Hedge funds
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Hedge Funds. MII Presentation September 17, 2002 Priyanka Chopra. What is hedging?. Simplistic definition to get started: An investment made in order to reduce the risk of adverse price movements in a security,

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Hedge funds

Hedge Funds

MII Presentation

September 17, 2002

Priyanka Chopra


What is hedging

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

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

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

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

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

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

“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

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 contd1

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 contd2

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 contd3

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 contd4

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 contd5

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 contd6

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 contd7

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 contd8

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 contd9

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 contd10

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 contd11

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 contd12

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

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

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

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:

  • Performance Evaluation

  • Level of regulatory control

  • Basis for Remuneration of Management

  • Portfolio Protection

  • Dependence on Markets


Differences contd

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 contd1

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 contd2

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

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

Questions?


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