Lecture 5 Flashcards
What are hedge funds?
Hedge funds are private investment vehicles that manage portfolios of securities and/or derivative positions using a variety of strategies. They may involve long and short positions and be highly leveraged, aiming to deliver performance independent of broader market trends.
How are hedge funds classified?
Hedge funds are considered alternative investments because of their specialized approach, even though they may be invested in traditional assets.
Why is defining hedge funds challenging?
Defining hedge funds is challenging because they vary widely in strategies and approaches. They are highly active investment funds and often have no real benchmark, operating unconstrained.
What characteristics are typical of hedge funds?
- High leverage
- Illiquidity
- High fees (including performance fees)
- Short positions
- Use of derivative instruments
- Cash benchmark
What are some Hedge funds strategies?
What is the aim of active managers, and why do market inefficiencies exist?
Active managers aim to exploit market inefficiencies for positive expected returns.
Market inefficiencies exist due to:
- Lack of Attention: Misunderstood businesses, creative accounting, complex securities.
- Corporate Events: Mergers, acquisitions, defaults, restructurings.
- Behavioral Finance: Short-selling constraints, leverage limits, non-economic participants (e.g., central banks).
- Structural Constraints: Cognitive/emotional biases, principal-agent problems
What is the difference between Hedge funds and Mutual funds?
What is short selling, and how does it work?
Short selling involves borrowing stocks to sell at a higher price, speculating that prices will fall.
Steps:
- Borrow shares from a broker.
- Sell the shares on the market.
- Buy back shares later at a lower price.
- Return shares to the broker, keeping the difference as profit (if successful).
What costs and risks are involved in short selling?
Costs and risks:
- Borrow fees (0.3%-0.5%, sometimes 25%+ p.a.).
- Obligation to pay dividends to the lender.
- Risk of unlimited losses if the stock price rises.
What are the purposes and practical implementations of short selling?
- Hedging: Offsetting equity risks.
- Speculation: Gaining from falling prices.
Implementations:
- CDFs (retail + professional).
- TRS (mainly professional).
- Short equity futures (for indices).
Selecting hedge funds- the 4 P of hedge fund due diligence
People: Team experience, structure, governance, and culture.
Process: Portfolio construction, risk management, and operational discipline.
Performance: Reliability of performance data, alpha generation, and historical drivers.
Partnership: Liquidity provisions, fees, legal terms, and stress scenario risks.
What is a convertible bond?
