Hedge Funds

Hedge funds are investment pools that are relatively unconstrained

in what they do. They are relatively unregulated (for now), charge
very high fees, will not necessarily give you your money back when
you want it, and will generally not tell you what they do. They are
supposed to make money all the time, and when they fail at this, their
investors redeem and go to someone else who has recently been
making money. Every three or four years they deliver a one-in-ahundred year flood. They are generally run for rich people in Geneva,
Switzerland, by rich people in Greenwich, Connecticut.
-Cliff Asness, Journal of Portfolio Management

What is a hedge fund?

Hedge Fund- A fund that can
take both long and short positions
use arbitrage
buy and sell undervalued securities
trade options or bonds, and
invest in almost any opportunity in any market where it foresees
impressive gains at reduced risk.

What is a hedge fund?

Opinions differ regarding the definition of the phrase Hedge Fund.
The most commonly accepted definition is that a hedge funds are the
funds which:
Have an absolute return performance objective
Allow the manager to be active on both the long and short sides of the
markets
Compensate the manager with performance related fees
Allow the manager tremendous flexibility in investment style and approach

What is a hedge fund?

To hedge ones bets i.e. betting on other side to limit the possibility
of loss on a speculation.
Hedge funds

pool of funds of the highly influential investors,

open to limited number of investors
require high investment
include high expertise based investment strategies and Risk management

Targeted Investments
They can invest in any type of asset class or opportunity luring in the any market,
be it
options,
derivatives,
equities,
bonds,
undervalued securities,
currencies,
Commodities
events such as mergers or bankruptcies,
domestic as well as international markets where they can expect to receive
attractive returns in all kind of risky situations.

Goal of the fund?

Lets break it up
The primary aim of most hedge funds is to
Reduce volatility and risk
while attempting to preserve capital, and
deliver positive returns under all market conditions.

In other words
Attempting to minimize the risk i.e. to hedge.
Protecting capital (i.e. the private pool of funds)
Generating superior returns in all kinds of markets (they are ready to take
bearish markets also)

Historic Hedging: Logic

Historically the hedging strategy centered around this logic:
Equities on the "long side" outperformed up markets. At the same time, the
equities on the "short side" did not create a drag on performance, and
possibly even added to the portfolios return since there are always stocks
that lose value, even in a bull market.
In a market correction, the short portfolio would outperform the long
portfolio, or at least "hedge" or reduce the slide in the long portfolios value.

Hedging Strategies
There are approximately 14 distinct investment strategies used by
hedge funds
Key: All hedge funds are not the same. The investment returns, volatility, and
risk vary enormously among the different strategies

Styles of Hedge Funds

Aggressive Growth: Invests in equities expected to experience acceleration in
growth of earnings per share

Hedges by shorting equities where earnings disappointment is expected or by

shorting stock indexes
Tends to be "long-biased."

The long-bias hedge fund strategy essentially serves as an investment halfway house in between a market-neutral fund
and a long-only fund. Rather than putting on positions that cancel out as found in a market neutral fund, or having
substantial long exposure as in a long-only fund, a long-bias fund maintains a differing ratio of long positions
(compared to short positions) that usually exceeds 40%. With this definition in mind, a hedge fund with a long/short
equity strategy could transition into a long-bias hedge fund, and vice versa, depending on how its assets were
allocated.
this type of long/short strategy, for example, investing at a 130/30 ratio of long to short (130% long and 30% short),
or 120/20, are known as long bias strategies. Fewer hedge funds employ a short bias over the longer term, as equity
markets tend to move up over time.

Expected Volatility: High

Styles of Hedge Funds (Contd.)

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 of the true value of the
deeply discounted securities

Majority of institutional investors cannot own below investment grade

securities.
Results generally not dependent on the direction of the markets.
Expected Volatility: Low - Moderate

Styles of Hedge Funds (Contd.)

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
Expected Volatility: Very High

Styles of Hedge Funds (Contd.)

Funds of Hedge Funds: Mix and match hedge funds and other pooled
investment vehicles
Blend of different strategies and asset classes aims to provide stable
long-term return than any of the individual funds.
Returns, risk, and volatility can be controlled
Capital preservation is generally important
Volatility depends on the mix and ratio of strategies employed
Expected Volatility: Low - Moderate - High

Styles of Hedge Funds (Contd.)

Income: Invests with primary focus on yield or current income rather than
solely on capital gains
May use leverage to buy bonds or fixed income derivatives, in order to
profit from principal appreciation and interest income.
Expected Volatility: Low

Styles of Hedge Funds (Contd.)

Macro: Aims to profit from changes in global economies

Typically brought about by shifts in govt. policy that impact interest

rates, in turn affecting currency, stock, and bond markets
Uses leverage and derivatives to accentuate the impact of market
moves
Uses hedging, but largest performance impact is from the leveraged
directional investments
Expected Volatility: Very High

Styles of Hedge Funds (Contd.)

Market Neutral - Arbitrage: Attempts to hedge out most market risk by
taking offsetting positions, often in different securities of the same issuer
Eg. Can be long convertible bonds and short the underlying issuers
equity.
Focuses on obtaining returns with low or no correlation to both the
equity and bond markets
Relative value strategies include fixed income arbitrage, mortgage
backed securities, capital structure arbitrage, and closed-end fund
arbitrage
Expected Volatility: Low

Styles of Hedge Funds (Contd.)

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
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
Expected Volatility: Low

Styles of Hedge Funds (Contd.)

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 increase volatility
Expected Volatility: High

Styles of Hedge Funds (Contd.)

Opportunistic: Investment theme changes from strategy to strategy as
opportunities arise to profit from events such as IPOs, hostile bids, etc.
May utilize several of these investing styles at a given time
Not restricted to any particular investment approach or asset class
Expected Volatility: Variable

Styles of Hedge Funds (Contd.)

Multi Strategy: Investment approach is diversified by employing various
strategies simultaneously to realize short- and long-term gains
Other strategies: Systems trading such as trend following and various
diversified technical strategies
Allows the manager to overweight or underweight different strategies to best
capitalize on current investment opportunities
Expected Volatility: Variable

Styles of Hedge Funds (Contd.)

Short Selling: Sells securities short, in anticipation of being able to
repurchase them at a future date at a lower price
Result of anticipated overvaluation, earnings disappointments, new
competition, change of management, etc.
Often used as a hedge to offset long-only portfolios by those who
expect bearish cycle.

Expected Volatility: Very High

Styles of Hedge Funds (Contd.)

Special Situations: Invests in event-driven situations such as mergers,
hostile takeovers, LBOs etc.
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
Results generally not dependent on direction of market

Expected Volatility: Moderate

Styles of Hedge Funds (Contd.)

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

Various Hedge Fund Strategies

Emerging Markets

Invest in emerging markets

Emerging markets offer less options for short selling, so these are mostly long biased
and employ growth or value approach to investing in equities.
These can be illiquid & carry a high risk due to correlation of emerging economies.

Convertible Arbitrage

Make profit from arbitrage of convertible securities

Make money from mispricing & volatility
Usually buy a convertible bond, and take a short position in underlying equity.

Long- Short Equity

Base strategy of the initial hedge fund formations by Jones.

Hedging portfolio of longs by portfolio of shorts.
Main focus on the stock picking opportunities.

Various Hedge Fund Strategies

Global macro

Invest in developed as well as developing countries.

Enough flexibility. Can invest in any security in any market where there is an
opportunity.

Event Driven

Focus on events of corporate life cycle like acquisitions, buybacks, demerger, spinoffs etc,.

Merger/Risk Arbitrage

Focus on the companies which are going through any merger or takeover
Both the acquiring company and the target.
The risk is deal risk rather than a market risk.

Various Hedge Fund Strategies

Distressed Securities
Buying the bonds or securities of companies facing or approaching
bankruptcy or restructuring
Tries to benefit from the price movement of these securities.

Equity Market Neutral

Market timing rather than stock picking.
Taking long and short position in the undervalued and overvalued securities
Has low volatility.

Some Other Strategies

Fixed Income Arbitrage
-Seeking arbitrage opportunities in in Fixed Income Securities
-Interest rate arbitrage
-Use of derivatives like Interest Rate futures, Caps, floors etc.

Managed Futures
-Strategic investment or arbitrage in futures(usually Commodities and Currency)
-Spot-future arbitrage
-Contango and Backwardation arbitrage
-Calendar spread in futures
Market Directional
-Market momentum strategy
-for very short term
-example is Jobbing

Things to Note:
FICTION: All hedge funds are volatile -- they all place large directional bets on
securities and commodities, while using lots of leverage
FACT: 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.

Some hedge funds don't actually hedge against risk. The term is applied to a
wide range of alternative funds, and encompasses funds that use high-risk
strategies without hedging against risk of loss

Management of Hedge funds

Most hedge funds are managed by experienced investment
professionals
Highly specialized
Trade only within their area of expertise and competitive
advantage
Remuneration heavily weighted towards performance incentives
Usually have their own money invested in their fund

How is a Hedge Fund different from a Mutual

Fund?

Hedge funds traditionally reserved for clients with initial minimum

investment of $1 million. Mutual fund companies beginning to
offer hedge fund products to wider client base

There are 5 key differences between them based on:

1. Performance Evaluation
2. Level of regulatory control
3. Basis for Remuneration of Management
4. Portfolio Protection
5. Dependence on Markets

Differences (Contd.)

Performance Evaluation:
Mutual funds are measured on relative performance compared
to a relevant index or to other mutual funds in their sector
Hedge funds are expected to deliver absolute returns under all
circumstances, even when the relative indices are down

Level of Regulation:
Unlike hedge funds, mutual funds are highly regulated,
restricting the use of short selling and derivatives. Makes it
difficult to outperform market, or protect assets in downturn.

Differences (Contd.)

Remuneration for Management

Mutual Fund managers are paid based on a % of AUM. Hedge funds pay
managers performance-related incentive fees plus a fixed fee

Portfolio Protection
Mutual funds are not able to effectively protect portfolios against declining
markets other than by going into cash or by shorting a limited amount of
stock index futures
Hedge funds are often able to protect against declining markets by using
various hedging strategies, and can generate positive returns even in
declining markets.

Differences (Contd.)

Dependence on Markets

The future performance of mutual funds depends on the

direction of the equity markets.
The future performance of many hedge fund strategies tends to
be highly predictable and not dependent on the direction of the
equity markets.

Fund of Funds
A fund of funds mixes the most successful hedge funds and other pooled investment
vehicles, spreading investments among many different funds or investment vehicles
Hedge fund strategies are complex and varied in their ranges of risk/return. Even
within a particular style, two managers can apply different amounts of hedging or
insurance and leverage to his/her portfolio
A fund of funds blends together funds of different strategies and asset classes in
order to accomplish:
More consistent return (than any of the individual funds)
Spreading out the risks among a variety of funds
Meeting a range of investor risk/return objectives

Indian Context
Asian countries are offering many opportunities

Market in UK and US are facing

huge meltdowns
investors are finding hard to sustain there
money making options are drying

India is offering various necessary conditions for hedge funds to explore

with its
secondary market liquidity
Futures
options, etc.

Why India?
Investment can be made through FII (Foreign Institutional Investors)
route.
Doesnt charge anything on performance or profit of the fund

Thus giving India a plus point from others

Thus attracting more HNIs to enter India through these.

Incremental Nominal GDP - (in Billion

US $)
40,000

35,000

2035-2050
30,000

2020-2035
2006-2020

25,000

20,000

15,000

10,000

5,000

China

India

United
States

Brazil

Mexico

Indonesia

Russia

United Germany
Kingdom

Japan

Working Age Population Growth Rates (% p.a.)

% p.a.

1.00%

0.50%

0.00%

-0.50%

-1.00%

-1.50%

Source: PwC Report

Hedge Funds in India

Cater to
Individual
Investors

First
Implication

Essentials for
HFs

Second
Implication

Registration

Uncorrelated
returns

Increase in
demand

Independent
audit

Surge in
earnings

Increase
competition

Transparency

Reducing
investment
fees

Proper
disclosure

Performance of Indian Hedge Funds

2006

$44,000 million AUM (assets under management) of all Indian hedge

funds
Indias high beta market generate effective returns.

2007

Bull Run
Q-India, Halbis, Baer Capital, Insynergy & FMG outperformed major
hedge fund indices.

2008

Experiment with complex strategies, resulted hard on the returns.

India index was the worst performing index with loss of around 50%.

2009

More cautious in year 2009 and 2010

Taking some worthwhile sectors and stock calls

2010

Gloomy picture of hedge fund success

First 7 months having almost deep losses and very bleak returns
Funds which focused on inflation sensitive India gained around
15.48% according to HFRX India index

 http://www.karvycapital.com/hedge.aspx

http://www.thehindubusinessline.com/markets/indian-hedge-fundsoutperform-sensex-over-the-last-year/article6397094.ece
http://www.funds-europe.com/news/14240-emerging-markethedge-funds-see-positive-performance
http://www.mydigitalfc.com/hedge-fund/13-hedge-funds-get-sebiapproval-555

HFRX
The Hedge Fund Research Index
Most Widely followed index for Hedge Fund Performance
It is comprised of all eligible hedge fund strategies. All strategies are equally
weighted.
Evaluates the performance of Hedge Funds based on Absolute Return and the
Relative Risk.
As a component of the optimization process, the index selects constituents
which exhibit lower volatilities and lower correlations to standard directional
benchmarks of equity market and hedge fund industry performance.
HFRX India is an index for the Indian Hedge Funds.

HFRX Returns

10

09

08

07

06

Avg

Stdev

Min

Max

Rank

Global Hedge Fund

5.19

13.4

(23.25)

9.26

2.72

1.46

14.40

(23.25)

13.4

Equal Weighted
Strategies

5.29

11.44

(21.9)

8.83

1.28

0.99

13.35

(21.9)

11.44

Absolute Return

(0.12)

(3.58)

(13.09)

7.43

(0.03)

(1.88)

7.45

(13.09)

7.43

11

Market Directional

9.32

29.34

(29.7)

10.45

4.2

4.72

21.48

(29.7)

29.34

Convertible
Arbitrage

8.76

42.46

(58.37)

9.57

(5.69)

(0.65)

36.77

(58.37)

42.46

10

Distressed Securities

8.34

(5.6)

(30.69)

9.56

1.21

(3.44)

16.41

(30.69)

9.56

12

Equity Hedge

8.92

13.14

(25.45)

9.23

4.19

2.01

15.67

(25.45)

13.14

Equity Market
Neutral

2.64

(5.56)

(1.16)

4.76

0.21

0.18

3.93

(5.56)

4.76

Event Driven

1.98

16.59

(22.11)

10.32

2.81

1.92

14.70

(22.11)

16.59

(1.73)

(8.78)

5.61

5.61

6.67

1.48

6.64

(8.78)

6.67

Merger Arbitrage

5.69

8.14

3.69

10.73

3.72

6.39

3.03

3.69

10.73

Relative Value
Arbitrage

7.65

38.47

(37.6)

10.65

(0.97)

3.64

27.39

(37.6)

38.47

Macro

Avg

Min

Max

Rank

3.24

-2.79

0.11

1.04

0.50

2.18

-2.79

3.24

0.81

2.04

-2.19

2.51

1.8

0.99

1.89

-2.19

2.51

Event Driven

0.6

1.6

-1.46

1.64

1.03

0.68

1.27

-1.46

1.64

Fixed Income Arbitrage

0.38

0.3

1.01

1.29

0.86

0.77

0.42

0.3

1.29

Global Macro

0.69

0.48

0.98

1.21

0.39

0.75

0.34

0.39

1.21

Long/Short Equity

0.58

1.47

-0.85

1.5

1.02

0.74

0.97

-0.85

1.5

Managed Futures

1.14

-1.08

2.29

1.39

0.99

0.95

1.24

-1.08

2.29

Dow Jones Credit Suisse

indices
Convertible Arbitrage

10

0.9

Emerging Markets

Stdev

HF strategies and Systematic risk

exposure

Evolution of HF strategies

Modern day HF strategies

Empirical Findings
Returns are considerably high during a volatile market which is mean reverting in
nature
Returns during a trending market in some of the HF strategies is low and even
negative in some cases
Well established and High Corpus HFs give a lower returns compared to the
relatively newer peers who have small corpus

How does size matter?

John Paulson
(HF: Paulson and Co.)
His claim to fame is his pay check for 2007: he is reported to have made $3.7 billion.
Strategy: Short-selling sub prime mortgage

He made a profit of $15 billion for his investors in 2007. His flagship fund

generated a return of 599%.

In 2010, he beat a hedge-fund record by making nearly $5 billion
His Flagship Fund (Paulson Advantage Fund) was down by 40% as on Sept. 2011

George Soros
(HF: Soros Fund Management)
Short sold 10 Billion pounds in 1992 and made 1.1 Billion $ in a single
day (Black Wednesday)
Similar speculation over the currency of Association of Southeast Asian
Nations (ASEAN) in 1997
As of March 2012 Soros was listed 22nd in Forbs among the richest
people in the world

Christopher Hohn
The hedge fund he manages reportedly lost $1 billion in a single month,
June 2008. The size of his hedge fund went from $8 billion to $7billion.
Interestingly Hohn was a topper at HBS.
Other smart people who lost money through Hedge Funds are the
Noble Laureates Myron S. Scholes and Robert C. Merton (The LTCM
case)

Hedge Fund Regulations In India

SEBI regulation seeks to cover all types of funds broadly under 3 categories

Category I AIF those AIFs (Alternative Investment Funds) with positive

spillover effects on the economy
Category II AIF those AIFs for which no specific incentives or concessions
are given by the government or any other Regulator; which shall not undertake
leverage other than to meet day-to-day operational requirements
Category III AIF those AIFs including hedge funds which trade with a view
to make short term returns; which employs diverse or complex trading
strategies and may employ leverage including through investment in listed or
unlisted derivatives.

Regulatory Constraints
Restricting participation:
The Alternative Investment Fund shall not accept from an investor an
investment of value less than rupees one crore. Further, the AIF shall have a
minimum corpus of Rs. 20 crore.

Avoiding wealth concentration hazards:

The fund or any scheme of the fund shall not have more than 1000 investors

Preventing Conflict of Interest:

For a Hedge Fund, the continuing interest shall be not less that 5% of the
corpus or rupees ten crore, whichever is lower.

Regulatory Constraints (contd..)

Trading in Secondary Market:
Units of AIF may be listed on stock exchange subject to a minimum tradable
lot of rupees one crore. However, AIF shall not raise funds through Stock
Exchange mechanism

Against Concentration Alpha and Speculation:

Hedge Funds shall invest not more than 10% of the corpus in one Investee
Company.

Preventing Moral Hazard:

AIF shall not invest in associates except with the approval of 75% of investors
by value of their investment in the Alternative Investment Fund

The Category III of AIFs (the Hedge Funds)

Proper disclosure:
Category III Alternative Investment Funds shall ensure that
calculation of the net asset value (NAV) shall be disclosed to
the investors at intervals not longer than a quarter for close
ended Funds and at intervals not longer than a month for
open ended funds.
Category III Alternative Investment Fund shall provide
quarterly reports to investors within 60 days of end of the
quarter.

How Hedge Fund Leverage Works (Exhibit

11.1)
Hedge fund investor capital can be leveraged in several ways to enhance overall returns.
Direct forms of leverage:
Bank borrowings
Hedge funds can take out margin loans (buying securities on margin) from banks. For example, assuming a 20%
margin on security ABC, a hedge fund could buy $10 worth of securities by paying only $2 upfront and having the
bank supply the remaining $8 in the form of a loan. To protect its loan balance, the bank requires the hedge fund to
deposit an agreed amount of securities as collateral. If the market value of the ABC securities drops, the bank can
require additional collateral from the hedge fund (margin call) to further protect itself.
Repossession agreements (repos)
Usually used by hedge funds to finance debt security purchases, a repo transaction involves one party agreeing to
sell a security to another party for a given price and then buying it back later at a higher price.
Implicit forms of leverage:
Short selling
Short selling is the practice of selling securities borrowed from banks or other counterparties. Funds raised from the
sale of these borrowed securities are used to buy other securities a practice known as long/short trading.

How Hedge Fund Leverage Works - Exhibit 11.1 (2

of 2)
Short selling
Short selling is the practice of selling securities borrowed from banks or other counterparties.
Funds raised from the sale of these borrowed securities are used to buy other securities a
practice known as long/short trading.
Off-balance-sheet leverage through derivatives and structured products
Derivatives include options, swaps, and futures. Investors can gain much larger risk exposures to
an asset class through the use of derivatives than from buying the assets directly. Investments in
the high-risk portions of structured products such as collateralized debt obligations (CDOs) also
provide implicit leverage.
Through the first half of 2008, total hedge fund industry leverage was estimated to be three to four
times investor capital.
Source: Farrell, Diana, et al. The New Power Brokers: How Oil, Asia, Hedge Funds and Private Equity Are Shaping the
Global Capital Markets. McKinsey Global Institute Oct. 2007.

For recent
figures refer
Figure 11.1
of text book
page 222

Exhibit 11.2 Hedge Funds Leveraged Assets Fell from $6.6 Trillion to $2.4 Trillion in Less Than a One-Year Period
Assets under management and estimated total investable assets1, $ in trillions
Leverage through derivative positions
Leverage through debt
Assets under management

4.8

2.9
1.5

Implied
Leverage
Ratio2 (total)

3.4

6.5

6.6

3.3

3.9

-64%

3.6
2.6

1.7

1.3

1.5

2.4

0.7

0.8

0.4
1.0

0.6
1.1

1.4

1.9

1.9

1.4

0.9
0.3
1.2

2004

2005

2006

2007

H1-08

H2-08

Q1-09

2.9

3.1

3.4

3.4

3.5

2.6

2.0

0.8

Note 1: Includes leverage from debt and off-balance sheet leverage through derivatives and other instruments
Note 2: Leverage ratio = (total leverage + AUM) / AUM
Source: McKinsey Global Institute; Global Capital Markets Survey; Dresdner Kleinwort Equity Research; International
Financial Services, London; Financial Risk Management, Ltd.; Financial Services Authority

For recent
figures refer
Figure 11.2
of text book
page 223

Exhibit 11.3 (1 of 2)

Estimated Total Number of Hedge Funds and Fund of Funds

1990 20008
12,000
10,096
9,462
9,176
8,661

10,000

7,436

8,000

6,000
4,000
2,000

6,297
5,379
4,454
3,873
3,325
3,617
2,7812,990
1,945 2,383
1,514
610 821 1,105

90

91

92

93

94

95

96

97

98

99

00

01

02

03

04

05

06

07

08

For recent
figures refer
Figure 11.3
of text book
page 223

Exhibit 11.3 (2 of 2)

Estimated Total Number of Hedge Funds versus Fund of Funds

1990 20008
9,000
Fund of Funds

8,000

7,634
7,241
6,808
6,665

Hedge Funds

7,000

5,782
5,065
4,598
3,904

6,000
5,000
4,000
3,000
2,000
1,000

1,277

3,102 3,335
2,5642,848
2,006
2,392
1,654

781
530 694 937
515 538 550
477
426
389
377
291
80 127 168 237

2,462
2,368
1,996 2,221
1,654
1,232

90

91

92

93

94

Source: Hedge Fund Research, Inc.

95

96

97

98

99

00

01

02

03

04

05

06

07

08

For recent
figures refer
Figure 11.4
of text book
page 224

Exhibit 11.4 (1 of 2)

Estimated Growth of Assets

Hedge Fund Industry 1990 2008, $ in billions

2,000
1,800
1,600
1,400
1,200
1,000
800
600
400
200
0
90 91

92

93

94

95 96

97

98

99

00 01

02

03

04

05

06

07

08

For recent
figures refer
Figure 11.5
of text book
page 224

Exhibit 11.4 (2 of 2)

Estimated Growth of Assets

Fund of Fund Industry 1990 2008, $ in billions

800
700
600

500
400
300
200

100
0
90

91

92

93

94

Source: Hedge Fund Research, Inc.

95

96

97

98

99

00

01

02

03

04

05

06

07

08

For recent
figures refer
Figure 11.6
of text book
page 226

Exhibit 11.5

61%

14%

Share of High Net Worth Individuals Has Fallen

54% 53% 54%

18% 20% 17%

42% 44% 44% 44% 40%

48%

20% 27% 24% 24% 30%

9%
8%

9%
7%

9%
8%

9%
8%

23%
18%

31% 30%
High net-worth
individuals
31% 32%

12% 12%

10% 8% 8%
7%
12% 11%
11%
7%
7% 8%
8% 7%
9%
12% 14% 15% 15% 15% 15% 12% 11% 14% 15%
5% 10%

Fund of hedge funds

Endowments and
foundations
Corporations and
institutions

Pension funds

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: McKinsey Global Institute; Hennessee Group LLC; International Financial Services, London estimates

For recent
table 11.1
of text book
page 227

Exhibit 11.6

Top 10 Hedge Funds by Assets Under Management at the End of 2008

Firm
Bridgewater Associates
J.P. Morgan
Paulson & Co.
D.E. Shaw Group
Brevan Howard1
Och-Ziff Capital Management
Man AHL1
Soros Fund Management
Goldman Sachs Asset Management1
Farallon Capital Management2
Renaissance Technologies2

Region
U.S.
U.S.
U.S.
U.S.
Europe
U.S.
Europe
U.S.
U.S.
U.S.
U.S.

Note 1: As of December 31, 2008. All other figures as of January 1, 2009.

Note 2: Tied for 10th place.
Source: Absolute Return Billion Dollar Club, March 2009 rankings

AUM ($bn)
38.6
32.9
29.0
28.6
26.8
22.1
22.0
21.0
20.6
20.0
20.0

For recent
figures refer
Figure 11.7
of text book
page 227

Exhibit 11.7

Hedge Fund Revenues are Highly Concentrated in the Top 205 Funds

Hedge Fund Revenue Pool for 2006

>$5bn (64 funds)
26%
43%

$3-5 bn (64 funds)

205 funds

$2-3 bn (77 funds)

13%

18%

<$2 bn (5,000+
funds)

74% of revenues are concentrated in the 205

largest funds based on AUM

Source: McKinsey Global Institute; Lipper Hedge World; Merrill Lynch; McKinsey Global Institute hedge fund
interviews

Exhibit 11.8

Hedge Fund Returns are Especially Strong in Bull Markets

Monthly Hedge Fund Returns, 1994 2008

Monthly Hedge Fund Returns, 1994 2008
HFRI
Fund
Weighted
Composite
HFRI
Fund
Weighted
Composite
IndexIndex
10%
8%
6%

4%
2%
0%
-2%
-4%
-6%
-8%

Note: A bull market (denoted in green shading) is a 20% rally preceded by a 20% decline in the DJIA; a bear market
(denoted in red shading) is a 20% decline preceded by a 20% rally in the DJIA.
Source: Hedge Fund Research, Inc.; DJIA data provided by Commodity Systems Inc.

Dec-08

Jun-08

Dec-07

Jun-07

Dec-06

Jun-06

Dec-05

Jun-05

Dec-04

Jun-04

Dec-03

Jun-03

Dec-02

Jun-02

Dec-01

Jun-01

Dec-00

Jun-00

Dec-99

Jun-99

Dec-98

Jun-98

Dec-97

Jun-97

Dec-96

Jun-96

Dec-95

Jun-95

-10%
Dec-94

For recent
figures refer
Figure 11.8
of text book
page 229

Since 1990, Hedge Fund Strategies Have Outperformed Both Bonds and
Equities (Even Accounting for Risk)

Exhibit 11.9

Risk vs. return for hedge fund strategies compared to blended portfolios of bonds and equities,
1990 - 2008
15
Macro

14

Equity Hedge

Average Return %

13
Event-Driven

12

11
Relative Value

10

Portfolio composition:

100% equities, 0% bonds

Additional 5% bonds, moving to the left

0% equities, 100% bonds

3

Standard Deviation %
Source: McKinsey Global Institute; Hedge Fund Research, Inc.; Datastream

10

11

12

13

Top Quartile Hedge Funds Outperformed U.S. Equities and Bonds1

Exhibit 11.10

Average annual returns (net of fees) by strategy for risk-adjusted quartiles, 2001 2007, %
Equity Hedge
1st
Quartile

Macro

Event-Driven

19.4

2nd
Quartile

31.3

11.2

3rd
Quartile

0.4

4th
Quartile

0.2

2.4 6.1

19.0

15.4

2.4 6.1

13.6

13.9

12.7

4.1

Relative Value

9.9

4.0

-2.6

7.5

2.2

2.4 6.1

2.4 6.1

S&P 500
Lehman US
Aggregate
Bond Index

Note 1: Quartiles are defined based on risk-adjusted performance, defined using fund Sharpe ratio between 2001 and
2007. The Sharpe ratio is given by Average (R Rf) / Standard Deviation (R), where R is the return and the benchmark
rate Rf is the S&P 500 average between 2001 and 2007 (2.43%).
Source: McKinsey Global Institute; Hedge Fund Research, Inc.

Exhibit 11.11 (1 of 2) Academic Research on Hedge Fund Performance

Due to limitations in the availability of hedge fund performance data, a clear assessment of industry
performance is difficult to obtain. However, based on what is available through the small but growing
number of academic papers on hedge funds, a number of observations can be made:
Hedge funds in aggregate have slightly outperformed the public equities market.
o Top-quartile hedge funds significantly out-perform equities.
Hedge funds in aggregate are slightly less volatile than the public equities market.
Absolute returns (alpha, or returns uncorrelated with the broader market) have been more
elusive:
o For many hedge fund strategies, over 70% of returns reflect returns of common market indices. 1
o Fund of funds delivered no alpha.2
o 3% of annual hedge fund returns can be attributed to alpha.3

o Top quartile hedge funds are able to achieve outsized alphas (as high as 15% annually), based on
data from a period of a few years.4
These findings suggest that investing in market indices can be a reasonable and less expensive
alternative to expensive hedge funds (with the exception of top performing hedge funds).
It is important to note that there are limitations to these observations as imperfect data can create a
number of biases:

Exhibit 11.11 (2 of 2) Academic Research on Hedge Fund Performance

Selection bias: participation in hedge fund databases is voluntary.
Survivorship bias: unsuccessful funds that have folded are not included in most hedge fund
databases.
Backfill bias: once a hedge fund registers with a database, returns from years prior to registration
are provided and incorporated into the database as well. Funds are typically included in databases
after they have accumulated a good performance track record.
Liquidation bias: returns are no longer reported before a fund enters into final liquidation.

Although difficult to aggregate the effect of all of these biases, by some estimates, just survivorship
and backfill bias together can inflate industry returns by as much as 4%.5
Note 1: Hasanhodzic, Jasmina and Andrew W. Lo, Can hedge-fund returns be replicated?: The linear case. Journal of
Investment Management, Q2 2007, Vol. 5, No. 2.
Note 2: Fung, William, et al. Hedge funds: Performance, risk, and capital formation. AFA 2007 Chicago Meetings
paper, 19 Jul. 2006.
Note 3: Ibbotson, Roger G. and Peng Chen. The A,B,Cs of hedge funds: Alphas, betas and costs. Yale ICF working
paper, Sep. 2006.
Note 4: Kosowski, Robert, et al. Do hedge funds deliver alpha? A Bayesian and bootstrap analysis. Journal of
Financial Economics, Vol. 84, No. 1, Apr. 2007, pp. 229-64.
Note 5: Fung, William and David Hsieh. Hedge funds: An industry in its adolescence. Federal Reserve Bank of
Atlanta, Economic Review, Q4 2006, Vol. 91, No. 4.
Source: Farrell, Diana, et al. The New Power Brokers: How Oil, Asia, Hedge Funds and Private Equity Are Shaping the
Global Capital Markets. McKinsey Global Institute Oct. 2007.

Exhibit 11.12

Comparison of Hedge Fund Returns to the S&P 500 Indexs Returns, 2000 2008

Annualized Total Return, %

26.4%
15.4%

4.9%

-10.1%

4.4%

9.6%
9.0%

13.9%
13.6% 12.6%
7.6%

3.0%

3.5%

3.0%

Hedge funds

-13.0%

-19.1%

S&P 500

-23.4%

-38.5%
2000

2001

2002

2003

2004

2005

Source: Credit Suisse/Tremont; S&P 500 data provided by Commodity Systems Inc.

2006

2007

2008

Exhibit 11.13 (1 of 2) Travails of the Hedge Fund Market in 2008

Hedge funds are supposed to thrive in rough markets.
Not in 2008. A historic decline in stocks, and troubles in almost every part of the bond market, dealt
hedge funds their worst year on record. By the end of the year, investors were scrambling to get out,
bringing an end to years of industry growth and creating uncertainty about the future of major
components of the business.
Through December 2008, hedge funds globally lost 19% on average, according to Hedge Fund
Research, a Chicago firm that tracks the industry. Although that's better than the 38% loss on the
Standard & Poor's 500-stock index (including dividends) over the same period, it's far from the gains
most funds posted for more than a decade. The biggest fund category within hedge funds, long-short
funds (where the strategy is to buy some shares while betting against others), was down 23% on
average. Funds that invest in emerging markets dropped 31%.
Assets controlled by hedge funds tumbled to $1.4 trillion from nearly $2 trillion at the start of the year,
according to Hedge Fund Research, and continued falling in 2009.

Fund managers and their investors are trying to figure out what went wrong. One conclusion: Too
many funds bought the same assets. As markets fell in September and October, and hedge funds came
under pressure, many moved to sell investments, sending prices even lower and causing losses for
other funds that hadn't yet sold.
Stocks favored by hedge funds performed even worse than the overall market, according to data from
Goldman Sachs. An index of 50 stocks "that matter most" to hedge funds lost nearly 45%, including
dividends, compared with a loss of 38.5% on the S&P 500.

Exhibit 11.13 (2 of 2) Travails of the Hedge Fund Market in 2008

One problem for many hedge funds was the amount they hold of hard-to-trade assets, such as loans,
real-estate holdings, and stakes in small, private companies. These illiquid investments at one time
accounted for 20% of some fund portfolios, estimated to total about $400 billion. As financial markets
come under pressure, it becomes harder to get out of these investments, or even to value them
accurately.
Another problem for the industry was the fallout from December 2008s arrest of Bernard Madoff for a
$50 billion Ponzi scheme. While Madoff wasn't a hedge-fund manager, his business of overseeing
private accounts for wealthy individuals in tight-knit social circles from Palm Beach, to Long Island, as
well as for charities and private-banking clients all across Europe, rattled investor trust in privateinvestment managers in general.
The scandal also tainted fund of funds, the professional investment firms that raise money from clients
to invest in a portfolio of other investment funds. Several such firms channeled billions of dollars to
Madoff through feeder funds, raising questions about how much due diligence those firms performed
and whether clients' investments are as diversified and safe as they should be.

Source: Zuckerman, Gregory and Jenny Strasburg. For Many Hedge Funds, No Escape. Wall Street Journal 2 Jan.
2009.

Exhibit 11.14

Hedge Funds Account for a Significant Share of Trading Volume

Hedge Funds Estimated Share of Trading, %

Cash Equity on NYSE and LSE

50

U.S. Government Bonds

High-Yield Bonds

30
25

Credit Derivatives - Plain Vanilla

Credit Derivatives - Structured

60
30

Emerging Market Bonds

45

Distressed Debt
Leveraged Loans

47
32

Source: McKinsey Global Institute; NYSE; LSE; U.S. Bond Market Association; IMF; Greenwich Associates; Financial
News; Gartmore; Stern School of Business; British Bankers Association; ISDA; McKinsey CIB practice

Exhibit 11.15

Gating

The illiquidity of hedge funds often means that, even if investors realize the manager of their fund has
run into trouble, it could be months before they can get their money back. Even then, arrangements
called gates may restrict the proportion of an investors holdings that can be redeemed. Hedge fund
managers use gates to control redemptions during difficult markets. For example, in the throes of the
subprime mortgage meltdown of 2007, an article in the New York Times blog DealBook described
how the Bear Stearns Asset-Based Securities Fund had moved to suspend investor redemptions.
According to a Bear spokesman, *+ we believe by suspending redemptions we can ensure the best
long term results for our investors *+ we dont believe it is prudent or in the interest of our investors
to sell assets in the current market environment. The ability of the Bear Stearns hedge fund managers
to suspend investor redemptions illustrates the power of gating. Because the fund had incurred serious
losses, investors in the fund likely would have pulled their money out were they not bound by gates.
Thus, gating allows hedge fund managers to have greater control over their investors funds by
preventing investors from obtaining redemptions at inopportune times.

Source: DealBook, Third Bear Stearns Fund Skids on Mortgages. New York Times 1 Aug. 2007.

Exhibit 11.16 (1 of 2) Recent Hedge Fund IPOs Have Underperformed the Broader Market
Fortress Investment Group (NYSE:FIG) versus the S&P 500 Index
February 9, 2007 (IPO date) to December 31, 2008
20%
0%

-20%
-40%
-60%
-80%

FIG

S&P 500

-100%
-120%
Feb-07 Apr-07 Jun-07 Aug-07 Oct-07 Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Dec-08

Exhibit 11.16 (2 of 2) Recent Hedge Fund IPOs Have Underperformed the Broader Market
Och-Ziff Capital Management Group LLC (NYSE:OZM) versus the S&P 500 Index
November 14, 2007 (IPO date) to December 31, 2008
10%
0%
-10%
-20%
-30%

-40%
-50%
-60%
-70%

OZM

S&P 500

-80%
-90%
-100%

Nov-07

Dec-07

Feb-08

Mar-08

Source: Data provided by Commodity Systems Inc.

May-08

Jun-08

Aug-08

Sep-08

Nov-08

Dec-08

Exhibit 11.17

Why Use a Fund of Funds Firm?

Diversification and access

o Immediate diversification with relatively modest capital investment
o Access to certain managers who might otherwise be closed for investment

Value-added investment process

o Fundamental knowledge of many different investment strategies
o Network of industry relationships assists in filtering manager universe
o Staffing resources and expertise necessary for manager due diligence and monitoring
o Understanding of quantitative and qualitative portfolio construction issues
o Dynamic process that requires constant attention

Operational efficiencies
o Legal due diligence and document negotiation
o Consolidated accounting, performance and financial reporting
o Cash flow management

Source: Grosvenor Capital Management