Lecture 10: Clients - Hedge Funds Flashcards
What are the six charachteristics of hedge funds?
1) Completely flexible investments, including both long and short positions
2) Highly leveraged
3) minimal Regulations
4) some illiquidity
5) Institutional investors - targeted wealth investors and institutions
6) Performance based fees
How are hedge funds different from mutual funds?
1) Pricing and liquidity: Mutual funds must price assets daily
(mark to market) ad offer daily liquidity, whereas hedges are only required to disclose quarterly value of assets and liquidity is subject to limitations
2) Investors: Mutual open to both retail and institutional investors, whereas hedges are only available to accredited investors
3) Regulation: Mutual are much more heavily regulated by ASIC
4) Fees: Mutual funds management fees are much lower than hedge funds, and mutual funds only receive mgt fees (no performance fees - only for hedges)
5) Leverage: Mutual have typically no leverage, hedges use alot of leverage
6) Flexibility: Hedges are more flexible compared to mutual fund
What are the similarities and differences for private equity and hedge funds?
Similarities:
- Both are private pools of capital
- Receive high mgt and performance fees based on the funds performance
- Both lightly regulated
Differences:
- Hedge funds invest in liquid assets (minority positions in company, bonds and many other assets - taking both long and short positions)
- Private equity funds - purchase entire companies, creating less liquid companies - held for 3-7 years
What is the typical fee structure of a hedge fund?
2 and 20 rule
Management fee: 2% NAV
Performance fee 20% increase in the funds NAV
What is a high water mark and hurdle rate? What do they relate to?
Relate to performance fees
- High watermark: Highest peak that a NAV has reached, and performance fees are only payable on the difference between the first watermark and then subsequent water marks. If there is a decline in NAV - $nil performance fee payable until the water mark is exceeded again
- Hurdle rate: whereby the fund receive a performance exceeds a benchmark rate or a rate determined by the market
What are absoloute returns? What effect does this have on fees?
Absolute returns: Means that investment returns will always be positive (avoiding yearly losses) and don’t depend on the performance of broad markets and the economy (unlike mutual funds)
How does a hedge fund leverage its investment position using a margin loan?
How do we calculate margin requirement?
When the hedge fund borrows money to buy a security, it will use the asset itself as collateral of the loan.
- if the value of the asset dips below the margin requirement, additional equity contribution required
- Margin requirement: (Current value of collateral - loan amount)/ (Current value of the collateral)
What are the two direct forms of leverage?
1) Margin financing
2) Repurchase agreement: agree to sell security for predetermined price, and then buy back for a higher amount later
What are the two indirect forms of leverage?
1) Structured products to utilise off balance sheet leveraging
2) Short selling (selling securities short and using the proceeds to purchase other securities - enables exposure to an asset with less capital than required through derivatives)
What impact does leverage have on performance?
Magnifies either losses or gains
What are the three limitations hedge funds place on investors?
1) Lock up provisions
2) Gate provisions
3) Side pocket accounts
What is a lock up provision?
- During initial investment period: prevents investors from withdrawing money from the fund
- HOWEVER - can be modified through a side letter agreement with investors
What is a gate provision?
- Limits the amount of with drawls after th lock up period
- 10-20% of a funds capital that can be withdrawn on a scheduled redemption date
- Allows hedge fund to manage assets without being exposed to a liquidity crisis
- Also protects non withdrawing members from excessive withdrawls by other members of the fund
What are side pocket accounts?
How are mgt fees determined?
- Created to house illiquid assets
- New investors don’t participate, and when existing members draw amounts from the hedge fund, they remain investors in the side pocket until it is either sold or becomes liquid
- Based on their cost rather than mark to market value
What are the three key benefits of funds of funds?
- Allow investors who may not qualify to invest in hedge funds to invest
- Diversification: Since many funds have investments in 10 or more hedges, investors have greater exposure to diversification
- Due diligence: Many high net worth and institutions will invest to take advantage of the due diligence process by which funds of funds weed out poor hedge fund managers
