Hedge Funds

An Hedge fund like a mutual fund is a pool of investments but unlike mutual funds, they go beyond traditional investments. Differences between hedge funds and traditional investments include:

• Regulatory structure: Hedge funds unlike traditional investments are unlisted and privately organized; they are not heavily regulated, unlike mutual funds. Hedge funds are also prohibited from advertising to the general public; they are sort of secretive in their operations, and it is usually high net worth individuals and institutional investors such as foundations, endowments, pension funds and others that invest in them. Hedge funds fall within the safe harbor exemptions of the investment company act 1940. This means that hedge funds do not have to deal with filling, disclosures, record keeping, and various reporting requirements which must be adhered to by mutual funds. Individuals qualify for the accredited investor standard by having a net worth in excess of $1 million for actual income greater than $200,000 for each of the past two years ($300,000 for married couples). Individuals meet the qualified purchaser standard by having a net worth greater than $5 million.

• Compensation: It is not uncanny to hear hedge fund managers raking in billions of dollars as their total annual pay (including bonuses). Hedge fund managers are offered performance based incentives in order to attract and retain the best elite managers with more sophisticated strategies.

• Trading structure: Hedge funds are not restricted in terms of investment strategies, they may invest in private securities, real assets, derivatives, structured products among a few. They may sometimes fund investments with leverage as we will see later in the note.

Hedge fund strategies

• Equity hedge fund strategies: They are strategies which can be used by hedge fund managers in dealing with stocks. The categories of equity hedge fund is

1. Long- short : An equity long-short strategy is primarily used by hedge funds. Hedge funds perform bottom up fundamental analysis on company’s stock; they analyze the intrinsic value of the stock with the market price and then go long on stocks they think are under valued, while going short on stocks that are overvalued. Going long means buying stocks now with the hope of selling it and making profit when it appreciates. Going short on the other hand means selling borrowed stocks. The trick is that the hedge fund borrows a stock it thinks is overvalued (usually from a broker), and then sells it. When the price falls, it repurchases the unit borrowed, but now at a cheaper price.The goal of any equity long-short strategy is to minimize exposures to the market in general, and profit from a change in the difference, or spread between the two stocks

1. Market neutral strategy: In this strategy, the hedge fund adopts the same concept with the long-short strategy; but it seeks to minimize its exposure to the broad market. The market neutral strategy can be accomplished by holding equal amounts of investment in both long and short positions, so that the net exposure of the fund would be zero.

• Relative value arbitrage: Relative value arbitrage seeks to take advantage of price differentials. It is an investment strategy adopted by hedge funds. It involves purchasing or buying a security that is expected to appreciate in value, while simultaneously selling short a related security that is expected to depreciate in value.Remember from the previous discussion that selling short means borrowing an overpriced security (usually from a broker), and then selling it off with the hope that when the value falls and subsequently the price, it would be able to purchase the same stock back, but at a cheaper price. Relative value arbitrage boils down to the stock picking ability or other financial instrument picking ability of the hedge fund manager; this is because the hedge fund invests in a pair of related securities which have high correlation (meaning that they tend to move in the same direction.)

• Convertible arbitrage: Convertible arbitrage is a type of equity long-short strategy whereby a security that is undervalued is held long and a security that is overvalued is held short. The twist in the convertible arbitrage is that a convertible arbitrage strategy takes a long position in a convertible security, while simultaneously taking a short position in the common stock of the same company. A convertible security is also referred to as a hybrid security because it is neither bond nor stock, but bares characteristics of both. They usually have lower yield that bonds, but they can be converted into stock at a discount to the market value of the stock. Hedge funds which implements the convertible arbitrage strategy seek to take advantage of pricing errors because sometimes a company’s convertible security may be priced inefficiently relative to its stock.The trick to the convertible arbitrage strategy is that when a company’s stock price falls, the hedge fund would benefit from its short position, but loses from its long position in the convertible security. It would then use the profit made in the short position to offset loses made in the long position. The plus is that convertible securities tend to decline less than its stock because they are protected by their value as fixed income securities.On the other hand, when the stock price rises, the hedge fund can benefit from its long position by converting the security into stock, and selling the stock at the market value thereby compensating for any loss it might have made from its short position. It is not as easy as it seems because a convertible bond must be held for a specified period of time before it can be converted into stock.

• Global Macro: Global macro funds base their strategies on educated guesses about macro-economic trends and developments around the world. The managers are at liberty to trade in any manner they feel will profit the fund. They can trade in any geographical location that can potentially create positive investment returns independent of the capital markets, shifts in the commodity cycle or momentum of the macro economy.Due to their possible global operation of trading in investments deemed to bring returns, they have the highest risk of any other fund strategy; but also the highest return profile because of the diversification possible under this strategy.
  Global macro funds can trade in asset classes such as stocks, bonds, currencies , commodities etc. and also financial instruments such as futures, derivatives and cash. Managers make investment decisions by first analyzing the current macroeconomic condition prevalent in the geographical location, and then predicting changes in the factors such as interest rates, inflation, economic cycles and political circumstances.

Hedge fund fees

Hedge fund fees consist of management fees and performance fees. The former is a fee charged as a percentage of the NAV (Net asset value) of the fund, while the former is a fee charged as a certain percentage of returns on the fund.

Management fees are collected on a quarterly, semi annual or annual basis, and they are collected regardless of the fund’s performance. Most hedge funds charge around 2% of the NAV of the fund at the beginning of the period as the management fee; others may charge anything between 1% to 3% depending on the size of the hedge fund and management’s preference.

Performance fees are also collected on an annual basis based on the profitability of the fund.  It is a way to reward managers for a job well done. A typical performance fee is 20%, but for some hedge funds it may rise as high as 40%.

A fund may have an high water mark provision whereby incentive fees are paid to the management only when the NAV  (Net Asset Value) rises above the maximum provision observed NAV . Apart from this, a hedge fund may also have an hurdle rate whereby incentives are paid only when the fund return exceeds a set threshold return.

Formulae

• Total annual fee as a percentage of AUM (Asset under Management ) = Mgt fee% (NAV _beg) + (Max (0₁ (incentive fee %) x (GR – Mgt fee- hurdle rate)

• Annual Management fee = % mgt fee x NAV _beg

• Incentive fee = % Incentive fee X   (NAV_end – NAV_beg – MGT fee)

• Total annual fee = Management fee + Incentive fee

• Ending Nav after fee = NAV_end – Mgt fee – Incentive fees)

Recommended Reading 

Ann Louge., Hedge funds for dummies.