fUNDS, AT X (2003) (PeRHAPS IN A BIT Of HIS OWN HeDgINg, JAegeR CAllS HIS DefINITION "PROVISIONAl."). KeY CHARACTeRISTICS Of HeDge fUNDS • Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and minimize the correlation with equity and bond markets. Many hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as puts, calls, options, futures, etc.). • Hedge funds vary enormously in terms of investment returns, volatility and risk. Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded. • Many hedge funds have the ability to deliver non-market correlated returns. • Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns. • Most hedge funds are managed by experienced investment professionals who are generally disciplined and diligent. Hemant Palav / MBA / Semester II 8.
  • 9. “Hedging Fund & Its Impact On Capital Market” • Pension funds, endowments, insurance companies, private banks and high net worth individuals and families invest in hedge funds to minimize overall portfolio volatility and enhance returns. • Most hedge fund managers are highly specialized and trade only within their area of expertise and competitive advantage. • Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards performance incentives, thus attracting the best brains in the investment business. In addition, hedge fund managers usually have their own money invested in their fund. fACTS ABOUT THe HeDge fUND INDUSTRY • Estimated to be a $1 trillion industry and growing at about 20% per year with approximately 8350 active hedge funds. • Includes a variety of investment strategies, some of which use leverage and derivatives while others are more conservative and employ little or no leverage. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or through the use of derivatives. • Most hedge funds are highly specialized, relying on the specific expertise of the manager or management team. • Performance of many hedge fund strategies, particularly relative value strategies, is not dependent on the direction of the bond or equity markets -- unlike conventional equity or mutual funds (unit trusts), which are generally 100% exposed to market risk. • Many hedge fund strategies, particularly arbitrage strategies, are limited as to how much capital they can successfully employ before returns diminish. As a result, many successful hedge fund managers limit the amount of capital they will accept. • Hedge fund managers are generally highly professional, disciplined and diligent. • Their returns over a sustained period of time have outperformed standard equity and bond indexes with less volatility and less risk of loss than equities. • Beyond the averages, there are some truly outstanding performers. Hemant Palav / MBA / Semester II 9.
  • 10. “Hedging Fund & Its Impact On Capital Market” • Investing in hedge funds tends to be favored by more sophisticated investors, including many Swiss and other private banks that have lived through, and understand the consequences of, major stock market corrections. • An increasing number of endowments and pension funds allocate assets to hedge funds. THe gROWTH Of HeDge fUNDS In the entire financial services area, the sector showing the most growth is clearly the area of hedge funds. While brokerage commissions continue to decline, investment banking fees start to come under pressure and the entire financial services industry worries about intensified regulatory scrutiny, the hedge fund industry with its rapid growth stands out from the crowd. New funds are starting up every week and many are beginning with an excess of a billion dollars under management from day one. The amount of money under management with hedge funds has gone up four times between 1996 and 2004 and is expected to further triple between now and 2010 to over $2.7 trillion. Public funds, endowments, and corporate sponsors have all increased their allocations to hedge funds within the context of an increased allocation towards alternative investments more generally. This move towards increased investments in real estate/private equity/hedge funds (alternative investments) is driven by the need for a higher return to compensate for the expected lower returns from more conventional investment strategies focused on US bonds and equities. There is also a clear desire among this investor base to be more focused on absolute-return strategies rather than relative return. Given the current level of allocations most of these large long-term investors have towards alternative investments, and their professed long-term target allocation, the flow of funds to these asset classes will remain strong. One of the intriguing developments in the hedge fund world is the clear desire and ability of the newer funds to charge higher fees and impose more stringent terms on investors. No longer are funds charging a 1 per cent management fee and 20 per cent of profits -- the norm for the first generation of funds set up in the early to mid 1990s. As per an interesting study done by Hemant Palav / MBA / Semester II 10.
  • 11. “Hedging Fund & Its Impact On Capital Market” Morgan Stanley's prime brokerage unit, about a third of the funds opening in the past six months are charging a 2 per cent management fee and 20 per cent of profits or higher, while the majority are charging a 1.5 per cent management fee and 20 per cent of profits. Many of the new funds have more stringent lock-ups and stiff penalties if you redeem early, as well as modified high- water marks. The hedge fund business thus seems to have the unique characteristic of being possibly the only business that I know of wherein new players (most of whom are unproven) have the ability to charge more and get better terms than the established operators. This implies a negative franchise value for the established large fund complexes which have survived and prospered through the years. Given that most of the best hedge fund complexes are closed to new investors, the new guys seem to be taking advantage of the huge demand-supply mismatch for quality money managers. There is a feeding frenzy currently under way in the world of alternative investments and clients are paying up the higher fees for fear of being locked out from these funds at a later date, if they actually survive and grow. One reason why the new boys are focusing more on fees and lock-ups could be the difficulty all hedge funds are having in generating adequate alpha (excess return) to ensure an adequate payout for themselves. In a study done by Morgan Stanley on the excess returns generated by hedge funds over the last decade, this trend of declining returns was very apparent. In the study they defined excess returns as the return of the Hedge Fund research composite over one month LIBOR (a proxy for cash returns). In the 1995-97 period, excess returns were 14 per cent; these returns have consistently declined dropping to as low as 5 per cent in 2001-03 and have dropped further since. The current huge inflows into funds focused on emerging markets make sense if you look at performance numbers over the past three years. Hedge funds focused on the emerging markets had the best returns with an 18 per cent annual return during 2001-04, closely followed by distressed debt focused funds at 17 per cent. Hemant Palav / MBA / Semester II 11.
  • 12. “Hedging Fund & Its Impact On Capital Market” More conventional hedge fund strategies of tech at 0 per cent and risk arbitrage at 3 per cent annual return lagged far behind. Given the constant inflows into new hedge funds, clients do not yet seem to be bothered about paying higher and higher fees for lower returns, but this is a discussion that I am sure will come up at some stage in most investment committees. At some stage if the hedge fund community continues to show declining alpha (excess returns), clients will need to question whether the proliferation of hedgies has reduced returns because the field has become too competitive. The beauty of the hedge fund business and the reason why the upward drift in fee structure is even more surprising is the ease of entry of new players into the game. The average long short hedge fund needs only about six back office staff per billion dollars, while a global macro fund needs about 11 people for a fund of similar size (Morgan Stanley survey). The typical long short US equity manager has only nine investment professionals and three in the back office. These funds are also not really regulated and have very limited disclosure requirements, if any. The start-up costs of these vehicles are also minimal and most funds will be able to break even at sub $100 million in assets under management. There is no other industry that I am aware of where exit and entry are as simple. Hedge funds till date in 2005 have had a tough year; there have been few strong trends to capitalise on and most funds are struggling to show a positive return. If the hedge fund industry ends the year flat or even (god forbid) negative after disappointing relative performance in 2003 and just about average numbers in 2004, some of the more sophisticated clients may migrate back to more conventional forms of investing with lower fee structures. Hedge funds are clearly here to stay, and continue to attract the best talent because of their payout structures; however, their ability to continue to command a premium fee structure will eventually be limited by their ability to differentiate themselves from their long-only brethren on the performance front. Hemant Palav / MBA / Semester II 12.
  • 13. “Hedging Fund & Its Impact On Capital Market” HeDge fUND DATA Top performing funds The top 50 performing hedge funds, based on average annual return over the previous three years, were ranked by Barron's Online in October 2007 (Hedge Fund 50). The top 10 are as follows: • 1. RAB Special Situations Fund (RAB Capital, London) - 47.69% • 2. The Children's Investment Fund (The Children's Investment Fund Management, London) - 44.27% • 3. Highland CDO Opportunity Fund (Highland Capital Management, Dallas) - 43.98% • 4. BTR Global Opportunity Fund, Class D (Salida Capital, Toronto) - 43.42% • 5. SR Phoenicia Fund (Sloane Robinson, London) - 43.10% • 6. Atticus European Fund (Atticus Management, New York) - 40.76% • 7. Gradient European Fund A (Gradient Capital Partners, London) - 39.18% • 8. Polar Capital Paragon Absolute Return Fund (Polar Capital Partners, London) - 38.00% • 9. Paulson Enhanced Partners Fund (Paulson & Co., New York) - 37.97% • 10. Firebird Global Fund (Firebird Management, New York) - 37.18% Because of the unavailability of reliable figures, the top 50 list excludes funds such as Renaissance Technologies' Renaissance Medallion Fund and ESL Investments' ESL Partners (each thought to have returned an average of over 35% in the previous 3 years) and funds by SAC Capital and Appaloosa Management, which might otherwise have made the list. The list also excludes funds with a net asset value of less than $250 million. The returns are net of fees. Hemant Palav / MBA / Semester II 13.
  • 14. “Hedging Fund & Its Impact On Capital Market” TOP eARNeRS Institutional Investor magazine annually ranks top-earning hedge fund managers. Earnings from a hedge fund are simply 100% of the capital gains on the manager's own equity stake in the fund plus the manager's share of the performance fee (usually 20% to 50% (depending on policy) of the gains on the other investors' capital). The 2004 top earner was Edward Lampert of ESL Investments Inc. who earned $1.02 billion during the year (PR Newswire link). The 2005 top earner was James Harris Simons with an earning of $1.6 billion according to Alpha magazine.[18] However, Trader Monthly reported that Simons only earned about $1 billion and that the top earner was instead T. Boone Pickens with an estimated earning of over $1.5 billion during the year.[19] The full top 10 list of hedge fund earners according to Trader Monthly Magazine. includes: • 1. T. Boone Pickens - estimated 2005 earnings $1.5bn + • 2. Steven A. Cohen, SAC Capital Advisers - $1bn + • 3. James H. Simons, Renaissance Technologies Corp. - $900m - $1bn • 4. Paul Tudor Jones, Tudor Investment Corp. - $800m - $900m • 5. Stephen Feinberg, Cerberus Capital Management - $500 - $600m • 6. Bruce Kovner, Caxton Associates - $500m - $600m • 7. Eddie Lampert, ESL Investments - $500m - $600m • 8. David E. Shaw, D. E. Shaw & Co. - $400m - $500m • 9. Jeffrey Gendell, Tontine Partners - $300m - $400m • 10. Louis Bacon, Moore Capital Management - $300m - $350m Hemant Palav / MBA / Semester II 14.
  • 15. “Hedging Fund & Its Impact On Capital Market” The 2006 top earner was John Arnold according to Trader Monthly Magazine. The list includes: • 1. John D. Arnold, Houston, Texas- of Centauras Energy- $1.5-2B • 2. James Simons, East Setauket, New York- of Renaissance Technologies Corp.- $1.5-2B • 3. Eddie Lampert, Greenwich, Connecticut- of ESL Investments- $1-1.5B NOTABle HeDge fUND MANAgeMeNT COMPANIeS Sometimes also known as alternative investment management companies. • Amaranth Advisors • Bridgewater Associates • Caxton Associates • Centaurus Energy • Citadel Investment Group • D. E. Shaw & Co. • Fortress Investment Group • Goldman Sachs Asset Management • Long Term Capital Management • Man Group • Pirate Capital LLC • Renaissance Technologies • SAC Capital Advisors • Soros Fund Management • Marshall Wace Hemant Palav / MBA / Semester II 15.
  • 16. “Hedging Fund & Its Impact On Capital Market” WHY HeDge fUNDS ARe ATTRACTIVe? There are a large number of investment vehicles that offer you good and stable returns. Products like diversified mutual funds, blue chip stocks and property are some of them. But for high net worth individuals (HNIs), there are more routes, especially in the international markets. Here we look at one such vehicle, namely hedge funds. A hedge fund is a common term used to describe private unregistered investment partnerships. Since most of them are not registered with financial regulators in their countries of origin, they do not need to meet the eligibility requirements to register as institutional investors. This is good in a way but could turn sour as well because there are no guidelines binding them. At present, there are no hedge funds operating out of India. But internationally, there are a large number of such funds. These funds are very manager-centric as the entire onus of their success or failure falls on the fund manager's ability to exploit existing market conditions. No wonder then that they charge a fixed fee of around 2 per cent a year of assets under management, along with a very high profit sharing percentage, which is mostly 20 per cent. Of course, they have to assure returns as well. Thus, profit sharing may start on the returns over and above say, the first 10 per cent returns. The fee is also based on a high watermarking concept, which means that the fund manager is entitled to a share of profits the first time. Thereafter, if the fund incurs losses and then recoups, the fund manager will not be entitled to any share of the recouped losses. The next time he will be entitled is when he beats his earlier performance. However, given the plethora of opportunities worldwide, the fund manager has the luxury of making investment decisions in stocks, bonds, commodities, currencies etc. The basic idea is to generate aggressive returns. The most important feature of hedge funds is that they seek to deliver absolute, rather than benchmarked returns. For example, equity mutual funds are benchmarked against an index like the Nifty or BSE 200, or a banking sector mutual fund could benchmark its returns against the banking index on a stock exchange and can show the investors how much better/worse he has performed. However, hedge funds managers do not have any such luxuries. Hemant Palav / MBA / Semester II 16.
  • 17. “Hedging Fund & Its Impact On Capital Market” Since they are not regulated, most countries do not allow them to raise money from the general public through a prospectus or advertisements. A few are registered with the regulators in their countries because their main investors are universities, pension funds and insurance companies. Most of the marketing is done through investment advisors or personal contacts, with their main investors being restricted to sophisticated HNIs. With the Reserve Bank of India [Get Quote] (RBI) allowing Indian residents to invest up to $200,000 abroad per head a year, it is another opportunity for HNIs to tap these funds as the minimum limit of many of them start from $100,000. But you need to remember that the amount invested is not very liquid and may be subject to a lock-in period, with quarterly, half-yearly or yearly exit windows. Those seeking to invest in hedge funds can approach a wealth manager, securities broker or investment consultant abroad, who can advise them on the available options and select the hedge fund they wish to invest in, based on its track record and management style. After that they can approach their bank in India to arrange for the foreign remittance to the hedge fund. Whenever they wish to redeem their investment, as permitted by the hedge fund, they can repatriate the proceeds to India into their bank account. Hemant Palav / MBA / Semester II 17.
  • 18. “Hedging Fund & Its Impact On Capital Market” WHAT INfORMATION SHOUlD I SeeK If I AM CONSIDeRINg INVeSTINg IN A HeDge fUND OR A fUND Of HeDge fUNDS? • Read a fund's prospectus or offering memorandum and related materials. Make sure you understand the level of risk involved in the fund's investment strategies and ensure that they are suitable to your personal investing goals, time horizons, and risk tolerance. As with any investment, the higher the potential returns, the higher the risks you must assume. • Understand how a fund's assets are valued. Funds of hedge funds and hedge funds may invest in highly illiquid securities that may be difficult to value. Moreover, many hedge funds give themselves significant discretion in valuing securities. You should understand a fund's valuation process and know the extent to which a fund's securities are valued by independent sources. • Ask questions about fees. Fees impact your return on investment. Hedge funds typically charge an asset management fee of 1-2% of assets, plus a "performance fee" of 20% of a hedge fund's profits. A performance fee could motivate a hedge fund manager to take greater risks in the hope of generating a larger return. Funds of hedge funds typically charge a fee for managing your assets, and some may also include a performance fee based on profits. These fees are charged in addition to any fees paid to the underlying hedge funds. • Understand any limitations on your right to redeem your shares. Hedge funds typically limit opportunities to redeem, or cash in, your shares (e.g., to four times a year), and often impose a "lock-up" period of one year or more, during which you cannot cash in your shares. Hemant Palav / MBA / Semester II 18.
  • 19. “Hedging Fund & Its Impact On Capital Market” • Research the backgrounds of hedge fund managers. Know with whom you are investing. Make sure hedge fund managers are qualified to manage your money, and find out whether they have a disciplinary history within the securities industry. You can get this information (and more) by reviewing the adviser’s Form ADV. You can search for and view a firm’s Form ADV using the SEC’s Investment Adviser Public Disclosure (IAPD) website. You also can get copies of Form ADV for individual advisers and firms from the investment adviser, the SEC’s Public Reference Room, or (for advisers with less than $25 million in assets under management) the state securities regulator where the adviser's principal place of business is located. If you don’t find the investment adviser firm in the SEC’s IAPD database, be sure to call your state securities regulator or search the NASD's BrokerCheck database for any information they may have. • Don't be afraid to ask questions. You are entrusting your money to someone else. You should know where your money is going, who is managing it, how it is being invested, how you can get it back, what protections are placed on your investment and what your rights are as an investor. In addition, you may wish to read NASD’s investor alert, which describes some of the high costs and risks of investing in funds of hedge funds. Hemant Palav / MBA / Semester II 19.
  • 20. “Hedging Fund & Its Impact On Capital Market” What protections do i have if i purchase a hedge fund? Hedge fund investors do not receive all of the federal and state law protections that commonly apply to most registered investments. For example, you won't get the same level of disclosures from a hedge fund that you'll get from registered investments. Without the disclosures that the securities laws require for most registered investments, it can be quite difficult to verify representations you may receive from a hedge fund. You should also be aware that, while the SEC may conduct examinations of any hedge fund manager that is registered as an investment adviser under the Investment Advisers Act, the SEC and other securities regulators generally have limited ability to check routinely on hedge fund activities. The SEC can take action against a hedge fund that defrauds investors, and we have brought a number of fraud cases involving hedge funds. Commonly in these cases, hedge fund advisers misrepresented their experience and the fund's track record. Other cases were classic "Ponzi schemes," where early investors were paid off to make the scheme look legitimate. In some of the cases we have brought, the hedge funds sent phony account statements to investors to camouflage the fact that their money had been stolen. That's why it is extremely important to thoroughly check out every aspect of any hedge fund you might consider as an investment. Hemant Palav / MBA / Semester II 20.
  • 21. “Hedging Fund & Its Impact On Capital Market” hedging strategies Wide ranges of hedging strategies are available to hedge funds. For example: • Selling short - selling shares without owning them, hoping to buy them back at a future date at a lower price in the expectation that their price will drop. • Using arbitrage - seeking to exploit pricing inefficiencies between related securities - for example, can be long convertible bonds and short the underlying issuer’s equity. • Trading options or derivatives - contracts whose values are based on the performance of any underlying financial asset, index or other investment. • Investing in anticipation of a specific event - merger transaction, hostile takeover, spin- off, exiting of bankruptcy proceedings, etc. • Investing in deeply discounted securities - of companies about to enter or exit financial distress or bankruptcy, often below liquidation value. • Many of the strategies used by hedge funds benefit from being non-correlated to the direction of equity markets popular Misconception The popular misconception is that all hedge funds are volatile -- that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, 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. Hemant Palav / MBA / Semester II 21.
  • 22. “Hedging Fund & Its Impact On Capital Market” Benefits of hedge funds • Many hedge fund strategies have the ability to generate positive returns in both rising and falling equity and bond markets. • Inclusion of hedge funds in a balanced portfolio reduces overall portfolio risk and volatility and increases returns. • Huge variety of hedge fund investment styles – many uncorrelated with each other – provides investors with a wide choice of hedge fund strategies to meet their investment objectives. • Academic research proves hedge funds have higher returns and lower overall risk than traditional investment funds. • Hedge funds provide an ideal long-term investment solution, eliminating the need to correctly time entry and exit from markets. • Adding hedge funds to an investment portfolio provides diversification not otherwise available in traditional investing. hedge fund styles The predictability of future results shows a strong correlation with the volatility of each strategy. Future performance of strategies with high volatility is far less predictable than future performance from strategies experiencing low or moderate volatility. Aggressive Growth: Invests in equities expected to experience acceleration in growth of earnings per share. Generally high P/E ratios, low or no dividends; often smaller and micro cap stocks which are expected to experience rapid growth. Includes sector specialist funds such as technology, banking, or biotechnology. Hedges by shorting equities where earnings disappointment is expected or by shorting stock indexes. Tends to be "long-biased." Expected Volatility: High 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 Hemant Palav / MBA / Semester II 22.
  • 23. “Hedging Fund & Its Impact On Capital Market” of the true value of the deeply discounted securities and because the majority of institutional investors cannot own below investment grade securities. (This selling pressure creates the deep discount.) Results generally not dependent on the direction of the markets. Expected Volatility: Low - Moderate 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, although Brady debt can be partially hedged via U.S. Treasury futures and currency markets. Expected Volatility: Very High Funds of Hedge Funds: Mix and match hedge funds and other pooled investment vehicles. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds. Returns, risk, and volatility can be controlled by the mix of underlying strategies and funds. Capital preservation is generally an important consideration. Volatility depends on the mix and ratio of strategies employed. Expected Volatility: Low - Moderate - High Income: Invests with primary focus on yield or current income rather than solely on capital gains. May utilize leverage to buy bonds and sometimes fixed income derivatives in order to profit from principal appreciation and interest income. Expected Volatility: Low Macro: Aims to profit from changes in global economies, typically brought about by shifts in government policy that impact interest rates, in turn affecting currency, stock, and bond markets. Participates in all major markets -- equities, bonds, currencies and commodities -- though not always at the same time. Uses leverage and derivatives to accentuate the impact of market moves. Utilizes hedging, but the leveraged directional investments tend to make the largest impact on performance. Expected Volatility: Very High Hemant Palav / MBA / Semester II 23.
  • 24. “Hedging Fund & Its Impact On Capital Market” Market Neutral - Arbitrage: Attempts to hedge out most market risk by taking offsetting positions, often in different securities of the same issuer. For example, can be long convertible bonds and short the underlying issuers equity. May also use futures to hedge out interest rate risk. Focuses on obtaining returns with low or no correlation to both the equity and bond markets. These relative value strategies include fixed income arbitrage, mortgage backed securities, capital structure arbitrage, and closed-end fund arbitrage. Expected Volatility: Low 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, but 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. Sometimes uses market index futures to hedge out systematic (market) risk. Relative benchmark index usually T-bills. Expected Volatility: Low 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 add to the volatility of this strategy. Expected Volatility: High Opportunistic: Investment theme changes from strategy to strategy as opportunities arise to profit from events such as IPOs, sudden price changes often caused by an interim earnings disappointment, hostile bids, and other event-driven opportunities. May utilize several of these investing styles at a given time and is not restricted to any particular investment approach or asset class. Expected Volatility: Variable Multi Strategy: Investment approach is diversified by employing various strategies simultaneously to realize short- and long-term gains. Other strategies may include systems trading such as trend following and various diversified technical strategies. This style of investing allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities. Expected Volatility: Variable Hemant Palav / MBA / Semester II 24.
  • 25. “Hedging Fund & Its Impact On Capital Market” Short Selling: Sells securities short in anticipation of being able to rebuy them at a future date at a lower price due to the manager's assessment of the overvaluation of the securities, or the market, or in anticipation of earnings disappointments often due to accounting irregularities, new competition, change of management, etc. Often used as a hedge to offset long-only portfolios and by those who feel the market is approaching a bearish cycle. High risk. Expected Volatility: Very High Special Situations: Invests in event-driven situations such as mergers, hostile takeovers, reorganizations, or leveraged buyouts. 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. May also utilize derivatives to leverage returns and to hedge out interest rate and/or market risk. Results generally not dependent on direction of market. Expected Volatility: Moderate 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 Hemant Palav / MBA / Semester II 25.
  • 26. “Hedging Fund & Its Impact On Capital Market” advantages of hedge funds over Mutual funds Hedge funds are extremely flexible in their investment options because they use financial instruments generally beyond the reach of mutual funds, which have SEC regulations and disclosure requirements that largely prevent them from using short selling, leverage, concentrated investments, and derivatives. This flexibility, which includes use of hedging strategies to protect downside risk, gives hedge funds the ability to best manage investment risks. The strong results can be linked to performance incentives in addition to investment flexibility. Unlike many mutual fund managers, hedge fund managers are usually heavily invested in a significant portion of the funds they run and shares the rewards as well as risks with the investors. "Incentive fees" remunerate hedge fund managers only when returns are positive, whereas mutual funds pay their financial managers according to the volume of assets managed, regardless of performance. This incentive fee structure tends to attract many of Wall Street’s best practitioners and other financial experts to the hedge fund industry. In the last nine years, the number of hedge funds has risen by about 20 percent per year and the rate of growth in hedge fund assets has been even more rapid. Currently, there are estimated to be approximately 8350 hedge funds managing $1 trillion. While the number and size of hedge funds are small relative to mutual funds, their growth reflects the importance of this alternative investment category for institutional investors and wealthy individual investors. Hemant Palav / MBA / Semester II 26.
  • 27. “Hedging Fund & Its Impact On Capital Market” Hedge Funds Outperform Mutual Funds in Falling Equity Markets S&P 500 VAN U.S. Hedge Fund Index Morningstar Average Equity Mutual Fund 1Q90 -3% 2.20% -2.80% 3Q90 -13.70% -3.70% -15.40% 2Q91 -0.20% 2.30% -0.90% 1Q92 -2.50% 5.00% -0.70% 1Q94 -3.80% -0.80% -3.20% 4Q94 -0.02% -1.20% -2.60% 3Q98 -9.90% -6.10% -15.00% 3Q99 -6.20% 2.10% -3.20% 2Q00 -2.70% 0.30% -3.60% 3Q00 -1.00% 3.00% 0.60% 4Q00 -7.80% -2.40% -7.80% 1Q01 -11.90% -1.10% -12.70% 3Q01 -14.70% -3.80% -17.20% 2Q02 -13.40% -1.40% -10.70% 3Q02 -17.30% -3.60% -16.60% 3Q04 -2.30% 1.40% -1.70% 1Q05 -2.59% .10% -2.20% Total -113.01% -10.30% -115.70% During the last 18 years, the S&P 500 Index has had 17 negative quarters, totaling a negative return of 113.01%. During those negative quarters, the average U.S. equity mutual fund had a total negative return of 115.7%, while the average hedge fund had a total negative return of only 10.3%, displaying the ability of hedge funds to preserve capital in falling equity markets. Hemant Palav / MBA / Semester II 27.
  • 28. “Hedging Fund & Its Impact On Capital Market” aBout WorKings of hedge funds A hedge fund is a private investment fund charging a performance fee and typically open to only a limited range of qualified investors. In the United States, hedge funds are open to accredited investors only. Because of this restriction, they are usually exempt from any direct regulation by regulatory bodies. Alfred Winslow Jones is credited with inventing hedge funds in 1949. [1] Hemant Palav / MBA / Semester II 28.
  • 29. “Hedging Fund & Its Impact On Capital Market” As a hedge fund's investment activities are limited only by the contracts governing the particular fund, it can make greater use of complex investment strategies such as short selling, entering into futures, swaps and other derivative contracts and leverage. As their name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging via any number of methods. However, the term "hedge fund" has come in modern parlance to be overused and inappropriately applied to any absolute-return fund – many of these so-called "hedge funds" do not actually hedge their investments. Hedge funds have acquired a reputation for secrecy. Unlike open-to-the-public "retail" funds (e.g., U.S. mutual funds) which market freely to the public, in most countries, hedge funds are specifically prohibited from marketing to investors who are not professional investors or individuals with sufficient private wealth. This limits the information a hedge fund can legally release. Additionally, divulging a hedge fund's methods could unreasonably compromise their business interests; this limits the information a hedge fund would want to release. Since hedge fund assets can run into many billions of dollars and will usually be multiplied by leverage, their sway over markets, whether they succeed or fail, is potentially substantial and there is a continuing debate over whether they should be more thoroughly regulated. Industry In 2005, Absolute Return magazine found there were 196 hedge funds with $1 billion or more in assets, with a combined $743 billion under management - the vast majority of the industry's estimated $1 trillion in assets.[2] However, according to hedge fund advisory group Hennessee, total hedge fund industry assets increased by $215 billion in 2006 to $1.442 trillion, up 17.5% on a year earlier, an estimate for 2005 seemingly at odds with Absolute Return. As large institutional investors have entered the hedge fund industry the total asset levels continue to rise. The 2008 Hedge Fund Asset Flows & Trends Report [4] published by HedgeFund.net and Institutional Investor News estimates total industry assets reached $2.68 trillion in Q3 2007. Hemant Palav / MBA / Semester II 29.
  • 30. “Hedging Fund & Its Impact On Capital Market” Fees Usually the hedge fund manager will receive both a management fee and a performance fee (also known as an incentive fee). Performance fees are closely associated with hedge funds, and are intended to incentivize the investment manager to produce the largest returns possible. Management fees As with other investment funds, the management fee is calculated as a percentage of the net asset value of the fund at the time when the fee becomes payable. Management fees typically range from 1% to 4% per annum, with 2% being the standard figure. Therefore, if a fund has $1 billion of assets at the year end and charges a 2% management fee, the management fee will be $20 million in total. Management fees are usually calculated annually and paid monthly. Performance fees Performance fees, which give a share of positive returns to the manager, are one of the defining characteristics of hedge funds. In contrast to retail investment firms, performance fees are prohibited in the U.S. for stock brokers.[citation needed] A hedge fund's performance fee is calculated as a percentage of the fund's profits, counting both unrealized profits and actual realized trading profits. Performance fees exist because investors are usually willing to pay managers more generously when the investors have themselves made money. For managers who perform well the performance fee is extremely lucrative. Typically, hedge funds charge 20% of gross returns as a performance fee, but again the range is wide, with highly regarded managers demanding higher fees. In particular, Steven Cohen's SAC Capital Partners charges a 50% incentive fee (but no management fee) and Jim Simons' Renaissance Technologies Corp. charged a 5% management fee and a 44% incentive fee in its flagship Medallion Fund before returning all investors' capital and running solely on its employees' money.[citations needed] Managers argue that performance fees help to align the interests of manager and investor better than flat fees that are payable even when performance is poor. However, performance fees have been criticized by many people, including notable investor Warren Buffett, for giving managers Hemant Palav / MBA / Semester II 30.
  • 31. “Hedging Fund & Its Impact On Capital Market” an incentive to take excessive risk rather than targeting high long-term returns. In an attempt to control this problem, fees are usually limited by a high water mark and sometimes by a hurdle rate. Alternatively, the investment manager might be required to return performance fees when the value of the fund drops. This provision is sometimes called a ‘claw-back.’ High water marks A "High water mark" is often applied to a performance fee calculation.[5] This means that the manager does not receive performance fees unless the value of the fund exceeds the highest net asset value it has previously achieved. For example, if a fund was launched at a net asset value (NAV) per share of $100, which then rose to $130 in its first year, a performance fee would be payable on the $30 return for each share. If the next year it dropped to $120, no fee is payable. If in the third year the NAV per share rises to $143, a performance fee will be payable only on the extra $13 return from $130 to $143 rather than on the full return from $120 to $143. This measure is intended to link the manager's interests more closely to those of investors and to reduce the incentive for managers to seek volatile trades. If a high water mark is not used, a fund that ends alternate years at $100 and $110 would generate performance fee every other year, enriching the manager but not the investors. However, this mechanism does not provide complete protection to investors: a manager who has lost money may simply decide to close the fund and start again with a clean slate -- provided that he can persuade investors to trust him with their money. A high water mark is sometimes referred to as a "Loss Carryforward Provision." Poorly performing funds frequently close down rather than work without fees, as would be required by their high water mark policies. [6] Hurdle rates Some funds also specify a hurdle rate, which signifies that the fund will not charge a performance fee until its annualized performance exceeds a benchmark rate, such as T-bills or a Hemant Palav / MBA / Semester II 31.
  • 32. “Hedging Fund & Its Impact On Capital Market” fixed percentage, over some period. This links performance fees to the ability of the manager to do better than the investor would have done if he had put the money elsewhere. Funds which specify a soft hurdle rate charge a performance fee based on the entire annualized return. Funds which use a hard hurdle rate only charge a performance fee on returns above the hurdle rate. Though logically appealing, this practice has diminished as demand for hedge funds has outstripped supply and hurdles are now rare.[citations needed] Strategies Hedge funds are no longer a homogeneous class. Under certain circumstances, an investor or hedge fund can completely hedge the risks of an investment, leaving pure profit.[citation needed] For example, at one time it was possible for exchange traders to buy shares of, say, IBM on one exchange and simultaneously sell them on another exchange, leaving pure profit.[citation needed] Competition among investors has leached away such profits, leaving hedge fund managers with trades that are partially hedged, at best. These trades still contain residual risks which can be considerable. Some styles of hedge fund investing, such as global macro investing, may involve no hedging at all. Strictly speaking, it is not accurate to call such funds hedge funds, but that is current usage. The bulk of hedge funds describe themselves as long / short equity, but many different approaches are used taking different exposures, exploiting different market opportunities, using different techniques and different instruments: • Global macro – seeking related assets that have deviated from some anticipated relationship. • Arbitrage – seeking assets that are mispriced relative to related assets. o Convertible arbitrage – between a convertible bond and the same company's equity. o Fixed income arbitrage – between related bonds. Hemant Palav / MBA / Semester II 32.
  • 33. “Hedging Fund & Its Impact On Capital Market” o Risk arbitrage – between securities whose prices appear to imply different probabilities for one event. o Statistical arbitrage (or StatArb) – between securities that have deviated from some statistically estimated relationship. o Derivative arbitrage – between a derivative and its security. • Long / short equity – generic term covering all hedged investment in equities. o Short bias – emphasizing or solely using short positions. o Equity market neutral – maintaining a close balance between long and short positions. • Event driven – specialized in the analysis of a particular kind of event. o Distressed securities – companies that are or may become bankrupt. o Regulation D – distressed companies issuing securities. o Merger arbitrage - arbitrage between an acquiring public company and a target public company. • Other – the strategies below are sometimes considered hedge strategies, although in several cases usage of the term is debatable. o Emerging markets- this usually means unhedged, long positions in small overseas markets. o Fund of hedge funds - unhedged, long only positions in hedge funds (though the underlying funds, of course, may be hedged). Additional leverage is sometimes used.[citation needed] o Quantitative o 130-30 funds - Through leveraging, 130% of the money invested in the fund is used to buy stocks. 30% of the money invested in the fund is used to short stock. hedge fund risK Investing in a hedge fund is considered to be a riskier proposition than investing in a regulated fund, despite the traditional notion of a "hedge" being a means of reducing the risk of a bet or investment. The following are some of the primary reasons for the increased risk: Hemant Palav / MBA / Semester II 33.
  • 34. “Hedging Fund & Its Impact On Capital Market” Leverage - in addition to putting money into the fund by investors, a hedge fund will typically borrow money, with certain funds borrowing sums many times greater than the initial investment. Where a hedge fund has borrowed $9 for every $1 invested, a loss of only 10% of the value of the investments of the hedge fund will wipe out 100% of the value of the investor's stake in the fund, once the creditors have called in their loans. At the beginning of 1998, shortly before its collapse, Long Term Capital Management had borrowed over $26 for each $1 invested. Short selling - due to the nature of short selling, the losses that can be incurred on a losing bet are theoretically limitless, unless the short position directly hedges a corresponding long position. Therefore, where a hedge fund uses short selling as an investment strategy rather than as a hedging strategy it can suffer very high losses if the market turns against it. Appetite for risk - hedge funds are culturally more likely than other types of funds to take on underlying investments that carry high degrees of risk, such as high yield bonds, distressed securities and collateralised debt obligations based on sub-prime mortgages. Lack of transparency - hedge funds are secretive entities. It can therefore be difficult for an investor to assess trading strategies, diversification of the portfolio and other factors relevant to an investment decision. Lack of regulation - hedge funds are not subject to as much oversight from financial regulators, and therefore some may carry undisclosed structural risks. Investors in hedge funds are willing to take these risks because of the corresponding rewards. Leverage amplifies profits as well as losses; short selling opens up new investment opportunities; riskier investments typically provide higher returns; secrecy helps to prevent imitation by competitors; and being unregulated reduces costs and allows the investment manager more freedom to make decisions on a purely commercial basis. Hemant Palav / MBA / Semester II 34.
  • 35. “Hedging Fund & Its Impact On Capital Market” legal structure A hedge fund is a vehicle for holding and investing the funds of its investors. The fund itself is not a genuine business, having no employees and no assets other than its investment portfolio and a small amount of cash, and its investors being its clients. The portfolio is managed by the investment manager, which has employees and property and which is the actual business. An investment manager is commonly termed a “hedge fund” (e.g. a person may be said to “work at a hedge fund”) but this is not technically correct. An investment manager may have a large number of hedge funds under its management. Domicile The specific legal structure of a hedge fund – in particular its domicile and the type of entity used – is usually determined by the tax environment of the fund’s expected investors. Regulatory considerations will also play a role. Many hedge funds are established in offshore tax havens so that the fund can avoid paying tax on the increase in the value of its portfolio. An investor will still pay tax on any profit it makes when it realises its investment, and the investment manager, usually based in a major financial centre, will pay tax on the fees that it receives for managing the fund. At the end of 2004 55% of the world’s hedge funds, accounting for nearly two-thirds of total hedge fund assets, were established offshore. The most popular offshore location was the Cayman Islands, followed by the British Virgin Islands, Bermuda and the Bahamas. The US was the most popular onshore location, accounting for 34% of funds and 24% of assets. EU countries were the next most popular location with 9% of funds and 11% of assets. Asia accounted for the majority of the remaining assets.[citations needed] the legal entity Limited partnerships are principally used for hedge funds aimed at US-based investors who pay tax, as the investors will receive relatively favorable tax treatment in the US. The general partner of the limited partnership is typically the investment manager (though is sometimes an offshore Hemant Palav / MBA / Semester II 35.
  • 36. “Hedging Fund & Its Impact On Capital Market” corporation) and the investors are the limited partners. Offshore corporate funds are used for non-US investors and US entities that do not pay tax (such as pension funds), as such investors do not receive the same tax benefits from investing in a limited partnership. Unit trusts are typically marketed to Japanese investors. Other than taxation, the type of entity used does not have a significant bearing on the nature of the fund.[7] Many hedge funds are structured as master/feeder funds. In such a structure the investors will invest into a feeder fund which will in turn invest all of its assets into the master fund. The assets of the master fund will then be managed by the investment manager in the usual way. This allows several feeder funds (e.g. an offshore corporate fund, a US limited partnership and a unit trust) to invest into the same master fund, allowing an investment manager the benefit of managing the assets of a single entity while giving all investors the best possible tax treatment. The investment manager, which will have organized the establishment of the hedge fund, may retain an interest in the hedge fund, either as the general partner of a limited partnership or as the holder of “founder shares” in a corporate fund. Founder shares typically have no economic rights, and voting rights over only a limited range of issues, such as selection of the investment manager – most of the fund’s decisions are taken by the board of directors of the fund, which is self-appointing and independent but invariably loyal to the investment manager. Open-ended nature Hedge funds are typically open-ended, in that the fund will periodically issue additional partnership interests or shares directly to new investors, the price of each being the net asset value (“NAV”) per interest/share. To realise the investment, the investor will redeem the interests or shares at the NAV per interest/share prevailing at that time. Therefore, if the value of the underlying investments has increased (and the NAV per interest/share has therefore also increased) then the investor will receive a larger sum on redemption than it paid on investment. Investors do not typically trade shares between themselves and hedge funds do not typically Hemant Palav / MBA / Semester II 36.
  • 37. “Hedging Fund & Its Impact On Capital Market” distribute profits to investors before redemption. This contrasts with a closed-ended fund, which has a limited number of shares which are traded between investors, and which distributes its profits. Listed funds Corporate hedge funds often list their shares on smaller stock exchanges, such as the Irish Stock Exchange, in the hope that the low level of quasi-regulatory oversight will give comfort to investors and to attract certain funds, such as some pension funds, that have bars or caps on investing in unlisted shares. Shares in the listed hedge fund are not traded on the exchange, but the fund’s monthly net asset value and certain other events must be publicly announced there. A fund listing is distinct from the listing or initial public offering (“IPO”) of shares in an investment manager. Although widely reported as a "hedge-fund IPO"[8] , the IPO of Fortress Investment Group LLC was for the sale of the investment manager, not of the hedge funds that it managed. Hedge fund management worldwide In contrast to the funds themselves, hedge fund managers are primarily located onshore in order to draw on larger pools of financial talent. The US East coast – principally New York City and the Gold Coast area of Connecticut (particularly Stamford and Greenwich) – is the world's leading location for hedge fund managers with approximately double the hedge fund managers of the next largest centre, London. With the bulk of hedge fund investment coming from the US, this distribution is natural. London is Europe’s leading centre for the management of hedge funds. At the end of 2006, three-quarters of European hedge fund investments, totalling $400bn (£200bn), were managed from London, having grown from $61bn in 2002. Australia was the most important centre for the management of Asia-Pacific hedge funds, with managers located there accounting for Hemant Palav / MBA / Semester II 37.
  • 38. “Hedging Fund & Its Impact On Capital Market” approximately a quarter of the $140bn of hedge fund assets managed in the Asia-Pacific region in 2006.[10] regulatory issues Part of what gives hedge funds their competitive edge, and their cachet in the public imagination, is that they straddle multiple definitions and categories; some aspects of their dealings are well- regulated, others are unregulated or at best quasi-regulated. US regulation The typical public investment company in the United States is required to be registered with the U.S. Securities and Exchange Commission (SEC). Mutual funds are the most common type of registered investment companies. Aside from registration and reporting requirements, investment companies are subject to strict limitations on short-selling and the use of leverage. There are Hemant Palav / MBA / Semester II 38.
  • 39. “Hedging Fund & Its Impact On Capital Market” other limitations and restrictions placed on public investment company managers, including the prohibition on charging incentive or performance fees. Although hedge funds fall within the statutory definition of an investment company, the limited- access, private nature of hedge funds permits them to operate pursuant to exemptions from the registration requirements. The two major exemptions are set forth in Sections 3(c)1 and 3(c)7 of the Investment Company Act of 1940. Those exemptions are for funds with 100 or fewer investors (a "3(c) 1 Fund") and funds where the investors are "qualified purchasers" (a "3(c) 7 Fund"). [6] A qualified purchaser is an individual with over US$5,000,000 in investment assets. (Some institutional investors also qualify as accredited investors or qualified purchasers.) [7] A 3(c)1 Fund cannot have more than 100 investors, while a 3(c)7 Fund can have an unlimited number of investors. Both types of funds can charge performance or incentive fees. In order to comply with 3(c)(1) or 3(c)(7), hedge funds are sold via private placement under the Securities Act of 1933. Thus interests in a hedge fund cannot be offered or advertised to the general public, and are normally offered under Regulation D. Although it is possible to have non-accredited investors in a hedge fund, the exemptions under the Investment Company Act, combined with the restrictions contained in Regulation D, effectively require hedge funds to be offered solely to accredited investors. An accredited investor is an individual with a minimum net worth of US $5,000,000 or, alternatively, a minimum income of US$200,000 in each of the last two years and a reasonable expectation of reaching the same income level in the current year. The regulatory landscape for Investment Advisors is changing, and there have been attempts to register hedge fund investment managers. There are numerous issues surrounding these proposed requirements. One issue of importance to hedge fund managers is the requirement that a client who is charged an incentive fee must be a "qualified client" under Advisers Act Rule 205-3. To be a qualified client, an individual must have US$750,000 in assets invested with the adviser or a net worth in excess of US$1.5 million, or be one of certain high-level employees of the investment adviser. Hemant Palav / MBA / Semester II 39.
  • 40. “Hedging Fund & Its Impact On Capital Market” For the funds, the tradeoff of operating under these exemptions is that they have fewer investors to sell to, but they have few government-imposed restrictions on their investment strategies. The presumption is that hedge funds are pursuing more risky strategies, which may or may not be true depending on the fund, and that the ability to invest in these funds should be restricted to wealthier investors who are presumed to be more sophisticated and who have the financial reserves to absorb a possible loss. In December 2004, the SEC issued a rule change that required most hedge fund advisers to register with the SEC by February 1, 2006, as investment advisers under the Investment Advisers Act. The requirement, with minor exceptions, applied to firms managing in excess of US$25,000,000 with over 15 investors. The SEC stated that it was adopting a "risk-based approach" to monitoring hedge funds as part of its evolving regulatory regimen for the burgeoning industry. The rule change was challenged in court by a hedge fund manager, and in June 2006, the U.S. Court of Appeals for the District of Columbia overturned it and sent it back to the agency to be reviewed. See Goldstein v. SEC. Although the SEC is currently examining how it can address the Goldstein decision, commentators have stated that the SEC currently has neither the staff nor expertise to comprehensively monitor the estimated 8,000 U.S. and international hedge funds. See New Hedge Fund Advisor Rule. One of the Commissioners, Roel Campos, has said that the SEC is forming internal teams that will identify and evaluate irregular trading patterns or other phenomena that may threaten individual investors, the stability of the industry, or the financial world. "It's pretty clear that we will not be knocking on [hedge fund] doors very often," Campos told several hundred hedge fund managers, industry lawyers and others. And even if it did, "the SEC will never have the degree of knowledge or background that you do. In February 2007, the President's Working Group on Financial Markets rejected further regulation of hedge funds and said that the industry should instead follow voluntary guidelines. Hemant Palav / MBA / Semester II 40.
  • 41. “Hedging Fund & Its Impact On Capital Market” Comparison to private equity funds Hedge funds are similar to private equity funds in many respects. Both are lightly regulated, private pools of capital that invest in securities and compensate their managers with a share of the fund's profits. Most hedge funds invest in relatively liquid assets, and permit investors to enter or leave the fund, perhaps requiring some months notice. Private equity funds invest primarily in very illiquid assets such as early-stage companies and so investors are "locked in" for the entire term of the fund. Hedge funds often invest in private equity companies' acquisition funds. Between 2004 and February 2006 some hedge funds adopted 25 month lock-up rules expressly to exempt themselves from the SEC's new registration requirements and cause them to fall under the registration exemption that had been intended to exempt private equity funds. Comparison to u.s. mutual funds Like hedge funds, mutual funds are pools of investment capital (i.e., money people want to invest). However, there are many differences between the two, including: • Mutual funds are regulated by the SEC, while hedge funds are not • A hedge fund investor must be an accredited investor with certain exceptions (employees, etc.) Hemant Palav / MBA / Semester II 41.
  • 42. “Hedging Fund & Its Impact On Capital Market” • Mutual funds must price and be liquid on a daily basis Some hedge funds that are based offshore report their prices to the Financial Times, but for most there is no method of ascertaining pricing on a regular basis. Additionally, mutual funds must have a prospectus available to anyone that requests them (either electronically or via US postal mail), and must disclose their asset allocation quarterly, while hedge funds do not have to abide by these terms. Hedge funds also ordinarily do not have daily liquidity, but rather "lock up" periods of time where the total returns are generated (net of fees) for their investors and then returned when the term ends, through a passthrough requiring CPAs and US Tax W-forms. Hedge fund investors tolerate these policies because hedge funds are expected to generate higher total returns for their investors versus mutual funds. Recently, however, the mutual fund industry has created products with features that have traditionally only been found in hedge funds. Mutual funds have appeared which utilize some of the trading strategies noted above. Grizzly Short Fund (GRZZX), for example, is always net short, while Arbitrage Fund (ARBFX) specializes in merger arbitrage. Such funds are SEC regulated, but they offer hedge fund strategies and protection for mutual fund investors. Also, a few mutual funds have introduced performance-based fees, where the compensation to the manager is based on the performance of the fund. However, under Section 205(b) of the Investment Advisers Act of 1940, such compensation is limited to so-called "fulcrum fees".[15] Under these arrangements, fees can be performance-based so long as they increase and decrease symmetrically. For example, the TFS Capital Small Cap Fund (TFSSX) has a management fee that behaves, within limits and symmetrically, similarly to a hedge fund "0 and 50" fee: A 0% management fee coupled with a 50% performance fee if the fund outperforms its benchmark index. However, the 125 bp base fee is reduced (but not below zero) by 50% of underperformance and increased (but not to more than 250 bp) by 50% of outperformance. Hemant Palav / MBA / Semester II 42.
  • 43. “Hedging Fund & Its Impact On Capital Market” Offshore regulation Many offshore centers are keen to encourage the establishment of hedge funds. To do this they offer some combination of professional services, a favorable tax environment, and business- friendly regulation. Major centers include Cayman Islands, Dublin, Luxembourg, British Virgin Islands and Bermuda. The Cayman Islands have been estimated to be home to about 75% of world’s hedge funds, with nearly half the industry's estimated $1.225 trillion AUM[11] . Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore centres. Typical rules concern restrictions on the availability of funds to retail investors (Dublin), protection of client confidentiality (Luxembourg) and the requirement for the fund to be independent of the fund manager. Many offshore hedge funds, such as the Soros funds, are structured as mutual funds rather than as limited partnerships. Hedge Fund Indices There are a number of indices that track the hedge fund industry. These indices come in two types, Investable and Non-investable, both with substantial problems. There are also new types of tracking product launched by Goldman Sachs and Merrill Lynch, "clone indices" that aim to replicate the returns of hedge fund indices without actually holding hedge funds at all. Investable indices are created from funds that can be bought and sold, and only Hedge Funds that agree to accept investments on terms acceptable to the constructor of the index are included. Investability is an attractive property for an index because it makes the index more relevant to the choices available to investors in practice, and is taken for granted in traditional equity indices such as the S&P500 or FTSE100. However, such indices do not represent the total universe of hedge funds and may under-represent the more successful managers, who may not find the index terms attractive. Fund indexes include BarclayHedge, Hedge Fund Research, Eurekahedge Indices, Credit Suisse Tremont and FTSE Hedge. Hemant Palav / MBA / Semester II 43.
  • 44. “Hedging Fund & Its Impact On Capital Market” The index provider selects funds and develops structured products or derivative instruments that deliver the performance of the index, making investable indices similar in some ways to fund of hedge funds portfolios. Non-investable benchmarks are indicative in nature, and aim to represent the performance of the universe of hedgefunds using some measure such as mean, median or weighted mean from a hedge fund database. There are diverse selection criteria and methods of construction, and no single database captures all funds. This leads to significant differences in reported performance between different databases. Non-investable indices inherit the databases' shortcomings, or strengths, in terms of scope and quality of data. Funds’ participation in a database is voluntary, leading to “self reporting bias” because those funds that choose to report may not be typical of funds as a whole. For example, some do not report because of poor results or because they have already reached their target size and do not wish to raise further money. This tends to lead to a clustering of returns around the mean rather than representing the full diversity existing in the hedge fund universe. Examples of non-investable indices include an equal weighted benchmark series known as the HFN Averages, and a revolutionary rules based set known as the Lehman Brothers/HFN Global Index Series which leverages an Enhanced Strategy Classification System. The short lifetimes of many hedge funds means that there are many new entrants and many departures each year, which raises the problem of “survivorship bias”. If we examine only funds that have survived to the present, we will overestimate past returns because many of the worst- performing funds have not survived, and the observed association between fund youth and fund performance suggests that this bias may be substantial. As the HFR and CISDM databases began in 1994, it is likely that they will be more accurate over the period 1994/2000 than the Credit Suisse database, which only began in 2000. When a fund is added to a database for the first time, all or part of its historical data is recorded ex-post in the database. It is likely that funds only publish their results when they are favourable, so that the average performances displayed by the funds during their incubation period are inflated. This is known as "instant history bias” or “backfill bias”. Hemant Palav / MBA / Semester II 44.
  • 45. “Hedging Fund & Its Impact On Capital Market” In traditional equity investment, indices play a central and unambiguous role. They are widely accepted as representative, and products such as futures and ETFs provide liquid access to them in most developed markets. However, among hedge funds no index combines these characteristics. Investable indices achieve liquidity at the expense of representativeness. Non- investable indices are representative, but their quoted returns may not be available in practice. Neither is wholly satisfactory. debates and Controversies Privacy issues As private, lightly regulated partnerships, hedge funds do not have to disclose their activities to third parties. This is in contrast to a fully regulated mutual fund (or unit trust) which will typically have to meet regulatory requirements for disclosure. An investor in a hedge fund usually has direct access to the investment advisor of the fund, and may enjoy more personalised reporting than investors in retail investment funds. This may include detailed discussions of risks assumed and significant positions. However, this high level of disclosure is not available to non- investors, contributing to hedge funds' reputation for secrecy. Several hedge funds are completely "black box", meaning that their returns are uncertain to the investor. Restrictions on marketing and the lack of regulation is that there are no official hedge fund statistics. An industry consulting group, HFR (hfr.com), reported at the end of the second quarter 2003 that there are 5,660 hedge funds world wide managing $665 billion. For comparison, at the same time the US mutual fund sector held assets of $7.818 trillion (according to the Investment Company Institute). Market capacity Analysis of the rather disappointing hedge fund performance in 2004 and 2005 called into question the alternative investment industry's value proposition. Alpha may have been becoming rarer for two related reasons. First, the increase in traded volume may have been reducing the market anomalies that are a source of hedge fund performance. Second, the remuneration model is attracting more and more managers, which may dilute the talent available in the industry. Hemant Palav / MBA / Semester II 45.
  • 46. “Hedging Fund & Its Impact On Capital Market” However, the market capacity effect has been questioned by the EDHEC Risk and Asset Management Research Centre through a decomposition of hedge fund returns between pure alpha, dynamic betas, and static betas. While pure alpha is generated by exploiting market opportunities, the dynamic betas depend on the manager’s skill in adapting the exposures to different factors, and these authors claim that these two sources of return do not exhibit any erosion. This suggests that the market environment (static betas) explains a large part of the poor performance of hedge funds in 2004 and 2005. Systematic risk Hedge funds came under heightened scrutiny as a result of the failure of Long-Term Capital Management (LTCM) in 1998, which necessitated a bailout coordinated by the U.S. Federal Reserve. Critics have charged that hedge funds pose systemic risks highlighted by the LTCM disaster. The excessive leverage (through derivatives) that can be used by hedge funds to achieve their return is outlined as one of the main factors of the hedge funds contribution to systematic risk. The ECB (European Central Bank) has issued a warning on hedge fund risk for financial stability and systemic risk: "... the increasingly similar positioning of individual hedge funds within broad hedge fund investment strategies is another major risk for financial stability which warrants close monitoring despite the essential lack of any possible remedies. This risk is further magnified by evidence that broad hedge fund investment strategies have also become increasingly correlated, thereby further increasing the potential adverse effects of disorderly exits from crowded trades." The Times wrote about this review: "In one of the starkest warnings yet from an official institution over the role of the burgeoning but secretive industry, the ECB sounded a note of alarm over the possible repercussions from any collapse of a hedge fund, or group of funds." However, the ECB statement itself has been criticized by a part of the financial research community. These arguments are developed by the EDHEC Risk and Asset Management Research Centre: The main conclusions of the study are that “the ECB article’s conclusion of a risk of “disorderly exits from crowded trades” is based on mere speculation. While the question of systemic risk is of importance, we do not dispose of enough data to reliably address this Hemant Palav / MBA / Semester II 46.
  • 47. “Hedging Fund & Its Impact On Capital Market” question at this stage”, “ it would be worthwhile for financial regulators to work towards obtaining data on hedge fund leverage and counterparty credit risk. Such data would allow a reliable assessment of the question of systemic risk”, and “besides evaluating potential systemic risk, it should be recognised that hedge funds play an important role as “providers of liquidity and diversification”. The potential for systemic risk was highlighted by the near-collapse of two Bear Stearns hedge funds in June 2007. The funds invested in mortgage-backed securities. The funds' financial problems necessitated an infusion of cash into one of the funds from Bear Stearns but no outside assistance. It was the largest fund bailout since Long Term Capital Management's collapse in 1998. The U.S. Securities and Exchange commission is investigating. Performance measurement The issue of performance measurement in the hedge fund industry has led to literature that is both abundant and controversial. Traditional indicators (Sharpe, Treynor, Jensen) work best when returns follow a symmetrical distribution. In that case, risk is represented by the standard deviation. Unfortunately, hedge fund returns are not normally distributed, and hedge fund return series are autocorrelated. Consequently, traditional performance measures suffer from theoretical problems when they are applied to hedge funds, making them even less reliable than is suggested by the shortness of the available return series. Innovative performance measures have been introduced in an attempt to deal with this problem: Modified Sharpe ratio by Gregoriou and Gueyie (2003), Omega by Keating and Shadwick (2002), Alternative Investments Risk Adjusted Performance (AIRAP) by Sharma (2004), and Kappa by Kaplan and Knowles (2004). An overview of these performance measures is available in Géhin, W., 2006, The Challenge of Hedge Fund Performance Measurement: a Toolbox rather than a Pandora’s Box, EDHEC Risk and Asset Management Research Center, Position Paper, December. However, there is no consensus on the most appropriate absolute performance measure, and traditional performance measures are still widely used in the industry. Relationships with analysts Hemant Palav / MBA / Semester II 47.
  • 48. “Hedging Fund & Its Impact On Capital Market” In June 2006. the U.S. Senate Judiciary Committee began an investigation into the links between hedge funds and independent analysts, and other issues related to the funds. Connecticut Attorney General Richard Blumenthal testified that an appeals court ruling striking down oversight of the funds by federal regulators left investors "in a regulatory void, without any disclosure or accountability." The hearings heard testimony from, among others, Gary Aguirre, a staff attorney who was recently fired by the SEC. Transparency Some hedge funds, mainly American, do not use third parties either as the custodian of their assets or as their administrator (who will calculate the NAV of the fund). This can lead to conflicts of interest, and in extreme cases can assist fraud. In a recent example, Kirk Wright of International Management Associates has been accused of mail fraud and other securities violations which allegedly defrauded clients of close to $180 million. impaCt of Hedge funds on Capital marKet The hedge fund universe is expanding rapidly, with more than 7,300 funds managing some $1.7 trillion in assets by mid-2007. The three largest hedge funds each manages at least $30 billion in investors' assets, and have estimated investment positions in financial markets of up to $100 billion. MGI projects that the value of hedge fund assets under management will more than double over the next five years to $3.5 trillion. Hemant Palav / MBA / Semester II 48.
  • 49. “Hedging Fund & Its Impact On Capital Market” Hedge funds have benefited capital markets by increasing liquidity and spurring financial innovations. Yet worries persist that their growing size and heavy use of borrowing could destabilize financial markets. When Long Term Capital Management ran into trouble in 1998, the fund's catastrophic losses prompted the Federal Reserve to coordinate a $3.6 billion rescue by a group of large banks. More recently, several multibillion-dollar hedge funds suffered big losses in mid-2007 as rising defaults on subprime mortgages caused turmoil in the debt and equity markets. Some smaller and midsize funds shut down. So the question arises again: could a hedge fund meltdown trigger a broader financial-market crisis? MGI's research suggests that several developments over the past decade may have reduced—but certainly not eliminated—the risks. Hedge funds have adopted more diverse trading strategies, reducing the likelihood that many would fail simultaneously. The banks that lend to hedge funds have improved their assessment and monitoring of risk, and they have reasonable financial cushions—collateral and equity—to protect them in case one or more of their hedge fund clients were to fail (as we saw last summer). The largest hedge funds have begun to raise permanent capital in public stock and bond markets, while imposing more restrictions on investor withdrawals—changes that should improve their ability to weather market downturns. Once financial-market mavericks, hedge funds are joining the mainstream. Private Equity Private equity is a relatively small industry, but one that has had a disproportionately large impact on the corporate world. The value of private-equity-owned companies is only 5 percent of the value of companies listed in the U.S. stock markets (and just 3 percent in Europe). However, private-equity firms now account for nearly one in three mergers or acquisitions. These firms have grabbed public attention with a series of huge deals, including the buyouts of energy giant TXU Corp. for $45 billion and health-care company HCA, Inc., for $33 billion. Hemant Palav / MBA / Semester II 49.
  • 50. “Hedging Fund & Its Impact On Capital Market” Private-equity firms are ushering in a new model of corporate governance, and the best funds improve the performance of many of the companies they buy. For instance, one study of 60 leveraged-buyout deals found that two-thirds of them improved company performance and posted risk-adjusted returns of twice the industry average. Seeing superior returns in companies taken private, shareholders of publicly listed companies are inclined to scrutinize the performance of their respective managements more closely and demand improvements. Although private-equity funds are sometimes accused of seeking short-term profits, most private- equity funds invest on a three- to five-year horizon, giving them leeway to engage in root-and- branch corporate restructuring. By adding debt to an acquired company's balance sheet, they force managers to hit tough financial targets. As the pace of buyouts quickened earlier in 2007, private-equity firms caused many public companies to rethink their attitudes toward debt and equity—in the United States, for instance, companies have increasingly been choosing to buy back shares, often purchasing them partly by raising levels of debt. The recent tightening of credit markets has complicated the financing of some recent buyout deals and may dampen the flow of investor money into private-equity firms. But even if growth slows in the short term, MGI projects that the industry's assets will increase to $1.4 trillion by 2012. As the industry expands, private-equity firms will mature, consolidate, and diversify their investments, amplifying their influence on the broader corporate and financial landscape. These new power brokers are here to stay, and they are increasingly venturing into each other's territory. Hedge funds are buying up companies. Asian central banks are starting to replicate the sovereign wealth funds of oil exporters. Oil exporters are creating more-sophisticated investment vehicles such as private-equity funds. The concerns about the new power brokers are genuine—and may well be justified. But we should make judgments based on the facts—not out of an emotional response to power's passing to a new set of actors on the financial stage. There is cause for qualified optimism that the benefits of liquidity, innovation, and diversification brought by the new players will outweigh the risks. Hemant Palav / MBA / Semester II 50.
  • 51. “Hedging Fund & Its Impact On Capital Market” role of Hedge funds in tHe Capital marKets The role that hedge funds are playing in capital markets cannot be quantified with any precision. A fundamental problem is that the definition of a hedge fund is imprecise, and distinctions between hedge funds and other types of funds are increasingly arbitrary. Hedge funds often are characterized as unregulated private funds that can take on significant leverage and employ complex trading strategies using derivatives or other new financial instruments. Private equity Hemant Palav / MBA / Semester II 51.
  • 52. “Hedging Fund & Its Impact On Capital Market” funds are usually not considered hedge funds, yet they are typically unregulated and often leverage significantly the companies in which they invest. Likewise, traditional asset managers more and more are using derivatives or are investing in structured securities that allow them to take on leverage or establish short positions. Although several databases on hedge funds are compiled by private vendors, they cover only the hedge funds that voluntarily provide data. Consequently, the data are not comprehensive. Furthermore, because the funds that choose to report may not be representative of the total population of hedge funds, generalizations based on these databases may be misleading. Data collected by the Securities and Exchange Commission (SEC) from registered advisers to hedge funds are not comprehensive either. The primary purpose of registration is to protect investors by discouraging hedge fund fraud. The SEC does not require an adviser to a hedge fund, regardless of how large it is, to register if the fund does not permit investors to redeem their interests within two years of purchasing them. While registration of advisers of such funds may well be unnecessary to discourage fraud, the exclusion from the database of funds with long lock-up periods makes the data less useful for quantifying the role that hedge funds are playing in the capital markets. Even if a fund is included in a private database or its adviser is registered with the SEC, the information available is quite limited. The only quantitative information that the SEC currently collects is total assets under management. Private databases typically provide assets under management as well as some limited information on how the assets are allocated among investment strategies, but they do not provide detailed balance sheets. Some databases provide information on funds’ use of leverage, but their definition of leverage is often unclear. As hedge funds and other market participants increasingly use financial products such as derivatives and securitized assets that embed leverage, conventional measures of leverage have become much less useful. More meaningful economic measures of leverage are complex and highly sensitive to assumptions about the liquidity of the markets in which financial instruments can be sold or hedged. Although the role of hedge funds in the capital markets cannot be precisely quantified, the growing importance of that role is clear. Total assets under management are usually reported to Hemant Palav / MBA / Semester II 52.
  • 53. “Hedging Fund & Its Impact On Capital Market” exceed $1 trillion. Furthermore, hedge funds can leverage those assets through borrowing money and through their use of derivatives, short positions, and structured securities. Their market impact is further magnified by the extremely active trading of some hedge funds. The trading volumes of these funds reportedly account for significant shares of total trading volumes in some segments of fixed income, equity, and derivatives markets. In various capital markets, hedge funds clearly are increasingly consequential as providers of liquidity and absorbers of risk. For example, a study of the markets in U.S. dollar interest rate options indicated that participants viewed hedge funds as a significant stabilizing force. In particular, when the options and other fixed income markets were under stress in the summer of 2003, the willingness of hedge funds to sell options following a spike in options prices helped restore market liquidity and limit losses to derivatives dealers and investors in fixed-rate mortgages and mortgage-backed securities. Hedge funds reportedly are significant buyers of the riskier equity and subordinated tranches of collateralized debt obligations (CDOs) and of asset- backed securities, including securities backed by nonconforming residential mortgages. At the same time, however, the growing role of hedge funds has given rise to public policy concerns. These include concerns about whether hedge fund investors can protect themselves adequately from the risks associated with such investments, whether hedge fund leverage is being constrained effectively, and what potential risks the funds pose to the financial system if their leverage becomes excessive. Investor Protection Hedge funds and their investment advisers historically were exempt from most provisions of the federal securities laws. Those laws effectively allow only institutions and relatively wealthy individuals to invest in hedge funds. Such investors arguably are in a position to protect themselves from the risks associated with hedge funds. However, in recent years hedge funds Hemant Palav / MBA / Semester II 53.
  • 54. “Hedging Fund & Its Impact On Capital Market” reportedly have been marketed increasingly to a less wealthy clientele. Furthermore, pension funds, many of whose beneficiaries are not wealthy, have increased investments in hedge funds. Concerns about the potential direct and indirect exposures of less wealthy investors from hedge fund investments and hedge fund fraud contributed to the SEC’s decision in December 2004 to require many advisers to hedge funds that are offered to U.S. investors to register with the commission. The SEC believes that the examination of registered hedge fund advisers will deter fraud. But fraud is very difficult to uncover, even through on-site examinations. Therefore, it is critical that investors do not view the SEC registration of advisers as an effective substitute for their own due diligence in selecting funds and their own monitoring of hedge fund performance. Most institutional investors probably understand this well. In a survey several years ago of U.S. endowments and foundations, 70 percent of the respondents said that a hedge fund adviser’s registration or lack of registration with the SEC had no effect on their decision about whether or not to invest because the institutions conducted their own due diligence. In the case of pension funds, sponsors and pension fund regulators should ensure that pension funds conduct appropriate due diligence with respect to all their investments, not just their investments in hedge funds. Pension funds and other institutional investors seem to have a growing appetite for a variety of alternatives to holding stocks and bonds, including real estate, private equity and commodities, and investments in hedge funds are only one means of gaining exposures to those alternative assets. The registration of hedge fund advisers simply cannot protect pension fund beneficiaries from the failures of plan sponsors to carry out their fiduciary responsibilities. As for individual investors, the income and wealth criteria that define eligible investors in hedge funds unavoidably are a crude test for sophistication. If individuals with relatively little wealth increasingly become the victims of hedge fund fraud, it may become appropriate to tighten the criteria for an individual to be considered an eligible investor. Excessive Leverage and Systemic Risk Hemant Palav / MBA / Semester II 54.
  • 55. “Hedging Fund & Its Impact On Capital Market” The near failure of the hedge fund Long-Term Capital Management (LTCM) in September 1998 illustrated the potential for a large hedge fund to become excessively leveraged and raised concerns that a forced liquidation of large positions held by a highly leveraged institution would create systemic risk by exacerbating market volatility and illiquidity. In our market-based economy, the primary mechanism that regulates firms’ leverage is the market discipline imposed by creditors and counterparties. Even when the government has oversight of leverage, as in the case of banks and broker-dealers, such oversight is intended to supplement market discipline rather than to replace it. In the case of LTCM, however, market discipline broke down. In the wake of the LTCM episode, the President’s Working Group on Financial Markets considered how best to constrain excessive leverage by hedge funds. The Working Group concluded that hedge funds’ leverage could be constrained most effectively by promoting measures that enhance market discipline by improving credit risk management by hedge funds’ counterparties and creditors, nearly all of which are regulated banks and securities firms. The Working Group termed this approach “indirect regulation” of hedge funds. The Working Group considered the alternative of direct government regulation of hedge funds, but it concluded that developing a regulatory regime for hedge funds would present formidable challenges in terms of cost and effectiveness. It believed that indirect regulation would address concerns about systemic risks from hedge funds most effectively and would avoid the potential attendant costs of direct regulation. The Federal Reserve and Hedge Funds The President’s Working Group made a series of recommendations for improving market discipline on hedge funds. These included recommendations for improvements in credit risk management practices by the banks and securities firms that are hedge funds’ counterparties and creditors and improvements in supervisory oversight of those banks and securities firms. As a Hemant Palav / MBA / Semester II 55.
  • 56. “Hedging Fund & Its Impact On Capital Market” regulator of banks and bank holding companies, the Federal Reserve has worked with other domestic and international regulators to implement the necessary improvements in supervisory oversight. Regulatory cooperation is essential in this area because hedge funds’ principal creditors and counterparties include foreign banks as well as U.S. banks and securities firms. In January 1999, the Basel Committee on Banking Supervision (BCBS) published a set of recommendations for sound practices for managing counterparty credit risks to hedge funds and other highly leveraged institutions. Around the same time, the Federal Reserve, the SEC, and the Treasury Department encouraged a group of twelve major banks and securities firms to form a Counterparty Risk Management Policy Group (CRMPG), which in July 1999 issued its own complementary recommendations for improving counterparty risk management practices. The BCBS sound practices have been incorporated into Federal Reserve supervisory guidance and examination procedures applicable to banks’ capital market activities. In general terms, routine supervisory reviews of counterparty risk management practices with respect to hedge funds and other counterparties seek to ensure that banks (1) perform appropriate due diligence in assessing the business, risk exposures, and credit standing of their counterparties; (2) establish, monitor, and enforce appropriate quantitative risk exposure limits for each of their counterparties; (3) use appropriate systems to measure and manage counterparty credit risk; and (4) deploy appropriate internal controls to ensure the integrity of their processes for managing counterparty credit risk. Besides conducting routine reviews and continually monitoring counterparty credit exposures, the Federal Reserve periodically performs targeted reviews of the credit risk management practices of banks that are major hedge fund counterparties. These targeted reviews examine in depth the banks’ practices against the BCBS and Federal Reserve sound practices guidance and the CRMPG recommendations. According to supervisors and most market participants, counterparty risk management has improved significantly since the LTCM episode in 1998. However, since that time, hedge funds have greatly expanded their activities and strategies in an environment of intense competition for hedge fund business among banks and securities firms. Furthermore, some hedge funds are among the most active investors in new, more-complex structured financial products, for which valuation and risk measurement are challenging both to the funds themselves and to their Hemant Palav / MBA / Semester II 56.
  • 57. “Hedging Fund & Its Impact On Capital Market” counterparties. Counterparties and supervisors need to ensure that competitive pressures do not result in any significant weakening of counterparty risk management and that risk management practices are evolving as necessary to address the increasing complexity of the financial instruments used by hedge funds. The Federal Reserve has also sought to limit hedge funds’ potential to be a source of systemic risk by ensuring that the clearing and settlement infrastructure that supports the markets in which the funds trade is robust. Very active trading by hedge funds has contributed significantly to the extraordinary growth in the past several years of the markets for credit derivatives. A July 2005 report by a new Counterparty Risk Management Policy Group (CRMPG II) called attention to the fact that the clearing and settlement infrastructure for credit derivatives (and over-the-counter derivatives generally) had not kept pace with the volume of trading. In particular, a backlog of unsigned trade confirmations was growing, and the acceptance by dealers of assignments of trades by one counterparty without the prior consent of the other, despite trade documentation requirements for such consent, was becoming widespread. To address these and other concerns about the clearing and settlement of credit derivatives, in September 2005 the Federal Reserve Bank of New York brought together fourteen major U.S. and foreign derivatives dealers and their supervisors. The supervisors collectively made clear their concerns about the risks created by the infrastructure weaknesses and asked the dealers to develop plans to address those concerns. With supervisors providing common incentives for the collective actions that were necessary, the dealers have made remarkable progress since last September. The practice of unauthorized assignments has almost ceased, and dealers are now expeditiously responding to requests for the authorization of assignments. For the fourteen dealers as a group, total credit derivative confirmations outstanding for more than thirty days fell 70 percent between September 2005 and March 2006. The reduction in outstanding confirmations was made possible in part by more widespread and intensive use of an electronic confirmation-processing system operated by the Depository Trust and Clearing Corporation (DTCC). The dealers have worked with their largest and most active clients, most of which are hedge funds, to ensure that they can electronically confirm trades in credit derivatives. By March 2006, 69 percent of the fourteen dealers’ credit derivatives trades were being confirmed electronically, up from 47 percent last September. Hemant Palav / MBA / Semester II 57.
  • 58. “Hedging Fund & Its Impact On Capital Market” Supervisors and market participants agree that further progress is needed, and in March the fourteen dealers committed themselves to achieving by October 31, 2006, a “steady state” position for the industry. The steady state will involve (1) the creation of a largely electronic marketplace in which all trades that can be processed electronically will be; (2) the creation by DTCC of an industry trade information warehouse and support infrastructure to standardize and automate processing of events throughout each contract’s life; (3) new processing standards for those trades that cannot be confirmed electronically; and (4) the creation of an automated platform to support notifications and consents with respect to trade assignments. The principal trade association for the hedge fund industry has stated its support for plans embodied in the dealers’ commitments. Hedge funds clearly are becoming more important in the capital markets as sources of liquidity and holders and managers of risk. But as their importance has grown, so too have concerns about investor protection and systemic risk. The SEC believes that the examination of registered hedge advisers will deter fraud. But investors must not view SEC regulation of advisers as an effective substitute for their own due diligence in selecting funds and their own monitoring of hedge fund performance. After the LTCM episode, the President’s Working Group on Financial Markets considered how best to address concerns about potential systemic risks from excessive hedge fund leverage. The Working Group concluded that hedge funds’ leverage could be constrained most effectively by promoting measures that enhance market discipline by improving credit risk management by funds’ counterparties and creditors, nearly all of which are regulated banks and securities firms. The Working Group considered the alternative of direct government regulation of hedge funds but concluded that it would be more costly and would be less effective than an approach focused on strengthening market discipline. The Federal Reserve has been seeking to ensure appropriate market discipline on hedge funds by working with other regulators to promote effective counterparty risk management by hedge funds’ counterparties and creditors. It has also sought to limit the potential for hedge funds to be a source of systemic risk by ensuring that the clearing and settlement infrastructure that supports the markets in which they trade is robust. Hemant Palav / MBA / Semester II 58.
  • 59. “Hedging Fund & Its Impact On Capital Market” 1. Examples of hedge fund databases include Trading Advisors Selection System (TASS), Centre for International Securities and Derivatives Markets (CISDM) Hedge Fund Database, and Hedge Fund Research Database. 2. The commission decided not to require such funds to register because it had not encountered significant problems with fraud at private equity or venture capital funds, which are similar in some respects to hedge funds but usually require investors to make long-term commitments of capital. 3. For a discussion of the definition and construction of economically meaningful measures of leverage, see appendix A in Counterparty Risk Management Policy Group (1999), Improving Counterparty Risk Management Practices (New York: CRMPG, June). 4. Some of these estimates may double count investments in funds of funds. At the end of last year, and excluding fund of funds, the TASS database included funds that had $979.3 billion in assets. Of course, not all funds are included in this database. 5. Greenwich Associates estimates that hedge funds in 2004 accounted for 20 to 30 percent of trading volumes in markets for below-investment-grade debt, credit derivatives, collateralized debt obligations, emerging-market bonds, and leveraged loans, and 80 percent of trading in distressed debt. See Greenwich Associates (2004), Hedge Funds: The End of the Beginning? (Greenwich Associates, December). These estimates were based on interviews with hedge funds and other institutional investors that Greenwich Associates conducted from February through April 2004. The last few years have been good to investors, investment funds, and the M&A market. Now, in another indication that the party may be over, capital investors are showing signs of retreating from hedge funds. In response, hedge funds are making new offers and improved terms in order to woo the investors that support them. Hemant Palav / MBA / Semester II 59.
  • 60. “Hedging Fund & Its Impact On Capital Market” After two prominent Bear Sterns funds specializing in subprime mortgages collapsed, other hedge funds in the same market began seeing requests from investors seeking to redeem their investment. The crunch in the subprime mortgage market was followed by a decline in the overall availability of credit and by falling share prices on the stock market. Since credit and share values are important factors in the M&A marketplace, the recent high pace of merger and acquisition deal activity is expected to slow, creating a challenge for funds that invest in stocks and acquisitions. Some of the hedge fund sector's prominent players, including AQR Capital Management, Highbridge Capital Management, DE Shaw, and Goldman Sachs, have recently seen heavy losses. Investors, ranging from wealthy individuals to chief investment officers for endowments and trusts, are becoming more cautious about risk. Investment funds are preparing for the possibility that new investors may be difficult to find and current investors may ask for their money back. KKR Financial Holdings, an affiliate of Kohlberg Kravis Roberts & Co., stated that it could lose up to $290 billion in its investments because investor faith in mortgages has been shaken. Advertisement Large-scale redemptions could drive hedge funds to sell off assets below value in order to create the liquidity necessary to return capital to investors. The greatest demand for redemptions will likely be seen by hedge funds focused on subprime mortgage investments and quantitative funds. Quantitative hedge funds, which select investments based on computer-based models and quantitative analysis, began posting steep losses in late July and early August, when the subprime mortgage crash triggered a crisis of confidence in credit markets. Hedge funds are not sitting quietly, waiting for their investors to pull out. Sentinel Management Group Inc., stating that it cannot meet its investors' requests to withdraw their money without selling investments at a steep discount, has frozen a $1.5 billion fund. Funds at Bear Sterns, Braddock Financial, and United Capital Markets have also taken actions to suspend redemptions. Sentinel Management has reportedly asked regulators for permission to suspend redemptions as well. Hemant Palav / MBA / Semester II 60.
  • 61. “Hedging Fund & Its Impact On Capital Market” Many hedge funds impose "gates," rule structures that limit the amount of assets withdrawn in a given quarter. These strictures help limit the impact that sudden investment withdrawals can have on markets as the funds would otherwise have to sell of assets at discount rates in order to meet the withdrawal requests. In the midst of all the concern, investment banking giant Goldman Sachs is making efforts to draw investors to its Global Equity Opportunities hedge fund, after stock market losses wiped out about $1.4 billion of its assets. Goldman is offering surprising terms to new participants in the fund - Goldman is waiving the fund's management fee and cutting its performance fees in half. Previously, Global Equity investors paid two percent of assets per year as a management fee and 20 percent of profits as an incentive fee. The new deal doesn't impose any incentive fees until the fund appreciates by ten percent. Goldman will then keep ten percent of the fund's profits above that threshold. There is a catch, however. Global Equity's existing investors can withdraw their money monthly with 15 days notice. New investors may not withdraw for six months. The deal is clear- ly structured to draw investors with the resources and confidence to commit for a longer investment period. The banking giant has an interest in keeping the fund going. Goldman has invested about $2 billion of its own money in the fund. After its recent market losses, the fund has about $3.6 billion in assets. The fund's value has declined since July 2006, so exisiting investors are not currently being charged the 20 percent performance fee. The fee will be applied when the funds performance surpasses its highest level from last year. It is too early to tell whether new strategies will save hedge funds. It is equally difficult to predict just how great the investor withdrawal will be. But the easy ride is definitely over, and the road ahead is likely to get rough. THREE MAIN ISSUE DISCUSS Hemant Palav / MBA / Semester II 61.
  • 62. “Hedging Fund & Its Impact On Capital Market” A. From a regulatory point of view, what are the key risks posed by hedge funds? B. What is the appropriate regulatory response to these risks? C. What is the approach being taken by the International Organisation of Securities Commissions to hedge funds, focusing in particular on its work on valuation policies and pricing procedures for hedge fund portfolios? From a regulatory perspective, what are the key risks posed by hedge funds? Before turning to the risks that are particular to hedge funds and hedge fund managers, it is worth stressing that the FSA believes firmly that a regulator should only intervene in markets where the market is failing to deliver acceptable outcomes, and where the costs of intervention are justified by the benefits to be delivered by regulation. Moreover, we are not a regulator who considers it sensible or desirable to deliver a regulatory regime that guarantees that failures will never occur. A non-zero failure regime of the sort we operate accepts that firms will from time to time fail. Hemant Palav / MBA / Semester II 62.
  • 63. “Hedging Fund & Its Impact On Capital Market” While we aim to minimise the impact of failures which arise from regulatory breaches, we must accept that firms will make errors of business judgement, timing, or strategy or simply fail to measure up to the competition. In any vibrant and successful marketplace some businesses must fail, and this reality helps drive standards higher for those who succeed. The Amaranth case is in some respects an interesting example of what I mean, and I digress for just a moment longer. There are inquiries underway and it is not possible to comment definitively, but there are aspects of this collapse that suggest that the overall regulatory framework did operate in an effective manner. The losses were catastrophic for the firm and sudden, but the overall impact on the market relatively insignificant. The prime brokers involved appear all to have had more than adequate collateral, and the positions of Amarath appear to have been liquidated or transferred without undue disruption to trading in the sector or its underlying physical markets. Judging from the information available to investors before the collapse, there may be interesting questions for fund of hedge fund managers and other investors in the fund to ask themselves about whether the collapse could have been foreseen, so there may be lessons to be learned about due diligence performed by hedge fund investors. But no one should expect that hedge funds will never lose money or forget that they indeed may from time to time disappear. This is part of the risk/reward framework that underlies all financial markets. Let me return then to the question of what the FSA considers are the key regulatory risks arising in respect of hedge funds and those who manage and provide services to them. I am speaking therefore of risks that arise to our regulatory objectives of proportionate investor protection and maintenance of market confidence. Once we have identified the key risks, we must determine the likelihood of them crystallising, in order to decide whether there are any proportionate mitigating actions that we or indeed others might be best placed to take. If these are the principal risks, what then is the appropriate response for a regulator to them? Firstly, I must emphasise the FSA is not seeking to authorise and regulate the funds themselves, which at present are located outside our jurisdiction. Our approach is to mitigate the risks Hemant Palav / MBA / Semester II 63.
  • 64. “Hedging Fund & Its Impact On Capital Market” through our existing authority over hedge fund managers and the broker/dealers who provide prime brokerage services to the funds. We do not consider that the assertion of extra-territorial jurisdiction is a necessary or desirable regulatory intervention in this market. With this in mind, the FSA set up a centre of hedge fund expertise in October 2005. A priority of this team has been to enhance our oversight of 31 of the largest hedge fund managers in the UK (accounting for 50% of assets managed). These managers have a dedicated supervisor in regular contact with the firms and undertaking periodic risk assessments to develop individual risk mitigation plans with them. Lower impact firms are subject to baseline monitoring through regulatory returns and other types of alerts and market intelligence. The centre of expertise advises and where relevant takes the lead on the FSA response to any hedge fund cases. Furthermore, it undertakes thematic supervision, covering a wide range of entities that have hedge fund mandates irrespective of where within the FSA that group or firm is primarily supervised – the approach is designed to address the risks posed to our objectives by the industry as a whole. That's how we have organised our resources, but now let me deal with our response to the specific risks to our objectives I outlined earlier. 1) Market disruption/systemic issues In 2004, we established a regular six monthly survey on the exposures to hedge funds of the main London based banks that provide prime brokerage services. The aim of this survey is to enhance our understanding of prime brokerage and to gather data on the exposures of the firms to major hedge funds, either via prime brokerage or via the trading of OTC derivatives. The survey targets the largest Prime Brokers (currently 15 firms) with 2 main data requests; the first looks at Hemant Palav / MBA / Semester II 64.
  • 65. “Hedging Fund & Its Impact On Capital Market” their credit exposures to hedge funds, the second focuses on the prime broker business. The quantitative benefits of the survey have worked in tandem with qualitative support; it has advanced supervisory discourse with firms, particularly those with large risk exposures, and encouraged the improvement of risk management systems in the prime brokers themselves. We are conscious of the importance to hedge fund managers of a small number of very large prime brokers, who provide both financial gearing and operational support to the hedge fund managers. These prime brokers are institutions with which we at the FSA already have a close regulatory relationship, and we have used this to develop a much improved understanding of the position of these banks vis-à-vis hedge funds. So what are the headline findings thus far? Our April 2006 survey showed: • Assets under management had grown, on an equity basis, by 29% per cent to $494 billion; • Aggregate average leverage had grown slightly from to 2.25 to 2.39; • Two prime brokers continued to account for just over half the sector's total exposure to hedge funds; • Average excess collateral remains unchanged at 100 per cent; • No fund with major exposures comparable to LTCM has been identified. Generally, the funds' gearing was significantly lower than LTCM, which was leveraged at 25:1 until early 1998, and 50:1 by the time of its collapse. Present leverage on average as revealed by our survey is 2.4:1. The highest gearing of any fund was 15:1 • We found that exposures of the prime brokers to the hedge funds were both limited in absolute amount and relative to capital, and were in general fully collateralised, as was evident as noted in the Amaranth collapse. A word about the limitations of this survey. With two exceptions, our information covers only exposures booked in London, so we do not have and do not purport to have the total global picture in respect of these prime brokers or indeed of any underlying hedge fund. Nonetheless, we consider that this information, which does cover a substantial percentage of the global market, is a good indicator of the present position. We are also discussing with the prime brokers Hemant Palav / MBA / Semester II 65.
  • 66. “Hedging Fund & Its Impact On Capital Market” and other regulators whether, and if so how, this voluntary survey might be extended internationally. 2) Market Integrity Our focus on market integrity has two strands. Firstly, seeking to deter abuse. Credible deterrence has four key components – pro-active surveillance of likely 'hot spots,' a modern transaction analysis system, industry cooperation to ensure a steady flow of information, and an effective enforcement programme. It is worth mentioning that we have been devoting significant supervisory efforts to enhancing managers' systems and procedures for dealing with price sensitive information. We have been active in encouraging an improvement of the hedge fund managers’ procedures in this area. We have also not hesitated to take enforcement action where warranted and have identified market abuse as an enforcement priority for the organisation going forward. 3) A co-ordinated global approach to reducing credit derivatives backlogs We, together with regulators in other major financial centres - notably the US Federal Reserve and the SEC - became very concerned about significant trade confirmation backlogs in the credit derivative markets last year. In assessing this risk, we became aware that the assignment of trades by hedge funds, without prior approval or even notification of their counterparty, was significantly contributing to this backlog. Our response has been to work as a group to set targets and encourage the banks to improve. This approach has proved effective, with very significant reductions in backlogs already achieved, and more still on the way. 4) Transparency/ side letters We made clear in our policy statement on hedge fund issues that a failure by a UK based hedge fund manager to make adequate disclosures of material side letters would amount to a breach of Principle 1 of our Principles for Businesses. This is one of our core principles, and states that a firm must conduct its business with integrity. As a minimum, we would expect acceptable market practice to be for managers to ensure that all investors are informed when a material side letter is granted. AIMA has recently published industry guidance on the disclosure of side letters. Hemant Palav / MBA / Semester II 66.
  • 67. “Hedging Fund & Its Impact On Capital Market” We have reviewed the guidance and confirmed that we will take it into account when exercising our regulatory functions, although this cannot affect the rights of third parties. In summary, firms will be required to disclose the existence of side letters which contain “material terms”, and the nature of such terms, where the firm is a party to the side letters. Material Terms focus essentially on granting more favourable treatment than other holders of the same class of share or interest and thereby conferring an advantage in respect of redemption or the right to redeem. We will be conducting some thematic work to test the market’s response to these standards in the near future. 5) Retailisation We published a discussion paper last year on the possibility of opening the UK retail market to a wider range of alternative investment products. We have decided to consult on the creation of an on-shore fund of hedge funds and other unauthorised funds regime. Given the increasing penetration of the UK retail market by alternative investment vehicles, it seemed anomalous that there was no similar on-shore vehicle that was more widely available to the retail market, and which would benefit from some of the structural and investment protections that characterised regulated investment funds on shore. We will be publishing our consultation paper in the first quarter of the New Year. 6) Mis-valuation of complex illiquid instruments/fraud Internationally, we have been at the forefront of work among regulators on the issue of valuations. I am chairing a sub-committee of the International Organisation of Securities Commissions, which is looking to develop a set of good practice principles for the valuation policies and pricing procedures of hedge fund portfolios. We have been given a mandate from the IOSCO Technical Committee and expect to publish our report at the annual meeting in Mumbai in April of 2007. This is a risk that I think deserves a fuller treatment, and I turn to that now as my third major point in today’s remarks. Hemant Palav / MBA / Semester II 67.
  • 68. “Hedging Fund & Its Impact On Capital Market” What is IOSCO's approach to hedge fund valuation risks? Valuation of the portfolio of assets of an investment fund is not a topic of unique interest to hedge funds. Regulators around the world have long sought to ensure that the net asset value of public traded funds such as mutual funds and UCITS in Europe is rigorously controlled to ensure that fair value is achieved for the underlying investors dealing in the funds. But IOSCO decided to focus on hedge funds in particular because of a number of factors and risks that are particularly heightened in hedge funds. First, as widely recognised, hedge funds have grown at an astonishing rate in recent years and have emerged as a very important component of global capital markets. They make a major contribution to the innovation, liquidity and efficiency of the capital markets and as such have a central place in the health and soundness of financial markets internationally. Second, hedge funds often deal in asset classes that can be hard to price making their strategies and portfolios difficult to value. AIMA estimated that in 2004 some 20% of Hedge Fund strategies were in hard to value securities (for example distressed debt, emerging markets, fixed income arbitrage). Moreover, an investor in a fund which focuses on just one of these strategies may have a 100% exposure to hard-to-value assets. Third, hedge funds often utilize substantial leverage in their trading, potentially magnifying the impact of a pricing mis-mark. Fourth, the performance based remuneration of hedge fund managers, coupled with difficult-to- value assets and in some cases self-administration of the funds, can create very substantial conflicts of interest in the pricing of assets. Fifth, in the case of some highly illiquid assets, it is virtually impossible to find a completely objective pricing source, forcing reliance upon models or observed or implied prices based upon the judgment of market participants, none of whom may be disinterested in the transaction. Last, but by no means least, it is estimated that in 2005, valuation-related losses in hedge funds globally totalled some $1.6 billion dollars. Poor valuation controls in combination with weak internal procedures were exploited to misrepresent hedge fund values and commit fraud. This Hemant Palav / MBA / Semester II 68.
  • 69. “Hedging Fund & Its Impact On Capital Market” was a wake up call to industry and the regulators to the real dangers of slipshod valuation policies and pricing practices. What is IOSCO doing about this? As I mentioned, I am chairing an IOSCO sub-committee that is looking to develop good practice valuation policies and pricing procedures for hedge fund managers. Unusually for IOSCO, the sub-committee includes industry representatives as contributing members of the sub-committee, working with us hand-in-hand throughout the process. They include a small number of representatives from hedge fund managers, fund of hedge fund managers, prime brokers, auditors, administrators and third party pricing providers. The group is mandated to develop a single set of valuation principles with a reasonable level of granularity. Without giving too much away at this stage of our work, you should expect us to be focusing on the existence of robust, written policies and procedures, the effective day-to-day operation of them, the role of the hedge fund manager, the role of independent parties in producing and/or verifying prices, and adequacy of disclosure to investors, among other key issues. Let me stress that we are not seeking to reinvent the wheel here. There is a good deal of excellent practice out in the market already. As you would expect, many institutional investors and funds of hedge funds undertake quite demanding due diligence in respect of their investments in hedge funds. We want to encourage the spread of that good practice. In addition, international trade associations like AIMA and the Managed Funds Association in the US have already undertaken substantial work in this area and continue to do so. Moreover, academics and industry experts have published a good deal about valuation issues for illiquid assets, and we have taken that work on board as well. Our aim is to produce a set of principles that are practical, and can be used by investors as a guide in real-life interactions with hedge fund managers, and have the added benefit of endorsement by the international regulatory community. We hope that will make a meaningful contribution to an evolving global standard for sound valuation policies and pricing procedures in the hedge fund sector. Hemant Palav / MBA / Semester II 69.
  • 70. “Hedging Fund & Its Impact On Capital Market” BIBLIOGRAPHY Hemant Palav / MBA / Semester II 70.

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