Hedge Funds

Some Information
y Hedge funds mark best returns in 10+ years. Hedge fund

performance double digit through Q3, 2009, on average 1216% according to various hedge fund tracking indices. Industry assets grew by $100B in Q2. Approximately half of funds underwater have now reached their high-water mark. y About 200 hedge funds left with $1 billion or more, controlling app of assets About 115 fund of funds with $1billion+ in assets, down from about 165 Consolidation of assets for fund of funds as well as redemptions continue, with 42 of 50 largest fund of fund assets dropping, $150 billion in redemptions in 08, 09. Top 10 new fund launches represent app 82% of new fund assetsYTD (Absolute Return).

Some Information
y While some hedge funds have reshaped their areas of

investment focus most have returned to their core areas of expertise and shed non-core assets/positions y Hedge funds have meanwhile suffered in terms of reputation due to investor redemptions and suspensions, gating, as well as how they marketed themselves

What are Hedge funds?

y A hedge fund is a term commonly used to describe any fund

that is not a conventional investment fund, i.e. it uses strategies other than investing long. y Hedge funds are unregistered private investment partnerships, funds or pools that may invest and trade in many different markets, strategies and instruments (including securities, non-securities and derivatives) and are not subject to the same regulatory requirements as mutual funds.

What are Hedge funds?

y The name hedge fund is a misnomer as the funds may not actually

hedge against risk. The returns can be high, but so can be losses. These investments require expertise in particular investment strategies. Usually, hedge funds: y Are organized as private investment partnerships or offshore investment corporations. y Use a wide variety of trading strategies involving position-taking in a range of markets. y Employ as assortment of trading techniques and instruments, often including short-selling, derivatives and leverage.

What are Hedge funds?

y Type of investors: Since they follow an extremely risky

philosophy, not suitable for small investors. These are meant for large, seasoned investors who are expected to understand risks being undertaken y Minimum investment limit: Exclusively favoring the crme de la crme, the usual minimum investment amount is Rs 100 lac in India and USD $ 1 million in world. y Not more than 100 investors allowed

Characteristics of Hedge Funds

y Hedge funds charge a performance fee y Hedge funds use leverage y Hedge fund managers invest in their own funds y Hedge fund managers aim for absolute returns y Hedge fund managers use derivatives y Minimum investment is usually high y Pension funds, endowments, insurance companies, private

banks and high net worth individuals and families invest in hedge funds y Hedge funds are based offshore

Structure of a typical Hedge fund

Participants
y Investment manager: Play the role of investment advisor.

Investment manager provides clarification to the investor on any matter related to hedge fund investment. y Fund administrator: Primarily responsible for processing investor's subscriptions and redemption. They may be an individual or a group of persons. Also calculate the value of investor's holding. y Prime brokers: Offer diverse range of services including: financing, clearing and settlement of trades, custodial services, and operational support facilities . Prime brokers help fund manager or investment manager to decide on allocation of investment funds to different brokers. There can be overlapping of roles and responsibilities with fund administrators. But prime brokers bring in investment and operational perspective to hedge funds.

Participants- Prime broker

y The bulk of prime brokers income comes from cash lending

to support leverage and stock lending to facilitate short selling y According to Eurekahedge, JP Morgan, Morgan Stanley and Goldman Sachs were the largest prime brokers in 2008 in terms of the number of clients, each accounting for around 10% of the market. y Major restructuring occurred amongst prime brokers during 2008 including the acquisition of Bear Stearns by JP Morgan, the takeover of Lehman Brothers by Barclays Capital and the acquisition of Merrill Lynch by Bank of America

Participants
y Custodian: The financial entity that holds hedge fund assets.

This includes cash in the fund as well as securities. Custodians may also control flow of capital to meet margin calls.
y Transaction broker: All investment activities are executed

through the transaction broker.

Typical Process in hedge funds

Investor chooses and decides hedge fund investment Subscription amount is paid to the custodian. Custodian confirms receipt of payment to fund administrator. Fund administrator instructs issue of share to investor. Fund administrator issues reports on hedge fund performance. Investment manager instructs custodian to move funds to prime broker for investment in market. During the process the prime broker and custodian are in direct contact with fund administrator.

Composition of Hedge funds- by source of capital

Management location of global hedge fund assets

Global Hedge fund

Difference- Hedge fund and mutual Fund

y Performance Evaluation

Hedge fund: make absolute profits. It is always on the lookout for special situations, and short term opportunities which offer the possibility of large or at least certain absolute returns. Mutual fund: Outperform a certain benchmark index. Mutual funds are measured on relative performance compared to a relevant index or to other mutual funds in their sector

Difference- Hedge fund and mutual Fund

y Regulation:

Mutual Fund: Regulated by SEBI.  Have to comply with several regulations regarding issue and redemption of units, observe high standards regarding disclosure of portfolios, valuation on investments etc.  Disclosure to shareholders of specific information about the fund's management, holdings, fees and expenses, and performance.  Not usually allowed to short sell (although they can use derivatives for hedging). Hence they cannot take full advantage of a bear market. Hedge fund: not subject to regulation imposed on a mutual fund.  A large number of hedge funds are not registered with the Securities Exchange Commission.  The reporting standards currently followed by such funds are more a function of competitive pressures rather than regulatory fiat. Hence such funds enjoy more flexibility.

Difference- Hedge fund and mutual Fund

Investor profile y Hedge funds-Only high net worth individuals are permitted to invest in. The threshold in the USA is around USD 1 million and in India is Rs 100 lack y Mutual funds: have been positioned as the best vehicle for the common investor. Threshold level is kept at a very low amount.

Difference- Hedge fund and mutual Fund

y Fee structure

Mutual Fund: managers are paid based on a % of AUM Hedge Fund: managers are paid performance-related incentive fees plus a fixed fee manager.  They takes a fee of 1 or 2 percent of net assets, plus 20 percent of annual return.  May also earn their fees only if they earn profits beyond a certain pre-agreed threshold. This is known as Watermarking.

Difference- Hedge fund and mutual Fund

y Leveraging Practices

Mutual Fund: SEBI severely restricts a mutual fund's ability to leverage or borrow against the value of securities in its portfolio. Hedge Fund: Leveraging and other higher-risk investment strategies are a hallmark of hedge fund management.

Difference- Hedge fund and mutual Fund

y Pricing and Liquidity

Mutual funds: are required to value their portfolios and price their securities daily based on market. Mutual funds also are required by law to allow shareholders to redeem their shares at any time (except in case of mandatory lock-ins imposed in the case of certain fund schemes). Hedge Funds: There are no specific rules governing hedge fund pricing. Hedge fund investors may be unable to determine the value of their investment at any given time.

Styles of Hedge Funds

y Aggressive Growth: Invests in equities expected to

experience acceleration in growth of earnings per share

y Hedges by shorting equities where earnings

disappointment is expected or by shorting stock indexes y Tends to be "long-biased." y ExpectedVolatility: High

Styles of Hedge Funds (Contd.)

y Distressed Securities: Buys equity, debt, or trade claims at

deep discounts of companies in or facing bankruptcy or reorganization

y Profits from the market's lack of understanding of the true

value of the deeply discounted securities y Majority of institutional investors cannot own below investment grade securities. y Results generally not dependent on the direction of the markets. y ExpectedVolatility: Low - Moderate

Styles of Hedge Funds (Contd.)

y Emerging Markets: Invest in equity or debt of emerging

(less mature) markets which tend to have higher inflation and volatile growth. y Short selling is not permitted in many emerging markets and also stock lending mechanisms are not well developed. y Hence effective hedging is often not possible. y Expected Volatility: Very High

Styles of Hedge Funds (Contd.)

y Funds of Hedge Funds: Mix and match hedge funds and

other pooled investment vehicles

y Blend of different strategies and asset classes aims to

provide stable long-term return than any of the individual funds. y Returns, risk, and volatility can be controlled y Capital preservation is generally important y Volatility depends on the mix and ratio of strategies employed y ExpectedVolatility: Low - Moderate - High

Styles of Hedge Funds (Contd.)

y Macro: Aims to profit from changes in global economies y Typically brought about by shifts in govt. policy that impact

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

Styles of Hedge Funds (Contd.)

y Market Neutral - Arbitrage:The strategy seeks to be beta

neutral, and only generate return from the relative outperformance of the long versus the short positions, regardless of how the market moves y Attempts to hedge out most market risk by taking offsetting positions, often in different securities of the same issuer y Eg. Can be long convertible bonds and short the underlying issuers equity. y Focuses on obtaining returns with low or no correlation to both the equity and bond markets y ExpectedVolatility: Low

Styles of Hedge Funds (Contd.)

y Market Neutral - Securities Hedging: Invest equally in

long and short equity portfolios generally in the same sectors of the market. y Market risk is greatly reduced, but effective stock analysis and stock picking is essential to obtaining meaningful results. y Leverage may be used to enhance returns. Usually low or no correlation to the market. y They sometime use market index futures to hedge out systematic risk. y Expected Volatility: Low

Styles of Hedge Funds (Contd.)

y Opportunistic: Investment theme changes from strategy to

strategy as opportunities arise to profit from events such as IPOs, hostile bids, , sudden price changes often caused by an interim earnings disappointment and other event-driven opportunities. etc. y May utilize several of these investing styles at a given time y Not restricted to any particular investment approach or asset class y ExpectedVolatility: Variable

Styles of Hedge Funds (Contd.)

y Short Selling: Sells securities short, in anticipation of being

able to repurchase them at a future date at a lower price y Result of anticipated overvaluation, earnings disappointments, new competition, change of management, etc. y uses all available techniques , including outright securities shorting, uncovered put options, and occasionally futures shorting. y Often used as a hedge to offset long-only portfolios by those who expect bearish cycle. y ExpectedVolatility: Very High

Styles of Hedge Funds (Contd.)

y Special Situations: Invests in event-driven situations such

as mergers, hostile takeovers, spin-offs, reorganizations etc. y 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 y Results generally not dependent on direction of market y ExpectedVolatility: Moderate

Styles of Hedge Funds (Contd.)

y Market Timing: They allocate assets among different asset

classes depending on the managers view of the economic or market outlook. y Portfolio emphasis may swing widely between asset classes. y Unpredictability of market movements and the difficulty of timing entry and exit from markets add to the volatility of this strategy. y Expected Volatility: High

Styles of Hedge Funds (Contd.)

y Multi Strategy: Investment approach is diversified by

employing various strategies simultaneously to realize short and long-term gains.

y Other strategies may include systems trading such as trend

following and various diversified technical strategies. y This style of investing allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities. y Expected Volatility: Variable

Styles of Hedge Funds (Contd.)

y Value: They invest in securities perceived to be selling at

deep discounts to their intrinsic or potential worth. y Such securities may be out of favour or inadequately followed by analysts. y Long-term holding, patience, and strong discipline are often required until the ultimate value is recognized by the market. y Expected Volatility: Low Moderate

Styles of Hedge Funds (Contd.)

y Income:They invest with primary focus on yield or current

income rather than solely on capital gains. y May utilize leverage to buy bonds and sometimes fixed income derivatives in order to profit from principal appreciation and interest income. y Expected Volatility: Low

Source: Centre for International Securities and Derivatives Market

SEBI Regulations
The Securities Exchange Board of India (SEBI) is concerned about the possibility of unregulated hedge funds investing heavily in the Indian markets and having a material effect on market volatility. Hence they have initiated certain safeguards for the entry of hedge funds in addition to the safeguards normally observed in case of FII registration. Some of these are: y The investment adviser to the hedge funds should be a regulated investment advisor under the relevant Investor Advisor Act or the fund is registered under Collective Investment Fund Regulations or Investment Companies Act.
y At least 20% of the corpus of the fund should be contributed by investors such as

pension funds, university funds, charitable trusts or societies, endowments, banks and insurance companies. y The fund should be a broad based fund as per SEBIs (Foreign Institutional Investors) Regulations.. y The fund manager or investment adviser must have experience of at least 3 years of managing funds with similar investment strategy that the applicant fund has adopted.

Performance Measurement
y Calculation of Returns y Nominal Return y Annualized Return

y Compound Returns

Measures of Investment Risk

y Standard Deviation y Downside deviation

y Largest Losing Month and Drawdown

y Drawdown measures the cumulative loss from the previous high

(Wealth Relative)
y Percent of Months with Losses

Performance Measures
y Sharpe Ratio y Sortino Ratio y Treynor Ratio y Jensens Alpha

y What is the issue if Jensons Alpha is used for performance

measurement

Issue
y Unlike conventional long-only portfolios, many hedge funds

seek returns that are independent of stock and bond returns. It may be misleading to benchmark this type of performance against market returns

Risks and Risk Management

Sources of Hedge Fund Risk

y The securities held by the fund y The presence of leverage y Operational Risks y Misrepresentation of Investments y Misappropriation of funds/general frauds y Unauthorized trading and style breaches y Inadequate resources for fund strategy

Hedge Fund Risks

y People/Operations y Technology y Data/Information

Risk management
y Fixed Income Risk Management
y A hedge fund may use duration to establish a long position in

one bond (short term) and short position in another bond (long term) so that the combination is hedged from changes in rates. y Duration and convexity are used to develop scenarios

Risk management
y Currency Risk Management
y Hedging using Options and other derivatives. y Consolidated positions into two or three currencies Proxy

hedging y Diversification
y Equity Risk Management
y Diversification y Following Established scripts like Nasdaq etc

Risk management
y Value at Risk (VaR)
y Accumulate the risks of the individual positions into normal

distribution y VaR calculations are based on a one-day holding period

y Credit Risk Measurement
y Managed by software Programs y KMV Credit Monitor Moodys

Option Risk Measurement

y DeltaSensitivity to Changes in the Underlying Asset: y GammaSensitivity of Delta to Changes in the Underlying

Asset y ThetaSensitivity to Time to Expiration

Creation of Hedge Fund Portfolio

Perils of Investing with Hedge Funds

y Not required to disclose any information y Most funds have a lock-up period y Investing with managers who turn out to be fraudulent or

incapable

Quantitative analysis
y Filtering through more than 8,000 funds y Return Distribution, Drawdown, Ratios

Qualitative analysis
y Organization y Assets y Portfolio Construction y Risk Management y Fee and Fund structures y Post-Investment due diligence

Thank You!!!!!