Introduction to Hedge Funds

Hedge funds – a separate asset class?

History, definition and characteristics of hedge funds

Risks, returns, correlations

Benchmarks and long term return outlook

Hedge funds in the context of a traditional investment portfolio


Introduction to Hedge Funds


Alternative investments

Alternative Asset Class Hedge funds Private equity Commodities Credit (HY/ABS/MBS/CDOs) Real estate (resid., comm., infrastr.) Other (insurance, art, hybrids, etc)

Forecasted Demand Growth High High High High High High

Introduction to Hedge Funds


Development of the hedge fund industry, 20% growth pa
1949: A.W. Jones launched the first hedge fund 1967: George Soros started out 2004: Hedge fund industry reached USD 1,000 bn mark 2007: Industry at USD 1,700 bn, managed by 3,000-4,000 HF managers in 10,000-15,000 HFs
$1,800,000 $1,700,000 $1,600,000 $1,500,000 $1,400,000 $1,300,000 $1,200,000
$1,745,214 $1,604,600 $1,464,526

USD 1 bn mark reached Institutional Investors enter LTCM

$1,105,385 $972,608

Assets (In $MM)

$1,100,000 $1,000,000 $900,000 $800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $0 ($100,000) 1990 1991 1992 1993 1994 1995 1996



Fed IR hike

$539,060 $490,580 $456,430 $374,770

$256,720 $185,750 $167,790 $167,360 $126,474 $99,436 $60,222 $73,585 $95,720 $91,431 $70,635 $57,407 $55,340 $58,663 $46,545 $46,907 $38,910 $58,370 $27,861 $36,918 $23,336 $14,698 $4,406 $8,463 ($1,141)











Q1 2007

Q2 2007

Introduction to Hedge Funds Net Ass et Flow Estimated Ass ets

Source: HFR Industry Report 2007 Q2 4

and private partnerships that » use derivatives intensively for hedging or for directional investing » and/or engage in short-selling » and/or use significant leverage through borrowing.” “NEW” definition of hedge funds Active.Hedge funds are a kind of progressive mutual funds “OLD” definition of hedge funds “All forms of investment funds. absolute return oriented investment funds Introduction to Hedge Funds 5 . companies.

albeit improving Introduction to Hedge Funds 6 .Hedge funds are more flexible than mutual funds Specific hedge fund characteristics Active management. markets. own money invested Infrequent liquidity and redemption dates High minimum investment levels Limited regulation and transparency. asset classes. and instruments Performance fee. take advantage of market inefficiencies Focus on absolute performance and risk management Great flexibility reg. trading styles.

It is important to distinguish between FoHFs and HFs ‘Hedge funds‘ Funds of hedge funds Hedge funds HF1 HF2 HF3 HF n Introduction to Hedge Funds 7 .

SICAV Unit trust Other Principal protected note Index certificate (fund-linked note) Call option Total return swap CFO Convertible Reinsurance-linked note Introduction to Hedge Funds 8 .Commonly used legal structures Fund of funds Hedge fund Managed account Investment fund Structured product Offshore limited co. US limited partnership Swiss mutual fund Swiss participation co.

Typical offshore structure of a fund of funds Investor Sponsor Auditor Fund of Funds Ltd. Administrator Investment Manager Investment Advisor Custodian Hedge funds Introduction to Hedge Funds 9 .

Typical offshore structure of a hedge fund Investor Auditor Hedge Fund Ltd. Administrator Investment Manager/Sponsor Investment Advisor Prime Broker Securities Execution Brokers Introduction to Hedge Funds 10 .

directors. and several share classes Holder of the non-voting. non-participating shares Investment Manager Discretionary portfolio manager.The role of the different counterparties Hedge Fund Ltd Offshore company with articles of association. typically onshore Auditor Audits the balance sheet and P&L Introduction to Hedge Funds 11 . typically offshore Investment Advisor Non-discretionary ‘advisor’. participating shares Investor Sponsor Holder of the voting.

The roles of the prime broker and the administrator Prime broker Stock lending and repos Leverage Custody of portfolio securities and cash Trade execution and settlement Back office facilities Office space Legal assistance for set up Marketing support („capital introduction“) Administrator Independent NAV calculation Handling of subscriptions and redemptions Introduction to Hedge Funds 12 .

Hedge Fund Portfolio Ltd.Master-feeder structures US investors Offshore investors EU investors Hedge Fund LP Hedge Fund (Cayman) Ltd. Hedge Fund (Dublin) Ltd. Introduction to Hedge Funds 13 .

Harcourt estimates Introduction to Hedge Funds 14 .Cayman and the US are the most popular hedge fund domiciles Hedge Fund Domiciles Channel Islands 3% Luxembourg 2% Dublin 4% Bahamas 2% Bermuda 8% BVI 9% Sweden 1% Other 7% US 30% Cayman Islands 34% Data: HFR.

but Europe and Asia are growing faster Hedge Fund Management Company Locations Asia 10% Greater NY 36% Other Europe 8% London 18% Other US 28% Data: Harcourt estimates Introduction to Hedge Funds 15 .2/3 of hedge fund managers are based in the US.

Roughly 20% of all assets invested in hedge funds come out of Switzerland (directly & indirectly) Hedge Fund Asset Origins Other 25% USA 50% Japan 5% Switzerland 20% Data: Harcourt estimates Introduction to Hedge Funds 16 .

Hedge funds – a separate asset class? History. returns. definition and characteristics of hedge funds Risks. correlations Benchmarks and long term return outlook Hedge funds in the context of a traditional investment portfolio Conclusions Introduction to Hedge Funds 17 .

Long/Short Sectors 21. Distressed Securities Directional Equity Strategies: 15. Convertible & Volatility Arbitrage 12. Structured Equity Linked 13. Energy Trading 27. Long/Short Credit 7. Multi-Strategy Equity 10. Long/Short Global Equity 16. Fixed Income Arbitrage 3. Long/Short European Equity 18. Global Macro 31. Emerging Markets Debt Directional Multi-Asset Class Strategies: 28. LT Trend-Following CTAs 29. Asset-Based Lending Directional Fixed Income Strategies: 5. Long/Short US Equity 17. Long/Short Rates 6. ST Systematic Trading CTAs 30. Short-Biased Equity Directional Commodity Strategies: 24. Multi-Strategy Commodity 23. Metals Trading 25. Multi-Strategy Fixed Income Equities Relative Value Equity Strategies: 9. ABS & MBS 4.Harcourt strategy classification framework Fixed Income Relative Value Fixed Income Strategies: 1. Market Neutral Equity Commodities Relative Value Commodity Strategies: 22. Relative Value Energy Relative Value 2. Insurance-Linked Introduction to Hedge Funds 18 . Power & Emissions Trading Directional 8. Agricultural Trading 26. Long/Short Japanese Equity 19. Long/Short EM Equity 20. Event Driven Equity 11. Statistical Arbitrage 14.

Harcourt estimates Introduction to Hedge Funds 19 .Long/short equity is the most popular hedge fund strategy Hedge fund strategies (by # of funds) CTAs & Macro 14% Directional Fixed Income 6% Relative Value Fixed Income 6% Relative Value Equity 26% Hedge fund strategies (by AUM) CTAs & Macro 22% Long/Short Equity 39% Long/Short Equity 48% Directional Fixed Income 8% Relative Value Fixed Income 5% Relative Value Equity 26% Data: HFR.

interest rate duration. ‘key people‘ risk. credit spreads. realized and implied volatilities Amplification effect. style drift. funding/margin call risk Bid-ask spread risk. back office risk. legal risk Strategy risks: Leverage: Liquidity risks: Valuation risks: Company risks: Introduction to Hedge Funds 20 . independent valuations Growth of AUM.Most important hedge fund risks Market risks: Stock market beta. specific strategy risks eg merger deal breaks. capacity. investor redemption risk Mark-to-market risk. trends/market patterns. spreads. mortgage prepayments. FX movements Supply/demand in each strategy eg inefficiencies.

7.0 : 1) Introduction to Hedge Funds 21 .2.0 : 1) Most long/short equity funds Most long/short credit funds Merger arbitrage Moderate leverage (2.Leverage: many hedge fund strategies are not or only moderately leveraged No leverage (0 .0 .20.1.0 : 1) Convertible arbitrage Statistical arbitrage CTAs Mortgage-backed securities arbitrage Fixed income arbitrage High leverage (8.1 .0 : 1) Some long/short equity funds Distressed securities Short-biased equity Low leverage (1.0 .

short delta stocks. 5% cash => net long exposure of 95% => leverage of 0. short exposure 200% => leverage of 4. short interest rates.0:1 800% long bonds. short credit => net long exposure of 0% => leverage of 6.0:1 20% margin in long and short futures positions => long exposure 200%.95:1 Long/Short US Equity Hedge Fund: 85% long stocks. 800% short bonds => net long exposure of 0% => leverage of 16.3:1 US Convertible Arbitrage Fund: 300% long convertibles.Leverage vs. market exposure: are hedge funds riskier than traditional mutual funds? Swiss Stocks Mutual Fund: 95% long stocks. as well as basis risk and other risks Introduction to Hedge Funds 22 . 45% short stocks => net long exposure of 40% => leverage of 1.0:1 Fixed Income Arbitrage Fund: CTA: => Conclusion: leverage should always be considered in connection with actual market risk exposure.

Aug 2007 23 .Hedge funds have performed similar to stocks and bonds over the last ten years 16% 14% Distressed 12% Merger Arb 10% CV Arb Return pa L/S Equity Sector Hedge Fund Index EM Macro MBS FI HY Fund of Funds 8% MN Equity JPM MSCI World 6% FI Arb CTAs 4% 2% Short 0% 0% 5% 10% Standard deviation pa 15% 20% 25% Introduction to Hedge Funds Data: HFR HF. Barclay CTA Indices 1994 .

Barclay 24 .All hedge fund strategies have outperformed stocks since January 2000 250 200 150 100 50 Mar-00 Jun-00 Mar-01 Jun-01 Mar-02 Jun-02 Mar-03 Jun-03 Mar-04 Jun-04 Mar-05 Jun-05 Mar-06 Jun-06 Mar-07 Dec-99 Sep-00 Dec-00 Sep-01 Dec-01 Sep-02 Dec-02 Sep-03 Dec-03 Sep-04 Dec-04 Sep-05 Dec-05 Sep-06 Dec-06 Jun-07 Sep-07 MSCI World $ MBS HFR HF Index Merger arb CV arb Sector Distressed Short-selling Eq hedge CTAs FI arb Funds of funds Introduction to Hedge Funds Data: HFR.

71 1.55% 5.74 0.73% 4.37% 5.08% 5.31% 7.09% 7.53% 10.19% 7.89% 7.62% 3.51% 5.15% 7.81% 1.02 0.89% 9.54% 1.73 0. Barclay Introduction to Hedge Funds 25 .71 0.74% 11.87% 6.88% 5.41% 20.50 0.41% 5.78% 9.80% 0.77% 7.97% 6.74% 8.39% 13.31 Data: FTSE.18% 3.61% 15.33% 6.47% 4.98% 3.29% 12.46% 8.61% 5.71% 7.05 -0.05% 10.10 0.38% 7.27 0.15% 6.35% 5.39% 7.23% 18.57 0.Each strategy has a different risk/return profile HFRI FoF Index (non-investable.29 0.36% 10.49% 8.82% 6.00 -0.16% 4.68% 3.32 0.49% 2.54% 1. net) Long/short equity Sector specialists Event driven Distressed securities Emerging markets Merger arbitrage Macro Relative value arbitrage MBS arbitrage Convertible arbitrage Market neutral equity Statistical arbitrage High yield Fixed income arbitrage CTAs Short-selling MSCI World JPM Global Bonds 2007 July YTD Est.69% 2.89% Corr MSCI 2000-2007 0. gross) CSFB/Tremont HFs (investable.57% n/a n/a 14.58% Ret pa 1994-2007 7.50% 4.90% Ret pa 2000-2007 6.08% 5.79% 7.76 0. 8.48% 7.20% 5.04% 1.62% 12.13 -0.87% 2.20% 12.83% 7.98% 13.46 0.50% 2. HFR.37% 7.67% 2.39% 3.65% 8.59% 6.88% 5.71% Stdev pa 2000-2007 4.10% 5.09 -0.77% 13. net) HFRI Global HF Index (non-investable.27% 6. gross) FTSEhx (investable.27% 2.30% 9.46 0.28% 5.31% 7.59 0.02% 8.04% 13.66 0.49% 1.48% 0.17% 9.40 0.29% 5.72% 3.

5% 0.2% 30% 23.2% -20% -19.0% 14.3% -17.6% -40% HFR Fund of Funds Index HFR Composite Index CSFB/Tremont HF Index CTA s HFR Long/Short Equity Index MSCI World (USD) S&P 500 NA SDA Q Composite SPI (CHF) JP Morgan Global Bond Index (USD) Pictet (CHF) Data: HFR.7% 0% -2.2% 10% 3.4% Light colors: 1/1994-3/2000 Dark colours: 4/2000-3/2003 -17.4% 7.5% 17.6% 6.2% 8.1% 16.5% 20% 10.0% 17. Barclay Introduction to Hedge Funds 26 .4% 5.8% 20.1% 6.7% -10% 0.5% 4.4% -30% -33.Hedge funds preserve capital in bad times 40% 33.

Aug 2007 27 .Low cross-correlations permit efficient portfolio diversification Introduction to Hedge Funds Data: HFR HF. Barclay CTA Indices 1994 .

20% Single manager managed futures 100 largest U.Diversification lowers risk The optimal number of funds seems to be between 15 and 30 However. HFR. MSCI 28 . stocks Single manager hedge funds 15% 10% 5% 0% 0 5 10 15 20 25 30 Number of funds/programs/stocks Note: Attrition rate of HFs is similar to attrition rate of mutual funds Introduction to Hedge Funds Data: TASS. depending on the investor‘s specific utility curve (eg single HF fall out risk) the number may be significantly higher 25% Standard deviation p.S.a.

40 -0.80 -1.60 -0.00 0.60 0.20 -0. . Other strategies are less correlated. 40%).40 0.00 M-90 M-91 M-92 M-93 M-94 M-95 M-96 M-97 M-98 M-99 M-00 M-01 M-02 M-03 M-04 M-05 M-06 M-07 Data: HFRI Introduction to Hedge Funds 29 1 2-mo nth ro lling correlatio n to glo bal sto cks 1 2-mo nth ro lling correlatio n to glo bal bo nds The high correlation to the MSCI World is mostly driven by the large amount of long-biased long/short equity hedge funds (appr.00 -0.The selection of the right hedge fund strategy is crucial to achieve a low correlation to stock and bond portfolios Correlation between FoHF composite and MSCI World.80 0. JPM Global Bonds 1.20 0.

correlations Benchmarks and long term return outlook Hedge funds in the context of a traditional investment portfolio Conclusions Introduction to Hedge Funds 30 .Hedge funds – a separate asset class? History. returns. definition and characteristics of hedge funds Risks.

hedgefundresearch. 10 FTSE Hedge Equal weighted.hedgeindex.djindexes. invested in 40 HFs Dow Jones www. invested in 138 HFs MSCI Introduction to Hedge Funds 31 .ftse.msci. 8 strategies. invested in 60 HFs Equal weighted. invested in 80 HFs Asset-weighted.Investable hedge fund indices CSFB Tremont Complex weighting. 5 non-directional strategies. 8 strategies. 1 directional. 8 strategies. invested in 32 HFs Triple investibility HFR X www.

18 strategies (2. 17 strategies ( Equal-weighted HFRI Index and 32 HF sub indices (1.barclaygrp.080 CTAs) Asset-weighted HF Index and 13 HF sub-indices (434 HFs) Several industry indices www.eurekahedge.Non-investable hedge fund indices Barclay Trading Group CSFB/Tremont Eureka Hedge Equal-weighted Several industry indices MSCI www.700 HFs) Hedge Fund Research InvestHedge www.800 HFs) Introduction to Hedge Funds 32 .com Equal-weighted and asset-weighted indices.hedgeindex.

Funds of funds have underperformed the HF index 16% 14% Distressed 12% Merger Arb 10% CV Arb Return pa L/S Equity Sector Hedge Fund Index EM Macro MBS FI HY Fund of Funds 8% MN Equity JPM MSCI World 6% FI Arb CTAs 4% 2% Short 0% 0% 5% 10% 15% 20% 25% Standard deviation pa Data: HFR HF.Aug 2007 Introduction to Hedge Funds 33 . Barclay CTA Indices 1994 .

low barriers to market entry Introduction to Hedge Funds 34 .0% to 4.Possible explanations for the perceived underperformance of funds of funds •Fund of fund fees (average management fee of 1.0% pa) •Bull market bias of hedge fund indices (40-50% of hedge funds do long/short equity) •Poor selection.5%) •Survivorship and selection bias disregarded in hedge fund indices (estimates range from 1.25% and average performance fee of 12.

TASS.10000 1000 100 Dec-85 Jun-86 Dec-86 Jun-87 Dec-87 Jun-88 Dec-88 Jun-89 Dec-89 Jun-90 Dec-90 Jun-91 Dec-91 Jun-92 Dec-92 Jun-93 Dec-93 Jun-94 Dec-94 Jun-95 Dec-95 Jun-96 Dec-96 Jun-97 Dec-97 Jun-98 Dec-98 Jun-99 Dec-99 Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 MSCI World Index JPM Global Bond Index Hedge Fund Composite Index Hedge funds are hedged and provide an asymmetric return profile Introduction to Hedge Funds Data: Harcourt. HFR. Barclay 35 .

ie market inefficiencies and supply/demand imbalances Expected long term returns: Libor + 500 pa Introduction to Hedge Funds 36 .Long term hedge fund return outlook Hedge fund returns are a function of: l Stock market returns l Libor and bond rates l Market liquidity l Strategy alpha.

returns. definition and characteristics of hedge funds Risks. correlations Benchmarks and long term return outlook Hedge funds in the context of a traditional investment portfolio Conclusions Introduction to Hedge Funds 37 .Hedge funds – a separate asset class? History.

Hedge funds are the perfect diversification tool for a traditional stock/bond portfolio Addition of hedge funds to a 50% stock and 50% bond portfolio results in lower risk/higher return portfolio 10% HFRI FoF Index MSCI World $ Return pa JPM Global Bonds $ 5% 0% 0% 4% Standard deviation pa Introduction to Hedge Funds 8% 12% Data: 1994-Aug 2007 38 .

00 0.20 0.60 0.40 0.20 0.Aggressive or conservative? Trade-off of equity correlation vs returns Fund of funds performance 20% 18% 16% 14% Aggressive FoF “Equity surrogate“ Net return pa 12% 10% 8% 6% 4% 2% 0% -0.80 1.00 Conservative FoF “Bond surrogate“ Correlation to S&P 500 Data: Altvest. Jan-94 to Dec-99 Introduction to Hedge Funds 39 . S&P.

There are two types of hedge fund investors Two types of investors Type A: HFs as a separate asset class • Diversification Type B: HFs as an active overlay to a passive portfolio • Passive Index + HFs = Active Introduction to Hedge Funds 40 .

portable alpha/overlay. PE. ABS. ETFs.Type A – Driven by „Core-Satellite“ investment approach Core portfolio: PASSIVE Major developed stock and bond markets (large caps) Satellite portfolio: ACTIVE HFs. high yield. small caps. real estate Indices. EM. hedge funds Introduction to Hedge Funds 41 . passive mandates Active long-only mandates/funds. tracker funds.

Type B – Driven by paradigm shift in the asset management industry Past 8% Present 10% Future Passive beta strategies 35% 90% 85% Active long only (beta) strategies 50% 2% 5% Active alpha 15% Beta will increasingly be bought cheaply through passive instruments (ETFs. indices) The importance of Alpha as a portfolio component will likewise increase Data: Man Investments Introduction to Hedge Funds 42 .

Speed and size . Structural alpha = free option due to structural advantages: .Stock market beta . Skill alpha = only few really skilled managers: .BARRA factors .Portfolio mgt .Spread risks .Liquidity risks .Prepayment risk etc. .Merger deal risk . Passive Active The source of returns varies significantly across the different HF styles.Regulatory constraints .Credit spreads .Analysis . HF strategies and HFs … and varies over time ! Copyright: Harcourt Research Introduction to Hedge Funds 43 .Risk mgt etc.Trend-following etc.Informational barriers .Interest rate duration .Structural inefficiencies .Volatility and correlations .Currencies etc.Hedge fund returns – Alpha oder beta? Hedge fund returns = Traditional betas + alternative betas + structural alpha + skill alpha Traditional beta = directional risk premia: Alternative beta = Directional and demand/supply premia: .

The asset management industry of the future ⇒ Hedge funds will become mainstream ⇒ Traditional and alternative asset management industries will merge ⇒ Seggregation of the traditional value chain: BETA exposure via low-fee index certificates. ALPHA (and Alternative Beta) via high-fee hedge fund-like investment vehicles Introduction to Hedge Funds 44 .

definition and characteristics of hedge funds Risks. returns.Hedge funds – a separate asset class? History. correlations Benchmarks and long term return outlook Hedge funds in the context of a traditional investment portfolio Conclusions Introduction to Hedge Funds 45 .

unbiased investing Transparency and regulation improving on the back of increasing institutionalisation => Hedge funds belong in every diversified investment portfolio => Demand for hedge funds will remain high.Why hedge funds ? Superior risk-adjusted returns in bear and bull markets Low to moderate correlation to traditional asset classes Asymmetric return distribution – downside protection Access to some of the best talent in financial markets Highly sophisticated. and hedge funds will become mainstream Introduction to Hedge Funds 46 .

There can be no assurance that the advice or information provided above will lead to superior performance.Disclaimer An investment in an alternative investment carries substantial risks. Investors bear the risk of losing all or part of their investment and thus should carefully consider the appropriateness of such investments for their portfolio. Past performance is not necessarily indicative of future performance. In particular. and it should not be relied on as such. The nature and extent of some of these risks differ from traditional investments in stocks and bonds. no representation is made as to its accuracy or completeness. the performance of an alternative investment may vary substantially over time. While the information contained in this document has been obtained from sources deemed reliable. Introduction to Hedge Funds 47 .

harcourt.Contact Harcourt Investment Consulting AG Stampfenbachstrasse 48 8006 Zürich .ch Introduction to Hedge Funds 48 .Switzerland Contact us: Tel: +41 (0)44 365 1000 Fax: +41 (0)44 365 1001 To access Harcourt research and educational material please visit: www.