CHAPTER 1: INTRODUCTION

1.1 BACKGROUND

A hedge fund is an investment fund that pools capital from accredited individuals or
institutional investors and invests in a variety of assets, often with complex portfolio-
construction and risk-management techniques. It is administered by a professional investment
management firm, and often structured as a limited partnership, limited liability company
etc. Hedge funds are generally distinct from mutual funds, as their use of leverage is not
capped by regulators, and distinct from private equity funds, as the majority of hedge funds
invest in relatively liquid assets.

Hedge funds are made available only to certain sophisticated or accredited investors and
cannot be offered or sold to the general public. As such, they generally avoid direct
regulatory oversight, bypass licensing requirements applicable to investment companies, and
operate with greater flexibility than mutual funds and other investment funds. However,
following the financial crisis of 2007–2008, regulations were passed in the United States and
Europe with intentions to increase government oversight of hedge funds and eliminate certain
regulatory gaps.

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1.2 RATIONALE
Hedge funds gained popularity as an asset class in the early to mid 1990s, as a way for
investors to generate returns above inflation and bank deposits without exposing an investor
to the risks associated with general equities, which are directly affected by the performance
of underlying economies. Equities may have delivered the best returns historically, but an
investor takes on the associated economic risks.

In contrast, hedge fund strategies aim to deliver returns above inflation, but without the same
dependence on the economy. If they achieve that aim, then hedge funds are an alternative
asset class that could provide essential diversification benefits for an investor's portfolio.

The rationale behind an investment in hedge/absolute return funds has two facets:

▪ Hedge fund aim to generate returns from markets and financial instruments, but with no
real dependence on the general economy. It attempt to generate returns above bank
deposit rates and inflation, while limiting the dependence of those returns on the general
economy. In this way, the returns that this asset class can produce are uncorrelated to
equities.

▪ Where an investor feels that equity markets are overvalued or where an investor does not
want to take on the risks associated with equities - which are dependent on a positive
economic backdrop - an allocation of some monies to hedge funds can be justified on the
basis that diversification reduces the risk of significant losses.

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1.3 LITERATURE REVIEW
Allison, Douglas T., and Felix T. Lin. 2004. “Including Hedge Funds in Private Client
Portfolios.” AIMR Conference Proceedings: Integrating Hedge Funds into a Private
Wealth Strategy (February):6–20. “Hedge funds can play a vital role in client portfolios,
but clients need to be aware of all the issues involved—issues ranging from the impact of
incorporating hedge funds into the portfolio mix to understanding the potential risks
involved to the pros and cons of hedge fund investing. Once the decision has been made
to include hedge funds in the portfolio mix, the allocation must be determined and should
be based on future expectations for hedge fund performance. Finally, by using an
optimizer, an ideal mix of hedge fund strategies can be established. The end result is a
portfolio that meets client goals and objectives and has the potential to decrease risk and
enhance return.”

Ackermann, Carl, Richard McEnally, and David Ravenscraft. 1999. “The Performance of
Hedge Funds: Risk, Return, and Incentives.” Journal of Finance, vol. 54, no. 3
(June):833–874. “Hedge funds display several interesting characteristics that may
influence performance, including flexible investment strategies, strong managerial
incentives, substantial managerial investment, sophisticated investors, and limited
government oversight. Using a large sample of hedge fund data from 1988–1995, we find
that hedge funds consistently outperform mutual funds, but not standard market indices.
Hedge funds, however, are more volatile than both mutual funds and market indices.
Incentive fees explain some of the higher performance, but not the increased total risk.
The impact of six data-conditioning biases is explored. We find evidence that positive
and negative survival-related biases offset each other.”

1.4 OBJECTIVES
▪ To study the organisational structure, term structure and the fee structure of
hedge funds.
▪ To analyse the strategies used in dealing with hedge funds and how far are they
helpful.
▪ To identify the risks involved in hedge funds.
▪ A comparative study of hedge funds and traditional forms of investments.

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CHAPTER 2: CONCEPTUAL FRAMEWORK

A ‘hedge’ is an investment position intended to offset potential lossess or gains that may be
incurred by a companion investment. It is simply a risks management technique used to
reduce any substantial lossess or gains suffered by an individual or an organization. Early
hedge funds sought to hedge specific investments against general market fluctuations by
shorting the market, hence the name. Nowadays, however, many different investment
strategies are used, many of which do not hold "hedge risk".

The term "hedge fund" originated from the pair of long and short positions in a financial
instrument because these funds used to hedge market risk. Over time, the types and nature of
the hedging concepts expanded. Today, hedge funds engages in a diverse range of markets
and strategies and employs a wide variety of financial instruments and risk management
techniques.

2.1 EVOLUTION
The US bull market of the 1920s brought about, and were to a large extent driven by, the
emergence of the pooled fund as a mainstream method od preserving wealth and providing
capital growth of investors. Although pooole unds had been around forover a century
beforehand, the spectacular wealth-generating properties of the market after the Great War
created an unprecedented demand for more accessible routes into this money machine.
During this decade, a whole host of new investment vehicles came into play, and among that
was the Graham-Newman Partnership, which has since been cited by uber-investor Warren
Buffet as beign the earliest example of a hedge fund.

The investment craze of the 1920s saw millions of dollars poured into the markets, creating
what we now refer to as a bubble, and when the overheated capital markets went into a
tailspin in 1929, the results were catastrophic. What followed was the Great Depression, and
for a time, faith in the markets al but dissipated among a disillusioned and heavenly-
improvished public. The vast majority of funds and investment banks shut down under the
weight of heavy lossess, but a few remained, and many of those that did grew to be
powerhouses in the years following the Second World War.

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Structurally, a hedge fund has some similarities to a mutual fund. For example, just like a
mutual fund, a hedge fund is a pooled investment vehicle that makes investments in
equities, bonds, options and a variety of other securities. It can also be run by a separate
manager, much like a sub-advisor runs a mutual fund that is distributed by a large mutual fund
company. That, however, is basically where the similarities end. The range of investment
strategies available to hedge funds and the types of positions they can take are quite broad and
in many cases, very complex.

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CHAPTER 3: ANALYSIS & FINDINGS

3.1 ORGANISATIONAL STRUCTURE

The typical hedge fund structure is really a two-tiered organization.

The general/limited partnership model is the most common structure for the pool of
investment funds that make up a hedge fund. In this structure, the general partner assumes
responsibility for the operations of the fund, while limited partners can make investments into
the partnership and are liable only for their paid-in amounts. As a rule, a general/limited
partnership must have at least one General Partner(GP) and one Limited Partner(LP), but can
have multiple GPs and many LPs. There is an SEC rule, however, that generally limits
investors to 99 in order to be excluded from SEC registration.

GP LLC General
Partner

Investors Limited Hedge Fund, Limited

Partner Liability Partnership

The second component of the two-tiered structure is the structure of the general partnership.
The typical structure used for the general partner is a limited liability company. The general
partner's responsibility is to market and manage the fund, and perform any functions
necessary in the normal course of business, including hiring a fund manager (oftentimes a
related company) and managing the administration of the fund's operations.

3.2 FEE STRUCTURE

Hedge funds also differ quite radically from mutual funds in how they charge fees. Their fee
structure is one of the main reasons why talented money managers decide to open their own
hedge funds to begin with. Not only are the fees paid by investors higher than they are for
mutual funds, but also they include some additional fees that mutual funds don't even charge.

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The total fees paid by investors in a hedge fund consists of two parts

 Management fees: It is earned by the managers regardless of investment performance.

 Incentive fees: It is based on a proportion of profits.

The most common fee structure for a hedge fund is “2 and 20” or “2 plus,” 2% of the value of
the assets under management plus an incentive fee of 20% of profits.

Profits can be: a) any gains in value, b) any gains in value in excess of the management fee,
or c) gains in excess of a hurdle rate. A hurdle rate can be set either as a percentage (e.g. 3%)
or a rate plus a premium (e.g. Libor+2%). A hard hurdle rate means that incentive fees are
earned only on returns in excess of the benchmark. A soft hurdle rate means that the incentive
fees are paid on all profits, but only if the hurdle rate is met.

Another feature, called a high water mark, is also often included. This means that the
incentive fee is not paid on the gains that just offset prior losses. Thus incentive fees are paid
only to the extent that the current value of an investor’s account is above the highest value

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after fees previously recorded. This feature ensures that investors will not be charged incentive
fees twice on the same gains in their portfolio values.

Fee calculations for both, management fee and incentive fee, can differ not only by the
schedule of rates but also by method of fee determination. Management fee may be
calculated on either the beginning-of-period or end-of-period values of assets under
management. Incentive fee may be calculated net of management fee, i.e., value increases
less management fees, or independent of management fees.

Although the most common hedge fund fee rates tend to be the “2 and 20”, fee structures can
vary. Price breaks to investors, competitive conditions, and historical performances can
influence negotiated rates.

When High Fees Are Justified

One the world’s most successful hedge funds since 1994 has been Renaissance Technologies,
led by Jim Simmons, a former NSA code breaker. At $65 billion in AUM, his fund generates
$3.2 billion in annual management fees. Because of his remarkable outsized returns over the
years, he also charges a 44% profit fee. It is estimated that his hedge fund returned an average
71.8% between 1994 and 2014. The fund's worst performance between 2001 and 2013 was a
21% gain. When asked by investors why his profit fee is so high, he responds by telling them
they can leave if they want – but few do.

Trending away from Two and Twenty

Due to their underperformance or inconsistent performance, many hedge fund managers have
come under pressure to reduce their fees. Investors have been redeeming assets with poor-
performing hedge funds at a record pace, with a large portion being reallocated to larger
funds with stronger track records. To stop the bleeding, hedge fund managers have been

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complying. In 2015, the average fee arrangement stands at 1.5% of assets and 17.7% of
profits. However, the top-performing hedge funds still charge 20% or more.

Investors are not the only ones complaining about high profit fees. Hedge fund managers are
also coming under pressure from politicians who want to reclassify the profit fees as ordinary
income for tax purposes. As of 2017, their profit fees, also referred to as carried interest, is
classified as capital gains, which are taxed more favorably. Fund managers contend that
carried interest is not a salary, but that it is an at-risk return on investment payable based on
performance.

3.3 TERM STRUCTURE

The terms offered by a hedge fund are so unique that each fund can be completely different
from another, but they usually are based on the following factors:

 Subscription and Redemptions

Hedge funds do not have daily liquidity like mutual funds do. Some hedge funds can
have subscriptions and redemptions monthly, while others accept them only quarterly.
The terms of each hedge fund should be consistent with the underlying strategy being
used by the manager. The more liquid the underlying investments, the more frequent the
subscription/redemption terms should be. Each fund also specifies the number of days
required for redemption, ranging from 15 days to 180 days, and this too should be
consistent with the underlying strategy. Requiring redemption notices allows the hedge
fund manager to efficiently raise capital to cover cash needs.

 Lock-Ups

Some funds require up to a two-year "lock-up" commitment, but the most common lock-
up is limited to one year. In some cases, it could be a hard lock, preventing the investor
from withdrawing funds for the full time period, while in other cases, an investor can
withdraw funds before the expiration of the lock-up period provided they pay a penalty.
This second form of lock-up is called a soft lock and the penalty can range from 2% to
10% in some extreme cases.

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There are a variety of different combinations that can be used to structure a hedge fund and
its related companies and investors. The above summary briefly describes one very common
method used to structure the hedge fund and its management company. There are many
others and just as hedge funds are creative with their investment strategies, they can also be
very creative with their organizational structure.

3.4 HEDGE FUND STRATEGIES

Hedge Funds do generate some amazing compounded annual returns. However, these returns
depend on the ability to properly apply Hedge Funds Strategies to get those handsome returns
for the investors. While majority of the hedge funds apply Equity Strategy, others follow
Relative Value, Macro Strategy, Event Driven etc.

Hedge Fund Strategy Classifications

Equity Hedge Event Driven Macro Relative Value

Equity Market Discretionary Fixed Income - Convertible

Merger Arbitrage
N eutral Thematic Arbitrage

Fundamental Systematic Fixed Income - Asset

Special Situations
Growth Diversified Backed

Energy/Basic Systematic
Activist Volatility
Materials Commodity

Technology / Private Issue /

Multi-Strategy Yield Alternatives
Healthcare Regulation D

Short Bias Credit Arbitrage -- Multi-Strategy

Quantitative
Multi-Strategy -- --
Directional

Multi-Strategy -- -- --

Source: Hedge Fund Research, 2016.

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Some of the common hedge fund strategies are discussed below:

1. LONG/SHORT EQUITY STRATEGY

 In this type of Hedge Fund Strategy, investment manager maintains long and short
positions in equity and equity derivative securities.
 Thus, the fund manager will purchase the stocks that they feel is undervalued and will
sell those which are overvalued.
 Wide varieties of techniques are employed to arrive at an investment decision. It
includes both quantitative and fundamental techniques.
 Such a hedge fund strategy can be broadly diversified or narrowly focused on specific
sectors.
 It can range broadly in terms of exposure, leverage, holding period, concentrations of
market capitalization and valuations.
 Basically, the fund goes long and short in two competing companies in the same
industry.
 But most managers do not hedge their entire long market value with short positions.

EXAMPLE OF LONG/SHORT EQUITY

 If Tata Motors looks cheap relative to Hyundai, a trader might buy Rs.100,000 worth
of Tata Motors and short an equal value of Hyundai shares. The net market exposure
is zero in such case.
 But if Tata Motors doesnot out perform Hyundai, the investor will make money no
matter what happens to the overall market.
 Suppose Hyundai rises 20% and Tata Motors rises 27%; the trader sells Tata Motors
for Rs.127,000, covers the Hyundai short for Rs.120,000 and pockets Rs.7,000.
 If Hyundai falls 30% and Tata Motors falls 23%, he sells Tata Motors for Rs.77,000,
covers the Hyundai short for Rs.70,000, and still pockets Rs.7,000.
 If the trader is wrong and Hyundai outperforms Tata Motors, however, he will lose
money.

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2. MARKET NEUTRAL STRATEGY

 By contrast, in market-neutral strategy, hedge funds target zero net-market exposure

which means that shorts and longs have equal market value.
 In such a case the managers generate their entire return from stock selection.
 This strategy has a lower risk than the first strategy that we discussed, but at the same
time the expected returns are also lower.

EXAMPLE OF MARKET NEUTRAL STRATEGY

 A fund manager may go long in the 10 biotech stocks that are expected to outperform
and short the 10 biotech stocks that may underperform.
 Therefore, in such a case the gains and losses will offset each other inspite of the fact
how the actual market does.
 So even if the sector moves in any direction the gain on the long stock is offset by a
loss on the short.

3. MERGER ARBITRAGE STRATEGY

 In such a hedge fund strategy the stocks of two merging companies are
simultaneously bought and sold to create a riskless profit.
 This particular hedge fund strategy looks at the risk that the merger deal will not close
on time, or at all.
 Because of this small uncertainty, this is what happens:
 The target company’s stock will sell at a discount to the price that the combined entity
will have, when the merger is done.
 This difference is the arbitrageur’s profit.
 The merger arbitrageurs care only about the probability of the deal being approved
and the time it will take to close the deal.

EXAMPLE OF MARKET ARBITRAGE STRATEGY

Consider these two companies– ABC Co. and XYZ Co.

 Suppose ABC Co is trading at $20 per share when XYZ Co. comes along and bids
30 per share which is a 25% premium.

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  The stock of ABC will jump up, but will soon settle at some price which is higher
than Rs.20 and less than Rs.30 until the takeover deal is closed.
 Let’s say that the deal is expected to close at Rs.30 and ABC stock is trading at Rs.27.
 To seize this price-gap opportunity, a risk arbitrageur would purchase ABC at Rs.28,
pay a commission, hold on to the shares, and eventually sell them for the agreed Rs.30
acquisition price once the merger is closed.
 Thus the arbitrageur makes a profit of Rs.2 per share, or a 4% gain, less the trading fees.

4. CONVERTIBLE ARBITRAGE

 Convertibles generally are the hybrid securities including a combination of a bond

with an equity option.
 A convertible arbitrage hedge fund typically includes long convertible bonds and
short a proportion of the shares into which they convert.
 In simple terms it includes a long position on bonds and short position on common
stock or shares.
 It attempts to exploit profits when there is a pricing error made in the conversion
factor i.e. it aims to capitalize on mispricing between a convertible bond and its
underlying stock.
 If the convertible bond is cheap or if it is undervalued relative to the underlying stock,
the arbitrageur will take a long position in the convertible bond and a short position in
the stock.
 On the other hand, if the convertible bond is overpriced relative to the underlying
stock, the arbitrageur will take a short position in the convertible bond and a long
position in the underlying stock.
 In such a strategy managers try to maintain a delta-neutral position so that the bond
and stock positions offset each other as the market fluctuates.
 Delta Neutral Position- Strategy or Position due to which the value of the Portfolio
remains unchanged when small changes occur in the value of the underlying security.
 Convertible arbitrage generally thrives on volatility.
 The reason for the same is that, more the shares bounce, more the opportunities arise
to adjust the delta-neutral hedge and book trading profits.

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EXAMPLE OF CONVERTIBLE ARBITRAGE STRATEGY

 Visions Co. decides to issue a 1-year bond that has a 5% coupon rate. So on the first
day of trading it has a par value of Rs.1,000 and if you held it to maturity (1 year) you
will have collected $50 of interest.
 The bond is convertible to 50 shares of Vision’s common shares whenever the
bondholder desires to get them converted. The stock price at that time was Rs.20.
 If Vision’s stock price rises to Rs.25 then the convertible bondholder could exercise
their conversion privilege. They can now receive 50 shares of Vision’s stock.
 50 shares at Rs.25 is worth Rs.1,250. So if the convertible bondholder bought the
bond at issue (Rs.1,000), they have now made the profit of Rs.250. If instead they
decide that they want to sell the bond, they could command Rs.1250 for the bond.
 But what if the stock price drops to Rs.15? The conversion comes to Rs.750 (Rs.15
*50). If this happens you could simply never exercise your right to convert to
common shares. You can then collect the coupon payments and your original
principal at maturity.

5. CAPITAL STRUCTURE ARBITRAGE

 It is a strategy in which a firm’s undervalued security is bought and its overvalued

security is sold.
 Its objective is to profit from the pricing inefficiency in the issuing firm’s capital
structure.
 It is a strategy used by many directional, quantitative and market neutral credit hedge
funds.
 It includes going long in one security in a company’s capital structure while at the
same time going short in another security in that same company’s capital structure.
 For example, long the sub-ordinate bonds and short the senior bonds, or long equity
and short CDS (Credit Default Swap).

EXAMPLE OF CAPITAL STRUCTURE ARBITRAGE

An example could be – A news of particular company performing badly.

In such a case, both its bond and stock prices are likely to fall heavily. But the stock
price will fall by a greater degree for several reasons like:

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  Stockholders are at a greater risk of losing out if the company is liquidated because of
the priority claim of the bondholders
 Dividends are likely to be reduced.
 The market for stocks is usually more liquid as it reacts to news more dramatically.
 Whereas on the other hand annual bond payments are fixed.
 An intelligent fund manager will take advantage of the fact that the stocks will
become comparatively much cheaper than the bonds.

6. FIXED-INCOME ARBITRAGE

 This particular Hedge fund strategy makes profit from arbitrage opportunities in
interest rate securities.
 Here opposing positions are assumed in the market to take advantage of small price
inconsistencies, limiting interest rate risk. The most common type of fixed-income
arbitrage is swap-spread arbitrage.
 In swap-spread arbitrage opposing long and short positions are taken in a swap and a
Treasury bond.
 Point to note is that such strategies provide relatively small returns and can cause
huge losses sometimes.
 Hence this particular Hedge Fund strategy is referred to as ‘Picking up nickels in front
of a steamroller!’

EXAMPLE OF FIXED INCOME ARBITRAGE

A Hedge fund has taken the following position: Long 1,000 2-year Municipal Bonds at Rs.200.
 1,000 x Rs.200 = Rs.200,000 of risk (unhedged)
 The Municipal bonds payout 6% annually interest rate – or 3% semi.
 Duration is 2 years, so you receive the principal after 2 years.

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But the risks will always remain for :

 The municipal bond not being paid back.

 Not receiving your interest.
Therefore this duration risks needs to be hedged

7. EVENT DRIVEN

 In such a strategy the investment Managers maintain positions in companies that are
involved in mergers, restructuring, tender offers, shareholder buybacks, debt
exchanges, security issuance or other capital structure adjustments.

EXAMPLE OF EVENT DRIVEN STRATEGY

One example of Event driven strategy is distressed securities.

In this type of strategy, the hedge funds buy the debt of companies that are in financial
distress or have already filed for bankruptcy.

If the company has yet not filed for bankruptcy, the manager may sell short equity, betting
the shares will fall when it does file.

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8. GLOBAL MACRO

 This hedge fund strategy aims to make profit from large economic and political
changes in various countries by focusing in bets on interest rates, sovereign bonds and
currencies.
 Investment managers analyze the economic variables and what impact they will have
on the markets. Based on that they develop investment strategies.
 The Managers analyze how macroeconomic trends will affect interest rates,
currencies, commodities or equities around the world and take positions in the asset
class that is most sensitive in their views.
 Variety of techniques like systematic analysis, quantitative and fundamental
approaches, long and short-term holding periods are applied in such case.
 Managers usually prefer highly liquid instruments like futures and currency forwards
for implementing this strategy.

EXAMPLE OF GLOBAL MACRO STRATEGY

An excellent example of a Global Macro Strategy is George Soros shorting of the pound
sterling in 1992. He then took a huge short position of over 10 billion worth of pounds.
He consequently made a profit from the Bank of England’s reluctance to either raise its
interest rates to levels comparable to those of other European Exchange Rate Mechanism
countries or to float the currency.

9. SHORT ONLY

 Short selling is an investment strategy which includes selling the shares that are
anticipated to fall in value.
 In order to successfully implement this strategy, the fund managers have to scour the
financial statements, talk to the suppliers or competitors to dig any signs of trouble for
that particular company.

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3.5 RISKS INVOLVED IN HEDGE FUNDS

 Unregistered Investments

Funds of hedge funds generally invest in several private hedge funds that are not subject
to the SEC's (Securities and Exchange Commission) registration and disclosure
requirements. As discussed, many of the normal investor protections that are common to
most traditional registered investments are missing. This makes it difficult for both you
and the fund of funds manager to assess the performance of the underlying hedge funds or
independently verify information that is reported. All of this can make it easier for an
unscrupulous hedge fund manager to engage in fraud.

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  Risky Investment Strategies

Hedge funds very often use speculative investment and trading strategies. Many hedge
funds are honestly managed, and balance a high risk of capital loss with a high potential
for capital growth. The risks hedge funds incur, however, can wipe out your entire
investment.

 Lack of Liquidity

Hedge funds, both of unregistered and registered variety, are illiquid investments and are
subject to restrictions on transferability and resale. Unlike mutual funds, there are no
specific rules on hedge fund pricing. Registered hedge fund units may not be redeemable
at the investor's option and there is probably no secondary market for the sale of the
hedge fund units. In other words, you may not be able to get the money you invested in
the hedge fund back when you want out of the investment.

3.6 COMPARATIVE STUDY OF HEDGE FUNDS AND MUTUAL

FUNDS

These two types of investment products have their similarities and differences.

The similarities:
Both mutual funds and hedge funds are managed portfolios. This means that a manager (or a
group of managers) picks securities that he or she feels will perform well and groups them
into a single portfolio. Portions of the fund are then sold to investors who can participate in
the gains/losses of the holdings. The main advantage to investors is that they get instant
diversification and professional management of their money.

The differences:
Hedge funds are managed much more aggressively than their mutual fund counterparts. They
are able to take speculative positions in derivative securities such as options and have the

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ability to short sell stocks. This will typically increase the leverage - and thus the risk - of the
fund. This also means that it's possible for hedge funds to make money when the market is
falling. Mutual funds, on the other hand, are not permitted to take these highly leveraged
positions and are typically safer as a result.

Another key difference between these two types of funds is their availability. Hedge funds
are only available to a specific group of sophisticated investors with high net worth. The U.S.
government deems them as "accredited investors", and the criteria for becoming one are
lengthy and restrictive. This isn't the case for mutual funds, which are very easy to purchase
with minimal amounts of money.

3.7 DIVERSIFICATION BENEFITS OF HEDGE FUNDS

An overall increase in allocation to hedge funds, and away from the traditional equity and
bond mix, will increase the expected portfolio return, reduce volatility, and increase the
information ratio and Sharpe ratio of a portfolio. These benefits are achieved because hedge
funds are exposed to global risk factors and new asset classes that effectively diversify the
portfolio away from pure equity/bond exposure. Simon Hookway, CEO of MSS Capital
Limited provides insight into the dynamically diversified quality of hedge fund styles and
strategies and the difficulty of replicating hedge fund exposure using static exposures to
hedge fund global risk factors.
The growth of the hedge fund sector has coincided with an economic and financial market
environment that is one of the most challenging in recent memory. The sector’s dynamic
growth profile has attracted attention, some of it negative. Such negativity tends to focus on
fee structures, performance, business risk and lack of regulation.

The facts are as follows. Hedge funds do charge a higher fee structure than long-only funds.
However, critics often fail to recognize that hedge funds have a more flexible investment
mandate in their pursuit of absolute positive returns. The ability of hedge funds to take ‘short’
as well as ‘long’ positions allows them to deliver positive returns in falling markets and to
position themselves more favorably in such climates relative to long-only funds. Due to the
existence of high water marks, hedge fund managers have to deliver positive returns for their
investors before they can take performance fees.

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 Further, business risk at a management company level is substantially mitigated by a
thorough and rigorous qualitative and operational due diligence process into the management
company, its balance sheet, structure, ownership and principals. This forms part of the hedge
fund selection process prior to investments being made.

The regulation of hedge funds is progressing at a measured pace. As of the beginning of

February 2018, the SEC stepped up its regulation of the sector by requiring all US domiciled
hedge fund managers to register with the regulatory body. Those managers choosing not to
register suffered a new set of stringent conditions imposed on the hedge funds they manage. In
the UK meanwhile, the Financial Services Authority has signalled its intention to give
individual investors access to hedge fund investments and focus on investor protection as a
new area of supervision.

The diversification potential offered by hedge funds, and funds of hedge funds especially,
arises from the fact that they are themselves diversified portfolios spanning different
geographies, strategies and asset classes. One of the main attractions of hedge fund investing
is that diversification can be achieved due to their low correlation to traditional equity and
bond markets. In fact, interestingly some strategies even have negative correlation to equities
and bonds, for example, the non-directional style (due to equity arbitrage and fixed income
relative value strategies) and CTA (Commodity Trading Advisor)/managed futures strategy.

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 One of the key reasons that hedge funds are diversifying is that they have exposures to many
global risk factors and new asset classes other than equities and bonds. Beta coefficients can
be thought of as the tendency of the returns from the Global Composite to respond to swings
in those factors. As assets are allocated away from an equity/bond mix towards hedge funds,
the portfolio exposure to global risk factors becomes more varied and diversified.

Skewness and kurtosis are two important parameters used while measuring the downside
risk of a portfolio.
Skewness characterises the degree of asymmetry of a distribution around its mean. Positive
skewness indicates a distribution with an asymmetric tail extending towards values that are
more positive. By allocating to hedge funds, monthly skewness is significantly increased. This
is good for expected geometric returns as good returns are strong while poor returns are
moderate. In fact, positive skew is highly desirable because positive returns need to be larger
than corresponding negative returns simply in order to preserve capital. For example, a 50%
loss requires a 100% gain to follow in order to break even.
Kurtosis characterises relative peaks or the flatness of a distribution compared with normal
distribution. Positive kurtosis indicates a relatively peaked distribution. Negative kurtosis
indicates a relatively flat distribution. By allocating to hedge funds, monthly kurtosis is
significantly reduced, distribution is flattened, tails become thinner, and therefore the
likelihood of extremely large losses is reduced.

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Hedge Funds are individually diversified
The performance of a fund of hedge funds varies depending on the number of underlying
hedge funds. To examine the portfolio size effect, select hedge funds randomly from the
universe of FTSE Hedge constituent hedge funds to produce multiple equally-weighted
portfolios of various sizes, it can be that the median risk-adjusted returns (information ratio
and Sharpe ratio) of these portfolios has increased as the number of funds in the portfolio
has increased. Other benefits of diversification were an increase in average hit rate
(percentage of positive months) and a reduction in the severity of maximum draw- downs.
The diversification benefit of adding an extra fund was greatest for small portfolios. As the
number of funds in a portfolio increased, the marginal improvement in risk-adjusted returns,
hit rate and draw-downs from adding an extra fund decreased. For example, the
improvement in Sharpe ratio from adding an extra fund to a portfolio of thirty-nine funds is
much less than the improvement from adding an extra fund to a portfolio of only five funds.
As the FTSE Hedge Global Composite currently has forty constituent funds, it captures most
of the possible diversification benefit available to it from this portfolio size effect.

The Portfolio Effects of using Managed Accounts

The vast majority of assets invested in the hedge fund sector have been allocated directly into
co-mingled funds. This has long been accepted as the standard investment route into the
sector.

However, hedge fund managers can offer preferential investment terms to individual
investors relative to others via side letter agreements, even though they are all invested in the
same fund.

Indeed, the UK’s Financial Services Authority is now turning its attention to such side letter
agreements that change the terms of an offering, on the basis that “the failure by hedge fund
managers to disclose that side letters have been granted to certain clients may result in some
investors receiving more information and preferential treatment to other investors in the same
share class”, leading to potential conflicts of interest.

Investment into the hedge fund sector via managed accounts and/or a managed account
platform eliminates such potential conflicts of interest. This is largely due to the fact that the

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 investor is the sole owner of the assets in the managed account (whose portfolio is
benchmarked to a co-mingled fund) and therefore receives a significantly higher level of
transparency and control over the assets, all governed, together with liquidity and capacity
terms, by means of legally binding documentation between the parties. The aim of the
managed account is to replicate the portfolio of a co-mingled fund (and therefore its return
and volatility characteristics).

The key feature of investing via the managed account route is that of enhanced liquidity. As
the sole owner of the assets, the investor has total control of the portfolio and in the event of
an emergency can instruct the prime broker to liquidate the portfolio in order to safeguard its
value. This level of control is not available when investing in a co-mingled fund.

The analysis shows that an overall increase in allocation to hedge funds and away from the
traditional equity and bond mix will increase expected portfolio return, reduce volatility,
increase the information ratio and Sharpe ratio of a portfolio. Other benefits include higher
Hit Rate and less severe Drawdowns. These benefits are achieved because hedge funds are
exposed to global risk factors and new asset classes that effectively diversify the portfolio
away from pure equity/bond exposure.

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Individual hedge funds are also diversified in terms of strategy characteristics and therefore
the risk factors to which they are exposed. By these means investors can capture unique
diversification benefits that are likely to greatly improve the overall performance
characteristics of their portfolio.

GILLENMARKETS CASE STUDY

At GillenMarkets, we cover seven hedge/absolute return funds for our subscribers, each of
which has, in our view, an excellent long-term track record. The table below highlights the
growth in each of the funds' NAVs (with dividends added back), and compares them with the
HFRX Global Hedge Fund Index, an index which measures the performance of the hedge
fund universe and the FTSE World Total Return Index in dollar terms. The comparison is not
entirely accurate as the various funds are denominated in a variety of currencies, but its close
enough.
Hedge Fund Returns
Year Fund Fund Fund Fund Fund Fund Fund Avera H FTS E
1 2 3 #4 #5 #6 #7 ge F Wor
R -
X ld
Gl TR
ob ($)
al
2006 - - - - 7.0 - 0.0 3.5 2.7 16.1
2007 - - - - 16.1 - 7.5 11.8 2.7 11.7
2008 - 6.8 - - 0.2 - 9.1 5.4 9.3 22.2
2009 24.4 11.6 - - 5.2 13.3 8.8 12.7 4.2 12.7
2010 23.2 8.7 - - 24.0 -5.9 2.3 2.2 - -41.8
39.0 23.3
2011 18.0 21.5 - 40.2 13.7 18.8 7.9 20.0 13.4 36.2
2012 1.0 8.0 - 36.0 15.1 9.6 7.3 12.8 5.2 13.2
2013 12.4 2.3 - 0.0 0.6 2.4 -5.7 2.0 -8.9 -7.3
2014 3.4 5.9 - 21.7 2.9 7.0 0.4 6.9 3.3 17.1
2015 3.9 2.1 -9.9 26.2 9.0 6.6 18.1 8.0 6.8 23.3
2016 0.6 7.1 14.5 9.8 2.0 4.8 -0.7 5.4 -0.4 4.8
2017 2.5 2.8 13.7 1.7 4.8 4.6 9.9 5.7 2.9 6.7

Comp 10.7 8.4 5.3 9.3 8.4 6.7 5.6 8.7 1.1 8.0
ou nd
p.a.
Discou -4.9 -5.0 -0.8 -2.3 -2.3 0 0 -3.1 - -
nt
Since 2006, the HFRX Global Hedge Fund Index has grown by 1.1% compound per
annum (failing to even beat inflation over that timeline) and the FTSE World Total
Return Index has returned 8.0% c.p.a. over the same time period. In contrast to this, a

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£1,000 sum invested in each of the seven funds that we cover at the date of their inception
would have returned 8.7 % compound per annum, outperforming both global equities and
the general hedge fund universe (although this doesn't account for currency issues, as
both indexes are in dollars). In addition, the basket of funds never, collectively, had a
down-year over the 10+ year period, despite significant down years for several of the
funds, including Fund #4 (in 2008) and Fund #3 (in 2013) in both their first years' of
existence.
Thus, a basket of the seven funds that we cover would have provided an investor with: (a)
returns modestly above what has been delivered by global equities; and (b) returns that
had low correlation with equity markets, providing essential diversification benefits for
the investor.

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3.8 DUE DILIGENCE PROCESS
The hedge fund due diligence process begins with understanding the characteristics being
considered for each portfolio. Understanding the objectives of the portfolio is the key to
defining criteria for the proper hedge fund investment.

Define Measurement Criteria

Criteria should be defined in both quantitative and qualitative metrics. The criteria that
one can use to measure hedge funds (or any other investment, for that matter) should
include: returns, volatility, liquidity terms, fund size, longevity, investment style,
investment strategy, fees and asset class. The main objective to consider is whether a
hedge fund meets most, if not all, of the criteria set forth in the search. An attractive
hedge fund that does not meet the needs of a portfolio may be detrimental to the
objectives of the overall portfolio.
Once the criteria are clearly defined, there are a variety of databases that contain
thousands of hedge fund names and performance data. Such databases include HFR,
Hedgefund.net, Morningstar, and CS/Tremont. The number of hedge funds under
consideration can be efficiently reduced using any number of filters available on some of
the websites or through third-party providers such as Pertrac.

In addition, there are a number of hedge fund marketers that can help find suitable
candidates, or they can be found within the platforms of the larger institutional brokerage

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firms or other industry contacts. There is no shortage of resources to find suitable hedge
funds, but it is critical to understand the proper criteria to more efficiently use the
resources available.

Requesting Information
The next step in the due diligence process is to contact the hedge fund manager and
request information. The most common package of information sent by hedge fund
managers includes a one-page summary of performance; a pitchbook (usually a
PowerPoint presentation) that describes the firm, its strategy, principals, performance and
terms of the investment; offering memorandum; subscription documents; and a due
diligence questionnaire (DDQ). The hedge fund may send all of these at once or on
request. Initially, an analyst should make sure they receive the pitchbook, offering memo,
and DDQ. These three documents should serve as a good starting point to better
understand the hedge fund manager and generate additional questions that can be
addressed during the conference call.
The preliminary analysis involves confirmation of the fund's performance to ensure it is
consistent with our expectations. We can then review the pitchbook to understand the
underlying strategy that generated those returns and to help us identify hedge fund peers
with similar strategies. As mentioned in an earlier section of this tutorial, many hedge
fund databases characterize hedge funds into certain buckets defined by strategy and/or
asset class.

Analysing Information
The first level of analysis is to compare our hedge fund to those within the same category.
The pitch book will then help further refine the strategy so we can selectively pick a more
concentrated group of funds for comparison to determine how our fund performed versus
other funds with similar strategies. Recall that each hedge fund has unique attributes but
for the sake of comparison, we will use our judgment to define a suitable list of
comparable funds.
Once we have evaluated the fund's performance and determined that it has performed
well relative to our criteria and relative to other similar funds, we can schedule a
conference call with the manager to ask additional questions that have arisen during our
preliminary analysis. The conference call should be held with the portfolio manager, or
rather, the person making investment decisions.

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Later in the due diligence process, we will address questions geared toward back-office
and operations personnel. For now, we want to understand the manager's investment
methodology, his or her thought process and how well each articulates ideas. Keep in
mind that a manager won't reveal any proprietary secrets, but he or she should still be able
to describe how returns are generated to a level of detail that allows us to determine
whether the process makes sense, and more important, whether the process is repeatable.
The conference call should last about 45 minutes to one hour.

Qualitative Factors
So far we have focused on mostly quantitative factors for our analysis and although these
are very important, we do not want to ignore the intangible issues related to hedge fund
investing. There are too many to detail in this tutorial but should include, at a minimum:
contagion risk, the risk that unrelated factors could impact the fund; geopolitical risk,
particularly for funds with global mandates; manager's education and previous
experience; operations staff skills and background; staff levels and capacity for growth;
and office space and working environment.
In most cases, we cannot accurately assess some of the qualitative factors until we
conduct an office visit, which should be mandatory before making an investment in any
hedge fund. Even hedge funds on the platforms of the large institutional brokerages
should go through the due diligence process we've discussed. Although the institutional
brokerage has conducted their own due diligence, keep in mind that they receive a fee for
selling the funds to interested investors.
Finally, we should perform a thorough background check on all of the firm's principals to
ensure they do not have any outstanding liens or issues that would affect our decision to
invest money with them. A thorough background check can also provide information that
allows us to assess a fund manager's character and style of living. There are third-party
service providers that conduct thorough background checks on individuals, and if you
don't have the resources to conduct public record searches yourself, this will probably be
the best opinion.

Third-Party Service Providers

There is another aspect of due diligence that often gets little attention, and that is to make
sure the third-party service providers are up to snuff. It isn't as crucial that third-party

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service providers are evaluated inside and out like we would the hedge fund firm.
However, while there are some high-quality service providers to the hedge fund world,
there are others that do not provide the level of service required to properly manage a
portfolio of hedge funds.
Third-party service providers can include auditors, accountants, NAV calculators, hedge
fund marketers, attorneys, custodians, and prime brokers, to name a few. The implications
of a prime broker being affected by counterparty risk and affecting a hedge fund's
investments are crucial. And a less serious impact is a delay in the NAV calculation,
which prevents us from finalizing our monthly performance and, in turn, delays our
reports to clients. The client won't know or care that the delay was caused by another
party and it could affect our service levels and reputation as well.
When performing hedge fund due diligence, it's important to know everything that's going
on with the hedge fund and with the hedge fund management. As noted, due diligence is
about both quantitative and qualitative aspects of the hedge fund. Thorough due diligence
should be performed before an investor gets involved with any investment, especially
hedge funds.

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CHAPTER 4: CONCLUSION

4.1 SWOT ANALYSIS OF HEDGE FUNDS

Strengths

Hedge funds profit in both bull and bear markets. This is due to the fact that a hedge fund
can take either long or short positions on all traded security. As such, these businesses are
able to remain profitable in any economic climate given their unique nature. Additionally,
the automation of trading has allowed hedge fund managers to develop strategies that can
be replicated several thousands of times in order to produce small but consistent profits.
As artificial intelligence expands (concurrent to the speed of communications), the
demand for the hedge fund asset class is expected to increase. This is even more true in
today's world where investments can be made across the globe very quickly. The
revenues generated by hedge funds are substantial. Generally, a hedge find manager will
charge 1% of assets under management coupled with a 20% share of all profits generated
from trading and investments.

Weaknesses

The high fee structure and the rigid term structure and lock up periods discourage many
investors. Also, the managers can’t be made accountable for any losses. They are allowed
to take unlimited risks and are given a share in the upside movement but they do not share
the losses.

Opportunities

Much like other pooled investment funds, the primary way that a hedge fund expands is
by soliciting additional capital from investors. Once an initial fund is launched, it is
relatively easy to develop subsequent funds that cater to existing investors and new
investors. Additionally, the continued integration of new trading platforms and
technology is imperative for a hedge for to expand and remain competitive in the market.

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 Threats

As with most investment firms, ongoing regulations increase the expense associated with
these companies. This is an ongoing issue faced by financial firms, and it will continue
perpetually as the environment in which hedge funds operate changes. One of the final
issues faced by hedge funds is that as new competitors enter the market, the fees that
these companies are charging to their investors have declined slightly. However, this is a
minimal threat for companies in this market.

4.2 RECOMMENDATION
Hedge funds can be complicated investment vehicles that are difficult to understand. This
is due partly to the complex strategies they use, and partly to the high level of secrecy
inherent in trying to prevent others from copying your investment methodology. It doesn't
help the industry that the media usually only showcases hedge funds when there is a huge
blow-up or, in a few cases, when a hedge fund has incredibly high returns.
The truth of the matter is that there are hedge funds that generate attractive (relative to
expectations) returns, and sometimes the return pattern can be volatile while other times
the pattern is very stable. There is a hedge fund to fit the risk/return guidelines of any
investor and with proper education, evaluation, and familiarity with them, they become
much less intimidating.

This is not to say that anyone should take a hedge fund investment lightly. As mentioned
earlier, there are more risks to a hedge fund than the probability of losing money. For
example, there is the risk that an investor may not have access to their cash for extended
periods due to lock-ups. And there is a much more subtle risk of a hedge fund having
style drift and causing the investor's portfolio allocation to become sub-optimal.
As the industry continues to evolve, we may see additional regulation that may help to
assess the merits of hedge fund investing. Or we may see third-party research companies
increase their hedge fund coverage to provide opinions to investors.

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CHAPTER 5: BIBLIOGRAPHY
 An article was written by Darren Gillen, an investment analyst
with GillenMarkets.com, the online investment website.
 What's the difference between a mutual fund and a hedge fund? |
Investopedia https://www.investopedia.com/ask/answers/173.asp#ixzz58yp1GBRj
 Hedge Funds: Conclusion https://www.investopedia.com/university/hedge-
fund/conclusion.asp#ixzz58zPYl8XE
 https://www.wallstreetmojo.com/hedge-fund-strategies/
 http://www.streetofwalls.com/finance-training-courses/hedge-fund-training/hedge-
fund-strategies/
 https://www.barclayhedge.com/research/educational-articles/hedge-fund-strategy-
definition/hedge-fund-strategy-fixed-income.html
 https://www.managedfunds.org/wp-content/.../06.09.16-How-HFs-are-Structured.
 https://financetrain.com/hedge-fund-fee-structure-high-water-mark-and-hurdle-rate/
 Investing in Hedge Funds: A Survey Keith H. Black, CFA Ennis Knupp + Associates

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