Hedge_Funds

Hedge Funds Introduction A commonly view of the public about the hedge funds is that it they are very risky, aggressive and highly leveraged financial tools. People may only focus on the ‘easy money’ made by some prime brokers such like George Soros’s Quantum Fund, and the mess they left behind in the Asian market during the 1990s’. However, those misconceptions may have provided people with a wrong image to understand the hedge funds. While some hedge (Matthew Ridley, 2004) funds are indeed aggressive, the vast majority of hedge funds are aiming to lower the risk profile than the one would associate with traditional long-only equity investments. Basically, a hedge fund (Alexander Ineihen, 2002) constitutes an investment program whereby the managers or partners seek absolute returns by exploiting investment opportunities while protecting principal from potential financial loss. Main characteristics of the Hedge Fund industry The hedge funds used to be very secretive, since it is far from our life. The hedge funds cannot be found in the high street, neither on the local yellow page book. That is because the hedge funds are not targeting the man or woman from the street. The clients of hedge funds are normally the very wealthy individuals and the professional investment companies which are controlling large amounts of funds such as pension funds and insurance firms. Therefore, the entry requirements of hedge funds are relatively high. To step into the hedge funds market, it normally requires a person with one million dollars or no less than two hundred thousand dollars net income from last fiscal year. For the clients, hedge funds are able to minimize the overall portfolio volatility and enhance returns. Hedge funds diversify the risk with a variety of instruments and minimize the correlation in different markets; they seldom take additional risk in their portfolios. The fund managers have many investment options such as short selling, leverage and derivatives. The managers are usually highly specialized and they only offer the service in their own expertise area. In that case, the fund managers are competitive and with related experience would help the investors make reduce the risk and staying competitive in the market. Furthermore, many hedge funds (magnum, 2010) have as an objective consistency of returns and they are able to provide non-market correlated returns. The hedge funds providers benefit by charging heavily weighting on the profit they make. Essential management fee is in the range from 1% to 3%, and the performance fees are from 15% to 25% in order to incentive the manager to achieve the highest returns (The peak value of the funds has to pass the high water mark, see figure 1.1). The performance fees can align the interests of managers more closely with those of investors’. It will benefit both sides if there are positive returns. However, there are some objections of the performance fees, for instance the notable investor Warrant Buffet, saying “paying performance fees to the fund managers may encourage them to take on excessive risk in order to achieve higher returns”. On the other hand, the higher risk the mangers bear the more efforts they have to make. The good earning attracts the best candidates to step into the competitive hedge funds industry. In addition, hedge fund managers usually have their own money in their funds. Figure 1.1 Hedging strategies Hedge funds are managed by managers with different styles and therefore will invest the funds with different strategies. Moreover, there is a wide range of hedging strategies are available to the hedge funds. The hedging strategies can mainly be divided into four categories, these are as follows: 1. Relative value 2. Event driven 3. Trading 4. Short selling Figure 1.3 indicates the make-up of the usage of main strategies under the four categories stated above. Relative value strategies (Flippo Stefanini, 2005) are arbitrage transactions that seek to profit from the spread between two securities rather than from the general market direction. Relative values strategies consists of merger arbitrage, convertible bond arbitrage, fixed income arbitrage, mortgage-backed arbitrage and capital structure arbitrage. While event strategies seek to capitalize on opportunities arising during a company’s life cycle, triggered by extraordinary corporate events, such as spin-offs, mergers, acquisitions, business combinations, liquidations and restructuring. Moreover, the trading strategies are looking for advantages of major market trends rather than focusing their analysis on single stocks. It includes two types of strategies which are managed futures and macro strategies. Nonetheless, selling short is to sell shares without owning them, hoping to buy them back at a time point in the future with expectation of lower price. Short selling is the most commonly used instrument among hedge funds. Trend of the Hedge Funds industry Alfred Winslow Jones, a reporter for Fortune, started the first hedge fund with an initial capital of a hundred thousand dollars in 1949.That was the first hedge fund ever in the history. However, there has been dramatic growth during the 60 years after the first hedge fund. If we focus on the rapid growth of hedge funds industry in the recent two decades, we can find the number of hedge funds (Flippo Stefanini, 2005) has gone from 610 in 1990 up to 7346 in 2004 (not including funds of hedge funds). Assets managed by hedge funds went from an estimated $38.9 billion to approximately $973 billion in 2004. From the figure 1.1, we can obtain that, the number of hedge funds has rocketed from less than one thousand to more than six thousand. Furthermore, the assets under management have also jumped from approximately 40,000 to 800,000 during the 14 years from 1990 to 2003. In addition, both the assets under management and the hedge funds number have an annual growth rate of around 23 percent. Despite the fluctuations in the global market, the dramatic increase in those numbers demonstrates the staggering expansion pace and the prosperity in the hedge funds industry. References 1. Matthew Ridley, (2004), How to invest in hedge funds, pp 3, Kogan Page Limited reprinted 2004 2. Alexander Ineichen, (2003), Risk and opportunities of Hedge Fund investing, pp 35-36, John Wiley & Sons, Inc, New Jersey 3. Magnum, (2010) Blackboard [Internet]. Available from: [accessed: 26 November 2010]. 4. Flippo Stefanini, (2005), Investment strategies of hedge funds, pp 14 – 15, John Wiley & Sons, Inc, New Jersey