2. FLOW OF PRESENTATION
What are Hedge Funds
History of Hedge Funds
Advantages & Disadvantages of hedge funds
Differences between Hedge Funds & Mutual Funds
Investors in Hedge Funds
Structure of Hedge Funds
Standealone structure
Side by side
Master Feeder
Fees of Hedge Funds
2
3. SEBI Alternate investmentsfunds
Current Regulations in India
Registration
Conditions for obtaining certificate
Investment inAIF
Investment Conditions
Leverage
Disclosure
3
5. HISTORY OF HEDGE
FUNDS
1949 - Alfred Winslow Jones devised and implemented an
investment strategy that would forever brand him as “the
father of the hedge fund industry. “
Jones decided to launch his own fund and raised a total of
$100,000.
Price movements of an asset
Overall market
Performance of the asset itself
To neutralize the effect of overall market movement, he
balanced his portfolio.
The effect is to 'hedge' that part of the risk due to overall
market movements.
5
6. The name "hedge fund" originated from the hedging techniques usedby
some of the funds.
A simple hedge fund definition is: a hedge fund is an alternativeinvestment
that is designed to protect investment portfolios from market uncertainty,
while generating absolute returns.
A hedge fund's purpose is to maximize investor returns and eliminaterisk,
hence the word "hedge.”
An alternative investment vehicle available only to sophisticatedinvestors,
such as institutions and individuals with significantassets.
A hedge fund uses a range of investment techniques and invests in awide
array of assets to generate a higher return for a given level of risk than
what's expected of normal investments.
6
11. INVESTORS IN A HEDGEFUND
Fund managers can only accept investment capital
from accredited investors or qualified purchasers
11
12. ACCREDITED INVESTORS
In order for an individual to qualify as an accredited investor,he
must accomplish at least one of the following:
1)Earn an individual income of more than $200,000 per year, or
a joint income of $300,000, in each of the last two years and
expect to reasonably maintain the same level of income.
2)Have a net worth exceeding $1 million, either individually or
jointly with his or her spouse.
3) An employee benefit plan or a trust can be qualified as accredit
investors if total assets are in excess of $5 million
12
13. QUALIFIED PURCHASERS
To be a qualified purchaser you must meet either of the following
criteria:
a)Individuals who own $5 million in investments held for
investment purposes.
b) Institutional investors who own $25 million in investments;
c) A family owned company that owns $5 million in investments
d)For trusts with less than $25 million, a trust where the trustee
and each person who contributes assets to the trust is a Qualified
Purchaser
13
14. WHO INVEST IN HEDGE FUNDS
66% of hedge fund assets are held by institutional investors.
These institutional investors include:
1. Public employee pension plans
2. Corporate employee pension plan
3. University and college endowments
4. Foundations and non-Profit Organizations
14
20. ADVANTAGES OF GOING FOR
OFFSHORE FUNDS
1. Exempt from federal tax but taxed on Unrelated Business
Taxable Income(UBTI)
2. Avoids UBTI by investing in a Corporation Type offshore
fund
3. Non U.S. investors can maintain anonymity with respect
to the U.S.
20
23. SIDE BY SIDE STRUCTURE 23
General
Partner LLC
Domestic
hedge fund LP
Investments
Offshore
hedge fund
Ltd.
Investments
Taxable
US
Investors
Non US & tax
exempt US
investors
24. The side-by-side structure is a two-fund structure which
includes a U.S. fund and an offshore fund
Addresses concerns of each type of investor
Different fund managers
May have different or same investments
24
25. MASTER FEEDER 25
General
Partner LLC
Domestic
hedge fund LP
Offshore
hedge fund
Ltd.
Taxable
US
Investors
Non US & tax
exempt US
investors
MASTER FUND (Ltd./LP)
Investments
26. In a master-feeder structure, like a side-by-side structure, a
domestic fund and an offshore fund are established.
Feeder funds invest into the master fund
The master fund is a pass-through entity for U.S. tax purposes
Single investments
Efficient and cost effective
Conflicts of interest
26
28. High water mark- Incentive fee is not paid on gains that offset
prior losses
Hurdle Rate – No performance fee until the performance exceeds
a benchmark rate.
37
30. SECURITIES AND EXCHANGE BOARD OF INDIA
(ALTERNATIVE INVESTMENT FUNDS) REGULATIONS, 2012
Regulation 2 (1) (b) defines “alternative investment fund” as:
Alternate investment fund means any fund established or incorporated in india inthe
form of a trust or a company or a limited liability partnership or a body corporate
which
(i)is a privately pooled investment vehicle which collects funds from investors, whether
indian or foreign, for investing it in accordance with a defined investment policy for the
benefit of its investors; and
(ii)is not covered under the securities and exchange board of india (mutual funds)
regulations, 1996, securities and exchange board of india (collective investmentschemes)
regulations, 1999 or any other regulations of the board to regulate fund management
activities”
31. The following have been kept out of the purview of the definition of AIF:
Family trusts set up for the benefit of ‘relatives’ as defined under CompaniesAct,
1956
ESOPTrusts
Employee welfare trusts or gratuity trusts
“Holding Companies” within the meaning of Section 4 of the Companies Act, 1956
Other special purpose vehicles not established by fund managers, including
securitization trusts, regulated under a specific regulatory framework
Funds managed by securitisation company or reconstruction company which is
registered with the Reserve Bank of India
Any such pool of funds which is directly regulated by any other regulator in India.
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32. TERRITORIAL SCOPE OF THEREGULATIONS
Regulation 2(1)(o) defines an “investee company” as:
“any company, special purpose vehicle or limited liability partnership or body
corporate in which an Alternative Investment Fund makes an investment”
As a body corporate includes a company registered outside India, the scope of
these Regulations extends to:
Funds established in India and investing in India and/or abroad;
Funds established abroad and investing in India.
32
33. CURRENT REGULATIONS IN INDIA
SEBI Regulations, 2012 (Alternative Investment Funds –AIF)
3 categories:-
Category I – VCF, SME Funds, Social Venture Funds and Infrastructure
Funds.
Category II - Private Equity Funds, Debt Funds, Fund of Funds and such
other funds that are not classified as category I or
Category III - Hedge Funds that are considered to have risk through
leverage or complex trading strategies including listed or unlisted
derivatives.
33
34. Features:
Min size of AIF – 20 crore
Min investment – 1 cr OR
0.1% of fund size
Should not have more than 1000 investors
Continuing interest shall not be less than 2.5% of the corpus or ₹5cr whichever is
lower.
Cannot invest more than 10% of the corpus in one investee company
34
35. Trading in Secondary Market:
Units of HF may be listed on stock exchange subject to a minimum
tradable lot of Rs.1 crore. However, HF cannot raise funds through
Stock Exchange mechanism
It can open ended or close ended.
Hedge Fund should fully liquidate within 1 year
Extension of tenure – 2 Yrs subject to approval of 2/3rd of the unit
holders by value of their investment in the Hedge Funds.
35
36. REGISTRATION OF ALTERNATIVE INVESTMENT FUNDS
To operate a Hedge Fund certificate of registration must be obtained by the applicant, the
Board shall consider the following conditions for eligibility:
The memorandum of association, the Trust Deed or the Partnership deed should permit
to carry on the activity of an Alternative Investment Fund;
The applicant is prohibited by its memorandum/deed from making an invitation to the
public to subscribe to its securities;
The applicant, Sponsor and Manager are fit and proper persons based on the criteria
specified in Schedule II of SEBI Regulations, 2008
36
37. The key investment team of the manager should have adequate experience
At least 1 key personnel having not less than 5 years experience in advising ormanaging
fund or asset or wealth or in the business of buying, selling and dealing of securities or
other financial assets and has relevant professional qualification
The applicant has clearly described at the time of registration:
The investment objective
The targeted investors
Proposed corpus
Investment style or strategy
Proposed tenure of the fund or scheme
Whether the applicant or any entity established by the sponsor or manager has earlier beenrefused
registration by the board
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38. INFORMATION MEMORANDUM
As specified in sub-regulation (1) shall contain all material Information about
the alternative investment fund:
The manager
Background of key investment team of the manager
Targeted investors
Fees and all other expenses proposed to be charged
Tenure of the alternative investment fund or scheme
Conditions or limits on redemption
Investment strategy
Risk management tools and parameters employed
Key service providers
38
39. Conflict of interest and procedures to identify and addressthem,
Terms and conditions on which the manager offers investment services,
Its affiliations with other intermediaries,
Manner of winding up of the alternative investment fund or the scheme
Any other information as may be necessary for the investor to take an
informed decision on whether to invest in the alternative investmentfund.
39
40. CONDITIONS OF CERTIFICATE
The certificate granted under regulation shall be subject to thefollowing
conditions:-
(a) it should abide by the provisions of the Act and theseregulations
(b) it shall not carry on any other activity other than permittedactivities
(c)it should inform the Board in writing, if any information or particulars previously
submitted to the Board are found to be false or misleading in any material particularor
if there is any material change in the information already submitted.
An Alternative Investment Fund registered under a particular category cannotchange
its category subsequent to registration, except with the approval of the Board.
40
41. INVESTMENT IN ALTERNATIVE INVESTMENT
FUND
Investment in hedge funds shall be subject to the following conditions:-
► The alternative investment fund may raise funds from any investor whetherindian,
foreign or non-resident Indians by way of issue of units
► Each scheme of the hedge fund shall have corpus of atleast twenty crore rupees
The hedge fund shall not accept from an investor, an investment of value less than one
crore rupees
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42. The manager or sponsor shall have a continuing interest in the hedge fund of not
less than 5% of the corpus or 10 crore rupees, whichever is lower, in the form of
investment in the hedge fund.
The manager or sponsor shall disclose their investment in the hedge fund to the
investors
Max no of investors permitted in a hedge fund is 1,000.
Hedge fund are allowed to collect only by way of privateplacement.
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43. INVESTMENT CONDITIONS FOR
HEDGE FUNDS
Hedge Funds may invest in securities of:
1) Listed or unlisted investee companies
2) Derivatives or complex or structured products;
3) Category I or Category II Alternative Investment Funds:
Hedge Funds may engage in leverage or borrow with consent from
the investors in the fund, subject to a maximum limit and shall
disclose information regarding:
1) the overall level of leverage employed
2) the level of leverage arising from borrowing of cash
3) the level of leverage arising from position held in derivatives or in any complex
product.
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44. LEVERAGE
Leverage – Ratio of exposure to NAVshould not exceed
2 times of the NAV
NAVis the total market value of all securities
Funds to inform regulators if breach occurs, action by regulators
If the leverage limit is breached, report to clients (before 10 am) and
Custodian.
44
45. DISCLOSURE
Alternative Investment Fund shall provide at least on an annual basis, within 180 day
from the year end, reports to investors including the following information, as may be
applicable to the Alternative Investment Fund:
► Financial information of investee companies.
► Material risks and how they are managed which may include:
(i) concentration risk at fund level
(ii) foreign exchange risk at fund level
(iii)leverage risk at fund and investee company levels
(iv)realization risk at fund and investee company levels
(v) strategy risk at investee company level
(vi)reputation risk at investee company level
(vii) extra-financial risks, including environmental, social and corporate governance risks, at fund
and investee company level.
45
46. SEBI REVISED GUIDELINES FOR ALTERNATIVE INVESTMENT
FUNDS
Disciplinary history
Reporting leverage
Requirement of maintaining minimum corpus
46
47. FIRST AIF CATEGORY III-HEDGEFUND
Karvy capital-systematic edge fund
This fund is an open-ended category-III AIF (alternate investment fund), under the
AIF guidelines issued by SEBI.
Collected 100 crores from HNIs and select institutions
Karvy invested in futures and options of equity stocks and indices.
47
48. DIFFERENCE BETWEEN HEDGE FUNDS &
MUTUAL FUNDS
Mutual funds Hedge Funds
-Subject to rigorous regulation -Are virtually unregulated.
-Designed to serve a large number of small
investors
-Small firms dominated by one or two key
investment people
-Designed to serve a small number of
large investors.
-Relative return as compared to benchmark
indices
-Absolute return as compared to relative
return.
48
49. Mutual funds Hedge Funds
-Manager is only an agent of client
-MF manager may have no personal
assets at all invested in the funds
-Client doesn’t merely hire the manager.
Instead client & manger become partners,
co-investing in situations.
-Limitations on strategies -Wide investment techniques like short
selling, leverage, diversification etc
-Return determined by :
Performance of the market in which
manager invests
Strategies adopted as per the skills of
manager
-Return determined by :
Strategies adopted as per the skills of
manager
49
50. Mutual funds Hedge Funds
-Larger -Hedge Fund firms tend to be smaller
-Daily liquidity -Limitations on investment and
redemption (lock-in-period)
-Fees is asset based -Fees is asset based and performance
based
-Broad access -Limitations to marketing & selling
-Investment objectives and strategies are
set out in Prospectus=Narrowly defined
-Information memorandum=mission
broadly defined
50
51. STRATEGIES EMPLOYED BY
HEDGE FUNDS
Arbitrage
Relative
Value
Convertible
Arbitrage
Equity
Hedge
Short
selling
Distressed
investment
Covered
call
Delta
hedging
Event
driven
T
actical
Trading
Global
Macro
51
53. RELATIVE VALUE
Also called ‘Pairs Trading’
Designed to take advantage of mis-pricing
Used in sideways market (within a specific range)
When the prices diverge – arbitrage arises
53
54. CONVERTIBLE ARBITRAGE
Relationship between company’s convertible bonds and stock
Buy convertible bonds
Sell stock
If stock price rises
If stock price falls
Effect of interest rate
54
55. Bond @ $1000
Stock @ $50
Bond convertible for 20 shares
If stock price is 55 – convert the bond and short stock
If stock price is 45 – hold the bond
55
57. SHORT SELLING
Seeks to profit from declines in the value of stocks
Eg. sell one month Futures @ rs.5000
Margin = Rs.1000 (assuming 20% margin)
Interest = Rs.8 (assuming 10% interest)
Buy back the stock at lower price say 4800
Total gain=(5000-4800) + 8 = Rs. 208
Loss if the stock prices rise
57
59. MARKET NEUTRAL STRATEGY
Overall delta value of the position is near to zero so
that changes in the underlying stock price do not
affect the overall value of the position.
The portfolio delta can be made to sum to zero, and
the portfolio is then delta neutral
59
60. Eg. buying an at the money call and buying an
At-The-Money put option
AssumeΔ=0.5
60
Futures Call 6000
@Rs.100
Put 6000
@Rs.100
6080 (20) (100)
6120 20 (100)
6000 (100) (100)
6100 0 (100)
61. COVERED CALL
Employed when manager is neutral about the market or is
moderately bullish
Buy stock and sell OTM call option
Eg. Buy stock @ rs.300
Sell call of rs.330 on the same stock for rs.20
61
Market Stocks
underlying
price
Option P&L
320 320-300 20 40
350 350-300 330-350+20 50
250 250-300 20 -30
63. 63
A position is taken to take advantage of price moves arising from new marketinformation
release or events occurring.
MergerArbitrage
Distressed Restructuring
Activist shareholder
64. Merger Arbitrage
After merger Company Aremains.
1:1 scheme of m&a is assumed.
i.e for every 1 share of Co B you will get 1 share of CoA
64
66. Distressed Restructuring
Buy Undervalue Securities of the firm in financial distress when analysis
shows that the value will increase by restructuring
The hedge funds may invest in debt or equity of such companies
66
67. Activist shareholder
Buying sufficient quantity of equity to influence companies policies
Goal is to increase the company’s value
67
68. GLOBAL MACRO STRATEGY
Focuses on investing in instruments whose prices fluctuate based on the changes in economic policies,
along with the flow of capital around the globe.
May invest in equities, fixed income, currency or commodities.
For example, if a manager believes that the U.S. is headed into recession, then he or she mightshort
sell stocks and futures contracts on major U.S. indexes or the U.S. dollar. Or, a manager seeing big
opportunity for growth in Singapore might take long positions in Singapore's assets.
68
70. Purchased Collateralized Debt Obligations (CDO’s)
Used more Leverage
Purchased Credit Default Swaps
Positive Carry
70
71. 71
Subprime Mortgage Backed Securities behaved well outside what was expected by the Hedge Fund
Managers
Default from Home-owners
They had insufficient credit insurance to protect these losses
Financers started asking for more money or collateral because of the drop in the value of thebond
72. These Funds had no cash on the sideline
Bear Stern was the first one in trouble
Cascading effect
Hedge Funds collapsed
72
74. Defaults from home owners in early 2007
Their High Grade Structured Credit fund received $1.6 Billion
High Grade structure credit fund and high grade structure credit leveraged funds lost almost theirentire
value
31st July 2007, both these funds filed forbankruptcy
74
77. Participatory Notes commonly known as P-Notes or PNs
PNs are instruments issued by registered foreign institutional investors
(FII) to overseas investors, who wish to invest in the Indian stock
markets without registering themselves with the market regulator, the
Securities and Exchange Board of India
Any dividends or capital gains collected from the underlying securities
go back to the investors
Investing through P-Notes is very simple and hence very popular
amongst foreign institutional investors
77
79. PN’s CRISIS OF 2007
Oct 16th - SEBI proposed to curb PNs
Oct 17th
Sensex crashed by 1744 points
Announcement by P.Chidambaram
Oct 18th
Sensex tumbled 717 points
Oct 22nd
Announcement by Mr.Damodaran
79
86. P-NOTES AND CGT EVASION
With P-Notes Without P-notes
Tom can buy Indian shares via FII via p-
notes.
Tom have to get PAN+DEMAT. Only
then, they can buy/sell Indian shares.
Tom sells this P-note to X @profit.
X doesn’t need to pay CGT to Indian
Government, because we cannot trace
what Tom did with that piece of paper in
USA!
Even if P-note is sold 10 times to 10
different people, we cannot get CGT.
We’ll get CGT only once, when the said p-
note owner instructs the FII to sell the
shares from its Indian DEMAT account/
portfolio.
If Tom sells his shares to X (and makes
profit), then That X will have to pay
Capital gains tax to India.
Because Income tax official can trace it by
monitoring the DEMAT activity of both
accounts.
86
88. SUMMARY OF EVENTS
88
In 1994, John Meriwether, the famed Salomon Brothers bond trader,
founded a hedge fund called Long-Term Capital Management
Meriwether assembled an all-star team of traders and academics in an
attempt to create a fund that would profit from the combination of the
academics' quantitative models and the traders' market judgement and
execution capabilities
Sophisticated investors, including many large investment banks, flocked to
the fund, investing $1.3 billion at inception
But four years later, at the end of September 1998, the fund had lost
substantial amounts of the investors' equity capital and was teetering on the
brink of default
90. To avoid the threat of a systemic crisis in the world financial
system, the Federal Reserve orchestrated a $3.5 billion rescue
package from leading U.S. investment and commercial banks
In exchange the participants received 90% of LTCM's equity
90
91. LTCM’S STRATEGY
91
The basic principle of LTCM’s strategy was that in the long term, the
price of a security would converge to its fair market value even though
there may be mispricing in the short term
LTCM utilized computer models to find arbitrage opportunities between
markets
LTCM's central strategy was convergence trades where securities were
incorrectly priced relative to one another
LTCM would take long positions on the under priced security and short
positions on the overpriced security
92. 92
The strategy depended on exploiting deviations in market value from
fair value. And it depended on "patient capital" -- shareholders and
lenders who believed that what mattered was fair value and not market
value. That is, because the fair values were hedged, it didn't matter what
happened to market values in the short run — they would converge to
fair value over time. That was the reason for the "Long Term" part of
LTCM's name.
93. 93
A convergence trading strategy in the stock markets, is a trade idea
based on the principle that when the price of a stock (or stock
portfolio) significantly deviates from its long-term trend, it will
sooner or later converge (move back) back to its original trend. For
example, a trading strategy that generates a buy signal at every dip of
the stock price in a general up trend is a convergence trading strategy.
94. CONVERGENCE TRADES
LTCM's main strategy was to make convergence trades. These trades
involved finding securities that were mispriced relative to one another,
taking long positions in the cheap ones and short positions in the rich
ones
When an arbitrage opportunity was identified by the computers then
LTCM would immediately trade and take on the position, and
when the price difference converged back to mean normal course, the
computer would identify this and LTCM would immediately close off
their position.
94
95. TYPES OF TRADES
Convergence among U.S., Japan, and European sovereign bonds
Convergence among European sovereign bonds
Convergence between on-the-run and off-the-run U.S. government
bonds
Long positions in emerging markets sovereigns, hedged back to dollars
95
96. Because these differences in values were tiny, the fund needed to
take large and highly-leveraged positions in order to make a
significant profit
At the beginning of 1998, the fund had equity of $5 billion and
had borrowed over $125 billion — a leverage factor of 25:01
96
97. LTCM's partners believed, on the basis of their complex computer models, that
the long and short positions were highly correlated and so the net risk was small
97
98. 98
On-the-run treasuries
The most recently issued U.S. Treasury bond or note of a particular
maturity. These are the opposite of "off-the-run treasuries".
Sovereign Bond
A debt security issued by a national government within agiven
country and denominated in a foreign currency.
99. LTCM’S POSITIONS
LTCM had fixed income and equity positions. The equity positions
were a mix of:
1) Index spread trades
2) Total return swaps
3) Takeover positions.
Index Spread Trades
A spread is defined as the sale of one or more futures contracts and the
purchase of one or more offsetting futures contracts. A spread tracks the
difference between the price of whatever it is you are long and whatever
it is you are short
99
100. TOTAL RETURN SWAP
In a total return swap, the party receiving the total return will receive
any income generated by the asset as well as benefit if the price of the
asset appreciates over the life of the swap
In return, the total return receiver must pay the owner of the asset the set
rate over the life of the swap
If the price of the assets falls over the swap's life, the total return
receiver will be required to pay the asset owner the amount by which
the asset has fallen in price
100
101. For example, two parties may enter into a one-year total return swap
where Party A receives LIBOR + fixed margin (2%) and Party B
receives the total return of the S&P 500 on a principal amount of $1
million. If LIBOR is 3.5% and the S&P 500 appreciates by 15%,
Party A will pay Party B 15% and will receive 5.5%. The payment
will be netted at the end of the swap with Party B receiving a
payment of $95,000 ($1 million x 15% - 5.5%)
101
103. FLIGHT TO LIQUIDITY
The ultimate cause of the LTCM debacle was the "flight to liquidity"
across the global fixed income markets
As Russia's troubles became deeper and deeper, fixed-income portfolio
managers began to shift their assets to more liquid assets
What LTCM had failed to account for is that a substantial portion of its
balance sheet was exposed to a general change in the "price" of liquidity.
If liquidity became more valuable (as it did following the crisis) its short
positions (rich assets) would increase in price relative to its long positions
(cheap assets)
This was essentially a massive, unhedged exposure to a single risk factor
103
104. 104
As the case demonstrates, the lenders are the first to get nervous when an external
shock hits
At that point, they begin to ask the fund manager for market valuations, not
models-based fair valuations
This starts the fund along the downward spiral:
illiquid securities are marked-to-market
margin calls are made
the illiquid securities must be sold
more margin calls are made, and so on
105. THE LESSONS TO BE LEARNED
FROM THIS CRISIS ARE
Market values matter for leveraged portfolios
Liquidity itself is a risk factor
Models must be stress-tested and combined with judgement
LTCM fell victim to a flight to liquidity. This phenomenon is common
enough in capital markets crises that it should be built into risk models,
either by introducing a new risk factor — liquidity — or by includinga
flight to liquidity in the stress testing
105
106. 106
Another key lesson to be learnt from the LTCM debacle is that even (or
especially) the most sophisticated a financial models are subject to
model risk and parameter risk, and should therefore be stress-tested and
tempered with judgement
According to the complex mathematical models used by LTCM, the
positions were low risk. Judgement tells us that the key assumption that
the models depended on was the high correlation between the long and
short positions.
107. Certainly, recent history suggested that correlations between corporate
bonds of different credit quality would move together (a correlation of
between 90-95% over a 2-year horizon)
During LTCM's crisis, however, this correlation dropped to 80%
Stress-testing against this lower correlation might have led LTCMto
assume less leverage in taking this bet
107
