Resume on hedge funds.
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Alfred Winslow Jones coined the term and the idea of a ęhedge fundĽ in 1940 when he wrote for ďFortuneĒ magazine. His idea was that by combining the use of long and short positions coupled with the use of leverage, a manager of a fund might outperform the market both in good and in bad times. What Jones stresses even more is that one must be always short and always use a leverage to be considered a real hedge fund manager. Moreover aggressively picking long stocks is accompanied by being short to neutralize for market swings. To resume, three basic notions characterise a hedge fund:

  • Short position is when a trader sells something that is not in his possession in order to buy it back later to earn the difference.
  • Long is a simple buy of a security with intention of holding it for a certain time.
  • Leverage is a mean of enhancing return or value of a portfolio without increasing investment. Classical example is buying securities on margin. That form of buying is a form of credit where the debt is covered by traderís own securitiesí portfolio.

 

Hedge funds came to the public spotlight when in August 26 in the late summer of 1998 Stanley Druckenmiller from the Soros organization announced a $2 billion lost in its flagship hedge Quantum Fund in the wake of the currency crisis in Russia. What the public didnít know and didnít care to know was that despite of that lost the fund was still one the best performing funds ever. The public confidence reached its lowest with Long-Term Capital Management (LCTM) hedge fund disaster. If the Federal Reserve (Fed) hadnít intervened all major European and American banks would have incurred very important losses. Whatís more, two Nobel price laureates Robert Merton and Myron Scholes and John Meriwether the inventor of the ďrocket scienceĒ for finance with its squadrons of Quanta specialists, were the people behind the sophisticated methods used by the fund. Their know-how didnít prevent the catastrophe. Whatís less publicised is that finally the fund recovered from all losses. Nevertheless itís not a privilege of a common fund to get a helping hand from the Fed. LTCM was simply too big to fail. The bailout of LTCM by the Fed was designed to ensure that the LTCM collapse didnít cause the credit markets to default and make the world look grisly.

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When you choose a fund to invest in, you better verify if managersí personal wealth is invested in it. Itís not always the case, especially with institutionalised funds. The tendency for all hedge funds is that their managers are deeply invested in them. We express it by saying that hedge fund managers put their money where their mouths are. Most hedge fund managers are interested in two things:

 

  • Preserving capital
  • Making money for their clients

Loosing the capital limits resources to invest further and leads to closing of the business.

 

Three essential differences between hedge and mutual funds concern:

 

  • Size of the industry and its regulations
  • Short selling, use of derivatives and risk arbitrage
  • Compensation for the work done

 

Size: hedge funds are smaller and are less regulated then mutual funds. Almost anybody who meets the minimum Security and Exchange Commission (SEC) investment requirements may invest in them. Hedge funds are not open to the general public. Only accredited investors as defined by SEC are allowed. Usually they are individuals who have a net worth of a million dollars and a net yearly income through the last two years of at least $200,000. There are funds that are calling themselves hedge funds but they arenít. Hedge funds must hedge (cover the risk) in order to be called hedge funds.

 

Short selling: the main feature of hedge fund investing is how to outperform the market both when itís growing up as when itís going down. Thatís why the hedge funds use both long and short positions and the derivatives (securities that take their values from another securities). Classical mutual fund is not allowed either to use short positions or derivatives.

 

Compensation: mutual fund managers are paid on the basis of the amount of assets they manage. Hedge fund managers are essentially paid based on performance of the fund. There is also a fixed commission based on the volume of assets managed. Alfred Winslow Jones fixed the performance fee as 20 % of the fundís performance and 1 to 1.6 percent as a management fee. There is one special kind of hedge fund that is composed of specialised hedge funds. The idea behind that hedge fund of hedge funds is to farm the money out to some selected hedge funds. For somebody who is a bad stock picker like Jones himself the effort to create a hedge fund was based on hiring managers to do the job of stock picking for him.

 

When starting a hedge fund one should consider three aspects to the business:

  • Marketing and raising capital
  • Legal and accounting work
  • Investing and trading

 

Marketing: concerning the marketing, the SEC doesnít let the hedge fund managers use conventional methods of advertising. Thatís why most of hedge funds work with prime brokers to do the advertising job for them.

Legal: legal and accounting work is mostly outsourced so that the hedge fund manager may concentrate on investing and trading issues.

Investing: framework for the trading and investing is defined through the investment guidelines set forth by the SEC.

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There are certain positive notes concerning hedge funds that do not reach the general publicís eye and that are worth mentioning. You must dig below the surface to reach for a lot of valuable and constructive elements. I mention only three of them. Here they are:

 

  • A recent study by IMF indicated that in most recent financial crises hedge funds seemed to have made the situation more stable.
  • The amount of money the hedge funds control is only a fraction of what is under institutional investors management thus their impact on financial environment is smaller.
  • Shorting currencies by hedge funds is always followed by buying them back to cover their positions. The operation though impacting the value of a currency is intended to look for itís real market value.

 

When investing in hedge funds a good understanding of their principal actors is necessary. Here they are:

  • Investment advisor
  • Institutional advisor
  • Third-party marketer
  • Individual investor
  • Consulting firm
  • Manager of managers

 

Ad. 1. Investment advisor helps client to determine what the money is for and what clientís investment objectives are. Possible portfolioís return is confronted with clientís aversion to risk using some basic and very comprehensible simulation techniques.

 

Ad. 2. Institutional advisors are the largest and the most important users of hedge funds. Amongst them are pension funds, insurance companies, banks brokerages and national and multinational corporations. As they operate in strict secrecy little is known about their investments. Usually they choose the managers based on their historical performance and the hedge fund is what comes with them. It looks more as if a manager is an asset and not the hedge fund thatís under his control.

 

Ad. 3. Third-party marketer is a professional who does the business of raising money for hedge funds. Though most hedge funds start business using inner circles consisting of family and close friends they need to reach the outer world of wealthy individuals and institutional investors. For certain fee hedge funds use services of third-party marketers.

 

Ad. 4. Individual investor if not sufficiently rich usually goes through family offices that fulfil the criteria for accredited investor. The family office invests in a core group of funds that meet the needs of most of the family, while allowing the individuals to invest in other funds too.

 

Ad. 5. Consulting firm recommends products for hedge fund investors. Quite often it does not invest himself and does not manage any money. The firm gives their clients investment advice and helps them with asset allocation and manager selection. It looks for inefficient area of the market and advices on convergence trades that are long on illiquid trades and short on liquid ones.

 

Ad. 6. Manager of managers or simply known as MOM acts as an advisor to investors looking for money managers. He customizes multi manager alternative investment strategies for institutional and high-net worth investors. The customization may include tailoring contracts with managers through limits on leverage, value-at-risk (VAR) limits, selection of instruments and use of counterparty. The manager of managers monitors portfoliosí performances through daily mark to market of every trade for liquid stocks and periodically for illiquid ones. MOM uses value-at-risk or stress testing analysis for global portfolio risk management.

 

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Note of comment

The principal source of the information for this article is Daniel A. Strachman book ďGetting started in hedge fundsĒ. Alternative investment has been a hot topic of my recent interviews with ALM managers. Itís also a personal need for the condensed information thatís useful when applying for a post in the banking area and an occasion to share it with others willing to see the top of a hedge fund investment iceberg. For a thorough comprehension read the entire Daniel A. Strachman book.