Topic 5-Alternative Investments ((iv) What is a Hedge Fund & differences from traditional funds)

Question 1

Definition of Hedge Fund

Answer 1

• The original concept of a hedge fund was to offer plays against the markets, using short selling, futures , and other derivative products. (Hedging activities)
• Today funds using the “hedge fund” appellation use all kinds of trading strategies. Example, some focus on making macroeconomic bets on commodities, currencies, interest rates etc.
• Rapid growth in hedge funds over the last decades
• In 2007, assets under management surpassed $2 trillion
• In 2007, the number of hedge funds exceeded 13,000

Question 2

What’s different about hedge funds compared to traditional funds?

Answer 2

-Seek absolute rather than relative returns
—Pursue specific investment bets

-They are not subject to some regulation
—Short sales, derivatives, leverage

-Have option-like fees, including a base management fee and an incentive fee proportional to realized profits.

Question 3

Hedge Funds (Absolute Returns)

Answer 3

• Money management has moves towards a focus on performance relative to preassigned benchmarks.
• Hedge Funds go against this trend because they believe that it can limit your investment opportunities
• Hedge Funds generally try to isolate specific bets for the purpose of generating alpha
• Hedge fund managers seek freedom to achieve high absolute returns and wish to be rewarded for their performance

Question 4

Hedge Funds (Regulations)

Answer 4

• Hedge Funds are typically set up as a limited partnership or offshore corporation allowing fund managers to take short and long positions in any asset, use any kind of derivative and to leverage the fund without any restrictions

Question 5

Hedge Funds (Fee Structure)

Answer 5

• The manager is compensated through a base management fee based on the value of the assets under management plus an incentive fee proportional to realised profits (ranging fro 15 to 30% of total profits)
• Base fee is guaranteed and the incentive fee is based on the profits. It cannot be negative so it returns are negative then you’ll just earn 0 incentive fee.
• Incentive fee is sometimes measured as an above risk-free rate
• Sometimes the fee structure includes a “high-water mark” which means that if the fund declined in value the year before, then the fund would have to recover those losses before any incentive fee is paid.

Question 6

Hedge fund managers can create leverage in trading by:

Answer 6

• Borrowing external funds to invest more than the equity capital that they put in.
• Borrowing through a brokerage margin account
• Use of financial instruments and derivatives.