Hedge Funds

Introduction to
Hedge funds
BY VINOD KOTHARI
1006-9 Krishna
224 AJC Bose Road
Kolkata 700 017. India
Phone 91-33-22813742/ 22811276/ 22817715/
23233863/ 23233864
Fax: 23233863/ 22811276
e-mail: vinod@vinodkothari.com
Hedge funds as alternative investment
strategy
Investment
Non-traditional
Traditional
Or alternative
Collective
Private Hedge funds
Direct Investment Real estate Commodities
equity /FOF
Schemes
Regulated Oil
Mutual funds and gas
Equities Bonds Timber
Metals
Vinod Kothari Hedge funds 2016

2
What are hedge funds
 The term is a misnomer - hedge funds are known not so much for their
hedging strategies but for their status as private and unregulated
investment vehicles
 Though, over a period of time, substantial regulation imposed on hedge funds in most markets
 Collective, private, investment devices:
 Typically unregistered / unregulated
 Structured as limited liability partnerships (or other convenient mode)
 Normally provide performance-based fees:
 Fees may go upto 20% of annualised returns:
 Typical fee structure is 2 and 20 – 2% management fee and 20% performance fee
 Normally execute strategies, borrowing money, borrowing stocks
 Normally built around some market inefficiency that they want to exploit
 Essentially, began as private investment pools of HNIs, investing primarily
in stocks
 Later, created hedges by short-selling stocks. Hence the name hedge funds
 Since hedge funds are based on individual investment manager skills, they
display very little correlation with market

3
Hedge fund features
 IOSCO (Hedge Fund Oversight Consultation Report

March 2009) defines the following features:
 Absence of borrowing and leverage restrictions
 Significant performance based fees
 Investors are allowed to redeem periodically
 Often, significant funds are invested by the manager
 Derivatives are commonly used, and short selling is
common too
 More diverse risks or complex underlying products
are involved
 With all this, IOSCO report recognises that it is
difficult to define hedge funds on a universal
basis

4
Traditional distinguishing features of
hedge funds
 Unregulated
 Mostly opaque
 Use of leverage:
 Economic leverage
 Debt
 Sophisticated investment strategies to exploit market
inefficiency
 Spectacular occasional implosions/episodes
 High attrition rate – over 5% hedge funds are closed
every year

5
Hedge funds – after the Global Financial Crisis
 Hedge funds have, at all times, been one of the hottest

topics in finance
 They commanded a significant power:
 In good times, approximately 30% of the daily trading on
NYSE is controlled by hedge funds
 One hedge funds commands about 5% of daily equity trade on
NYSE
 Nearly 45% of trades in emerging market bonds, 47% of
distressed bonds; 58% of credit derivatives
 The hedge funds AUM has never reached pre-GFC levels,
however, there has been a substantial growth in 2017
 Currently AUM above USD 3 trillion
 Growth over the last 2 years has been almost 24%
 But whether this is result of comprehensive reporting coverage,
or net subscriptions, is not yet clear
 In any case, in the universe of alternative investments,
hedge funds have outperformed – slide to come

6
Hedge funds AUM
Hedge funds, 2018

7
Assets Under Management
2nd Qtr 2018 1st Qtr 2018 4th Qtr 2017
https://www.barclayhedge.com/solutions/assets-under-management/hedge-
(USD Billions)
HEDGE FUNDS * $3014.3B $2993.7B $2905.7B
Hedge funds AUM strategy-
FUNDS OF FUNDS $263.9B $259.3B $259.0B
SECTORS
BALANCED (STOCKS & BONDS) $244.8B $250.9B $222.9B

CONVERTIBLE ARBITRAGE $19.1B $19.3B $19.6B
DISTRESSED SECURITIES $72.0B $75.2B $81.7B
EMERGING MARKETS $278.1B $295.9B $278.3B
EMERGING MARKETS - ASIA $108.2B $111.2B $99.8B
EMERGING MARKETS - EASTERN EUROPE $15.7B $18.4B $17.3B
EMERGING MARKETS - GLOBAL $131.4B $141.2B $135.6B
EMERGING MARKETS - LATIN AMERICA $ 14.2B $ 17.3B $17.6B

fund-assets-under-management/
EQUITY LONG BIAS $335.1B $316.3B $315.8B

EQUITY LONG/SHORT $214.9B $221.4B $225.0B
EQUITY LONG-ONLY $163.8B $166.6B $168.0B
EQUITY MARKET NEUTRAL $95.8B $92.1B $85.8B
EVENT DRIVEN $144.5B $141.7B $148.8B
FIXED INCOME $572.3B $553.9B $534.3B
MACRO $204.6B $207.3B $203.0B
MERGER ARBITRAGE $63.9B $66.3B $65.0B
wise
MULTI-STRATEGY $330.0B $315.7B $294.9B

OPTIONS STRATEGIES $50.6B $55.2B $54.0B
OTHER ** $61.4B $60.4B $60.7B
SECTOR SPECIFIC *** $163.5B $155.6B $147.9B
Hedge funds, 2018
8
Hedge funds vs other alternative
investments
Source: https://www.fidante.com/-
/media/Fidante/resources/Articles/20180906_AI_FINAL.pdf
Hedge funds, 2018
9
Some hedge fund facts
 Based on IOSCO’s Hedge fund survey, 2017

 Cayman Islands continues to be the jurisdiction of
choice, with some 53% of hedge funds located there
Hedge funds, 2018

10
Hedge fund regulation after Global Financial Crisis
 The massive US regulation Dodd Frank Act eliminated the

exemption for private hedge fund advisers
 Pursuant to Dodd Frank, SEC brought rules laying
registration requirements for hedge fund advisers
 All fund managers with more than USD 100 million AUM need
SEC registration
 Those dealing in derivatives come under CFTC regulation too
 Also hedge funds can raise capital only from “accredited
investors” by way of non-public offering.
 Investors to have minimum USD 5 million investments; pension
funds min USD 25 million
 In EU, hedge fund managers come under Alternative
Investment Fund Managers Directive
 Require registration with local regulators

11
Brief history
 First hedge funds: Andrew Winslow Jones in 1940s

 Gained popularity during the 1970s and 1980s
 Suffered during the technology meltdown
 Debacles:
 Long Term Capital Management in 1998
 Julian Robertson’s hedge fund closure in 2000
 In 2006, Amaranth was liquidated with $ 6.5 billion losses
 Bear Stearns’ hedge funds bankrupted in 2007
 Many more hedge funds under liquidation – see hf-implode.com
 In flat markets of 2001 onwards, hedge funds have seen lot of
activity:
 Hedge fund assets are now about USD 1.6 trillion
 US volume at $ 984 billion in July 2006 (Hedge Fund Intelligence)
 Europe approx $ 325 billion
 Asia approx $ 115 billion
 Number of hedge funds nearly 9000
 Substantial activity in 2006 – nearly 1500 new funds launched;
750 liquidated

12
Trends in hedge funds
 Institutionalisation
 Amenability to regulation
 Public offers by a hedge fund:
 Fortress and Blackstone – investment manager going public
 Och-Ziff went public in Nov 2007
 Blackstone June 2007
 Broadened activities – many of them operate in largely the same
spheres in which banks do
 Increasing mutual complementarity between banking and hedge
funds:
 Banks increasingly structure products where they need first loss risk buyers
 Hedge funds take equity positions in structured products
 Blurring distinction between hedge funds and institutional investors:
 Institutional investors are allowed to engage in derivatives and short selling
 Many follow 130/30 (long/short) positions
 Move towards longer durations as hedge funds start investing in
emerging market debt and equity, distressed debt, etc.
 On shore hedge funds in several emerging market jurisdictions –
South Africa, Brazil, etc.

13
Features of hedge funds
 Known more by regulatory status and investing/rewarding style than
as a type of investment vehicle
 Not an alternative investment class but an alternative investment strategy
 An alternative investment vehicle, mostly unregulated and consisting
of private, knowledgeable investors, where managers follow one or
more strategies to maximise absolute returns, and wherein managers
are rewarded based on performance
 Features:
 Mostly unregulated structure
 No public participation; usually a high minimum investment
 Absolute returns strategy
 No fixed style of investing – known by one or more strategies but
essentially aim at making returns
 Broader mandate for the manager
 Use of leverage (both debt and economic leverage) to enhance
performance
 Invest in a wide variety of financial instruments
 Managers paid incentives based on performance
 Lock in periods

14
Hedge fund industry vs global economy
 Today, hedge funds are a major force in the financial markets,

from the following viewpoints
 AUM:
 Hedge fund equity crossed $ 1.5 trillion, roughly half of banks’ equity put together
 No of hedge funds nearly 10149
 Extent of turnover in several markets controlled by hedge funds
 Share in the OTC derivatives markets
 Suppliers of equity for several structured finance vehicles
Change in assets managed by hedge funds

15
European hedge funds

16
Hedge funds across the world
 Major centers include North America and Europe

 USA hold the top position in global hedge funds
Hedge fund concentration across the world

17
Structure of the hedge fund industry
 Hedge funds are private investment pools and

are not publicly available
 FoFs are quite often registered as investment
companies:
 As such, they get the ability to solicit investments
 Thus allowing wider investor access to hedge fund
investments

18
Performance of Hedge Funds

19
Hedge funds and mutual funds
 Mutual funds are regulated, hedge funds are not
 Mutual funds generally open to public, hedge funds are private
 Hedge fund investors, called limited partners, are typically limited to 499
 Hedge funds engage in short selling, mutual funds either do not, or do
to a very limited extent
 Mutual funds maintain certain liquidity, are normally redeemable, have
pricing and disclosure regulations, etc. Hedge funds have none of
these:
 Most hedge funds have long lock up periods
 Hedge funds are leveraged, mutual funds are not
 Hedge funds are typically very small; mutual funds are large in size
 Hedge funds typically hold hard-to-market assets; mutuals limit to
marketable securities
 Mutual funds make small investments; hedge funds typically invest in
$ million denominations
 Hedge funds strategies are typically designed to produce absolute
returns even in adverse market conditions; mutual funds normally try
to produce relative value

20
Performance fees of hedge funds
 Typically, expressed as x% of performance

over previous highest performance
 The hedge fund manager has to cross the
previous watermark to get performance fees
 Manager’s alpha:
 Excess returns over a passive non-managed returns
from the same strategy

21
Benefits of hedge fund investing
 No correlation with the rest of the capital

markets:
 Dependence on skills of individual managers
 As returns are not dependent on any index
(equity or bonds), may offer absolute positive
returns
 Hedge fund managers typically operate across
market segments:
 Hence are not dependent on returns from a
particular market
 Downsides:
 The hedge fund manager has option-like fees:
 He benefits by assuming more risks
 No restrictions on the size of the managed assets
22
Structure of hedge funds

23
Hedge fund strategies - overview
 Long only:
 Straight forward equity investments
 Limited diversification to reap upsides
 Long/ Short:
 Go long as well as short on securities
 Market Neutral:
 Neutralising risk by adopting beta-based strategies
 Alpha:
 The return above the beta-adjusted return from the portfolio
 Indicative of the efficiency of the portfolio manager
 Risk Arbitrage:
 Event driven strategies:
 Such as buy the acquired and short-sell the acquiror
 Distressed Debt:
 Buy distressed debt and hold it during bankruptcy
 Convertible arbitrage:
 Buy convertibles and sell the converted equity
 Dynamically alter the hedge as the stock prices move
 Fixed income arbitrage
 Cash market versus synthetic markets arbitrage
 High Yield
 Structured Products
 Macro:
 Aiming to profits from changes in global economies
 Fund of funds

24
Comparative view of hedge fund strategies

25
Distribution of hedge funds by strategy

26
Hedge fund strategies - directional
 Equity long/short strategy:

 Progenitor of all strategies; reason for the use of the word “hedge”
 The manager selects some attractive stocks, and some unattractive stocks
 Goes long the attractive ones
 Goes short the unattractive ones
 The short position acts as an economic leverage as well as hedge
 Generally, hedge funds are long small cap stocks and short large cap stocks
 In addition, the manager may borrow money to create financial leverage
too
 Advantages:
 Over long run, markets go up, giving positive returns
 Ease of entry and limited amount of capital required
 Wide variety of ELS funds with different focus areas
 Simple strategy – easy to understand
 Performance has so far been stellar
 Disadvantages:
 High degree of correlation with equities:
 14 year correlation with S&P 500 is nearly 0.69
 Short squeeze problems
 Adverse selection

27
Directional strategies - 2
 Managed futures:
 The term comes from the commodity market:
 Trade in futures of various markets, managed by a manager
 Managed futures funds take long and short positions in a
variety of markets
 Benefits:
 Diversification; no correlation with financial markets
 Insurance against major macro events; economic hedges
 Global macro:
 Though a small part of the total landscape, one of the
most talked about hedge fund strategies
 Trade based on global economic trends
 Essentially, on central govt macro-economic policies
 Trade in equities, bonds, currencies, commodities on the
basis of macro economic trends
 Often make use of leverage to magnify returns

28
Event driven strategies
 Merger arbitrage:
 Try to make profits out of mergers
 Corporate life cycle investing:
 Close to restructuring, bankruptcy, reorganization,
etc
 Distressed securities:
 One of the hottest asset classes in the recent past
 Substantial investments in China, Japan, Malaysia,
etc in distressed loans

29
Relative value strategies
 Equity market neutral:
 Go long and short on a substantial number of stocks so as to be left with minimal
systematic risk
 And exploit price inefficiencies
 Generally leveraged to enhance the otherwise-nominal returns
 Difference between ELS and market neutral strategies:
 The manager typically tries to equate the betas of the long position with that of the short position,
to stay beta neutral
 Convertibles arbitrage
 Exploit pricing inefficiencies in convertible debt
 Generally, the manager will hedge by shorting the equities of the same entity
 Producing coupon on the convertible, and interest on the cash raised by short sale
 Fixed income arbitrage:
 Try to exploit price inefficiencies in the fixed income/credit derivatives markets:
 Yield spread trades – going long on higher yielding bonds and short on low yielding treasuries,
trying to match the durations
 Yield curve arbitrages – exploits price inefficiencies between long-dated and short dated securities
 Credit spreads
 Cash market versus futures market arbitrage
 Cash market versus synthetic market arbitrage
 New strategies:
 Real estate
 Insurance and reinsurance
 Energy trading
 Emission trading
 Credit derivatives
 Direct financing
 CDO investments

30
The manager’s alpha
 The superior performance of the hedge fund

depends upon the manager’s alpha
 Alpha = (fund return – risk free rate) – Beta
(market return – risk free rate)
 Beta = correl (fund return, market return) *
sigma (fund return) / sigma(market)

31
Decomposition of returns

32
Attrition rates in hedge fund industry
Chart 13 Hedge fund attrition rates
 Estimated at about
40% over a 5 year
period for hedge % share
funds; about 25% for
FoFs
1999 4.7
2000 6.4
2001 4.3
2002 3.8
2003 5.4
2004 6.2
2005 5.4
2006 5.1
2007 4
2008 10

Sources: Hennessee Group; IFSL estimates 33
Leverage in hedge funds
Global Hedge Funds - Use of Leverage¹
Hedge Fund Style As of December 2003 Use Leverage
Don't Use
Leverage
Low (<2.0:1) High (= >2.0:1) Total
Aggressive Growth 30.7% 55.0% 14.3% 69.3%
Distressed Securities 46.3% 42.6% 11.1% 53.7%
Emerging Markets 39.5% 40.9% 19.5% 60.5%
Income 40.0% 31.8% 28.2% 60.0%
Macro 16.2% 29.3% 54.5% 83.8%
Market Neutral - Arbitrage 20.5% 19.5% 60.0% 79.5%
Market Neutral - Securities Hedging 28.6% 26.1% 45.4% 71.4%
Market Timing 36.9% 24.3% 38.7% 63.1%
Opportunistic 22.9% 45.5% 31.6% 77.1%
Several Strategies 29.2% 38.3% 32.5% 70.8%
Short Selling 31.8% 45.5% 22.7% 68.2%
Special Situations 22.2% 57.6% 20.2% 77.8%
Value 30.1% 52.3% 17.6% 69.9%
Total Sample 28.8% 41.4% 29.8% 71.2%
© 2004 by Van Hedge Fund Advisors International, LLC and/or its licensors, Nashville, TN, USA.
¹Please see Explanatory Notes under Legal Considerations section.

34
Leverage levels by types of funds

35
Leverage data as per IOSCO 2017
survey
 Gross leverage of the hedge funds in the

Survey was 7.1x NAV.
 This figure includes the notional values of
interest rate and FX derivative contracts.
 Removing those from the data, gross leverage
was 3.1x
 Gross leverage in case of ELS funds includes total of
long and short positions
 net leverage was 1.1x.
Hedge funds, 2018

36
Use of long/short positions
Hedge funds, 2018

37
Use of financial leverage
Hedge funds, 2018

38
Characteristics of typical hedge funds
Global Hedge Fund Characteristics¹
As of December 31, 2003
Mean Median Mode
Fund Size $83 million $26.5 million $20 million
Fund Age 6.8 years 6.2 years 8.0 years
Minimum Investment Required $649,000 $250,000 $1,000,000
Number of Entry Dates per Year 22 12 12

Number of Exit Dates per Year 17 4 4
Management Fee 1.4% 1.0% 1.0%
Performance Allocation ("Fee") 17.2% 20.0% 20.0%
YES
Fund has hurdle rate (of those with a performance allocation) 14%
Fund has high water mark 93%
Fund has audited financial statements or audited performance 95%
Manager has $500,000 of own money in fund 78%
Fund can handle "hot issues" 56%
Fund is diversified 44%
Fund can short sell 82%
Fund can use leverage 71%
Fund uses derivatives for hedging only, or none 69%
Level of turnover Low (0-25%) Medium High (>75%) = 58%
= 17% (26-75%)
Capitalization of underlying Small = 26%
Medium ($500-$1,000m) Large (>$1,000m) Mixed = 73%
investments ($1-$500m) = 4% = 10%
= 12%
© 2004 by Van Hedge Fund Advisors International, LLC and/or its licensors, Nashville, TN, USA.
¹Please see Explanatory Notes under Legal Considerations section.

39
Fund of funds
 These are regulated funds that invest into

hedge funds
 Typically, 15 to 25 hedge funds
 Diversification advantage
 Cost disadvantage:
 Duplicate the management fees
 Typical management fee 1%, performance fee 10%

40
Where does hedge fund capital come from?
 Declining share of HNIs – roughly about 40%

in 2006;
 Increasing share of institutional investors

41
Liquidity management in hedge
funds
 One of the key hedge fund risks is liquidity
 Open-ended funds have to provide for redemption option;
hedge funds are open-ended, though with a limited lock-in
 On the asset side, liquidity is subject to asset types
 In stressed market scenarios, liquidity may get strained or
completely disappear
 Hedge funds use several liquidity management tools as a
part of their documentation
 Swing pricing – pricing the increase in fixed costs/management
fees on outgoing unitholders
 Notice period – prescribing pre-redemption notice period
 Redemption gates – prescribing time windows within which
redemption will be allowed
 In-kind redemption – paying off assets rather than selling assets
 Side pockets – putting illiquid assets in a separate side pocket,
so as to crate an illiquid vertical; redemptions to be allowed
based on liquid vertical
 Complete suspension
Hedge funds, 2018
42
Regulation of hedge funds
 Ever since the crisis hit global markets, hedge

funds have been the centerpiece of regulatory
attention
 G20’s suggestions on global financial reform spent
good attention to hedge funds
http://www.g20.org/Documents/g20_summit_declar
ation.pdf
 IOSCO set up a Task Force on Unregulated Financial
Entities in Nov 2008

43
IOSCO’s regulatory initiatives
 International regulators are working on ways

to ensure that the following concerns are
addressed:
 Market disruption/ system collapse caused by
sudden hedge fund liquidations
 Most funds deal in assets that are hard to value –
such as distressed debt
 Substantial use of leverage
 Managerial remuneration based on results, coupled
with difficult to value investments, may create
conflicts of interests
 Hence, IOSCO is reportedly working on
valuation norms

44
Key hedge fund risks
 Transparency on valuation practices and independence

of valuations
 Risk policies and internal controls and control on
managers
 Control on price sensitive information and other typical
controls in investing intermediaries
 Key man risk
 Liquidity risk
 Model risk
 VaR models for assessing market risk and allocating
exposures
 Credit risk for derivatives deals
 NAV computation

45
Key measures of hedge fund performance
 Mean returns
 Sigma
 Semi deviation
 Skewness and kurtosis of the returns
 VaR and expected shortfall
 Sharpe ratio

46
Typical hedge fund organisation
Investors
Management
company Feeder
funds
Managers
Master trust
Satellite
fund
Satellite
fund
Satellite
fund Satellite
fund

47
Use of side letters
 A common practice among hedge funds is to

use
 Offer document, circulated to all potential investors
 Side letters, signed with individual clients
 The side letter is used as a document
containing private negotiations between a
particular investor and the hedge fund
 For instance, fees charged from a particular investor
may be different from that from others
 Preferential access to portfolio information
 UK FSA requires disclosure of the fact that side
letters have been issued to some investors

48

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Introduction to

Equities Bonds Timber

Vinod Kothari Hedge funds 2016

Vinod Kothari Hedge funds 2018

 IOSCO (Hedge Fund Oversight Consultation Report

 Significant performance based fees

 Investors are allowed to redeem periodically

 Often, significant funds are invested by the manager

 Derivatives are commonly used, and short selling is

Vinod Kothari Hedge funds 2016

Vinod Kothari Hedge funds 2016

 Hedge funds have, at all times, been one of the hottest

Vinod Kothari Hedge funds 2016

Hedge funds, 2018

BALANCED (STOCKS & BONDS) $244.8B $250.9B $222.9B

EMERGING MARKETS - EASTERN EUROPE $15.7B $18.4B $17.3B

EMERGING MARKETS - GLOBAL $131.4B $141.2B $135.6B

EMERGING MARKETS - LATIN AMERICA $ 14.2B $ 17.3B $17.6B

EQUITY LONG BIAS $335.1B $316.3B $315.8B

MULTI-STRATEGY $330.0B $315.7B $294.9B

 Based on IOSCO’s Hedge fund survey, 2017

Hedge funds, 2018

 The massive US regulation Dodd Frank Act eliminated the

Vinod Kothari Hedge funds 2016

 First hedge funds: Andrew Winslow Jones in 1940s

Vinod Kothari Hedge funds 2016

Vinod Kothari Hedge funds 2016

Vinod Kothari Hedge funds 2016

 Today, hedge funds are a major force in the financial markets,

Change in assets managed by hedge funds

Vinod Kothari Hedge funds 2016

Vinod Kothari Hedge funds 2016

 Major centers include North America and Europe

Hedge fund concentration across the world

Vinod Kothari Hedge funds 2016

 Hedge funds are private investment pools and

Vinod Kothari Hedge funds 2016

Vinod Kothari Hedge funds 2016

Vinod Kothari Hedge funds 2016

 Typically, expressed as x% of performance

Vinod Kothari Hedge funds 2016

 No correlation with the rest of the capital

Vinod Kothari Hedge funds 2016

Vinod Kothari Hedge funds 2016

Vinod Kothari Hedge funds 2016

Vinod Kothari Hedge funds 2016

 Equity long/short strategy:

Vinod Kothari Hedge funds 2016

Vinod Kothari Hedge funds 2016

Vinod Kothari Hedge funds 2016

Vinod Kothari Hedge funds 2016

 The superior performance of the hedge fund

Vinod Kothari Hedge funds 2016

Vinod Kothari Hedge funds 2016

Vinod Kothari Hedge funds 2016

Aggressive Growth 30.7% 55.0% 14.3% 69.3%

Distressed Securities 46.3% 42.6% 11.1% 53.7%

Emerging Markets 39.5% 40.9% 19.5% 60.5%

Income 40.0% 31.8% 28.2% 60.0%