83. Hedge Funds

What are the five broad classifications of hedge funds?

1. Equity hedge funds 2. Event-driven hedge funds 3. Relative value hedge funds 4. Opportunistic hedge funds 5. Multi-manager hedge funds

What are the two main opportunistic hedge fund strategies?

1. Global macro 2. Managed futures

What are the 7 features distinguishing hedge funds from traditional investments?

1. Less legal and regulatory constraints 2. Flexible mandates permitting the use of shorting and derivatives 3. A larger investment universe on which to focus 4. Aggressive investment styles that allow concentrated positions in securities offering exposure to credit, volatility, and liquidity risk premiums 5. Relatively liberal use of leverage 6. Liquidity constraints that include lockups and liquidity gates 7. Relatively high fee structures involving management and incentive fees

Rank the following products from least liquid to most liquid: 1. Closed-end funds 2. Mutual funds 3. SMAs 4. Limited partnerships 5. ETFs

1. Limited partnerships 2. SMAs 3. Closed-end funds 4. Mutual funds 5. ETFs

What are the 5 main examples of equity hedge fund strategies?

1. Long/short equity 2. Short biased 3. Market neutral 4. Fundamental Growth 5. Fundamental Value

The performance of hedge funds can be attributed to what three distinct sources?

1. Market beta - the broad market beta that can be realized using market index-based funds/ETFs 2. Strategy beta - the beta attributed to the investment strategy of the hedge fund applied across the board market. 3. Alpha - the manager-specific returns, due to the selection of specific positions.

What are the four main event driven hedge fund strategies?

1. Merger arbitrage 2. Distressed 3. Special situations 4. Activist

What are some differences between mutual funds and hedge funds?

1. Mutual fund managers are paid a fixed compensation and may not necessarily invest in the funds they manage. Hedge fund managers are paid a performance based fee and many require the managers to invest in the hedge fund. 2. Hedge fund managers have a great deal of freedom to make trading decisions and to decide how to allocate client funds. Mutual funds are highly regulated since they are available to public investors, whereas hedge funds are only available to institutional and accredited investors. 3. Hedge funds are privately owned and are lightly regulated.

What should an investor consider when choosing a hedge fund?

1. Review the LP capabilities 2. They should also consider a GP's fiduciary management guidelines, manager experience, and alignment of interests towards the fund's strategies. 3. Strategy, transparency, liquidity, and reporting practices. 4. The investor should thoroughly evaluate the fund manager's past performance and be aware of how the fund compensates the fund managers and calculates the fees charged to investors.

What are the downsides to SMAs?

1. SMAs are operationally more complex and demand greater governance oversight, making them appropriate for larger institutional investors 2. Managers do not have a stake in the fund. 3. Although investors negotiate lower fees and fund expenses, they may receive allocations only to the fund manager's most liquid investment trades. 4. Manager motivation is reduced, causing conflicts of interest.

What are some specific sources of alpha?

1. The manager skills in specific stock selection. 2. Utilizing higher-return strategies that minimize risk.

What is a common structural characteristic of a hedge fund?

A common structural characteristic of a hedge fund is that it is set up as a private investment partnership either onshore or in a tax-advantaged offshore locations.

What is another example of distressed/restructuring?

A fund may purchase a debt instrument that is expected to be converted into new equity upon restructuring or bankruptcy, typically called a fulcrum security, and then either hold onto the equity or exit.

What is convertible bond arbitrage?

A market-neutral investment strategy seeking to exploit a perceived mispricing between a convertible bond and its component parts: the underlying bond and the embedded call option. This involves buying the convertible debt securities and selling a certain amount of the same issuer's common stock based on the delta of the embedded call option.

What is a separate managed account (SMA)?

A separate investment account over which the investor retains more influence. The investor creates his or her own investment vehicle and the underlying assets are held and registered in the name of the investor. Day-to-day management of the account is delegated to the hedge fund manager.

Select the statements that are true: A. The primary drivers of returns from stocks are growth projections, dividends, and retained earnings. B. The primary drivers of returns from a bond are interest rates, credit risk, and coupon payments. C. The primary drivers of return from hedge funds are market volatility and market inefficiency.

All are true

What does an SMA allow for?

An SMA allows for a customizable portfolio, with investor-specific investment mandates, better transparency, efficient capital allocation, and higher liquidity, over which the investor can exercise greater control while keeping lower fees.

Choose the correct statements regarding benefits of a master feeder structure. A. It allows investors in taxable jurisdictions to invest in an offshore hedge fund without any tax liability. B. Pooling funds from offshore and onshore funds creates economies of scale. C. This structure allows hedge funds to accept funding from global investors with relative ease. D. Many regional regulatory requirements can be avoided by such a structure.

B,C, and D are correct.

Both hedge funds and private equity invest in equity stock of public or private enterprises, and there are many commonalities between them. The following statements are some of the commonalities, and one of these statements is false. Choose the false statement. a. Both are structured as partnerships of investors with private pooling of funds and are primarily intended for high-net-worth individuals. b. Both utilize leverage to invest in a variety of marketable securities. c. Both are less liquid than mutual funds or ETFs. d. Both are less regulated, and the transparency/reporting requirements are not strict.

Both utilize leverage to invest in a variety of marketable securities

What can CTAs be relied on for?

CTAs can be relied on to profit from having purchased short positions in falling markets.

Why are commodity-focused managed futures funds unique?

Commodity-focused managed futures funds are unique because there is a constant price tension between suppliers and consumers: high prices cripple demand (tending to lower prices), and low prices shut in supply (and thus raise prices).

Both hedge funds and private equity invest in equity shares of public or private enterprises. However, there are many differences between them. The following statements lists some of their differences. Choose the statement that is false. a. Private equity funds invest for the long term, while hedge funds invest in equities for the shorter term. b. Typical hedge funds are transaction oriented; they make several offsetting trades. Private equity funds make stable, long-term investments in few companies. c. An investor normally funds the hedge fund at the start of the investment, while private equity funds are committed at the start and funded over time, upon demand. d. Private equity is redeemable on a periodic basis, while hedge funds require a longer-term commitment.

D is the correct answer choice because the statement is false. Hedge funds are redeemable on a periodic basis, and private equity funds require a longer-term commitment. The other statements are correct.

Hedge Fund Investment Features

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Hedge Fund Investment Forms

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Hedge Fund Investment Risk, Return, and Diversification

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Introduction

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Which of the following statements is least accurate about hedge funds? a. Merger arbitrage strategies generally assume that an acquirer will be overpaying for the target. b. Event-driven hedge funds flourish in a stable market environment, where minor deviations in asset prices quickly converge to equilibrium. c. An activist strategy expects to realize higher returns due to the manager being more effective in driving the corporate policies or strategic direction of the investment.

Event-driven hedge funds flourish in a stable market environment, where minor deviations in asset prices quickly converge to equilibrium.

What are event-driven strategies?

Event-driven strategies are bottom-up strategies that seek to profit from defined events that are expected to change valuations, typically involving changes in corporate structure, such as an acquisition or restructuring.

Event-driven strategies are biased in what direction?

Event-driven strategies are long biased.

How many of the following statements comparing hedge funds and ETFs are true? 1. ETFs are exchange-traded public securities, while hedge funds are private partnership funds. 2. Any investor can invest in an ETF, while specific restrictions apply to who can invest in a hedge fund. 3. ETFs have very low fees and expense ratios compared to hedge funds. 4. ETFs are highly regulated, with specific reporting requirements, while hedge funds are lightly regulated. a. One of the statements is true. b. Two of the statements are true. c. Three of the statements are true. d. Four of the statements are true

Four of the statements are true

What is the main multi-manager fund strategy?

Fund of funds

What is a fund of hedge funds?

Funds of hedge funds pool funds from investors and invest the proceeds in a diversified portfolio of hedge fund investments across a variety of hedge funds. This provides direct diversification benefits across fund strategies.

What are funds of hedge funds?

Funds that create a diversified portfolio of hedge funds, which is attractive to smaller investors without the resources to select individual hedge funds and build a portfolio of them.

What is merger arbitrage?

Generally, these strategies involve going long (buying) the stock of the company being acquired at a discount to its announced takeover price and going short (selling) the stock of the acquiring company when the merger or acquisition is announced. Since the expected risk and return on a merger arbitrage strategy stems from the modest spread in prices, leverage is regularly used to amplify returns but also increases losses when the strategy fails.

What kind of returns do hedge fund ETFs generate?

Hedge fund replication ETFs seek to generate returns with high correlations with actual hedge fund performance. The returns often fall short compared to pure hedge fund strategies because these instruments are publicly traded, are subject to much heavier regulatory burden, do not impose restrictions on redemptions, and cannot use leverage to the same extent.

Which of the following is not a characteristic of hedge funds? a. Hedge funds are mostly illiquid, with little trading possibilities. b. Hedge fund managers use leverage; however, the overall risk is lower. c. Hedge funds are a different asset class, with a distinct risk/reward profile. d. Managers demand higher remuneration and have more discretionary freedom in the choice of investments.

Hedge funds are a different asset class, with a distinct risk/reward profile. Hedge funds are not considered a distinct asset class.

How are hedge funds typically classified?

Hedge funds are classified based by strategy

How are hedge funds distinguished?

Hedge funds are distinguished by their investment approach rather than the underlying investments.

Hedge funds versus mutual funds: Choose the false statement. a. Mutual funds are open to any investor and are generally more liquid instruments with minimal constraints on redemptions. b. Hedge fund fees are typically negotiable by an investor, while mutual funds operate with the same fees for all investors. c. Hedge funds are more restricted in what they can trade compared to mutual funds.

Hedge funds are more restricted in what they can trade compared to mutual funds

How are hedge funds normally classified?

Hedge funds are normally classified by strategy. A variety of classifications is possible, which helps in the selection of appropriate investment strategies and appropriate performance benchmarks and in reviewing aggregate performance.

Which statement about hedge funds is most accurate? a. Hedge funds are investment products offered to the public and are traded daily on the OTC market. b. Hedge funds are benchmarked to an index or industry/sector, and managers use complex strategies to mimic the index or industry/sector. c. Hedge funds are private pooled funds, applying strategies with a goal of maximizing returns while reducing risk.

Hedge funds are private pooled funds, applying strategies with a goal of maximizing returns while reducing risk.

What are hedge funds?

Hedge funds are private pooled investment vehicles that can invest in a wide variety of products, including equities, fixed income, derivatives, foreign exchange, private capital, and real assets.

What do hedge funds use to enhance their returns?

Hedge funds combined traditional debt and equity instruments with leverage, derivatives, short selling, and other strategies to generate and enhance their returns.

How are hedge funds different from private equity funds?

Hedge funds differ from private equity funds, in that hedge funds have a shorter time horizon and invest in more liquid assets.

How do hedge funds evaluate their performance?

Hedge funds evaluate their performance using an absolute return standard instead of tracking a benchmark.

Hedge funds utilize what kind of management strategy?

Hedge funds utilize active management by experienced managers and an integrated risk management approach.

What happens ideally?

Ideally, the manager achieves an overall beta relative to the market close to zero.

What happens in all cases of this strategy?

In all cases, the strategy takes a long position in those securities (buys stocks or call options) whose valuations are underestimated/undervalued by the market or have a potential for growth that the market has not yet identified. It also shorts stocks or an index to reduce the risk.

What happens in the "two and twenty" structure?

In the "two and twenty" structure, the hedge fund partnership entity that operates and administers the fund receives a 2% management fee. The manager receives a 20% cut of the fund's net profits.

What is the fundamental long/short strategy?

In this strategy, the hedge fund takes a long position in companies that are trading at inexpensive levels compared to their potential intrinsic value and shorts those that trade in the other direction, with the intention of reversing this trade to obtain alpha.

This comes with what downside?

Investors face higher fees. Fee layering reduces the end investor's initial gross investment and may result in an investor paying fees more than once for management of the same assets.

Investors in modern hedge funds are subject to what regarding their investments?

Investors in modern hedge funds are subject to extended holding periods and notice periods before an investment redemption is possible. Some hedge funds limit fund redemptions through a liquidity gate provision so that assets can be liquidated over a longer time period. Mandatory lockup and notice periods allow hedge funds more flexibility than mutual funds or other types of investments.

What distinguishes hedge funds?

It is the investment approach rather than the underlying investments that distinguish hedge funds.

What is often used by hedge funds to enhance their returns?

Leverage - through short selling, borrowing, or derivatives and occasionally combining all three - is often used by hedge funds to enhance returns.

What do long/short equity funds focus on?

Long/short equity funds focus on public equity markets and take long and short positions in equity and equity derivative securities.

Identify the investment structure most appropriate for the investor. A. Managed futures B. SMA C. Fund of funds 1. A high-net-worth investor who requires tax-efficient investment channels with a high degree of control over allocation decisions 2. An institutional investor intending to invest in commodity markets 3. A small investor who would like hedge fund exposure at a lower risk

Managed futures --> an institutional investor intending to invest in commodity markets. SMA --> a high-net-worth investor who requires tax-efficient investment channels with a high degree of control over allocation decisions Fund of funds --> a small investor who would like hedge fund exposure at a lower risk

What are managed futures funds?

Managed futures funds are actively managed funds making diversified directional investments primarily in the futures markets on the basis of technical and fundamental strategies. Managed futures funds are also known as commodity trading advisers (CTAs) because they historically focused on commodity futures.

How can managers realize the strategy beta and alpha returns?

Managers can realize strategy beta and alpha returns due their skills in identifying mispriced securities and sectors, correctly timing the market, and utilizing operational control of the company business model, as well as using leverage.

What approach do most equity hedge strategies use?

Most equity hedge strategies use a "bottom-up" security-specific approach - company level analysis, followed by overall industry analysis, followed by overall market analysis.

How are most hedge funds set up?

Most hedge funds are set up as limited partnerships, with the portfolio manager acting as the general partner and the institutional investors acting as limited partners.

This strategy is biased in which direction?

Most hedge funds that use a long/short strategy have a long bias.

Short-bias strategies are what with the market index-based strategies over short time frames?

Over short time frames, short-bias strategies are negatively correlated with the market index-based strategies.

What overall position is created in a fundamental long/short strategy?

Overall, the manager maintains a net long exposure but may adjust the amount of net market risk depending on their market forecast.

What are relative value strategies?

Relative value strategies seek to profit from a pricing discrepancy between related securities based on an unusual short-term relationship. The expectation is that the short-term discrepancy will be resolved over time.

Which of the following statements about SMAs is least accurate? a. SMAs are a preferred choice of high-net-worth investors with specific investment mandates because they are highly customizable. b. SMAs provide better transparency for the investor than other fund structures. c. SMAs are characterized by simpler fee structures compared to mutual funds. d. The potential for conflicts of interest exists for SMAs since managers are not personally invested in the funds and the regulation requirements are light.

SMAs are characterized by simpler fee structures compared to mutual funds.

What are activist strategies?

Short for "activist shareholder." Managers secure sufficient equity holdings to allow them to seek a position in a company's board and influence corporate policies or direction.

Shorting the acquirer says what?

Shorting the acquirer is a way to express the risk of merger overpayment.

What are side leters?

Side letters address the specific legal, regulatory, tax, operational, and reporting requirements of an investor. They can complement or supersede the terms of the fund's documents and are used when a hedge fund investor requires concessions without changing the private placement memo.

The choice of indirect exposure is motivated by what?

The choice of indirect exposure is motivated by reducing management costs, increasing performance transparency, and improving liquidity.

What is the expectation behind this strategy?

The expectation is that these securities should be valued at par or at least a significant premium to the current bond purchase price in a bankruptcy reorganization or liquidation.

What do the fund documents (private placement memorandum, partnership agreement, articles of incorporation) do?

The fund documents lay out the legal and contractual relationship between the fund manager and the fund investor and creates the operational framework for the fund.

What is the goal of a hedge fund?

The goal of a hedge fund is to generate high returns, either in an absolute sense or on a risk-adjusted basis relative to its portfolio-level volatility.

What is the intent of a market neutral strategy?

The intent of a market neutral strategy is to profit from the movements of individual securities, undervalued ones rising and overvalued ones falling, while avoiding movements in the overall market. To achieve a meaningful return, market-neutral portfolios may require leverage and seek stable, single-digit returns that are independent of the market.

How do hedge funds "hedge?"

The investment strategy of a hedge fund splits a portfolio such that each component helps hedge the risks from the other. Thus, by internally neutralizing market risk and by managing the portfolio components, the hedge fund manager can obtain risk-enhanced returns.

Which of the following statements about relative value strategies is least accurate? a. Relative value strategies seek to profit from a price or return discrepancy between securities based on a short-term relationship. b. Relative value funds are inherently structured to minimize net market risk and credit risks. c. The investments made under a relative value strategy are all within a single asset class or sector, using assets with a sufficient price differential to arbitrage their movements to equilibrium prices.

The investments made under a relative value strategy are all within a single asset class or sector, using assets with sufficient price differential to arbitrage their movements to equilibrium prices.

When does the manager expect to profit?

The manager may expect to profit once this initial deal spread narrows to the closing value of the transaction. A spread exists because of timing and uncertainty over the closure of the deal due to legal and regulatory hurdles, or the acquirer may decide to step away.

What is the master feeder structure?

The master feeder structure is setup for optimum tax efficiency and consists of an offshore feeder fund and an onshore feeder fund - both feeding into a master fund that invests the capital based on its contractual partnership agreements.

What is a common hedge fund form?

The master feeder structure.

How does return generation differ between hedge funds and traditional portfolios?

The most significant difference is that hedge funds seek to limit market exposure and returns from beta and primarily focus on generating idiosyncratic returns by identifying sources of unique return, or alpha.

What is a soft lockup?

The presence of a redemption fee for an investor to redeem and leave the fund early.

What is the primary risk of merger arbitrage?

The primary risk in merger arbitrage is that the announced combination fails to occur and the value of the fund holdings are negatively impacted before it can unwind its position.

What is the primary source of hedge fund excess return?

The primary source of hedge fund excess return is market inefficiencies and the skills of the manager in leveraging them.

What drives portfolio performance?

The spread between growth and value expectations drives the investment strategy and portfolio performance.

How do the return characteristics of hedge funds differ from those of ETFs and mutual funds?

The typical relative value hedge fund generates returns using a combination of long and short positions in equities, increases its asset base using borrowed funds, and implements opportunistic positions in special situations, seeking to earn very different risk-return profiles than those of common long-only funds.

What kind of transparency is present for more complex hedge fund investments?

There is reduced transparency for more complex hedge fund investments and asymmetric information between managers and investors. This leads to incentive based performance fees to bridge the gap.

What are macro-strategies?

These are strategies that emphasize a top-down approach to identify economic trends, in which trades are made on the basis of expected movements in economic variables. Macro hedge funds use long and short positions to profit from a view on overall market direction as it is influenced by major economic trends and events. These funds benefit from periods of higher volatility.

What are general fixed income strategies?

These focus on relative value within fixed-income markets, with an emphasis on sovereign debt and sometimes relative pricing of investment-grade corporate debt. Strategies may include long-short trades between two different issuers, between corporate and government issuers, between differnet parts of the same issuer's capital structure, or between different parts of an issuer's yield curve.

What do hedge fund ETFs benefit from?

These investments benefit from greater liquidity, lower fees, and increased transparency.

These strategies are biased in what way?

These portfolios tend to be long biased. They may not be market neutral.

What are special situation strategies?

These strategies focus on opportunities to buy the equity of companies engaged in security issuance or repurchase, special capital distributions, rescue finance, asset sales/spin-offs, or other catalyst-oriented situations.

What is the distressed/restructuring strategy?

These strategies focus on securities of companies either in or perceived to be near bankruptcy. In one approach, hedge funds simply purchase fixed-income securities trading at a significant discount to par but that are still senior enough to be backed by sufficient corporate assets.

What is the multi-strategy strategy?

These strategies trade relative value within and across asset classes or instruments. Rather than focusing on one type of trade (e.g., convertible arbitrage), a single basis for a trade (e.g., merger arbitrage), or a particular asset class (e.g., fixed income), this strategy instead looks for any available investment opportunities, often with different pods of managers executing unique market approaches. The goal of a multi-strategy manager is to initially deploy (and later redeploy) capital efficiently and quickly across various strategy areas as conditions change.

What is the fundamental growth strategy?

These strategies use fundamental analysis to identify companies expected to exhibit high growth and capital appreciation. The hedge fund will take a long position in these stocks and short companies with business models that are under downward pressure and expected to exhibit low or negative growth.

What is the fundamental value strategy?

These strategies use fundamental analysis to identify undervalued and unloved companies for which there is a possibility that a corporate turnaround, with future revenue and cash flow growth, will result in higher valuations. The hedge fund takes positions in these companies to capture expected future price rises. It is the spread between value and growth expectations that drives portfolio performance.

What is a market neutral strategy?

These strategies use quantitative, fundamental, and technical analysis to identify under- and overvalued equity securities. The hedge fund takes long positions in undervalued securities and short positions in overvalued securities, while seeking to maintain a market-neutral net position.

What is the short biased strategy?

These strategies use quantitative, technical, and fundamental analysis to short overvalued equity securities with limited or no long-side exposures. These funds vary their short exposure over time. Short-biased managers tend to be contrarian; they are shorting shares in otherwise successful companies. The funds have had difficult times posting meaningful long-term returns during the past 30 years.

How are hedge funds set up?

They are legally incorporated and organized as private limited partnerships or LLCs with a general partner or managing member who is the hedge fund manager. The managing member receives a management fee, and the general partner receives compensation based on fund performance. Hedge fund investors purchase a share of the fund and receive in return a fixed percentage of the fund returns, minus applicable fees.

What can CTAs be used?

They are used in times of strong trending market conditions and during periods of extended market stress.

What is this sensitive to?

This is sensitive to bankruptcy risks, although it may may hedged away using either equity put options or credit default swap derivatives on the issuer.

What are the three main relative value hedge fund strategies?

1. Convertible bond arbitrage 2. Fixed-income arbitrage 3. Multi-strategy