Hedge Funds Intro

Valeri Sokolovski
 Hedge Fund Curriculum
• The content of your notes and prescribed
readings are based on the Chartered
Alternative Investment Analyst (CAAI)
curriculum.
• However because we have only 3 lectures and
hedge funds is a colossal field we will not be
able to examine everything in great detail.
 What is a Hedge Fund?
“Anything that charges you 2 and 20”

“An investment company that uses high-risk techniques, such

as borrowing money and selling short, in an effort to make
extraordinary capital gains”
American Heritage Dictionary
 What is a Hedge Fund?
• A better definition:
“A privately organized investment vehicle that
manages a concentrated portfolio of public
and private securities and derivative
instruments on those securities, that can
invest both long and short, and that can apply
leverage”
Hedge funds are only for sophisticated investors

• Hedge funds are not subject to regulation by the Securities

Exchange Commission (SEC) or Commodity Futures Trading
Commission (CFTC)
• This freedom comes at a cost.
• Hedge funds are allowed to attract only high-net worth
individuals.
• In the US each fund is allowed to have not more than 100
accredited investors and not more than 500 qualified purchasers.
• Accredited Investor: NW> $ 1 million
• Qualified Purchaser: Individuals or Institutions NW > $ 5 million
• Hedge Funds are not allowed to raise funds through a public
offering and are not allowed to advertise.
 A very brief history of hedge funds
• In 1949 Alfred Jones established a fund, Jones Hedge Fund, that
invested in US stocks both long and short.
• The intent was to limit market risk while focusing on stock selection.
• Fortune magazine published an article on Jones in the fifties and
within two years number of hedge funds grew from1 to 140.
• Many hedge funds closed down during the bear market of the 70s,
and interest was only revived in the late 1980s.
• In the 1990s and 2000s the appeal of hedge funds increased
dramatically and we saw an explosion of funds.
• By 2008 there was almost 10 000 hedge funds with close to $1. 8
trillion in total assets under management.
• As a contrast mutual funds (2007) had about $11.5 trillion under
management.
• It is estimated that around 50% of trading on NYSE and LSE.
 Hedge Funds and their Managers do very
well (until they blow up)
• In 2008, the worst year to date, hedge funds lost on average 18% of
their value.
• In contrast the S&P 500 fell 38%.
• The highest paid “hedgies” in 2007
• John Paulsen $3.7 billion
• George Soros $2.9 billion
• James Simons $2.8 billion
• Hedge fund managers often have a large part of their personal
wealth tied in the fund, however they often get paid unsymmetrical
performance fees. Typically managers receive positive incentive
fees for gains but are not required to rebate fees for losses.
 Long Term Capital Management (LTCM)
• LTCM founded in 1994 by a group of brilliant ex-Salomon Brothers traders as well as two Nobel
Prize winning financial economists Myron Scholes and Paul Merton.
• The group specialised in relative value trades (mostly fixed income arbitrage), however closer
to its collapse it was experiencing significant strategy drift.
• Due to arbitrage often yielding tiny returns, they had to operate with colossal levels of
leverage. It’s leverage on cash positions was on average 25:1, while leverage on derivative
products was in the region of 250:1. They picked up pennies in front of a steam roller.
• Their connections, secrecy, reputation and mysticism allowed them to amass positions close to
1 trillion dollars with only a few billion under management.
• In 1998 Russia’s sovereign debt default dealt a vital blow to the convergence strategies, there
was a flight to safety and spreads diverged.
• The LTCM dealers, being ethical financial professions, become ever more stricter on margin
calls and began betting against LTCM.
• On 23 September 1998, the NY FED intervened and gathered all the leading Wall Street banks
to persuade them to take over as to prevent “systemic failure”.
• The banks infuse $3.6 billion into LTCM and received 90% ownership.
• Scholes is currently the chairman of Platinum Grove Asset Management, Merton cried ad ran
back to academia, John Meriwether (founder LTCM) started two new funds JWM Partners (1999-
2009) and JM Advisors (2010-)
 Awesome Hedge Fund Quotes
“If we don’t charge 2 and 20, nobody will take us seriously”

“We charge 3 and 30 because that is the only way we

can keep our assets below several billion dollars”
“Basically I look at screens all day and go with my gut”

“He will be with you in just a minute, sit – he’s

still meeting with his architect”