27.2 Hedge funds Flashcards
differences between hedge funds and mutual funds
hedge funds escape certain regulations that apply to mutual funds (although hedge funds may face some restrictions posed by their prime broker, the bank that provides the hedge fund with financing and trade processing).
they do not need to provide the redemption of shares at any time the investor chooses, a daily calculated NAV, or the full disclosure of their investment policies and strategies.
Hedge funds use leverage while mutual funds are not. HF use long short and treated like alternatives. HF charge additional incentive fee MF cannot.
term hedge fund implies that the fund is hedging some form of risk
This may be the case if the fund is using both long and short positions (long positions for expected outperformers and short positions for expected underperformers), but not all hedge funds focus on risk reduction. Some involve no hedging and focus on risk enhancement.
Since hedge funds are not required to redeem shares any time an investor requests, they have lockup periods. lockup period is a certain amount of time (often one year) in which the investor is not able to withdraw his funds.
A lockup period exists for one key reason—many hedge fund investments are not easy to unwind on short notice. Some hedge fund investments are illiquid, which means managers cannot sell them quickly and retain a proper value. In addition, some hedge fund investments are bets on certain asset mispricing, and those trades can take time to unwind.
Calculate the return on a hedge fund investment and explain the incentive fee structure
2+20%
An assumption needs to be made as to whether management fees are computed based on beginning or end of year assets and whether incentive fees are computed 0.2 × max(R × A − 0.02 × A, 0)
where:
R = return on assets for the year before or after deducting management fees.
Hedge funds do soften the incentive fee structure with a few safeguards for investors
1st safeguard is the hurdle rate
2nd safeguard is a high-water mark clause, which essentially states that previous losses must first be recouped and hurdle rates surpassed before incentive fees once again apply.
3rd safeguard for investors is a clawback clause, which enables investors to retain a portion of previously paid incentive fees in an escrow account that is used to offset subsequent investment losses should they occur.
Hedge funds deploy numerous different strategies in their attempt to capture incentive fees.n follows the classification system used by the Dow Jones, which provides indices to track various hedge fund strategies.
Long/short equity hedge funds endeavor to find mispriced securities. Managers of a long/short equity fund spend a great deal of time conducting fundamental analysis on stocks that are largely ignored by most analysts, in an attempt to find mispricings.Sometimes funds can have a net long bias or a net short bias depending on what opportunities they see in the markets. Funds can also be sector neutral, where they net long and short positions that cancel out sector exposure (e.g., automobile stocks General Motors and Ford).
Dedicated short
Dedicated short hedge funds are focused exclusively on finding a company that they think is overvalued and then short selling the stock. Traditionally, short sellers are looking for companies with weak financial performance that has not been captured by the market. Due to the lack of hedging of overall markets, dedicated short funds do not perform well when markets are performing well.
Distressed debt
Bonds with a CCC rating are considered distressed. Distressed bonds usually trade at deep discounts to par value. Distressed debt hedge funds are searching for distressed bonds with the potential to turn things around. Many of these distressed companies are in or close to being in bankruptcy proceedings. Some distressed bond investors take an active approach to influencing the target company’s reorganization to their advantage. For example, if they a large enough position of any class of a bond, then they can block any reorganization plan that is not in their best interest.
Merger arbitrage hedge funds
Merger arbitrage hedge funds try to find arbitrage opportunities after mergers are announced, but before the deal is closed.The underlying assumption here is that any assessment of a merger arbitrage strategy takes into account public (and not insider) information.
Convertible arbitrage
using convertible bonds, which are fixed-income instruments that can be converted into shares of stock if the stock price rises above a prespecified value. Convertible arbitrage hedge funds develop a sophisticated model to value convertible bonds. The idea is that if the market price is not the same as the model price, then profits can be made if the two prices converge.
Fixed-income arbitrage
attempt to exploit perceived mispricing—long positions in underpriced bonds and short positions in overpriced bonds. The positions are usually highly leveraged to be profitable.
Emerging market hedge funds
hedge funds invest using American depository receipts (ADRs), which are certificates issued in the United States that provide ownership in foreign countries coupled with currency exposure. There are occasionally pricing discrepancies between the ADR and the underlying asset that an adept hedge fund manager can exploit as well. If managers decide to invest using emerging market debt, then they need to consider default risk because some countries have defaulted numerous times (e.g., Russia, Argentina, Brazil, and Venez
Global macro hedge funds
Global macro hedge funds attempt to profit from a macroeconomic trend that they feel is in disequilibrium (i.e., not currently priced correctly and rationally). They will place very large dollar bets on the equilibrium being reestablished. investment focus may be on foreign exchange rates, interest rates, or inflation.
Managed futures hedge funds
Managed futures hedge funds involve strategies that try to predict future movements in commodity prices and invest according to those predictions. Fund managers will often backtest their trading rules using historical data. A key drawback of backtesting is that there is no distinction made between strategies that truly worked based on proper fundamental analysis or strategies that were successful strictly because of luck and subsequently may might not have repeated success.
Hedge Fund Performance and Measurement Bias
Hedge fund performance is not as easy to assess as mutual fund performance, which is readily available and accurately reported by numerous independent parties. Participation in hedge fund indices is voluntary
there is measurement bias in hedge fund index reporting. When returns are reported by a hedge fund, the database is then backfilled with the fund’s previous returns. This is known as backfill bias and it creates an issue with reliability for hedge fund benchmarks. It is common for a hedge fund to have a string of several good years and then have a meltdown.
