FTSE Guide to Hedge Funds

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FTSE Guide to Hedge Funds


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Contents

Background 2

Hedge Funds 6A New Asset Class

Investment Strategy 8Overview

Performance and 12Returns

The Evolution of the 14

Hedge Index

Glossary 16


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Hedge funds are not for the faint-hearted. Or are

they? Hedge funds are not regulated. Or are they?

Hedge funds are more volatile than more traditional

investments. Or are they? Hedge funds are not

accessible for small investors. Or are they? Hedge

fund performances are not measurable. Or are they?

Just a few observations that illustrate the mystique

behind one of the most talked about, but leastunderstood areas in the investment community.

By way of an illustration, the answers to the four

opening statements is that they could all be

perceived to be correct by investors, which goes

some way towards explaining the nature of these

phenomena of the fund management industry.

By investment standards hedge funds are relative

newcomers on the block. The first hedge fund is

accredited to Alfred Winslow Jones who decided in

1949 that he had a better system of managing

money than traditional fund managers. His novel

approach, discovered while researching an article for

his employers at Fortune Magazine, was to hedge

potential risk in his long stock positions by sellingother stocks to offset the impact on his portfolio of

any wider market reversal.

However, like many successful investors before him

and since, he kept his new techniques to himself. It

was not until he was finally outed in 1966 that

investors woke up to the delightful simplicity of

what the by now extremely wealthy Mr Jones had

been doing. Once the news article pointed out that

Background

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in the past year Jones funds had outperformed the

best performing mutual fund by 44% and that over

the previous five years had a return 85% better than

its nearest traditional rival, it wasnt long before

others were rushing to copy him.

Within two years over 200 new hedge funds were

launched including ones by several individuals set to

become legends of the industry, including GeorgeSoros, Warren Buffet and Michael Steinhardt.

However, many of these new hedge fund managers

quickly drifted away from Jones original principles

when they found that allocating a portion of their

assets to short sales weighed heavily on

performance returns during the boom markets of

the late 1960s. This lack of insurance began to be

exposed as markets turned in 1969/70 and

eventually saw many simply close their doors as the

bear market turned into a rout in 1973. This

shakeout served to discourage many new entrants

to this sector, even as markets began to improve

towards the end of the 1970s and by the mid-

1980s research indicated that less than 70 fundswere operating with any conviction.

But the early 1990s brought its rewards for the

survivors, most spectacularly George Soros Quantum

Fund and its forays into the currency market

particularly its aggressive short stance on sterling

that eventually accelerated sterlings exit from the

European Exchange Rate Mechanism in 1992.

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The ability of hedge funds to diversify into new

markets and the advent of new trading tools,

combined with the favourable press the hedge

funds were starting to attract, saw a re-birth of the

industry. By the end of that decade there were an

estimated 4,000 hedge funds in operation.

The onset of another bear market shortly into the

new Millenium once again produced turmoil in the

industry. But the experience of past mistakes,

combined with much more widely diversified

investment strategies both in terms of marketsand more sophisticated instruments/techniques

limited the fallout.

Today there are an estimated 7,000 hedge funds.

Clearly that is too many for the individual to

research and to identify opportunities or risks

even if they had money to invest in these funds.

More recently, fund of funds have been developed

as a means of encouraging smaller investors to

invest in the hedge fund market.

We will look at more specific details of how these

funds operate and their different trading strategies

a little later. However FTSE, a leading index provider,

has launched FTSE Hedge, a hedge fund index thattracks the investable opportunity as it exists today

and in the future. This index provides investors with

a low cost and transparent tool to facilitate hedge

fund investing.

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Hedge Funds A New Asset Class

The specialist nature of hedge funds, in terms of

their relative freedom from regulation, their

exclusive investor profile and the diverse nature

of their investments are the main factors that set

them aside from mutual funds. The other defining

difference is leveraged investment, with hedge

funds openly borrowing (sometimes as much as10 times the pledged investment capital) in order

to be able to dominate some of the investment

opportunities they identify.

A key factor differentiating hedge funds from their

publicly traded mutual counterparts is the

remuneration of the funds partners or managers.

Typically they will keep 20% of the profits, as wellas a management fee that is often 1% or more

annually of the assets under management. Huge

potential rewards, but it also ensures a commitment

to maximise returns for the other investors.

Many classify hedge funds as alternative

investments, in that a typical portfolio looks for

alternatives to traditional long-only positions instocks and bonds. However, while popular

perceptions of hedge funds present them as

high risk high return initiatives, only a small

percentage fit this profile. Many are more

conservative entities looking to maximise only

better than market returns.

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Given the scope available to fund managers a wide

range of strategies are used. Some of the more

popular include: Equity Hedge, Commodity Trading

Association (CTA) / Managed Futures, Global Macro,

Merger Arbitrage, Distressed & Opportunities,

Convertible Arbitrage, Equity Arbitrage and Fixed

Income Relative Value.

Of course, many will be multiples of these and one

individual investment could be defined under several

of the listed headings. One way for an investor to

access a cross section of hedge fund management

strategies is to follow the fund of funds route,

effectively specialist hedge funds that invest in other

individual specialist funds.

More difficult to follow is the way some hedge fund

managers drift away from their original stated

investment mandate, potentially exposing investors

to risk they would prefer to avoid or duplicating

investments held elsewhere. In a mutual fund these

developments would be quickly identified throughthe much more transparent nature of the industry

imposed by strict regulatory control. A fund of funds

manager will be better positioned to keep closer

scrutiny on these possible developments.

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FTSE HedgeIndex

Directional(47%)*

Event Driven(23%)*

Non-Directional(30%)*

Equity Hedge(30%)*

CTA/MF(9%)*

Global Macro(8%)*

Merger Arb(11%)*

Dist & Opps(12%)*

Convertible Arb(7%)*

Equity Arb(8%)*

Fixed Income(15%)*

Investment StrategyOverview

FTSE Hedge comprises twelve indices with Net Asset Value (NAV)

and Gross Asset Value (GAV) for each. The indices are the FTSE

Hedge Index, three Management

Style Indices and eight Trading

Strategy Indices:

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*As at Februaury 2005


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As already identified, hedge funds are primarily

private partnerships to provide maximum flexibility

in constructing a portfolio. They can take both long

and short positions, make concentrated investments,

use leverage, use derivatives, and invest in many

markets. This is in sharp contrast to mutual funds,

which are highly regulated and do not have the

same breadth of investment instruments at theirdisposal. In addition, most hedge fund managers

commit a portion of their wealth to the funds in

order to align their interest with that of investors.

Thus the objectives of managers and investors are

the same, and the nature of the relationship is

(intended to be) one of true partnership. Here are

some examples of the trading tactics employed.

Equity Hedge

These hedge funds consist of a core holding of long

equities hedged at all times with tactical short sales

of stocks and/or stock index options. In addition to

equities, some hedge funds may have limited assets

invested in other types of securities.

Commodity TradingAssociation (CTA) /Managed Futures

Managed futures funds take long and short

positions in liquid financial futures such as

currencies, interest rates, stock market indices andcommodities.

Global Macro

Macro funds make leveraged investments on

anticipated price movements of stock markets,

fixed interest securities, interest rates, foreign

exchange and physical commodities and derivatives

on such instruments. Macro managers employ a

top-down global approach to forecast shifts inworld economies, political fortunes or global supply

and demand for resources, both physical and

financial. They may invest in any markets using

any instruments to participate in expected market

movements.

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Merger Arbitrage

Merger Arbitrage involves investments in event-

driven situations such as leveraged buy-outs,

mergers and hostile takeovers. Normally, the stock of

an acquisition target appreciates while the acquiring

companys stock decreases in value. These strategies

generate returns by purchasing stock of the

company being acquired and in some instances,

selling short the stock of the acquiring company.

Distressed & Opportunities

Distressed Securities strategies invest in, and may

sell short, the securities of companies where thesecuritys price has been, or is expected to be,

affected by a distressed situation. This may involve

reorganisations, bankruptcies, distressed sales and

other corporate restructurings. Depending on the

managers style, investments may be made in bank

debt, corporate debt, trade claims, common stock,

preferred stock and warrants.

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Opportunities involve investing in opportunities

created by significant transactional events, such

as spin-offs, mergers and acquisitions, bankruptcy

reorganisations, recapitalisations and share

buybacks. Instruments include long and short

common and preferred stocks, as well as debt

securities and options.

Convertible ArbitrageConvertible Arbitrage involves purchasing a portfolio

of convertible securities and hedging a portion of

the equity risk by selling short the underlying

common stock. Managers may also seek to hedge

interest rate exposure under some circumstances.

Equity ArbitrageThe Equity Arbitrage strategy is a market neutral

strategy that seeks to profit by exploiting pricing

inefficiencies between related equity securities,

neutralising exposure to directional market risk by

combining long and short positions in broadly equal

amounts.

Fixed Income Relative ValueFixed Income Relative Value is a market neutral

hedging strategy that seeks to profit by exploiting

pricing inefficiencies between related fixed income

securities while neutralizing exposure to interest

rate risk. Managers attempt to exploit relative

mispricing between related sets of fixed incomesecurities. The generic types of fixed income hedging

trades include: yield-curve arbitrage, corporate

versus Treasury yield spreads, municipal bond versus

Treasury yield spreads and cash versus futures.

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Spectacular is a word used regularly when

discussing hedge funds performance, both on the

upside and the reverse. Certainly the long-term

performance of the entire hedge fund universe

stands up to scrutiny when compared with Equity

Mutual Funds or for equity benchmarks.

But it is also well known that there have been some

high profile failures, often with far-reaching

consequences as in Long Term Capital Managements

demise in 1998. According to some estimates around

a fifth of all hedge funds failed in 2002. However, this

does not seem to have deterred those who specialise

in the industry with the total number of funds

continuing to grow. It should also be remembered

that spectacular failure is not something unique to

hedge funds in the financial services universe, as all

investment styles have been subject to their share of

unwanted scrutiny in recent years.

Total funds under management in hedge funds are

now estimated to exceed $750 billion worldwide

(though by comparison little more than 10% of that

in mutual funds) in some 7,000 funds. In fact at the

current rate of expansion growing more than

sixfold in Europe in the past 5 years the total undermanagement will exceed $1 trillion by the end of this

decade. For example, new legislation became law in

Germany from the start of 2004 and many expect

this to herald a new wave of hedge fund expansion

in Europe.

The different strategies outlined in the previous

section are obviously weighted to encompass

completely different investment scenarios and will

therefore mirror risk to reward. This is another

reason why some of these specialist funds are left

to specialist or professional investors who have the

supporting capital to absorb downside risk.

Evening out returns across the hedge fund investmentspectrum leads back to the fund of funds approach,

something which an investable index like FTSE

Hedge is aiming to approximately replicate. These

fund of funds broadly fall into three categories:

Very Conservative, Moderately Conservative and

More Aggressive.

Performanceand Returns

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A very conservative fund of funds will target returns

of 8-12% and will contain many market neutral

hedge funds that exhibit a very low correlation to the

underlying markets. In other words the investment

intention is to remove market volatility.

A moderately conservative fund of funds will target

12-17% returns over a pre-determined multi-year

strategy. These will combine a selection of market

neutral funds with a smattering of other higher risk

strategies.

A more aggressive fund of funds will still only aim

for returns of 15-20% as it will still be aiming to have

a lower-than-market statistical risk. However, it will

contain a higher weighting of funds that are more

closely correlated with the markets.

Something to take into consideration when

examining hedge fund performance is whether

returns are net of fees, or calculated prior to fees.

Many funds report performance numbers before fees

are extracted, which can distort numbers greatly in

the funds favour. This is key, as a positive month can

instead turn negative when fees are factored in

and we have already emphasised the much higher

level fees awarded.

The next factor when judging hedge fund

performance is how returns are classified, with some

of the basic breakdowns used in the industry being:

pro forma, managed account, estimated, confirmed,

and audited.

Hedge fund performance that is pro-forma basically

means the numbers have one or more assumptions

or hypothetical conditions built into the data. So if in

a fund of funds there are ten funds that are planned

to be invested in, and the data is compiled for thelast year from those funds, the numbers would be

classified as pro-forma. These are not actual returns,

just hypothetical ones generated through a test.

This is just one example of where the lack of

transparency in the hedge fund sector places a

much greater onus on the individual investor thanhe would have to be aware of if purely investing in

traditional markets.

For this reason, many consider the fund of funds

route as the most accessible. Due diligence, allocation

of percentages, monitoring of existing investments

and searching for new opportunities becomes a full

time job and a difficult one. Most investors are not

able to perform all these tasks and that is why the

fund of funds phenomenon has grown significantly

over recent years.

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Hedge funds might have been conceived in the late

1940s and seen a boom in interest in the late 1960s,

but there hadnt been much of an attempt to

measure them as an industry until the 1980s.

Research became more sophisticated over the next

decade, by which time some rudimentary regular

analysis and specialised indices started to emerge.It was well into the early part of the new Millennium

before investable indices arrived.

The launch of FTSE Hedge brings not only the

experience of the worlds leading index provider

to this sector, but also a discipline in index

management that prevents style drift and enables

accurate tracking.

The design of FTSE Hedge provides investors with a

low cost, transparent view of the investable hedge

fund market by presenting a series that reflects the

aggregate risk and return characteristics of the

open, investable hedge fund universe.

To ensure the highest quality funds are included

there is daily risk monitoring and evaluation of

underlying funds, as well as a qualitative due

diligence overlay process. The aim of these activities

is to improve transparency and increase investor

confidence.

The Evolution of theHedge Index

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In the absence of more formal regulatory

stipulations, FTSE sets the following criteria for

index eligibility:

Have independent audited financial statements

Have at least $50 million of unleveraged assets

under management

Have a minimum 2-year track record at the timeof the annual review

Have monthly reporting with a minimum of

quarterly liquidity screening

Be open to new investor subscriptions as well as

having significant remaining investment capacity

The methodology behind construction of the index

include:

Base universe of 6,000 funds established from

various databases and industry sources

Classification on basis of strategy and other

criteria down to 250 funds

Constituent selection using mathematical

sampling to reduce to 75 funds

Final committee due diligence to filter to eventual40 constituents

Apart from full scale annual reviews, including

background checks and interviews, there is daily

monitoring of each constituent hedge fund for the

purposes of portfolio risk, position risk and most

importantly, for any breaches of individual fund

investment restrictions and guidelines.

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All industries have a range of specialist language, or

jargon, used to denote specific terms or actions. It is partlyan industry shorthand and partly maintains a feeling of

exclusivity. The hedge fund sector is no different. Here are

a few of the key words and phrases, with the restatement

of a few others in context which can also be used in the

hedge fund industry. We have excluded those that

specifically refer to investment strategies mentioned earlier.

Measures the value a fund manager produces, bycomparing performance to that of a risk-free investment

(Treasury bills). For example, if a fund had an alpha of 1.0

during a given month, it would have produced a return

during that month that was one percentage point higher

than the benchmark Treasury. Alpha can also be used as a

measure of residual risk, relative to the market in which a

fund participates.

Gauges the risk of a fund by measuring the volatility of its

past returns in relation to the returns of a benchmark. A

fund with a beta of 0.7 has experienced gains and losses

that are 70% of the benchmarks changes. A beta of 1.3

means the total return is likely to move up or down 30%

more than the index. A fund with a 1.0 beta is expected to

move in tandem with the index.

A hedge fund or open-end mutual fund that has at least

temporarily stopped accepting capital from investors,

usually due to rapid asset growth. Not to be confused with

a closed-end fund.

Glossary

Alpha

Beta

Closed fund

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The percentage loss that a fund incurs from its peak net

asset value to its lowest value. The maximum drawdown

over a significant period is sometimes employed as a means

of measuring the risk of a vehicle. Usually expressed as a

percentage decline in net asset value.

An investment vehicle consisting of shares in hedge funds

and private equity funds. Some of these multi-manager

vehicles limit holdings to specific managers or investment

strategies, while others are more diversified. Investors in

funds of funds are willing to pay two sets of fees, one to

the fund of funds manager and another set of (usually

higher) fees to the managers of the underlying funds.

The individual or firm that organises and manages a limited

partnership, such as a hedge fund. The general partner

usually assumes unlimited legal responsibility for the

liabilities of a partnership.

A provision to ensure a fund manager only collects

incentive fees on the highest net asset value previouslyattained at the end of any prior fiscal year - or gains on

actual profits for each investor. For example, if the value of

an investors contribution falls to $750,000 from $1 million

in the first year and then rises to $1.25 million in year two,

the manager would only receive incentive fees from that

investor on the $250,000 that represented actual profits in

year two.

The minimum return necessary for a fund manager to start

collecting incentive fees. The hurdle is usually tied to a

benchmark rate such as Libor or the one-year Treasury bill

rate plus a spread. If the manager sets a hurdle rate equal

to 5% and the fund returns 15%, incentive fees would

only apply to the 10% above the hurdle rate.

Drawdown

Fund of funds

General partner

High-water mark

Hurdle rate

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The charge - typically 20% - that a fund manager assesses

on gains earned during a given 12 month period. For

example if a fund posts a return 40% above its hurdle rate,

the incentive fee would be 8% (20% of 40%) - provided

that the high-water mark does not come into play.

The borrowed money that an investor employs to increase

buying power and increase its exposure to an investment.

Users of leverage seek to increase their overall invested

amounts in hopes that the returns on their positions will

exceed their borrowing costs. The extent of a funds

leverage is stated either as a debt-to-equity ratio or as a

percentage of the funds total assets that are funded by

debt. Leverage can also come in the form of short sales,

which involve borrowed securities.

Many hedge funds are structured as limited partnerships,

organisations managed by one or more general partners

who are liable for the funds debts and obligations. The

investors in such a structure are limited partners who do

not participate in day-to-day operations and are liable only

to the extent of their investments.

The period of time - often one year - during which hedge

fund investors are initially prohibited from redeeming their

shares.

The charge that a fund manager assesses to coveroperating expenses. Investors are typically charged

separately for costs incurred for outsourced services. The

fee ranges from an annual 0.5-2.0% of an investors entire

holdings, usually collected quarterly.

Incentive/Performance fee

Leverage

Limited partnership

Management fee

Lock-up

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A common hedge fund structure through which a manager

sets up two separate vehicles - one based in the U.S. and

an offshore fund - which serve as the only investors for a

third non-U.S. fund. The two smaller entities are known as

feeder funds, while the large offshore vehicle acts as themaster fund. The purpose of this is to create a single

investment vehicle for both U.S. and non-U.S. investors.

A large bank or securities firm that provides various

administrative, back-office and financing services to hedge

funds and other professional investors. Prime brokers can

provide a wide variety of services, including trade

reconciliation (clearing and settlement), custody services,

risk management, margin financing, securities lending for

the purpose of carrying out short sales, record keeping, and

investor reporting. A prime brokerage relationship doesnt

preclude hedge funds from carrying out trades with other

brokers, or even employing others as prime brokers. To

compete for business, some prime brokers act as incubators

for funds, providing office space and services to help newfund managers get off the ground.

A measure of the degree to which a hedge funds returns

are correlated to the broader financial market. A figure

of 1 would be a perfect correlation, while 0 would be no

correlation and minus 1 would be a perfect inverse

correlation. Any figure below 0.3 is considered non-

correlated. The result is used to determine whether a hedgefund follows a market-neutral investment strategy. This is

sometimes referred to as R2.

Master-feeder fund

Prime broker

R-squared (R2)

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A provision in the Securities Act of 1933 that allows

privately placed transactions to take place without SEC

registration and prohibits hedge funds from advertising

themselves to the general public. It also outlines which

parties qualify as insiders.

An approach in which the fund manager provides financing

to publicly traded companies, usually in exchange for a

privately placed convertible note issued at a discount. It is

also known as PIPES (private investments in public entities).

A measure of how well a fund is rewarded for the risk it

incurs. The higher the ratio, the better the return per unitof risk taken. It is calculated by subtracting the risk-free rate

from the funds annualised average return and dividing the

result by the funds annualised standard deviation. A Sharpe

ratio of 1:1 indicates that the rate of return is proportional

to the risk assumed in seeking that reward. Developed by

Prof. William R. Sharpe of Stanford University.

Also called the upside potential ratio. Similar to theSharpe ratio, it was developed by the Pension Research

Institute to determine the amount of good volatility that

a funds investment portfolio possesses that is, it seeks to

define the amount by which the investment pools value

may increase, based on expected pricing fluctuations.

Money given to corporate start-ups and other new high-risk

enterprises by investors who seek above average returns

and who are often willing to take illiquid positions.

The likelihood that an instruments value will change over a

given period of time, usually measured as beta.

Regulation D

Regulation D investment strategy

Sharpe ratio

Sortino ratio

Venture capital

Volatility

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Designed and produced by Meriden Marketing

FTSE International Limited 2005. All rights reserved in and to the FTSEHedge Index Series are vested in FTSE International Limited. "FTSE","FT-SE" and "Footsie" are trade marks of the London Stock ExchangePlc and The Financial Times Limited and are used by FTSE InternationalLimited under licence. All information is provided for informationpurposes only. Every effort is made to ensure that all information givenin this publication is accurate, but no responsibility or liability can beaccepted by FTSE International Limited for any errors or for any loss fromuse of this publication or from the use of the FTSE Hedge Index Series.


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Documents

FTSE Guide to Hedge Funds