CHAPTER 6: HEDGE FUNDS Flashcards
History of Hedge Funds
Origin: Started in 1949 to hedge long-only stock portfolios.
Initial Principles:
- Maintain short positions.
- Use leverage.
- Charge only an incentive fee of 20% of profits, no fixed fees.
Characteristics of Modern Hedge Funds
Management: Aggressively managed portfolios across asset classes and regions.
Strategies: Use leverage, take long/short positions, and/or use derivatives.
Goals: Aim for high returns, either absolute or relative to a benchmark.
Structure: Private investment partnerships with a limited number of investors making large initial investments.
Lockup Period: Investors must keep money in the fund for a certain period; redemptions require a notice period of 30 to 90 days.
Flexibility: Fewer restrictions, allowing investment in high-return opportunities.
Hedge Fund Investment Features
Private Investment Vehicles:
- Pool money from institutions and high net worth individuals (accredited investors).
- More flexible investment strategies than mutual funds and ETFs.
Leverage:
- Utilize leverage through short selling, borrowing, derivatives, or a combination of all three to enhance potential returns.
Diverse Strategies:
- Not an asset class but a collection of investment vehicles driven by various strategies.
Categories of Hedge Fund Strategies
- Event-Driven:
- Short-term, bottom-up strategy.
- Profit from pricing inefficiencies before major corporate events (bankruptcy, acquisition, merger, restructuring, asset sale).
- Relative Value:
- Profit from price discrepancies between related securities like stocks and bonds.
- Opportunistic:
- Focus on macro events and commodity trading.
- Equity Hedge:
- Bottom-up strategy.
- Take long and short positions in publicly traded equity/equity derivative securities, not focused on event-driven or macro strategies.
- Multi-Manager Hedge Funds:
- Fund-of-fund hedge funds, combining various managers and strategies.
Hedge Fund Investment Features
Event-Driven Category
- Merger Arbitrage:
Strategy:
- Go long on the stock of the company being acquired.
- Go short on the stock of the acquiring company.
Risk:
- Corporate events like mergers may not occur as planned, leading to potential losses if positions are not closed in time.
- Distressed/Restructuring:
Strategy:
- Purchase debt securities of companies in or near bankruptcy at a discount.
- Profit by selling at a higher price during settlement (liquidation or equity stake).
Other strategies:
- Buy senior debt/short junior debt. Senior is going to be paid first, so you get paid & junior is going to go to 0 due to bankruptcy, so you make even more anyway.
- Buy preferred stock/short common stock.
- Activist or Corporate Raiders:
Strategy:
- Purchase a managing equity stake in a mismanaged public company.
- Influence policies, restructure, change strategy, or sell non-profitable units. - Special Situations:
Strategy:
- Purchase equity of companies engaged in restructuring activities other than merger or bankruptcy.
Relative Value Category: HF Investment Strategies:
- Fixed-Income Convertible Arbitrage:
Exploit mispricing between convertible bonds and the issuer’s stock.
Long position in convertible debt + short position in issuer’s common stock.
Notes:
Market neutral strategy with theoretical zero-beta portfolio.
Convertible bonds can be converted into common stock at a predetermined price and time.
- Fixed-Income Asset Backed:
Exploit mispricing of asset-backed securities.
- Fixed-Income General:
Exploit mispricing between corporate issuers or between corporate and government issuers.
Also involves trades between different parts of the same issuer’s capital structure.
- Volatility:
Go long or short on market volatility within a specific asset class.
- Multi-Strategy:
Allocate capital across various strategies like equity long/short, convertible arbitrage, and merger arbitrage.
Aim for consistently positive returns regardless of market conditions.
Execute strategies within one fund group without the extra fees associated with a fund of funds.
Opportunistic Strategies
- Macro Strategies:
Strategy:
Top-down approach to identify trends from global economic policy changes.
Focus on currency markets, fixed income markets, or changes in interest rates.
Trades are based on expected movements in economic variables.
- Managed Futures:
Strategy:
Actively managed funds making diversified directional investments in futures markets using technical and fundamental strategies.
Historically focused on commodity futures, hence also known as commodity trading advisers (CTAs).
TYPES OF HFs:
EQUITY:
1. Long/Short Equity
2. Short-Biased
3. Market Neutral
EVENT-DRIVEN:
1. Merger Arbitrage
2. Distressed
3. Special Situations
4. Activist
RELATIVE VALUE:
1. Convertible Bond Arbitrage
2. Fixed Income Arbitrage
3. Multi-Strategy
OPPORTUNISTIC:
1. Global Macro
2. Managed Futures
MULTI-MANAGER:
Fund of Funds (FOF)
Hedge Fund Investment Features
Equity Hedge Category
- Fundamental Long/Short:
- Long positions in undervalued securities and short positions in overvalued securities.
- Manager maintains net long exposure, adjusting based on market forecast.
- Market Neutral:
- Buy (long) undervalued securities and sell (short) overvalued securities.
- Hold equal dollar amounts in both positions, aiming for a portfolio beta close to zero.
- Fundamental Growth:
- Identify companies with high growth potential using fundamental analysis.
- Take long positions in these stocks.
- Fundamental Value:
- Identify undervalued companies using fundamental analysis.
- Take long positions in these stocks.
- Short Bias:
- Identify overvalued securities using quantitative/fundamental analysis.
- Take short positions in these securities.
Distinguishing Characteristics of Hedge Fund Investments
- Fewer Legal and Regulatory Constraints:
- Hedge funds operate with less regulation compared to traditional investments.
- Flexible Mandates:
- Allows for the use of shorting and derivatives.
- Larger Investment Universe:
- Access to a broader range of investment opportunities.
- Aggressive Investment Styles:
- Permits concentrated positions in securities, exposing to credit, volatility, and liquidity risk premiums.
- Use of Leverage:
- Relatively liberal use of leverage to enhance potential returns.
- Liquidity Constraints:
- Includes lockup periods and liquidity gates restricting investor withdrawals.
- High Fee Structures:
- Typically charge both management and incentive fees.
Which of the following hedge fund strategies is most likely a top down strategy?
A Event Driven
B Macro
C Equity Hedge
B is correct. Macro uses a top-down approach to identify trends based on changes in economic policies across the globe. The strategies could focus on currency markets, fixed income markets, or based on changes in interest rates. Trades are based on expected movement in economic variables.
Event-driven is a short term, bottom-up strategy that aims to profit from pricing inefficiencies before a major potential corporate event. Ex: bankruptcy, acquisition, merger, restructuring of a company, asset sale (large pocket of land in a prime location).
Equity hedge entails taking long and short positions in publicly traded equity/equity derivative securities. It is a bottom-up strategy and is not focused on event-driven or macro strategies.
Which relative valuation strategy is most likely to consistently generate absolute positive returns irrespective of how the markets are performing?
A Fixed-Income Asset Backed
B Fixed-Income General
C Multi-Strategy
C is correct. Multi-Strategy is likely to consistently generate absolute positive returns irrespective of how the equity, debt, or currency markets are performing.
It does not focus on one strategy, but allocates capital across different strategies where investment opportunities exist. Ex: equity long/short, convertible arbitrage, merger arbitrage, etc.
Which of the following is not a characteristic of hedge funds?
A Redemptions are immediate.
B Subject to minimal restrictions
C Aggressively managed portfolios of investments across asset classes and regions
A is correct. Redemptions are not immediate.
Investors are required to keep the money with the fund for a certain period – lockup period. Usually, a minimum notice period of 30 to 90 days is required.
Hedge Fund Structures and Fee Arrangements
- Structure:
Limited Partnerships:
- Majority of hedge funds are structured as limited partnerships.
- Portfolio manager serves as the general partner (GP).
- Institutional investors serve as limited partners (LPs).
- This is known as the direct form of hedge fund setup.
- Fee Structures:
HF: “2 AND 20”:- Manager receives a 2% management fee on the fund’s assets under management (AUM).
- Manager also receives 20% of the fund’s net profit.
FOF: “1 OR 30”:
- Manager receives the greater of a 1% management fee or an incentive fee of 30% of the fund’s outperformance against a benchmark.
- This structure has emerged due to investor pressure for more performance-based fees. This is for FUND OF FUNDS.
- Legal and Contractual Relationships:
Fund Offering Documents:
- Govern the legal and contractual relationship between GPs and LPs.
Side Letters:
- Applicable to certain investors, offering different legal, regulatory, tax, operational, or reporting requirements.
- Alternative Structures for Larger Investors:
Fund of One:
- Hedge fund created for a single investor. Custody of shares with fund.
Separately Managed Account (SMA):
- Investor creates their own investment vehicle.
- Underlying assets are held and registered in the investor’s name.
- Day-to-day management of the account is delegated to the hedge fund manager.
- Benefits include customizable portfolio with investor-specific mandates, improved transparency, efficient capital allocation, increased liquidity, and lower fees.
FUND OF FUNDS
Benefits:
1. Better redemption terms
2. Due diligence expertise
3. More diversification as they invest in HFs across geographies & strategies
Cons:
Need to pay 2 fees: 1% management & 10% incentive fee on top of the fees charged by underlying HFs
This double layer of fees can significantly reduce after fee returns to the investor
