Essay: Hedge funds

Introduction:

Hedge funds are investment funds that pose restriction on the number of investors and undertake a huge range of trading and investment activities like leverage, long, short and derivative positions in both domestic and international markets that pay a performance fee to the related investment manager with the objective of generating huge returns.

Hedge funds are legally generated as private partnerships with lesser number of investors and high initial investments. Liquidity in case of hedge funds is restricted as there are often restrictions on the amount of money invested which cannot be withdrawn till a period say one year or two. Hedge funds have different investment strategy which determines the method and type of investment undertaken. The primary mode of investment is in shares, commodities and debt. They are much similar to mutual funds but not registered hence their regulation falls under the Securities and Exchange Commission.

Hedging in finance means to reduce risk but the main motive of every hedge fund is to maximize ROI i.e. return on investments. The process of hedging started with attempts to minimize the bottom line risks of bear market by shorting the investment unlike mutual funds that cannot enter the short market owing to their objectives. But today hedge funds have numerous strategies to speculate more risk factors than the overall market like derivatives and short selling. The term hedge fund is also used with those funds in which there is no hedging and which tend to short sell thereby increasing the risk rather than reducing it with the motive of generating more profit or ROI. (Hedge Fund Definition)

Most of the jurisdictions allow hedge funds to be available only to a short range of wealthy investors meeting the criteria and following the rules and regulations set by the regulatory body but in exchange the hedge funds are free from all regulations governing ordinary investment options. The regulations thus relaxed include restrictions on derivatives, short selling, liquidity, fee structures and leverage. Light regulation and fee on performance ere the key factor that determine the hedge funds.

The net asset value NAV, the term denoting a company’s assets minus its derivatives, can be billions of dollars. Hedge funds are the dominators of markets like trading within derivatives and investments in those companies that are already bankrupt or moving towards this depressive situation. (Hedge Fund)

The famous financial journalist Alfred Jones holds the credit to have started the first hedge fund in 1949. According to him an asset could be figured out as made up an overall market component and performance of the asset itself. In order to neutralize the market movement effects he insisted on buying those assets whose cost was stronger than the market and by short selling of the assets he expected price to be lower than the markets. Thus the whole method was to reduce the risks i.e. to hedge them hence such investments came to be known as hedge funds. Recent investments show that hedge funds have a total of $2 trillion in AUM (assets under management).

Fee structure:

The manager of a hedge fund receives two types of fee from the investments:

• Management Fee:
  it is determined from the net asset value (NAV) of the fund. It ranges from 1% to 4% annually with the standard figure being at 2%. The fee is paid monthly or quarterly although calculated on an annual basis. It can form a large part of the manager’s profit and thus charged immensely. The management fee is currently under scrutiny of regulatory bodies to force managers to reduce fees.
• Performance Fee
  : Calculated as percentage of the fund does profit usually comprise both realized and unrealized profits. It aligns the interests of the investor and manager and also can be lucrative to mangers since performance fee is meant for staff bonus and so managers if perform well can be entitled to this income. The standard charges are 20% with experienced and trusted managers charging in the range of 35% to 50%.
• During the global meltdown the fee dropped to around 19% and also the total amount of hedge funds dropped to 6.9%. Investors like Warren Buffet have criticized the performance fee as it gives no measure for the manager to share losses on the funds but only the profits. Hence they are under severe criticism.

Calculation of performance fee:

Performance fee is calculated using the high water mark technique. The manager is only entitled to receive fee on the increase of the NAV ahead of the highest value previously attained.

This safeguards the interest of the manager and the investors by avoiding fee on the losses incurred. A manager can also change the policies of the performance fee in regards of the customer base. All this is done by entrusting the client with confidence and satisfaction on a hedge satisfaction. (About Hedge Funds-What is Hedge Fund?)

Hurdle rates:

Hurdle rate is another method for determining the performance fee in which the manager takes fee only when the annual performance of the fund’s performance exceeds the benchmark setup. This links manager to have high returns by outdoing with risks involved to some amount.

In soft hurdle the fee is charged on the annualized returns if the hurdle point is crossed whereas in hard hurdle it is charged on the difference between the benchmark and the returns.

Redemption fees:

Investors are required to pay a redemption fee if they withdraw their investments from the funds. The redemption fee is charged only at fixed intervals after the date of investment. This is done to discourage short term investments in the hedge fund and favour the use of more rigid and long term investments. The redemption fee adds to the fund and not the manager thus benefitting other investors too.

Strategies:

As already stated earlier hedge funds employ many strategies for trading and investment and no standard process. The key elements of the strategies include:

• Style
• Instrument
• Exposure
• Market
• Method
• Sector
• Diversification

Global -Macro uses the style to assess the macroeconomic event using all types of investments and markets to generate returns. It is of two types:

Discretionary macro:

trading by managers by selecting investments and not generated by the use of software.

Systematic Macro:

trading is done by mathematical calculations that require the use of software and not by humans other than developing the software. Some of the methods include:

1. Systematic diversified
2. Commodity trading advisors
3. Systematic currency
4. Trend and non-trend following.

Multi strategy

– a combination of both the above macros.

Directional

Hedge investments or funds employed for the purpose of equities fall in this category.

• Long -Short equity: longing those equities having short selling of its stocks.
• Sector funds: excellence in the areas of healthcare, technology etc.
• Emerging markets: investments in India, China etc.
• Fundamental values and growth
• Multi strategy is again a combination of above.

Event Driven:

• The prices of the funds are exploited as per the assessment of corporate events.
• Distressed Debt:

  employed in those companies that are on the verge of potential bankruptcy.

• Risk arbitrage

  : exploit price variations during the merger of two or more companies.

• Special cases

  : used during corporate transactions.

• Regulation D:

  specialised in dealing with private equities.

• Credit risks:

  in companies having fixed commercial income securities.

Relative Value:

The mismatches in the prices of two commodities are used to exploit their prices. The various methods include:

• Equity Market neutral: maintain a balance between long and short positions.
• Convertible arbitrage: exploitation of inefficiency in the prices between the securities those are inter-convertible.
• Fixed income arbitrage: related to securities with a fixed income.
• Statistical arbitrage: use statistical models to maintain a neutral level of equities in the market.
• Regulatory arbitrage: exploit the prices by making use of regulations imposed on the markets. Asset backed securities and fixed income corporate.

Miscellaneous:

Multi-manger funds are those in which there exist a number of hedge funds. In the F cube category funds are invested into other hedge funds. Unhedged equity funds with 130% long and 30% short components thereby the market level remains at 100%.

Hedge Fund Risks:

Although hedging is done to reduce the risks of investment but they can be more risky than investment in some regulated funds. The main risks are listed as follows:

• Leverage: besides borrowing money from the investors hedge funds will also trade with large amount of sums borrowed much greater than the initial investment.

Short sell : losing a bet has a higher probability from the opinion of short selling unless the short point hedge a long position. Short selling is rare in the case of ordinary funds.

• Appetite for risk: hedge funds have a higher degree of taking on underlying investments having higher risks such as distressed debts, mortgage etc.
• Lack of regulation: hedge fund manager are not strictly regulated hence they may undertake policies with disclosed risks.
• Lack of Transparency: it makes it difficult for an investor to invest in the hedge funds because of non disclosure of policies, portfolio diversification etc.
• Short volatility: these include those strategies of hedge funds that involve huge risks by writing out call or putting of money.
• Thus investors are required to be sophisticated who are known to the risks and can invest in the risks for the high rewards through them. Leverage will increase both the profits and the losses, higher the risk higher will be the return and likewise some other methodologies. Operational due diligence may be used to determine risks involved in a hedge fund.

Hedge Fund Structure:

Hedge funds are incubators that take in investments and let them grow. The fund has only an investment portfolio and money no other employee or asset. The management of hedge funds is carried by an investment manager and this is the only business that requires employees linked with hedge funds.Some other people engaged in the process of hedge funds include:

Prime Broker:

he is involved in the process of lending money, lending securities for the purpose of short selling, trade execution, settlement and clearing. They form an important part of large investment banks.Administrator: he deals with any redemption in case of shares calculates NAV of a fund and performs other functions. In some countries this role is played by the investment manager himself like US but outside the roles are different.Distributor:he is the person who holds the responsibility for marketing the fund to potential investors but like above many a times this role is also played by the investment manager himself who is generally located onshore to tap the highest number of possibilities.

Legal Entities:

Limited partnerships are often setup to deal with hedge funds as is the case in US where investors will receive favourable taxation policies. Tax policy determines the nature of the firm and its structure in different regions otherwise it has no impact on the selling of hedge funds.

There are master-feeder funds like Soros hedge fund in which the investments are made to the feeder fund which then invests the total amount into the master fund which is then managed by the investment manager, thus many different types of feeder funds can invest into the same master fund reducing risks and having a higher probability of high returns.

The strategic decisions of the hedge fund are taken by the appointed board of directors who generally favour the interests of the investment manager.

Open Ended Nature and Side Pockets:

Hedge funds are open ended that is periodically there will be invitations for investors or partnership firms at the NAV value of the fund. Investors are not allowed to trade among themselves or share profits but in the above process as the NAV increases above its initial value the investor makes a lot of profit on redemption than it paid during investment. This is completely opposite to close ended fund which are limited in number and traded among the investors only and profit shared in the same way.

Side manager helps in dealing with the issues of those assets that are relatively illiquid. The fund segregates illiquid assets into side pockets and issues to the investors a new class of shares whose participation is restricted only to the assets in the side pockets. These help in equiv-distribution of the risks among all investors. Side Pockets are generally used in emergency measures. They were used to a great extent after the collapse of Lehman Brothers in 2008 when the assets of the agency became illiquid to be sold or invested.

Hedge funds are often listed on smaller stock exchanges to provide a low degree of regulation on them. Often referred to as hedge fund IPO, it is much different from an actual initial publics offering. Thus, in many ways they seem similar to private equity funds.

Hedge Fund Indices:

The three main indices that track the hedge funds in their historic order are listed as follows:

1. Non investable indices: They are simply indicative in nature and represent the nature using statistical tools on the database like mean, median and mode. As no single database can cover complete aspects of any hedge fund they suffer from errors on this front and are sometimes biased too. This is evident since funds can publish their reports at the time of being favourable and not when facing losses.
2. Investable Indices: The shareholders are provided with the return of the index by delivering structured indices and derivatives.
3. Clone: rather than reporting the statistics of the fund they use tools to analyze historic data and predict the returns on the basis of common situations.

Some of the notable hedge fund firms are as follows:

1. Bridge water associates
2. Amaranth Advisors
3. DE Shaw
4. Fortress Investment Group
5. Marshall Wace

Conclusion:

Hedge funds are an important part of the financial economy as they help in coupling both risk reduction and high returns although sometimes they can pose higher risks for higher returns. They give freedom from regulations and allow a large number of investors to participate in the process. Being open ended there are opportunities for investors to get into the streamline and invest in funds having high returns. The indices too help in locating the right fund for investment. Thus coupled with all the factors the future of hedge funds is bright and secure in the hands of the investors.

Recommendation:

High returns and low risks make hedge funds suitable for investment but there are also reasons why some may not wish to invest in hedge funds such as:

• Hedge funds have high degree of individuality.
• They are not beneficial in times of diversification of assets.
• The investment managers charge a huge fee from the investors.

These are some prominent factors that affect investments into the hedge funds. But from my opinion hedge funds overcome these pitfalls by having a strong return policy to its investors so that they get more than what they plough. Hence hedge funds are a good medium for capital generation amongst other risk taking factors.