Meeting 9

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Meeting 9

• Winter Term
• Week 11 3rd December 2008

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Seminar

• Todays presentation will be taken by .....
• not me but James

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Hedge Funds
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1) What is a hedge fund?2) Hedge fund
strategies 3) Case studies 4) Hedge funds in the
credit crunch 5) Investing in hedge funds 6)
Hedge fund careers
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Hedge fund is a very loose term each hedge
fund is different.
But there is a basic framework that all modern
hedge funds have in common.
Sources The incredible shrinking funds, The
Economist, 23/10/08All You Need to Know About
the City by Christopher Stoakes Absolute
Returns by Alexander M. Ineichen
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Think of hedge funds as a special sort of
investment fund. Basics of an investment fund

• Investors (individuals or institutions) put their
  money into the fund
• The fund's managers invest this pool of money
• The investors receive a share of the profit (or
  take a share of the loss)
• The fund managers are paid a management fee
  typically 2 of the fund's Net Asset Value (NAV)?

Hedge funds share this basic structure, but with
some special alterations.
Hedge funds still pool some investors' money and
invest it. And the investors still take a share
of profit (or loss), and the managers are still
paid.
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i. Hedge funds have a special legal status.
This gives special capabilities, e.g. short
selling
Can also reduce taxes in USA, hedge fund
profits can be taxed as low as 15
ii. Regulators only permit hedge fund investors
with very high net worth (because they consider
it very risky)?
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iii. On top of management fees, hedge fund
managers also paid a performance fee typically
20 of the fund's profits.Some funds only pay
this if performance is very good, e.g. beating
certain indices (hurdle rates).
iv. Hedge funds use prime brokerage departments
of investment banks for services (credit, trade
execution, and fund administration).
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All modern hedge funds share these special
characteristics, setting them apart from regular
investment funds.

• Investors (only rich individuals or large
  institutions) invest in the fund
• The hedge fund's managers invest this pool of
  money with far less regulation on the strategies
  they can use, and using services from prime
  brokerages.
• The investors receive a share of the profit (or
  take a share of the loss)
• The fund managers are paid a management fee
  typically 2 of the fund's Net Asset Value (NAV),
  but also a performance fee typically 20 of
  the fund's profits, subject to certain
  performance-related criteria being filled.

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Common misconceptions

1) Leverage Hedge funds aren't necessarily very
leveraged. Recent study (McKinsey) industry
average 2 or 3 times equity. Most IBs run at over
20 times equity.
But some are e.g. LTCM had leverage of 301 when
it went bust in 1998
2) Hedging Hedge funds don't necessarily 'hedge'
their bets. Derivatives are almost always used
for speculation rather than hedging.
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The significance of hedge funds (pre- credit
crunch)?

• There were around 8000 hedge funds worldwide
• Held 7.5trn in assets
• 99.5 managed under 10bn
• Constituted a significant proportion of market
  activity(E.g Citadel Investment Group's daily
  trading volume 3 of average daily activity in
  London, New York, and Tokyo)?

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In summary (from the BBC) Hedge fund managers
are essentially a group of investment managers
who invest in a variety of asset classes, with
the licence to invest in a very flexible way.
However, the characteristics that all hedge funds
share end here. Now we will go on to look at
hedge fund strategies and each fund employs a
different strategy to the next.
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1) What is a hedge fund?2) Hedge fund
strategies 3) Case studies 4) Hedge funds in the
credit crunch 5) Investing in hedge funds 6)
Hedge fund careers
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Hedge funds are far less regulated than standard
investment funds. This opens up a far wider
selection of strategies.
There is no 'standard' hedge fund strategy.
However, there are a few broad strategies that
hedge funds frequently use.
For a longer list of strategies, see
http//richard-wilson.blogspot.com/2008/03/hedge-f
und-strategy.html
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Equity Long/Short

• First used by Alfred Winslow Jones (invented
  hedge funds in the 1940s). Now just one of many
  hedge fund strategies.
• Aim minimize exposure to the market instead
  just profit from a change in the spread of two
  stocks.

ProcessBuy an undervalued stock, short an
overvalued stock.If market moves, position
mostly neutralizedExceptIf market rises,
overvalued falls by slightly more If market
falls, undervalued rises by slightly more ?
Profit
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Global macro

• Aim profit from macroeconomic events
• Use any markets and instruments (e.g.
  currencies, commodities, equities)
• Popular in 80s and 90s
• By investing in so many markets, can avoid bear
  markets in one country and use bull markets in
  another
• E.g. George Soros' Quantum Fund. Earned 1bn by
  shorting pound sterling in 1992

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Event-driven strategies

• Aim Profit from opportunistic 'events' wherever
  managers see fit
• Example events IPOs, mergers, writedown
  announcements, macroeconomic events

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Arbitrage strategies

• Arbitrage is a broad term covers many
  strategies
• Aim simultaneously buy and sell in different
  markets, exploiting price discrepancies of the
  same asset

E.g Relative arbitrage funds, Merger arbitrage,
Municipal arbitrage, Convertible bond arbitrage
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1) What is a hedge fund?2) Hedge fund
strategies 3) Case studies 4) Hedge funds in the
credit crunch 5) Investing in hedge funds 6)
Hedge fund careers
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The hedge fund industry has had both spectacular
successes and failures.

• Famous successes
• Paulson Co. made 37bn shorting the mortgage
  market ahead of the credit crunch. John Paulson
  was highest paid hedge fund manager of 2007
  (3.7bn)
• Quantum (George Soros) shorting sterling in
  1992 for a 1bn profit.
• James Simons, one of the world's most successful
  hedge fund managers - estimated current net worth
  approximately 5.5 billion
• Paul Tudor Jones using global macro strategies,
  shorted Black Monday in 1987, tripling his money

• Famous failures
• Amaranth Advisors LLC collapsed in one week
  after losing 6bn on natural gas futures. Largest
  hedge fund collapse in history.
• Long Term Capital Management (LTCM), collapsed
  spectacularly in 1998. See When Genius Failed.
• The Tiger funds short squeezed during the tech
  bubble in 2000.

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1) What is a hedge fund?2) Hedge fund
strategies 3) Case studies 4) Hedge funds in the
credit crunch 5) Investing in hedge funds 6)
Hedge fund careers
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The credit crunch has damaged the hedge fund
industry.
Why exactly have hedge funds been failing?
1) Poor hedge fund management the industry does
hold many illiquid assets
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2) Bans on short-selling made many strategies
unworkable
3) Prime brokers also tightened lending to some
funds (the most highly leveraged ones)?
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4) Main reason hedge funds are failing
Withdrawals

• As hedge funds grew in popularity they gained
  more institutional investors (instead of loyal
  private investors)

(Institutions and fund-of-funds went from 5
of hedge fund investors in 1990 to 40 today)?

• But now we're in recession institutions are
  withdrawing to raise funds

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• Stats on current redemptions (withdrawals)
• European and Asian hedge funds hardest hit
  25-30 withdrawals
• US hedge funds 15-20

The ResponseMany hedge funds are imposing rules
to stop withdrawals. This is being justified as
"saving investors from themselves".
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• However
• As unsuccessful funds prevent withdrawals, it
  forces desperate investors to withdraw from
  genuinely successful funds
• It may simply prolong the damage being done to
  the markets
• Many investors are unhappy. In future, more
  attention will be paid to how easily a hedge fund
  can sell assets to pay out withdrawals

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Only the best performers are likely to survive
It won't be the end of hedge funds per se, but
it may be the end of mediocre hedge funds.
Source Darwinian rules threaten hedge funds,
Financial Times, 4/11/08
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1) What is a hedge fund?2) Hedge fund
strategies 3) Case studies 4) Hedge funds in the
credit crunch 5) Investing in hedge funds 6)
Hedge fund careers
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• Must meet minimum requirements to invest in hedge
  funds.
• In the USA, individuals must have
• 1million Net worth, or
• 200k Income for last 3 years
• Investing is largely done online
• There is a secondary market for locked-in hedge
  fund assets, e.g. www.hedgebay.com

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1) What is a hedge fund?2) Hedge fund
strategies 3) Case studies 4) Hedge funds in the
credit crunch 5) Investing in hedge funds 6)
Hedge fund careers
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• eFinancialCareers claim New York and the West End
  of London to be the main hedge fund locations.
• Employees tend to be ex-bankers. A handful of
  graduates find hedge funds jobs, but usually
  through contacts
• Being small institutions, most hedge funds do not
  have in-house training facilitiesSo some value
  postgraduate degrees that prepare new
  employeeseFinancialCareers lists some good
  masters degree programmes at http//news.students.
  efinancialcareers.co.uk/NEWS_ITEM/newsItemId-10201
  

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Whats going down in the City!

• Job cuts CS, AM, Citi
• RBS and NR delays repossessions
• Banks plan overdraft refund
• Bank forced into administration
• US carmakers beg for 34bn
• Ford and GM to merge!!
• Oil up on production cut prospect
• BA and Qantas to merge!

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VTG Update
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Whats coming up next week

• VTG final update of 2008
• More Financial News
• Social plans
• Last speaker of the year Leon Grant, SocGen,
  Associate Leverage Capital Markets

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• SEE YOU ALL NEXT WEEK!!