Hedge Funds Have Acquired a Fearsome Reputation in Recent Years

8/8/2019 Hedge Funds Have Acquired a Fearsome Reputation in Recent Years

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Hedge funds have acquired a fearsome reputation in recent years, largely because

people still remember how George Soross Quantum Fund helped to force the pound

out of the European exchange-rate mechanism in 1992.

The irony is that, despite their high-risk image, hedge funds were originally

designed to protect against risk, rather than maximise it.

So here is a quick explanation of what hedge funds are, how they operate and how

you can invest in them.

What is a hedge fund?

An investment that aims to make money year in, year out, no matter what the

financial climate (known as an absolute-return strategy). How to define hedge funds

is tricky because it is an umbrella term for a huge range of different investment

strategies and risk levels. One thing that they have in common is that wealth

preservation - not losing money - comes very high up the list of priorities.

Why do they seem so scary?

Their sheer size (many funds are worth billions of pounds) is enough on its own to

command attention, but it is the frequency with which they trade that gives them a

profile even bigger than their size alone would merit. Market experts reckon that

hedge funds account for as much as 50 per cent of all trades on the London Stock

Exchange.

When hedge funds combine to bet on a particular outcome, as they did with the

pound in 1992, even governments can find themselves powerless to resist the

momentum they generate.

How do hedge funds work?


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They use a number of strategies to make money for investors. Perhaps the most

notable is the long-short equity strategy. This allows the fund manager both to "go

long" - the traditional approach of buying an asset in the hope that it will rise in

value - and to "go short". The latter is when the fund manager sells a borrowed

asset in the hope of buying it back more cheaply later.

Another approach is arbitrage, where the fund manager takes advantage of

anomalies in the pricing of assets. For example, when a company's shares are

quoted in two different countries, arbitrageurs may see a slight advantage in buying

the shares in one country rather than the other. To see arbitrage in action, use an

online calculator.

A third method of making money is to take a significant stake in a company in the

hope that a profitable takeover or management shakeout will follow.

Are hedge funds suitable for the man in the street?

There are a number of hurdles that a typical private investor needs to clear before

putting money in a hedge fund. The first is that the initial investment required is

usually very high. It is rarely less than 50,000 and can be 1 million or more, which

rules out all but the wealthiest investors.

Hedge funds are based offshore and are not regulated by the Financial Services

Authority, so the usual warning about seeking advice before buying applies with

extra force in this case.

Although not all hedge funds are high-risk, some of the strategies used by some of

the funds undoubtedly are. For example, the use of specialist instruments known as

derivatives offers highly geared bets on the future price of things such as shares orcommodities, and investors need to be sure that they appreciate the level of risk.

Hedge funds typically use leverage. This involves borrowing additional money to

increase the size of the bets they are taking.

How much does all this expertise cost?


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Quite a lot. Hedge funds typically charge 2 per cent a year in annual fees, plus a

performance fee of 20 per cent or more of any rise in the funds value. Performance

fees are rewards to managers for achieving a certain level of return. The idea is that

by offering these incentives the fund ensures that both the managers and theinvestors have a strong interest in the fund doing well.

Does the performance of these funds justify the high fees?

It is impossible to give a blanket answer to that question, but it is certainly fair to

say that the high charges act as a drag on performance.

For example the average return on European hedge funds in 2008 was a little less

than 10 per cent, according to HedgeFund Intelligence, the industry information

group. This compares with the return of 18.1 per cent posted by ordinary European

equity funds.

However, hedge funds fared much better in the bear market of 2001 and 2002.

While the stock market was down 45 per cent, hedge funds were up by between 1

per cent and 2 per cent. Because hedge funds aim for absolute returns, they tend to

perform better than the stock market in bad times but less well in good times.

How do you go about buying a hedge fund?

Your financial adviser should be able to point you in the right direction, but you will

need a substantial initial sum and could be buying into a very risky investment.

Charles Cade, of Winterflood Securities, the stockbroker, says that he would not

recommend direct investment in hedge funds. A better route would be a fund of

hedge funds. These invest in a number of different funds and there are more than

20 listed on the London Stock Exchange.


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But these, too, have drawbacks. They usually charge another layer of performance

fees on top of those levied by the underlying hedge funds, and like hedge funds,

they are not regulated by the FSA, though the watchdog is thinking about bringing

some funds of hedge funds under its regulatory umbrella.

http://www.timesonline.co.uk/tol/money/reader_guides/article3034518.ece[hhedgefunds work]

Home Investing How hedge funds work

Michael Clarke, This is Money

12 July 2006

Deals

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These funds now reportedly manage over 750bn of clients' money and their highly-

paid managers can achieve remarkable returns.

Retail investors have so far been barred from investing in the funds, but that could

change next year. But what are these funds and what makes them so different to

normal collective investments? Read our report to find out.

What is a hedge fund?

Hedge funds are collective investments that aim to make money whether the

market is moving up, down or sideways. Unlike unit trusts, Oeics or investment

trusts, which tend to only grow when shares rise, hedge funds can make money

when share prices are falling.

They do this using a range of complicated specialist techniques. The most

commonly used is by going long or short on a share. Most private investors simplygo long on a share, buying it in the hope that the price will rise.

Where an investor goes short, they believe that the equity will fall in value. There

are two main ways that hedge funds can do this. The first is by 'shorting' the stock,

where the investor 'borrows' a stock to sell it, with the hope that it will decrease in

value so they can buy it back at a lower price and keep the difference.

For example, if an investor borrows 500 shares of X company at 10 each, they

would then sell those shares for 5,000. If the price then falls to 8 per share, the

investor would buy the shares back for 4,000, return them to the original owner

and make a profit of 1,000.


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Another way of taking advantage of falling share prices is by dealing in 'contracts

for difference'. This allows the investor to make money on share price movements

without actually buying the shares. A CFD on a company's shares will specify the

price of the shares when the contract was started. The contract is an agreement to

pay out cash on the difference between the starting share price and when the

contract is closed.

However, hedge funds are not only restricted to equities. They will invest in

anything that will make them a profit, including foreign currency, bonds or

commodities. The return achieved by the fund is likely to be dependent on the skillof the manager rather than underlying economic conditions and that is why they are

so well paid.

Can I invest in a hedge fund?

At the moment, hedge funds are only available to high wealth individuals who are

prepared to invest around 500,000 or to professional investors, such as pension

funds or insurance companies. Individual retail investors cannot buy directly into

hedge funds as the City watchdog, the Financial Services Authority, is concerned

about how the funds are operated and their risk. Plus, it is unclear whether the

hedge fund operators would welcome dealing with a large number of small

investors due to the costs involved.

However, the FSA will launch a consultation next year on whether it should increase

the scope of funds it authorises to include funds of hedge funds. Retail investors still

wouldn't be able to invest directly, but would be able to invest in an authorised

collective investment scheme that would put money into hedge funds.


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Currently, if investors want exposure to hedge funds they can purchase shares in

the companies that operate funds, such as Man Group. It is also possible to buy into

foreign funds over the internet, although investors cannot expect the same financial

protection that they would receive in the UK.

Read more: http://www.thisismoney.co.uk/investing/article.html?

in_article_id=410685&in_page_id=166#ixzz0jSMwiYNz

http://www.thisismoney.co.uk/investing/article.html?

in_article_id=410685&in_page_id=166 [how hedge funds works and meaning ]

How do hedge funds work?

Hedge funds have the unusual characteristic of causing both anxiety and

excitement. Most investors remember the time that George Soros - probably the

most famous hedge fund manager - broke the Bank of England in 1992, and the

near-collapse of Long-Term Capital Management in 1998.

Friday, August 31st 2001, 4:20PM

But they also suspect that such funds offer ways to get spectacular returns which

are not available to the average person.

Hedge funds are essentially vehicles that use unconventional techniques to allow

them to prosper in all market conditions. For example, hedge funds can "short-sell"

or bet on falling markets or securities, and can therefore perform well even when

sharemarkets are falling.

The ability of hedge funds to grow, or at least fall less, even when markets are

falling is one of their main attractions. According to the weighted index calculated

by the Hedge Fund Research Institute, from January 1991 to May 2001 the average

returns of hedge funds on a global level were 13.67%, which is slightly less than the

14.84% of the S&P500 Index.
http://www.thisismoney.co.uk/investing/article.html?in_article_id=410685&in_page_id=166#ixzz0jSMwiYNzhttp://www.thisismoney.co.uk/investing/article.html?in_article_id=410685&in_page_id=166#ixzz0jSMwiYNzhttp://www.thisismoney.co.uk/investing/article.html?in_article_id=410685&in_page_id=166http://www.thisismoney.co.uk/investing/article.html?in_article_id=410685&in_page_id=166http://www.thisismoney.co.uk/investing/article.html?in_article_id=410685&in_page_id=166#ixzz0jSMwiYNzhttp://www.thisismoney.co.uk/investing/article.html?in_article_id=410685&in_page_id=166#ixzz0jSMwiYNzhttp://www.thisismoney.co.uk/investing/article.html?in_article_id=410685&in_page_id=166http://www.thisismoney.co.uk/investing/article.html?in_article_id=410685&in_page_id=166


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However, the average volatility of the hedge funds was 8.11%, compared with

14.9% for the S&P500. If the Sharpe ratio - which measures return relative to risk -

is taken into account, then hedge funds perform substantially better than the

S&P500.

A comparison of hedge fund performance with that of the S&P500 over four discrete

periods gives some insight into their relative performance: from February 1994 to

January 1995, July to October 1998, from March to December 2000 and the first five

months of this year. In all these intervals except the third, hedge funds increased

more than the S&P500. (It is important to note that the return of hedge funds is

uncorrelated with that of the stockmarket. In fact, the correlation between the

S&P500 and the average returns on hedge funds rarely exceeds 10%.)

These general results show the potential hedge funds can offer investors, but it is

useful to remember that these results represent an average for the sector as a

whole.

To properly understand hedge funds, it is important to classify them according to

the strategies that they follow.

Long/short equity

Short-selling

Event Driven

Distressed Securities

Convertible arbitrage

Fixed income arbitrage

Equity Neutral

Macro

Long/short equity

This strategy includes constructing a portfolio with a long position (buying) in

undervalued shares, and a short position (selling) in overvalued shares. The

difference between the long position and the short is the net exposure to the


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market. The average return of this strategy from 1990 until today has greatly

exceeded both the S&P500 and the MSCI World Index. In addition, the average

volatility was lower than both of these indices, and accordingly these hedge funds

have had the best ratio of risk to returns.

The strategy is not risk-free. The hedge fund manager must not only be on top of

the individual share position, but must also decide on the net exposure to the

market. Investors should also remember that managers with a short position face

the possibility that the intermediaries may recall the borrowed shares.

Short-selling

This strategy is a more specialised version of the long/short strategy. It consists of

selling shares in companies with specific problems, or selling shares because of themarket sentiment. In other words, it means betting on falling markets or securities.

The stockmarket boom of the last few years has not benefitted this strategy. Short-

sellers tend to perform best when markets fall: between March and December of

last year, the short-selling hedge funds gained 60 percent compared to negative

returns for almost all the main world stockmarket indices. These funds are valid

instruments for hedging against a fall in the market, because they are characterized

by a strong negative correlation with stockmarket indices. But they are not free of

risk, as fund managers who pursue this strategy must get their timing right.

Event-driven

The event-driven strategies are focused on particular events, which can produce a

rise in the price of the shares. The underlying principles are represented by merger

arbitrage and distressed securities. The strategy of merger arbitrage is focused on

mergers and acquisitions. These hedge funds buy, after the announcement of

mergers, the shares of the company that is being acquired, and sell those of the

purchaser, in an amount that depends on the prefixed exchange rate between the

two sets of shares. The objective is to gain the spread between the market price

and the offer price (the premium). If the transaction proceeds without a problem,

the market quotes will reflect the offer price.

This strategy has generally attained positive returns in recent years, as the funds

have benefitted from a favourable market environment. The most common risk of


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this strategy is that the mergers are not completed. The situation depends on many

factors: government disposition, willingness of the shareholders, the nature of the

operation - hostile or willing - and interests of other companies. There is also the

risk spread, that is, that the estimated premium is lower than it seems.

Distressed securities

Hedge fund managers which follow the 'distressed securities' strategy focus on the

opportunities that arise from situations of bankruptcy, liquidation, and restructuring.

These funds typically invest in different fixed income securities, such as high-yield

bonds or "junk bonds" (the debt of companies with a poor credit rating). The typical

risk for these hedge funds is that market conditions might move against them. An

economic downturn or an increase in interest rates typically hit the profit margins of

distressed companies.

Convertible arbitrage

This strategy consists of the acquisition of convertibles (bonds which can convert to

shares), and the sale of a specific amount of shares from the same company. The

hedge fund manager aims to take advantage of mispriced situations with relation to

the price between the convertible bonds and shares. These hedge funds have given

satisfaction to their investors in the 1990s, with a Sharpe ratio more than double

that of the S&P500 Index. But it is once again important to take into account the

specifics of this time period. This strategy does not generally benefit from changes

in interest rates or market volatility.

Fixed income arbitrage

There are numerous variables that exist within this strategy. In general, the short

position is composed of securities with the highest credit rating, such as Treasury

bills, while the long positions are corporate bonds or emerging markets debt. The

objective is to gain from the convergence of interest rates. Although this strategy

has not attained exciting results over the last years, it has enjoyed low volatility.

The risks characterising this strategy are those typical of bond investments: the

exposure to interest rate fluctuations and credit risk.

Equity market neutral


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The portfolios of this strategy are composed of long positions in undervalued

shares, equally balanced with a short position in overvalued firms, to cancel the

fluctuations of the market. This method of investment is equivalent to the

long/short, with no market exposure. For the choice of shares in general, it uses

quantitative models to discover those that are inefficiently priced.

The strategy has produced optimum results over the 1990s, and has a low volatility.

It has also generated positive results in all of the four negative periods discussed

above. The returns of this strategy are almost completely attributable to the ability

of the manager, and/or to the quantitative methods, to support the share selection.

Therefore, the risk resides in these two factors, but also in the possible lack of

correlation between the long and short parts of the portfolio.

Macro

The macro funds take long and short positions in shares, bonds, options, futures,

and commodities, using high financial instruments. The name of the strategy

derives from the fact that these funds are not simply interested in the future

evolution of the companies, but of the entire country or sector. This strategy has

provided consistent returns with low volatility. It is important to note that compared

to other hedge fund strategies, macro funds are characterised by a strong

correlation with stockmarket indices.

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[how does this work stretegies]
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Hedge Funds Have Acquired a Fearsome Reputation in Recent Years