Just what is a Hedge Fund, anyways?



    To the Greater Philadelphia Senior Executive Group
             Financial Execu...
Legal Disclaimer



This presentation is intended for general
information purposes only and should not be
construed as inv...
RICHARD G. HOOEY

Strategic Finance Executive with expertise in relative valuation
and decision support analyses
Nine year...
Today‟s Objective


Some History

Some Basics

Recent Evolutionary Trends

What now, what next?
Idiomatic

hedge [ hej ]

2. protective method: a means of protection against something, especially a means of
   guarding...
The Beginning

 1949 - Alfred W. Jones




 1966 - Carol Loomis
The Simplest Form

 You have a strong belief that one company is
  undervalued, especially relative to its peers.
 You h...
A Simple Pairs Trade

 Pesky Soda Company (NYSE: PES) $40.28
 Coconut Cola Company (NYSE: NUT) $ 31.80


 To create a p...
If the Market is Up 5%

                0.07
 PES up 6%
                        6.0%
                0.06
               ...
But, if the Market is down 6%

 PES down 4%      0
                        PES     NUT     DJIA
                -0.01

 ...
A Second Opinion
Two Contrasting Definitions


Generate positive returns in both rising and falling
 equity and bond markets

             ...
Shorting 101




He who sells what isn’t his’n
Must cover up or go to prison
Mechanics of a Short



     Stock Loan                        Common Stock
        Desk               1.             Issu...
Mechanics of a Short – Key Steps

The Short Sale
1)   Original shareholder holds stock with custodian – agrees that the
  ...
Sentiment vs. Reality of Short Selling

Negative Sentiments towards short selling
 Contrary to most enlightened self inte...
Characteristics of Hedge Funds

 Limited Partnership Structure
 Lower level of Regulation
 “Knowledgeable” Investors
 ...
Alpha and Beta


Beta represents the correlation of a funds returns to
 the return of the underlying market or index. (e.g...
Generating Alpha


Generating Beta is relatively easy – Index Funds – and
 does not produce a premium fee.

Generating Alp...
Two and Twenty

Most common hedge fund fee structure has two
 components:


 Two per cent of Capital Invested (paid quart...
High Water Mark

Loss – Carry Forward Provision

Incentive Fees only applicable to performance in
  excess of High Water M...
High Water Mark Application
160%

140%

120%

100%

80%

60%

40%
             19%
20%    12%         10%    8%           ...
Risks that can be hedged

 Market Risk
 Industry Risk
 Concentration Risk
 Currency Risk


Company Risk is hard to hed...
Notable Failures

 Long Term Capital Management – 1998
   Significant Leverage (25x)

   Russian Default

   Lack of D...
Measuring Hedge Funds

 Returns
      Not appropriate for risk mitigating strategies
 Sharpe Ratio
      Return / Volati...
Hedge Fund Due Diligence

 Track Record
 Significant Investment by Manager
 Pricing Characteristics of Strategy
 Size ...
Red Flags

 Manager looks outside Original Strategy
 Cash on hand
 Response Times to Inquiries
 Terms of Investment Ag...
Hedge Fund Defaults


1994 – 0.3995%         (751 Funds)

1998 – 0.5216%          (1,917 Funds)

2004 – 0.2157%          (...
2008 Returns – Credit Suisse Tremont Indices

                                    Up     Down
Style                    Ret...
Conclusions

 Hedge Funds were originally intended to manage
    risk, especially of down markets
   Fee structures evol...
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Just What Is A Hedge Fund, Anyways Gpseg

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With all of the recent media attention surrounding hedge funds, there are bound to be some misconceptions regarding the hedge fund industry. Dick Hooey led a stimulating discussion surrounding the evolution of this esoteric investment vehicle and tried to answer the question “Just what is a Hedge Fund, anyways?”. Dick is a strategic minded finance executive with expertise in valuation and decision support analyses of transactions including acquisitions and new business ventures in consulting and corporate environments. In addition, Dick has 13 years experience managing a market neutral equity portfolio representing capital in excess of $100 million for a leading billion dollar hedge fund.

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Just What Is A Hedge Fund, Anyways Gpseg

  1. 1. Just what is a Hedge Fund, anyways? To the Greater Philadelphia Senior Executive Group Financial Executives Sub Group June 11, 2009 PRESENTED B Y: DICK HOOEY
  2. 2. Legal Disclaimer This presentation is intended for general information purposes only and should not be construed as investment advice. It does not constitute an offer or solicitation of an offer to buy a security or investment. The opinions expressed herein are solely those of the author.
  3. 3. RICHARD G. HOOEY Strategic Finance Executive with expertise in relative valuation and decision support analyses Nine years evaluation of Mergers, Acquisitions, New Business Ventures, Large Capital Expenditures Capital Market Transactions and Corporate Investment Programs Thirteen years managing market neutral equity portfolios (up to $100 Million in capital) in fundamental-based and quantitative environments Primary Coverage: Utilities, Pharmaceuticals, Healthcare, Consumer Goods, Retail, Restaurants, Media, Transportation Secondary Coverage: Financials, Technology, REITs, Energy, Insurance, Paper & Forest Products, Telecommunications
  4. 4. Today‟s Objective Some History Some Basics Recent Evolutionary Trends What now, what next?
  5. 5. Idiomatic hedge [ hej ] 2. protective method: a means of protection against something, especially a means of guarding against financial loss "I, I, I myself sometimes, leaving the fear of God on the left hand and hiding mine honour in my necessity, am fain to shuffle, to hedge and to lurch ." William Shakespeare, Merry Wives of Windsor - 1598 "You think that you have Hedged in that Debt by a greater, by your Letter in Verse.“ John Donne's Letters to Sir Henry Goodyere, circa 1620 "Now, Criticks, do your worst, that here are met; For, like a Rook, I have hedg'd in my Bet." George Villiers, The Rehearsal - 1672
  6. 6. The Beginning  1949 - Alfred W. Jones  1966 - Carol Loomis
  7. 7. The Simplest Form  You have a strong belief that one company is undervalued, especially relative to its peers.  You have no opinion on the direction of the market but are concerned that you can be right and still lose capital if the market falls Solution: Buy the undervalued company and sell short an equivalent dollar amount of its overvalued competitor
  8. 8. A Simple Pairs Trade  Pesky Soda Company (NYSE: PES) $40.28  Coconut Cola Company (NYSE: NUT) $ 31.80  To create a portfolio balanced by dollar invested:  Buy 5,000 shares PES  Sell Short 6,300 NUT
  9. 9. If the Market is Up 5% 0.07  PES up 6% 6.0% 0.06 5.0%  NUT up 2% 0.05 0.04  You make 4% 0.03 2.0% 0.02 0.01 0 PES NUT DJIA
  10. 10. But, if the Market is down 6%  PES down 4% 0 PES NUT DJIA -0.01  NUT down 7% -0.02 -0.03  You make 3% -0.04 -4.0% -0.05 -0.06 -6.0% -0.07 -7.0% -0.08
  11. 11. A Second Opinion
  12. 12. Two Contrasting Definitions Generate positive returns in both rising and falling equity and bond markets Vs. Generate results that are uncorrelated to equity and bond markets
  13. 13. Shorting 101 He who sells what isn’t his’n Must cover up or go to prison
  14. 14. Mechanics of a Short Stock Loan Common Stock Desk 1. Issuer 2. 1. Short Seller Shareholder 2. Buyer
  15. 15. Mechanics of a Short – Key Steps The Short Sale 1) Original shareholder holds stock with custodian – agrees that the shares are available to short. 2) Short Seller “borrows” shares from custodian - obligation to deliver shares in future – subject to call Dividend Payments 1) Issuer payments accrue to the original shareholder 2) Short Seller pays the dividend to the Buyer Custodian Issues ─ Shorts typically collateralized by long positions ─ Sales proceeds also held as collateral ─ Short Seller receives interest on cash position – Short Interest Rebate
  16. 16. Sentiment vs. Reality of Short Selling Negative Sentiments towards short selling  Contrary to most enlightened self interests  Hope for the worst  Spreading negative rumors  Shady trading techniques Actual Benefits of Short Selling  Price Discovery  Provision of Liquidity
  17. 17. Characteristics of Hedge Funds  Limited Partnership Structure  Lower level of Regulation  “Knowledgeable” Investors  Pricing  Liquidity  Leverage  Fees
  18. 18. Alpha and Beta Beta represents the correlation of a funds returns to the return of the underlying market or index. (e.g. A rising tide raises all boats) Alpha represents the increment over the underlying market return provided by the fund manager (e.g. the value added)
  19. 19. Generating Alpha Generating Beta is relatively easy – Index Funds – and does not produce a premium fee. Generating Alpha (beating the market) is harder Strategies that consistently generate alpha have the higher fee structure
  20. 20. Two and Twenty Most common hedge fund fee structure has two components:  Two per cent of Capital Invested (paid quarterly)  Twenty per cent of Alpha (profit generated)
  21. 21. High Water Mark Loss – Carry Forward Provision Incentive Fees only applicable to performance in excess of High Water Mark Usually increased annually Links Managers‟ interest with Investors‟
  22. 22. High Water Mark Application 160% 140% 120% 100% 80% 60% 40% 19% 20% 12% 10% 8% 8% 0% Yr1 Yr2 Yr3 Yr4 Yr5 Yr6 -20% -11%
  23. 23. Risks that can be hedged  Market Risk  Industry Risk  Concentration Risk  Currency Risk Company Risk is hard to hedge
  24. 24. Notable Failures  Long Term Capital Management – 1998  Significant Leverage (25x)  Russian Default  Lack of Diversification  Quant skills – Market knowledge?  Madoff – 2008  NOT a Hedge Fund  "split-strike conversion strategy“  Regulation was poor, not non-existent  Too Good to be True – requires Due Diligence
  25. 25. Measuring Hedge Funds  Returns Not appropriate for risk mitigating strategies  Sharpe Ratio Return / Volatility – proxy for risk  Sortino Ratio Return / Downside deviation  Bias Ratio Designed to detect improper asset pricing
  26. 26. Hedge Fund Due Diligence  Track Record  Significant Investment by Manager  Pricing Characteristics of Strategy  Size of Fund  Concentration Risk  “Too Good to be True”  Third Party Involvement  Auditors  Administrators
  27. 27. Red Flags  Manager looks outside Original Strategy  Cash on hand  Response Times to Inquiries  Terms of Investment Agreement  Sub – Advisors  Redemption Gates  In-Kind Redemptions  Manager of Previous Fund
  28. 28. Hedge Fund Defaults 1994 – 0.3995% (751 Funds) 1998 – 0.5216% (1,917 Funds) 2004 – 0.2157% (5,563 Funds) More current data not available
  29. 29. 2008 Returns – Credit Suisse Tremont Indices Up Down Style Return Funds Funds Best Worst Managed Futures 18.3% 28 3 93% -4% Dedicated Short 14.9% 7 2 68% -49% Global Macro -4.6% 19 18 66% -68% Event Driven -17.7% 9 67 33% -75% Equity Long / Short -19.8% 19 147 47% -77% Multi-Strategy -23.6% 4 29 26% -93% Fixed Income Arbitrage -28.8% 8 24 14% -65% Emerging Markets -30.4% 2 67 27% -78% Convertible Arbitrage -31.6% 1 21 12% -61% Equity Market Neutral -40.3% 9 12 36% -100%
  30. 30. Conclusions  Hedge Funds were originally intended to manage risk, especially of down markets  Fee structures evolved to compensate managers for the more difficult task of generating alpha  Bull markets in late „90‟s led to more managers, often charging “alpha” fees for “beta” strategies  Like in 1973-74, 2008 has exposed many of these strategies  Now more than ever, due diligence is key in choosing Hedge Fund managers

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