Hedge Funds Flashcards
Hedge funds
aims to generate positive returns for their investors regardless of market conditions.
They are pooled investment funds that use various strategies to maximize profits while also attempting to minimize risk.
they can invest in a wide range of assets and employ more complex strategies
A fund that can
take both long and short positions
use arbitrage
buy and sell undervalued securities
trade options or bonds, and
invest in almost any opportunity in any market where it foresees impressive gains at reduced risk.
Traditional Funds characteristics
Mostly market (Beta) Dependent (some skill)
Mostly hold stocks and bonds
mostly long
strict style constraints
frequent liquidity
generally scalable capacity
Hedge Funds characteristics
Mostly skill development (Some Beta)
Hold stocks, bonds, derivatives, anything that makes money
long and/or short
loose style constraint
restricted liquidity capital lock-ups
most are capacity constrained
Key Aspects of Hedge Funds
Diversification (spread risk across multiple markets and investment opportunities.)
Alternative Strategies (generate returns that are uncorrelated with traditional asset classes)
Risk Management (protect the capital of their investors while seeking attractive returns.)
Performance Fees (interests of the fund managers with those of the investors)
Liquidity and Lock-up Periods (cannot withdraw their money)
Accredited Investors (ensure that investors have sufficient financial resources and understanding)
Regulatory Environment (more flexibility and are subject to less stringent regulatory oversight.)
Performance Variation
Sophisticated Investors (can tolerate higher risk)
Hedge fund distinctions: Transparency
Most managers do not want to share their positions
Provides the ability to evaluate and understand the manager’s process/strategy
Institutions have asked for more transparency over recent years
Information usefulness
Hedge fund distinctions: Liquidity
Usually a 6 month to 1 year initial lock up unless some event occurs (key man provision)
Redemptions can usually occur every quarter with a 60 – 90 day notice
Gates/Suspensions
Side pocket investments
Hedge fund distinctions: Leverage
Employed by HFs to magnify gains, but magnifies losses as well
Funds can employ different types of leverage
Financial (borrowing)
Use of derivatives
Hedge fund distinctions: hedge fund managers
Hedge fund managers that invest their capital into other hedge fund managers
Tactically allocate capital
Pros of Hedge fund managers that invest their capital into other hedge fund managers
Immediate hedge fund diversification
Fund of Funds (FoF) have infrastructure and expertise to conduct due diligence and monitor underlying managers
Knowledge transfer to staff
Cons of Hedge fund managers that invest their capital into other hedge fund managers
Double layer of fees (investors pay underlying hedge fund fee and FoF manager fee) could be substantial
Asset allocation in the hands of the FoF manager
Over-diversification is possible
Hedge fund distinctions: Compensation structure
Performance-based incentive fees that attract elite managers
was once “2 and 20,” which reflects a 2% management fee and a 20% incentive fee; both fees are paid by LP investors.
The average industry fee is now closer to a 1.6% management fee and 17.75% incentive fee
may charge investors a 1% management fee and a 10% incentive fee
Management fee
collected on a quarterly, semi-annual, or annual basis
Collected regardless of performance (1% - 3%)
Performance fee
collected annually but only if fund is profitable (usually 20%)
High water mark provision – incentive fee only paid if NAV is above previous NAV
Hurdle rate – incentive fee only paid after fund exceeds a set threshold return
Calculated based on NAV
