HEDGE FUNDS

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HEDGE FUNDS

• An Introduction to

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Presentation Outline

• What Is a Hedge Fund?
• A Brief History of Hedge
• Hedge Fund Strategies
• Measures of Risk
• Performance Measures
• Downside Protection

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Hedge Funds vs Traditional Mutual Funds

• Traditional Mutual Funds
• Governed by Investment Company Act of 1940
• Available to most investors
• Low minimum requirement
• Transparent operations
• Heavily advertised
• Mostly long only strategies
• Active versus passive
• No or low leverage
• Relative performance
• Compared to an benchmark index

• Hedge Funds
• Escaped ICA1940 3(c)1
• 99 accredited investors or less
• National Securities Market Improvement Act of
  1996- 3(c)7
• 500 qualified purchasers or less
• No transparency
• Cannot advertise
• Alternative investment strategies
• High leverage
• Absolute performance

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Hedge Fund History

• Alfred Winslow Jones established the first hedge
  fund in 1949. He used two techniques, leverage
  and short-selling, to protect his portfolio
  during market downturns.
• Jones believed stock selection was the key to
  performance, regardless market direction.
• Jones was very successful, and established hedge
  fund fee structures that are still largely used
  today-keeping 20 profits for himself.
• Wall Street took notice and many money managers
  launched their own hedge funds. Unfortunately,
  many of these managers strayed from Jones
  original concepts and used leverage without short
  selling. As a result, when the market fell, these
  funds suffered tremendous loss and gave hedge
  funds a reputation of being high-risk
  investments.
• In the late 1970s, hedge funds began to attract
  positive attention as high profile managers like
  Julian Robertson and George Soros posted
  extraordinary long term returns.
• Greenwich Alternative Investments (GAI) has been
  collecting and analyzing hedge fund data for more
  a decade.

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Growth and Composition
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Growth and Composition
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Hedge Fund Strategies

• Market Neutral Group
• Equity Market Neutral
• Event-Driven
• Distressed securities
• Merger arbitrage
• Special situations
• Market Neutral Arbitrage
• Convertible arbitrage
• Fixed income arbitrage
• Statistical arbitrage

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Hedge Fund Strategies

• Long/Short Equity Group
• Aggressive Growth
• Opportunistic
• Short Selling
• Value
• Directional Trading Group
• Emerging Markets
• Income
• Multi-strategy

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Equity Market Neutral

• The manager invests similar amounts of capital in
  securities both long and short, maintaining a
  portfolio with low net market exposure. Long
  positions are taken in securities expected to
  rise in value while short positions are taken in
  securities expected to fall in value. These
  securities may be identified on various bases,
  such as the underlying company's fundamental
  value, its rate of growth, or the security's
  pattern of price movement. Due to the portfolio's
  low net market exposure, performance is insulated
  from market volatility.

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Event-Driven

• The manager focuses investment activities on
  significant catalyst-type events, such as
  spin-offs, mergers and acquisitions, bankruptcy
  reorganizations, recapitalizations and share
  buybacks. Some managers who employ Event-Driven
  trading strategies may shift the majority
  weighting between Merger Arbitrage and Distressed
  Securities, while others may take a broader
  scope. Typical trades and instruments used may
  include long and short common and preferred
  stocks, debt securities, options and credit
  default swaps. Leverage may be employed by some
  managers.

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Event-Driven

• Distressed Securities - The manager invests in
  the debt and/or equity of companies having
  financial difficulty. Such companies are
  generally in bankruptcy reorganization or are
  emerging from bankruptcy or appear likely to
  declare bankruptcy in the near future. Because of
  their distressed situations, the manager can buy
  such companies' securities at deeply discounted
  prices. The manager stands to make money on such
  a position should the company successfully
  reorganize and return to profitability. Also, the
  manager could realize a profit if the company is
  liquidated, provided that the manager had bought
  senior debt in the company for less than its
  liquidation value. "Orphan equity" issued by
  newly reorganized companies emerging from
  bankruptcy may be included in the manager's
  portfolio. The manager may take short positions
  in companies whose situations he deems will
  worsen, rather than improve, in the short term.

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Event-Driven

• Merger Arbitrage - The manager will take
  positions in companies undergoing special
  situations for example, when one firm is to be
  acquired by another, or is preparing for a
  reorganization or spin-off. A frequent trade is
  long the acquiree, short the acquirer.
• Special Situations - The manager invests both
  long and short, in stocks and/or bonds which are
  expected to change in price over a short period
  of time due to an unusual event. Such events
  include corporate restructurings (e.g. spin-offs,
  acquisitions), stock buybacks, bond upgrades, and
  earnings surprises. This strategy is also known
  as event-driven investing.

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Market-Neutral Arbitrage

• The manager seeks to exploit specific
  inefficiencies in the market by trading a
  carefully hedged portfolio of offsetting long and
  short positions. By pairing individual long
  positions with related short positions,
  market-level risk is greatly reduced, resulting
  in a portfolio that bears a low correlation and
  low beta to the market. The manager may focus on
  one or several kinds of arbitrage, such as
  convertible arbitrage, risk (merger) arbitrage,
  capital structure arbitrage or statistical
  arbitrage. The paired long and short securities
  are related in different ways in each of these
  different kinds of arbitrage but in each case,
  the manager attempts to take advantage of pricing
  discrepancies and/or projected price volatility
  involving the paired long and short security.

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Market-Neutral Arbitrage

• Convertible Arbitrage - This strategy typically
  involves buying and selling different securities
  of the same issuer (e.g. the common stock and
  convertibles) and working the spread between
  them. The manager buys one form of security he
  believes to be undervalued (usually the
  convertible bond) and sells short another
  security (usually the stock) of the same company.
  
• Fixed Income Arbitrage - The manager takes
  offsetting positions in fixed income securities
  and their derivatives in order to exploit
  interest rate-related opportunities. These fixed
  income securities are often backed by residential
  mortgages i.e., mortgage-backed securities.

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Market-Neutral Arbitrage

• Other Arbitrage - may include managers utilizing
  various arbitrage strategies, including but not
  limited to capital structure arbitrage, credit
  arbitrage, multi strategy arbitrage, options
  arbitrage, and Regulation D arbitrage.
• Statistical Arbitrage - The manager uses
  quantitative criteria to choose a long portfolio
  of temporarily undervalued stocks and a roughly
  equal-sized short portfolio of temporarily
  overvalued stocks. Trades tend to be short-term
  and the overall portfolio is usually neutral in
  terms of various risk characteristics (beta,
  sector exposure, etc.). Pairs trading is a
  common form of statistical arbitrage.

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Long/Short Equity Group

• Aggressive Growth - A primarily equity-based
  strategy whereby the manager invests in companies
  experiencing or expected to experience strong
  growth in earnings per share. The manager may
  considers a company's business fundamentals
  and/or technical factors, such as stock price
  momentum. Companies in which the manager invests
  tend to be micro, small, or mid-capitalization in
  size rather than mature large-capitalization
  companies. These companies are often listed on
  (but are not limited to) the NASDAQ. Managers
  employing this strategy generally utilize short
  selling to some degree, although a substantial
  long bias is common.

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Long/Short Equity Group

• Opportunistic- Rather than consistently selecting
  securities according to the same strategy, the
  manager's investment approach changes over time
  to better take advantage of current market
  conditions and investment opportunities.
  Characteristics of the portfolio, such as asset
  classes, market capitalization, etc., are likely
  to vary significantly from time to time. The
  manager may also employ a combination of
  different approaches at a given time.

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Long/Short Equity Group

• Short Selling- The manager maintains a consistent
  net short exposure in his portfolio, meaning that
  significantly more capital supports short
  positions than is invested in long positions.
  Unlike long positions, which one expects to
  increase in value, short positions are taken in
  those securities the manager anticipates will
  decrease in value. In order to short sell, the
  manager borrows securities from a prime broker
  and immediately sells them on the market. The
  manager later repurchases these securities,
  ideally at a lower price than he sold them for,
  and returns them to the broker. Short selling
  managers typically target overvalued stocks
  characterized by prices they believe are too high
  given the fundamentals of the underlying
  companies.

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Long/Short Equity Group

• Value- A primarily equity-based strategy whereby
  the manager focuses on the price of a security
  relative to the intrinsic value of the underlying
  business. The manager takes long positions in
  stocks that he believes are undervalued. The
  manager takes short positions in stocks he
  believes are overvalued. As the market comes to
  better understand the true value of these
  companies, the manager anticipates the prices of
  undervalued stocks in his portfolio will rise
  while the prices of overvalued stocks will fall.
  The manager often selects stocks for which he can
  identify a potential upcoming event that will
  result in the stock price changing to more
  accurately reflect the company's intrinsic worth.

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Directional Trading Group

• Futures - Managers strive to be profitable in any
  type of economic climate since they have the
  flexibility to go long (buy in anticipation of
  rising prices) or "short" (sell in anticipation
  of declining prices). They can be classified as
  systematic, discretionary or a combination of the
  two. Collectively, the performance of Futures
  managers has a relatively low correlation to many
  other strategies.
• Macro - The manager constructs his portfolio
  based on a top-down view of global economic
  trends, considering macro factors such as
  interest rates, inflation, etc. Rather than
  considering how individual corporate securities
  may fare, the manager seeks to profit from
  changes in the value of entire asset classes. For
  example, the manager may hold long positions in
  the U.S. dollar and Japanese equity indices while
  shorting the Euro and U.S. treasury bills.
• Market Timing - The manager attempts to predict
  the short-term movements of various markets and,
  based on those predictions, moves capital from
  one segment to another in order to capture market
  gains and avoid market losses. While a variety of
  investment categories may be used, the most
  typical ones are various mutual funds and money
  market funds. Market timers focusing on these
  mutual funds are sometimes referred to as mutual
  fund switchers.

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Specialty Strategies Group

• Emerging Markets- The manager invests in
  securities issued by businesses and/or
  governments of countries with less developed
  economies that have the potential for significant
  future growth. Examples include the BRIC
  countries (Brazil, Russia, India and China). This
  strategy is defined purely by geography. The
  manager may invest in any asset class (e.g.,
  equities, bonds, currencies) and may construct
  his portfolio using any strategies.
• Income- The manager invests primarily in
  yield-producing securities, such as bonds, with a
  focus on current income. Other strategies (e.g.
  distressed securities, market neutral arbitrage,
  and macro) may heavily involve fixed-income
  securities trading as well this category does
  not include those managers whose portfolios are
  best described by one of those other strategies.
• Multi-Strategy- The manager typically utilizes
  two or three specific, pre-determined investment
  strategies. Although the relative weighting of
  the chosen strategies may vary over time, each
  strategy plays a significant role in portfolio
  construction. Managers may choose to employ
  Multi-Strategy approach in order to better
  diversify their portfolios and/or to more fully
  use their range of portfolio management skills
  and philosophies.

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Measures of Risk

• Annualized Volatility - Standard deviation is a
  measure of how dispersed the investments returns
  are from its arithmetic mean. It is derived by
  calculating the square root of the difference of
  the returns of the investment from its arithmetic
  mean. Volatility has historical precedence as one
  of the most commonly used risk measures.  
• Downside Deviation It is the same as
  volatility, except downside deviation only
  measures the volatility of the investment returns
  that fall below the investors defined minimum
  acceptable return. For example, if the minimum
  acceptable return is 5, the downside deviation
  would only measure the volatility of the returns
  falling below 5. Investors prefer upside over
  downside volatility.  
• Drawdown - A drawdown occurs when an investments
  price falls below its last peak (high-water
  mark). Drawdown measures the investments
  cumulative drop in price from its previous
  high-water mark as a percentage of the peak
  price. Investors look at various statistics
  related to the measure of time regarding a
  drawdown. How long did it take to recover? (The
  period between the trough and the recapturing
  peak is called the recovery.) What was the
  average length of time a drawdown occurred? (This
  is called the length of the drawdown.) What is
  the worst drawdown? (This is the maximum drawdown
  and represents the greatest peak to trough
  decline over the life of the investment.)

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Measures of Risk

• Skewness A return distribution that is not
  symmetrical is called skewed. The skewness for a
  normal distribution is zero.  
• Positively skewed distribution - characterized by
  many small losses and a few extreme gains and has
  a long tail on its right side. Relative to the
  mean return, positive skewness amounts to
  limited, though frequent, downside compared to a
  somewhat unlimited, but less frequent upside.  
• Negatively skewed distribution - characterized by
  many small gains and a few extreme losses and has
  a long tail on its left side. Relative to the
  mean return, negative skewness amounts to a
  limited, though frequent, upside compared with a
  somewhat unlimited, but less frequent downside.

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Measures of Risk

• Kurtosis -Kurtosis characterizes the relative
  peakedness or flatness of an investments
  return distribution compared with the normal
  distribution. The higher the kurtosis, the more
  peaked the return distribution is the lower the
  kurtosis, the more rounded the return
  distribution is. A normal distribution has a
  kurtosis of 3.
• Value at Risk (VaR) -Unlike other risk metrics
  such as volatility that measure historical risk,
  VaR quantifies market risk while it is being
  taken. It measures the odds of losing money but
  does not indicate certainty.

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Performance Measures

• Alpha measures excess return, relative to a
  representative benchmark. It is common to compare
  a managers performance to that of a risk-free
  investment (usually a Treasury bill) or to a
  benchmark that represents the market in which the
  fund participates such as the Greenwich Global
  Hedge Fund Index.
• Alpha Fund Return Benchmark Return
• For example, if a fund had an alpha of 2.0, it
  would have produced a return that was two
  percentage points higher than the benchmark.

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Performance Measures

• Beta measures the risk of a fund by measuring the
  volatility of its past returns in relation to the
  returns of a benchmark.
• For example, a fund with a beta of .7 versus the
  SP 500 Index has experienced gains and losses
  that are 70 of the SP 500 Indexs changes. A
  fund with a beta of 1.0 is expected to follow the
  moves of the index.

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Performance Measures

• Sharpe Ratio measures return per unit of risk.
  The higher the Sharpe Ratio, the better the
  funds historical risk-adjusted performance. It
  is calculated as return minus the risk free rate
  divided by standard deviation

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Performance Measures

• Sortino Ratio measures return per unit of bad
  volatility by replacing the denominator in the
  Sharpe Ratio (standard deviation) with downside
  deviation. It provides a measure of the funds
  performance without penalizing it for upward
  swings in return. A large Sortino Ratio indicates
  a low risk of large losses occurring.
• Treynor Index is a helpful measurement of the
  funds excess return from each unit of systematic
  risk. It measures the funds excess return
  (funds rate of return minus the risk free rate
  of return) per unit of risk using beta as the
  measure of risk as opposed to the standard
  deviation of the funds returns.

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Hedge Fund Diversification Benefits
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Downside Protection-historical facts
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Downside Protection-historical facts
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Downside Protection-historical facts