Art22 Hf

HEDGE FUNDS “All these countries have spent 40 years trying to build up their economies and a moron like Soros comes along with a lot of money to speculate and ruin things.” --Mahathir Mohamad, Prime Minister of Malaysia, 1998 (from ‘The Color of Hot Money’) ‘To hedge’ means to minimize risk or insulate oneself. Conventionally the term 'hedge fund' is used to refer to a type of private investment vehicle that invests all or most of its assets in publicly traded securities and hedges the investors’ risk from market exposure. These investment vehicles are commonly structured as limited partnerships in which the investment manager, or the investment manager's capital management company, acts as the general partner while the investors act as the limited partners. These funds are alternative investment vehicles and are generally available to high net worth individuals and institutional investors. For the investors who make up the fund, there is usually little or no market liquidity. In fact they usually have a minimum lock in period ranging from one to three years. Albert Willson Jones formed the first hedge fund in 1949. The unique feature of the fund was that it offered operational flexibility and use of unconventional strategies to the managers. It took both long and short positions (see strategies below) in securities to increase returns while reducing net market exposure and used leverage to further enhance the performance. This fund earned substantially higher and more regular than the normal mutual funds. Today the term ‘hedge funds’ takes on a much broader connotation, as many of the hedge funds control risk by hedging one or more methods. Moreover hedge funds are broadly defined by their structural characteristics, rather than their ‘hedged’ nature. They are considered to be an asset class that aims in producing absolute (not relative) returns, irrespective of how the markets perform. The best of these funds offer greater diversification, less risk and more stable returns than conventional equity investments moreover some offshore hedge funds can offer plan sponsors a third advantage: tax-free hedge fund investing. The conventional equity and bond manager’s performance is largely related to the performance of the underlying markets. On the other hand, performance of hedge funds depends on the skills of the fund manager, who risk his own as well as his clients’ capital. The manager receives a fee for managing the fund, only if it is productive. This is called an “incentive based fee” or a “performance based fee”. Some funds also add a “watermark” or “hurdle” (a benchmark), which the fund must outperform in order for the General Manager to earn his fee. The General Manager's fee is typically 1-2% of the total assets of the fund and 20-30% of the profits. The general manager may use any investment strategy or style he chooses, no matter how risky or "volatile", to manage the fund's assets for greater return.

Projected and historical growth rates, assets: Global Hedge Funds Hedge Fund Performance CAGR 1984-1994 26% 1990-1996 40% 1996-2006 (Expected) 26% Source: Bekier, RRCM, KPMG An excellent overview of the industry by Business Week characterized the pattern more pointedly. "Bankers, security industry professionals, mutual fund managers — all are beating the drum…It’s no secret that Wall Street hates hedge funds." But why? "It’s not just jealousy or scapegoat that makes the hedge funds anathema to the powers on Wall Street. Fear is another possibility—fear that the public may demand incentive-based compensation for their funds as well." The concept of performance-based compensation may well be unsettling to an industry that charges according to the volume of transactions made or the total assets under management, regardless of whether the customers earn profits or not.

COMPARISON OF GROWTH PATTERNS: HEDGE FUNDS Vs MUTUAL FUNDS Source: Bekier, Cottier, ICI Looking at these curves, it appears that the rapid growth of mutual funds began some ten years prior to that of hedge funds; approximately 1980 for mutual funds and 1990 for hedge funds. The rapid growth stage for mutual funds has lasted more than 15 years (1980-1997). Granted, that some of the underlying drivers of growth may be different for mutual funds than for hedge funds. However, if one assumes that the growth cycles will parallel each other to some extent, then one can conclude that hedge funds are at the beginning of their journey and the growth cycle for hedge funds could last another ten years taking us well into the next century. STRATEGIES OF HEDGE FUNDS Hedgers use the futures market to protect themselves from risk. Similarly the portfolio managers hedge stock fund risk. Commonly, prices in the cash markets have a fundamental relationship to the futures prices. When the forces of demand and supply change the prices in the cash market, the future prices are supposed to move in a parallel fashion. But in reality they do not move in exact amounts. Hedgers take advantage of this relationship between cash and futures prices. Analysts attempt to classify them into a number of different strategies and sectors, but each set of managers is essentially looking to exploit pricing anomalies through trading, rather than through simply buying and holding assets. In each case, hedge fund managers aim to exploit price differentials, remaining market-neutral but buying one asset and selling another. Price convergence will lead to profit irrespective of the overall price movements in the sector. The successful funds with good track records make money and prosper, although limits to the size of trades and the need to stay nimble do limit a manager's size.

There are approximately 14 distinct investment strategies used by hedge funds, each offering different degrees of risk and return. Very high risk strategies Emerging Markets: Invests in equity or debt of emerging (less mature) markets that tend to have higher inflation, volatile growth and the potential for significant future growth. Examples include Brazil, China, India, and Russia. Short selling is not permitted in many emerging markets, and, therefore, effective hedging is often not available. This strategy is defined purely by geography; the manager may invest in any asset class (e.g., equities, bonds, currencies) and may construct his portfolio on any basis (e.g. value, growth, arbitrage) Short Selling: In order to short sell, the manager borrows securities from a prime broker and immediately sells them on the market. The manager later repurchases these securities, ideally at a lower price than he sold them for, and returns them to the broker. In this way, the manager is able to profit from a fall in a security's value. Short selling managers typically target overvalued stocks, characterized by prices they believe are too high given the fundamentals of the underlying companies. It is often used as a hedge to offset long-only portfolios and by those who feel the market is approaching a bearish cycle. ARBITRAGE USING SHORT SALES 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. Rather than considering how individual corporate securities may fare, the manager constructs his portfolio based on a top-down view of global economic trends, considering factors such as interest rates, economic

policies, inflation, etc and seeks to profit from changes in the value of entire asset classes. For example, the manager may hold long positions in the U.S. dollar and Japanese equity indices while shorting the euro and U.S. treasury bills. Uses leverage and derivatives to accentuate the impact of market moves. The leveraged directional investments tend to make the largest impact on performance High risk strategies Aggressive Growth: A primarily equity-based strategy whereby the manager invests in companies, with smaller or micro capitalization stocks, characterized by low or no dividends, but experiencing or expected to experience strong growth in earnings per share. The manager may consider a company's business fundamentals when investing and/or may invest in stocks on the basis of technical factors, such as stock price momentum. Managers employing this strategy generally utilize short selling to some degree, although a substantial long bias is common. This includes sector specialist funds such as technology, banking, or biotechnology. Market Timing: The manager attempts to predict the short-term movements of various markets (or market segments) and based on those predictions, moves capital from one asset class to another in order to capture market gains and avoid market losses. While a variety of asset classes may be used, the most typical ones are mutual funds and money market funds. Market timing managers focusing on these asset classes are sometimes referred to as mutual fund switchers. Unpredictability of market movements and the difficulty of timing entry and exit from markets add to the volatility of this strategy. Moderate risk strategies Special Situations: The manager invests, both long and short, in stocks and/or bonds which are expected to change in price over a short period of time due to an unusual event. Examples of event-driven situations are mergers, hostile takeovers, reorganizations, or leveraged buyouts. It 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. Value: A primarily equity-based strategy whereby the manager invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth. The manager takes long positions in stocks that he believes are undervalued, i.e. the stock price is low given company fundamentals such as high earnings per share, good cash flow, strong management, etc. Possible reasons that a stock may sell at a perceived discount could be that the company is out of favor with investors or that its future prospects are not correctly judged by Wall Street analysts. 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. The manager can take short positions in stocks he believes are overvalued.

Funds of Hedge Funds: The manager invests in other hedge funds (or managed accounts programs) rather than directly investing in securities such as stocks, bonds, etc. These underlying hedge funds may follow a variety of investment strategies or may all employ similar approaches. Because investor capital is diversified among a number of different hedge fund managers, funds of funds generally exhibit lower risk than do single-manager hedge funds. Funds of funds are also referred to as multi-manager funds. It’s a diversified portfolio of generally uncorrelated hedge funds and it’s a preferred investment of choice for many pension funds, endowments, insurance companies, private banks and high-net-worth families and individuals. Variable risk strategies Opportunistic: Rather than consistently selecting securities according to the same strategy, the manager's 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. Characteristics of the portfolio, such as asset classes, market capitalization, etc., are likely to vary significantly from time to time. The manager may also employ a combination of different approaches at a given time Multi Strategy: The manager typically utilizes many specific, pre-determined investment strategies, e.g., Value, Aggressive Growth, and Special Situations in order to better diversify their portfolio and/or to more fully use their range of portfolio management skills and philosophies and also in order to realize short or long term gains. This style of investing allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities. Although the relative weighting of the chosen strategies may vary over time, each strategy plays a significant role in portfolio construction. Low risk strategies Distressed Securities: The manager invests in the debt and/or equity of companies having financial difficulty. Such companies are generally in bankruptcy reorganization or are emerging from bankruptcy or appear likely to declare bankruptcy in the near future. Because of their distressed situations, the manager can buy such companies' securities at deeply discounted prices. The manager stands to make money on such a position should the company successfully reorganize and return to profitability. Also, the manager could

realize a profit if the company is liquidated, provided that the manager had bought senior debt in the company for less than its liquidation value. "Orphan equity" issued by newly reorganized companies emerging from bankruptcy may be included in the manager's portfolio. The manager may take short positions in companies whose situations he deems will worsen, rather than improve, in the short term. Income: Invests with primary focus on yield or current income rather than solely on capital gains, though it may also utilize leverage to buy bonds and (sometimes) fixed income derivatives in order to profit from principal appreciation and interest income. Other strategies (e.g. distressed securities, market neutral arbitrage, macro) may heavily involve fixed-income securities trading as well. Market Neutral - Securities Hedging: The manager invests similar amounts of capital in securities both long and short, generally in the same sectors of the market, maintaining a portfolio with low net market exposure. Long positions are taken in securities expected to rise in value while short positions are taken in securities expected to fall in value. Due to the portfolio's low net market exposure, performance is insulated from market volatility. 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. It sometimes uses market index futures to hedge out systematic (market) risk. It uses T- bills as a relative benchmark index. Market Neutral - Arbitrage: The manager seeks to exploit specific inefficiencies in the market by trading a carefully hedged portfolio of offsetting long and short positions. By pairing individual long positions with related short positions, market-level risk is greatly reduced, resulting in a portfolio that bears a low correlation to the market. For example, long convertible bonds and short underlying issuer’s equity. For example, can be long convertible bonds and short the underlying issuers equity. It may also use futures to hedge out interest rate risk. These relative value strategies include fixed income arbitrage, mortgage backed securities, capital structure arbitrage, and closed-end fund arbitrage.

Are all hedge funds speculative and risky? A majority of the funds stress on returns. At the other extreme, for the highly risk-averse investor, there is a whole group of funds that emphasizes low volatility. Some managers do an excellent job of keeping volatility down close to government-bond level but handily beating bond returns. E.g.: Relative benchmark index used for Market neutral security hedging is usually T-bills. Risk & Reward Comparisons Hedge Funds vs. Traditional Assets (1986-1995) Various studies indicate that hedge funds as a group provide higher absolute returns on average compared to the S&P 500. The normal view is that hedge funds are highly risky - that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. Even though the inference of gambling is not usually correct, it is easily made when viewed in the context of tools used- like leverage and short selling. These are perceived by most investors as purely speculative tools. But many hedge funds successfully employ them to increase performance while actively managing risk. Most hedge funds use derivatives only for hedging or don't use derivatives at all, and many use no leverage. The reality is that less than 5% of hedge funds are global macro funds causing speculative waves and contagions, like Quantum, Tiger, and Strome. Estimated to be growing at about 20% per year, there are between 4,000 and 5,000 active hedge funds in this industry. Measured against major equity and bond indices, global hedge fund indices do indeed appear more attractive, with lower volatility and higher return. But there is a wide range of outcomes, and history is full of people who thought they had found the alchemist's stone - some magical ingredient that turns dross into gold.

Indeed, in 1998, John Meriwether, the anti-hero of Michael Lewis' book Liars Poker, bet his firm, Long Term Capital Management (LTCM), on the theories espoused by his partners, the Nobel prize-winning economists, Robert Merton and Myron Scholes, and lost. LTCM was a hedge fund, founded by Meriwether in 1994, engaged in arbitraging pricing differentials in the bond markets, through betting on convergence in the prices of similar assets. The theory worked very well - for a time - but when differentials blew out, the firm's highly leveraged positions quickly lost money, necessitating an eventual bail-out by a group of banks. LTCM had nearly $1 trillion in bad investments, but only $2 billion in assets that it could sell to pay off its debts. Its borrowing in the 1997 alone averaged between 50 and 100 times its asset base, and it borrowed from the biggest of banks and brokerage houses in the world, thereby endangering a banking system already rocked by losses in Russia and the Far East. Quantum Funds: A brief history Hedge funds became (in)famous in 1992 with George Soros’s Quantum Funds. At that time, UK was a part of the European Union, because of which it was following the highly conservative monetary policy of the German Central Bank - Deutsche Bundesbank. The British economy was suffering from a recession despite of which, it had to keep its interest rates high, making the pound sterling very strong. Because of this conflict faced by UK, it was widely believed that the country would soon let the pound go. This is where Quantum Funds stepped in. George Soros borrowed 15 billion pounds and short sold the currency intensifying the pressure on the pound and what would have happened over 4-5 months, was made to happen immediately. UK pulled out of the EU, lowered its interest rates and let the sterling fall (it depreciated by 15%). Soros made a quick profit of 2 billion pounds. For a common man, he became a villain overnight, who twisted the market conditions to make a quick profit. However it must be noted that Quantum Funds did not lead to UK pulling out the EU. It just hastened the whole process. Note: The average annual return of Quantum Funds for the past 5 years has been 41% CONCLUSION The size of the hedge fund industry, relative to the markets in which the funds operate, is too small for hedge funds alone to move the market. The total net assets of the industry are estimated to be around $800 to $1000 billion; therefore, hedge funds represent only about 4 percent of the $25 trillion in investments held by institutional investors. However, it is possible that they may move the market because other investors follow their lead—an effect referred to as “herding.” But studies of the role of hedge funds in the currency crises find little evidence that hedge funds were the market leader— or even the lead bull in the herd. Hedge funds managers and marketers are reluctant to entertain comparisons between the LTCM debacle and their own activities. But, says Damien Hatfield, the chairman of the Australian chapter of AIMA, the hedge fund's industry body, hedge funds are not wholly different from other businesses. LTCM was highly geared, but so are most banks and investment banks. And although some hedge funds do gear internally, only a fifth of them have debt-to-asset ratios above 50 per cent, on a par with many industrial companies. Hedge funds can only play a limited role in the sense, they do not create conditions themselves, they only capitalize on the sometimes warped fundamentals of the markets.

REFERENCES • “The Return of Depression Economics”, by Paul Krugman • “The Truth about Hedge Funds”, by P. Osterberg and James B. Thomson • “Risk Management Lessons from Long Term Capital Management”, Philippe Jorion, June 1999. • “Alternative Software Development - Hedge-Funds - Finance Software - Free simulation” • “A Primer on Hedge Funds”, William Fung and David A. Hsieh, August 1999. • “The Coming Evolution of the Hedge Fund Industry: A Case for Growth and Restructuring”, RR Capital Management Corporation, KPMG Peat Marwick LLP, March 1998 • “The Eve of Destruction”, by David Shirreff • Webliography o www.fraternityfunds.com o www.E-Hedge.com o www.hedgefundresources.com Anoop Goplani Neha Agarwal Vaibhav Kalia Students 1st year PGDM IIMC

Art22 Hf

by Chandan Rastogi on Aug 26, 2009

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