NEW Hedge Guide 180mm.

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FTSE Guide to Hedge Funds

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Contents

● Background 2

● Hedge Funds – 6
A New Asset Class

● Investment Strategy 8
Overview

● Performance and 12
Returns

● The Evolution of the 14

Hedge Index

● Glossary 16
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Background
Hedge funds are not for the faint-hearted. Or are
they? Hedge funds are not regulated. Or are they?
Hedge funds are more volatile than more traditional
investments. Or are they? Hedge funds are not
accessible for small investors. Or are they? Hedge
fund performances are not measurable. Or are they?

Just a few observations that illustrate the mystique

behind one of the most talked about, but least
understood areas in the investment community.
By way of an illustration, the answers to the four
opening statements is that they could all be
perceived to be correct by investors, which goes
some way towards explaining the nature of these
phenomena of the fund management industry.

By investment standards hedge funds are relative

newcomers on the block. The first hedge fund is
accredited to Alfred Winslow Jones who decided in
1949 that he had a better system of managing
money than traditional fund managers. His novel
approach, discovered while researching an article for
his employers at Fortune Magazine, was to hedge
potential risk in his long stock positions by selling
other stocks to offset the impact on his portfolio of
any wider market reversal.

However, like many successful investors before him

and since, he kept his new techniques to himself. It
was not until he was finally “outed” in 1966 that
investors woke up to the delightful simplicity of
what the by now extremely wealthy Mr Jones had
been doing. Once the news article pointed out that

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in the past year Jones’ funds had outperformed the

best performing mutual fund by 44% and that over
the previous five years had a return 85% better than
its nearest traditional rival, it wasn’t long before
others were rushing to copy him.

Within two years over 200 new “hedge funds” were

launched including ones by several individuals set to
become legends of the industry, including George
Soros, Warren Buffet and Michael Steinhardt.

However, many of these new hedge fund managers

quickly drifted away from Jones’ original principles
when they found that allocating a portion of their
assets to short sales weighed heavily on
performance returns during the boom markets of
the late 1960s. This lack of insurance began to be
exposed as markets turned in 1969/70 and
eventually saw many simply close their doors as the
bear market turned into a rout in 1973. This
shakeout served to discourage many new entrants
to this sector, even as markets began to improve
towards the end of the 1970s and by the mid-
1980s research indicated that less than 70 funds
were operating with any conviction.

But the early 1990s brought its rewards for the

survivors, most spectacularly George Soros’ Quantum
Fund and its forays into the currency market –
particularly its aggressive short stance on sterling
that eventually accelerated sterling’s exit from the
European Exchange Rate Mechanism in 1992.

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The ability of hedge funds to diversify into new

markets and the advent of new trading tools,
combined with the favourable press the hedge
funds were starting to attract, saw a re-birth of the
industry. By the end of that decade there were an
estimated 4,000 hedge funds in operation.

The onset of another bear market shortly into the

new Millenium once again produced turmoil in the
industry. But the experience of past mistakes,
combined with much more widely diversified
investment strategies – both in terms of markets
and more sophisticated instruments/techniques –
limited the fallout.

Today there are an estimated 7,000 hedge funds.

Clearly that is too many for the individual to
research and to identify opportunities or risks –
even if they had money to invest in these funds.
More recently, fund of funds have been developed
as a means of encouraging smaller investors to
invest in the hedge fund market.

We will look at more specific details of how these

funds operate and their different trading strategies
a little later. However FTSE, a leading index provider,
has launched FTSE Hedge, a hedge fund index that
tracks the investable opportunity as it exists today
and in the future. This index provides investors with
a low cost and transparent tool to facilitate hedge
fund investing.

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Hedge Funds –
A New Asset Class
The specialist nature of hedge funds, in terms of
their relative freedom from regulation, their
exclusive investor profile and the diverse nature
of their investments are the main factors that set
them aside from mutual funds. The other defining
difference is leveraged investment, with hedge
funds openly borrowing (sometimes as much as
10 times the pledged investment capital) in order
to be able to dominate some of the investment
opportunities they identify.

A key factor differentiating hedge funds from their

publicly traded mutual counterparts is the
remuneration of the fund’s partners or managers.
Typically they will keep 20% of the profits, as well
as a management fee that is often 1% or more
annually of the assets under management. Huge
potential rewards, but it also ensures a commitment
to maximise returns for the other investors.

Many classify hedge funds as “alternative”

investments, in that a typical portfolio looks for
alternatives to traditional long-only positions in
stocks and bonds. However, while popular
perceptions of hedge funds present them as
“high risk – high return” initiatives, only a small
percentage fit this profile. Many are more
conservative entities looking to maximise only
better than market returns.

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Given the scope available to fund managers a wide

range of strategies are used. Some of the more
popular include: Equity Hedge, Commodity Trading
Association (CTA) / Managed Futures, Global Macro,
Merger Arbitrage, Distressed & Opportunities,
Convertible Arbitrage, Equity Arbitrage and Fixed
Income Relative Value.

Of course, many will be multiples of these and one

individual investment could be defined under several
of the listed headings. One way for an investor to
access a cross section of hedge fund management
strategies is to follow the fund of funds route,
effectively specialist hedge funds that invest in other
individual specialist funds.

More difficult to follow is the way some hedge fund

managers drift away from their original stated
investment mandate, potentially exposing investors
to risk they would prefer to avoid or duplicating
investments held elsewhere. In a mutual fund these
developments would be quickly identified through
the much more transparent nature of the industry
imposed by strict regulatory control. A fund of funds
manager will be better positioned to keep closer
scrutiny on these possible developments.

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Investment Strategy
Overview
FTSE Hedge comprises twelve indices with Net Asset Value (NAV)
and Gross Asset Value (GAV) for each. The indices are the FTSE
Hedge Index, three Management
Style Indices and eight Trading
Strategy Indices:
FTSE Hedge
Index

Directional Event Driven Non-Directional

(47%)* (23%)* (30%)*

Equity Hedge CTA/MF Global Macro Merger Arb Dist & Opps Convertible Arb Equity Arb Fixed Income
(30%)* (9%)* (8%)* (11%)* (12%)* (7%)* (8%)* (15%)*

*As at Februaury 2005

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As already identified, hedge funds are primarily Global Macro

private partnerships to provide maximum flexibility
in constructing a portfolio. They can take both long Macro funds make leveraged investments on
and short positions, make concentrated investments, anticipated price movements of stock markets,
use leverage, use derivatives, and invest in many fixed interest securities, interest rates, foreign
markets. This is in sharp contrast to mutual funds, exchange and physical commodities and derivatives
which are highly regulated and do not have the on such instruments. Macro managers employ a
same breadth of investment instruments at their “top-down” global approach to forecast shifts in
disposal. In addition, most hedge fund managers world economies, political fortunes or global supply
commit a portion of their wealth to the funds in and demand for resources, both physical and
order to align their interest with that of investors. financial. They may invest in any markets using
Thus the objectives of managers and investors are any instruments to participate in expected market
the same, and the nature of the relationship is movements.
(intended to be) one of true partnership. Here are
some examples of the trading tactics employed.

Equity Hedge
These hedge funds consist of a core holding of long
equities hedged at all times with tactical short sales
of stocks and/or stock index options. In addition to
equities, some hedge funds may have limited assets
invested in other types of securities.

Commodity Trading
Association (CTA) /
Managed Futures
Managed futures funds take long and short
positions in liquid financial futures such as
currencies, interest rates, stock market indices and
commodities.

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Merger Arbitrage
Merger Arbitrage involves investments in event-
driven situations such as leveraged buy-outs,
mergers and hostile takeovers. Normally, the stock of
an acquisition target appreciates while the acquiring
company’s stock decreases in value. These strategies
generate returns by purchasing stock of the
company being acquired and in some instances,
selling short the stock of the acquiring company.

Distressed & Opportunities

Distressed Securities strategies invest in, and may
sell short, the securities of companies where the
security’s price has been, or is expected to be,
affected by a distressed situation. This may involve
reorganisations, bankruptcies, distressed sales and
other corporate restructurings. Depending on the
manager’s style, investments may be made in bank
debt, corporate debt, trade claims, common stock,
preferred stock and warrants.

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Opportunities involve investing in opportunities Fixed Income Relative Value

created by significant transactional events, such Fixed Income Relative Value is a market neutral
as spin-offs, mergers and acquisitions, bankruptcy hedging strategy that seeks to profit by exploiting
reorganisations, recapitalisations and share pricing inefficiencies between related fixed income
buybacks. Instruments include long and short securities while neutralizing exposure to interest
common and preferred stocks, as well as debt rate risk. Managers attempt to exploit relative
securities and options. mispricing between related sets of fixed income
securities. The generic types of fixed income hedging
Convertible Arbitrage trades include: yield-curve arbitrage, corporate
Convertible Arbitrage involves purchasing a portfolio versus Treasury yield spreads, municipal bond versus
of convertible securities and hedging a portion of Treasury yield spreads and cash versus futures.
the equity risk by selling short the underlying
common stock. Managers may also seek to hedge
interest rate exposure under some circumstances.

Equity Arbitrage
The Equity Arbitrage strategy is a market neutral
strategy that seeks to profit by exploiting pricing
inefficiencies between related equity securities,
neutralising exposure to directional market risk by
combining long and short positions in broadly equal
amounts.

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Performance continuing to grow. It should also be remembered

that spectacular failure is not something unique to

and Returns hedge funds in the financial services universe, as all

investment styles have been subject to their share of
unwanted scrutiny in recent years.
‘Spectacular’ is a word used regularly when
discussing hedge funds’ performance, both on the Total funds under management in hedge funds are
upside and the reverse. Certainly the long-term now estimated to exceed $750 billion worldwide
performance of the entire hedge fund universe (though by comparison little more than 10% of that
stands up to scrutiny when compared with Equity in mutual funds) in some 7,000 funds. In fact at the
Mutual Funds or for equity benchmarks. current rate of expansion – growing more than
sixfold in Europe in the past 5 years – the total under
But it is also well known that there have been some management will exceed $1 trillion by the end of this
high profile failures, often with far-reaching decade. For example, new legislation became law in
consequences as in Long Term Capital Management’s Germany from the start of 2004 and many expect
demise in 1998. According to some estimates around this to herald a new wave of hedge fund expansion
a fifth of all hedge funds failed in 2002. However, this in Europe.
does not seem to have deterred those who specialise
in the industry with the total number of funds The different strategies outlined in the previous
section are obviously weighted to encompass
completely different investment scenarios and will
therefore mirror risk to reward. This is another
reason why some of these specialist funds are left
to specialist or professional investors who have the
supporting capital to absorb downside risk.

Evening out returns across the hedge fund investment

spectrum leads back to the fund of funds approach,
something which an investable index like FTSE
Hedge is aiming to approximately replicate. These
fund of funds broadly fall into three categories:
Very Conservative, Moderately Conservative and
More Aggressive.

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A very conservative fund of funds will target returns Hedge fund performance that is pro-forma basically
of 8-12% and will contain many “market neutral” means the numbers have one or more assumptions
hedge funds that exhibit a very low correlation to the or hypothetical conditions built into the data. So if in
underlying markets. In other words the investment a fund of funds there are ten funds that are planned
intention is to remove market volatility. to be invested in, and the data is compiled for the
last year from those funds, the numbers would be
A moderately conservative fund of funds will target classified as pro-forma. These are not actual returns,
12-17% returns over a pre-determined multi-year just hypothetical ones generated through a test.
strategy. These will combine a selection of “market
neutral” funds with a smattering of other higher risk This is just one example of where the lack of
strategies. transparency in the hedge fund sector places a
much greater onus on the individual investor than
A more aggressive fund of funds will still only aim he would have to be aware of if purely investing in
for returns of 15-20% as it will still be aiming to have traditional markets.
a lower-than-market statistical risk. However, it will
contain a higher weighting of funds that are more For this reason, many consider the fund of funds
closely correlated with the markets. route as the most accessible. Due diligence, allocation
of percentages, monitoring of existing investments
Something to take into consideration when and searching for new opportunities becomes a full
examining hedge fund performance is whether time job and a difficult one. Most investors are not
returns are net of fees, or calculated prior to fees. able to perform all these tasks and that is why the
Many funds report performance numbers before fees fund of funds phenomenon has grown significantly
are extracted, which can distort numbers greatly in over recent years.
the funds’ favour. This is key, as a positive month can
instead turn negative when fees are factored in –
and we have already emphasised the much higher
level fees awarded.

The next factor when judging hedge fund

performance is how returns are classified, with some
of the basic breakdowns used in the industry being:
pro forma, managed account, estimated, confirmed,
and audited.

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The Evolution of the

Hedge Index
Hedge funds might have been conceived in the late
1940s and seen a boom in interest in the late 1960s,
but there hadn’t been much of an attempt to
measure them as an industry until the 1980s.
Research became more sophisticated over the next
decade, by which time some rudimentary regular
analysis and specialised indices started to emerge.
It was well into the early part of the new Millennium
before investable indices arrived.

The launch of FTSE Hedge brings not only the

experience of the world’s leading index provider
to this sector, but also a discipline in index
management that prevents “style drift” and enables
“accurate tracking.”

The design of FTSE Hedge provides investors with a

low cost, transparent view of the investable hedge
fund market by presenting a series that reflects the
aggregate risk and return characteristics of the
open, investable hedge fund universe.

To ensure the highest quality funds are included

there is daily risk monitoring and evaluation of
underlying funds, as well as a qualitative due
diligence overlay process. The aim of these activities
is to improve transparency and increase investor
confidence.

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In the absence of more formal regulatory

stipulations, FTSE sets the following criteria for
index eligibility:
● Have independent audited financial statements
● Have at least $50 million of unleveraged assets
under management
● Have a minimum 2-year track record at the time
of the annual review
● Have monthly reporting with a minimum of
quarterly liquidity screening
● Be open to new investor subscriptions as well as
having significant remaining investment capacity

The methodology behind construction of the index

include:
● Base universe of 6,000 funds established from
various databases and industry sources
● Classification on basis of strategy and other
criteria down to 250 funds
● Constituent selection using mathematical
sampling to reduce to 75 funds
● Final committee due diligence to filter to eventual
40 constituents

Apart from full scale annual reviews, including

background checks and interviews, there is daily
monitoring of each constituent hedge fund for the
purposes of portfolio risk, position risk and most
importantly, for any breaches of individual fund
investment restrictions and guidelines.

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Glossary
All industries have a range of specialist language, or
jargon, used to denote specific terms or actions. It is partly
an industry shorthand and partly maintains a feeling of
exclusivity. The hedge fund sector is no different. Here are
a few of the key words and phrases, with the restatement
of a few others in context which can also be used in the
hedge fund industry. We have excluded those that
specifically refer to investment strategies mentioned earlier.

Alpha Measures the value a fund manager produces, by

comparing performance to that of a risk-free investment
(Treasury bills). For example, if a fund had an alpha of 1.0
during a given month, it would have produced a return
during that month that was one percentage point higher
than the benchmark Treasury. Alpha can also be used as a
measure of residual risk, relative to the market in which a
fund participates.

Gauges the risk of a fund by measuring the volatility of its

Beta
past returns in relation to the returns of a benchmark. A
fund with a beta of 0.7 has experienced gains and losses
that are 70% of the benchmark’s changes. A beta of 1.3
means the total return is likely to move up or down 30%
more than the index. A fund with a 1.0 beta is expected to
move in tandem with the index.

Closed fund A hedge fund or open-end mutual fund that has at least
temporarily stopped accepting capital from investors,
usually due to rapid asset growth. Not to be confused with
a closed-end fund.

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Drawdown The percentage loss that a fund incurs from its peak net
asset value to its lowest value. The maximum drawdown
over a significant period is sometimes employed as a means
of measuring the risk of a vehicle. Usually expressed as a
percentage decline in net asset value.

Fund of funds An investment vehicle consisting of shares in hedge funds

and private equity funds. Some of these multi-manager
vehicles limit holdings to specific managers or investment
strategies, while others are more diversified. Investors in
funds of funds are willing to pay two sets of fees, one to
the fund of funds manager and another set of (usually
higher) fees to the managers of the underlying funds.

General partner The individual or firm that organises and manages a limited
partnership, such as a hedge fund. The general partner
usually assumes unlimited legal responsibility for the
liabilities of a partnership.

High-water mark A provision to ensure a fund manager only collects

incentive fees on the highest net asset value previously
attained at the end of any prior fiscal year - or gains on
actual profits for each investor. For example, if the value of
an investor’s contribution falls to $750,000 from $1 million
in the first year and then rises to $1.25 million in year two,
the manager would only receive incentive fees from that
investor on the $250,000 that represented actual profits in
year two.

Hurdle rate The minimum return necessary for a fund manager to start
collecting incentive fees. The hurdle is usually tied to a
benchmark rate such as Libor or the one-year Treasury bill
rate plus a spread. If the manager sets a hurdle rate equal
to 5% and the fund returns 15%, incentive fees would
only apply to the 10% above the hurdle rate.

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Incentive/Performance fee The charge - typically 20% - that a fund manager assesses
on gains earned during a given 12 month period. For
example if a fund posts a return 40% above its hurdle rate,
the incentive fee would be 8% (20% of 40%) - provided
that the high-water mark does not come into play.

Leverage The borrowed money that an investor employs to increase

buying power and increase its exposure to an investment.
Users of leverage seek to increase their overall invested
amounts in hopes that the returns on their positions will
exceed their borrowing costs. The extent of a fund’s
leverage is stated either as a debt-to-equity ratio or as a
percentage of the fund’s total assets that are funded by
debt. Leverage can also come in the form of short sales,
which involve borrowed securities.

Limited partnership Many hedge funds are structured as limited partnerships,

organisations managed by one or more general partners
who are liable for the fund’s debts and obligations. The
investors in such a structure are limited partners who do
not participate in day-to-day operations and are liable only
to the extent of their investments.

Lock-up The period of time - often one year - during which hedge
fund investors are initially prohibited from redeeming their
shares.

Management fee The charge that a fund manager assesses to cover

operating expenses. Investors are typically charged
separately for costs incurred for outsourced services. The
fee ranges from an annual 0.5-2.0% of an investor’s entire
holdings, usually collected quarterly.

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Master-feeder fund A common hedge fund structure through which a manager

sets up two separate vehicles - one based in the U.S. and
an offshore fund - which serve as the only investors for a
third non-U.S. fund. The two smaller entities are known as
feeder funds, while the large offshore vehicle acts as the
master fund. The purpose of this is to create a single
investment vehicle for both U.S. and non-U.S. investors.

Prime broker A large bank or securities firm that provides various

administrative, back-office and financing services to hedge
funds and other professional investors. Prime brokers can
provide a wide variety of services, including trade
reconciliation (clearing and settlement), custody services,
risk management, margin financing, securities lending for
the purpose of carrying out short sales, record keeping, and
investor reporting. A prime brokerage relationship doesn’t
preclude hedge funds from carrying out trades with other
brokers, or even employing others as prime brokers. To
compete for business, some prime brokers act as incubators
for funds, providing office space and services to help new
fund managers get off the ground.

R-squared (R2) A measure of the degree to which a hedge fund’s returns

are correlated to the broader financial market. A figure
of 1 would be a perfect correlation, while 0 would be no
correlation and minus 1 would be a perfect inverse
correlation. Any figure below 0.3 is considered non-
correlated. The result is used to determine whether a hedge
fund follows a market-neutral investment strategy. This is
sometimes referred to as “R2.”

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Regulation D A provision in the Securities Act of 1933 that allows

privately placed transactions to take place without SEC
registration and prohibits hedge funds from advertising
themselves to the general public. It also outlines which
parties qualify as insiders.

Regulation D investment strategy An approach in which the fund manager provides financing
to publicly traded companies, usually in exchange for a
privately placed convertible note issued at a discount. It is
also known as PIPES (private investments in public entities).

Sharpe ratio A measure of how well a fund is rewarded for the risk it
incurs. The higher the ratio, the better the return per unit
of risk taken. It is calculated by subtracting the risk-free rate
from the fund’s annualised average return and dividing the
result by the fund’s annualised standard deviation. A Sharpe
ratio of 1:1 indicates that the rate of return is proportional
to the risk assumed in seeking that reward. Developed by
Prof. William R. Sharpe of Stanford University.

Sortino ratio Also called the “upside potential ratio.” Similar to the
Sharpe ratio, it was developed by the Pension Research
Institute to determine the amount of “good” volatility that
a fund’s investment portfolio possesses – that is, it seeks to
define the amount by which the investment pool’s value
may increase, based on expected pricing fluctuations.

Venture capital Money given to corporate start-ups and other new high-risk
enterprises by investors who seek above average returns
and who are often willing to take illiquid positions.

Volatility The likelihood that an instrument’s value will change over a

given period of time, usually measured as beta.

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© FTSE International Limited 2005. All rights reserved in and to the FTSE
Hedge Index Series are vested in FTSE International Limited. "FTSE®",
"FT-SE®" and "Footsie®" are trade marks of the London Stock Exchange
Plc and The Financial Times Limited and are used by FTSE International
Limited under licence. All information is provided for information
purposes only. Every effort is made to ensure that all information given
in this publication is accurate, but no responsibility or liability can be
accepted by FTSE International Limited for any errors or for any loss from
use of this publication or from the use of the FTSE Hedge Index Series.

Designed and produced by Meriden Marketing

NEW Hedge Guide 180mm.qxd 3/2/05 11:52 am Page 24

FOR FURTHER INFORMATION PLEASE VISIT WWW.FTSE.COM/HEDGE, EMAIL INFO@FTSE.COM OR CALL YOUR LOCAL FTSE OFFICE:
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