Hedge Funds

Mohammad Ali Saeed

What is hedging?

Simplistic definition to get started:

An investment made in order to reduce the risk of adverse price movements in a security, by taking an offsetting position in a related

security, such as an option or a short sale.

Trivia!

The use of the term "hedge" in the US originally was coined by the agriculture industry. Farmers were the first "hedgers" by selling crops

or cattle yet to be harvested at a price for future delivery.

In doing so, they locked in a price today and were "not exposed" to future market fluctuations.

In essence, they "hedged" their market exposure for the period of time it took them to harvest and deliver their product.

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.

Goal of the fund?

Let’s 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.

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 portfolio’s 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 portfolio’s 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." 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, LBO’s 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

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 Evaluation2. Level of regulatory control3. Basis for Remuneration of Management4. Portfolio Protection5. 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

Questions?