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,
 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 Evaluation
2. Level of regulatory control
3. Basis for Remuneration of Management
4. Portfolio Protection
5. 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?