All about hedge funds

Defining Hedge Funds and its background: Hedge Fund is a pool of funds which is supposed to get an absolute return i.e. a return independent of market, political or economical condition; however, it has recently changed dramatically in its nature and purpose. Nowadays, it has become just another fund type which can earn a superior return than market. That means it is not all about the capital preservation anymore, but to earn a performance on the capital more than a risk free rate such as LIBOR. Currently hedge fund market is valued at $ 1.5 trillion and there are 10000 active hedge funds worldwide. Investing in hedge funds tends to be favored by more sophisticated investors, including many pension funds, endowments, private banks and high net worth families and individuals. These investors have lived through, and understand the consequences of, major stock market corrections.


The aim was to safeguard the return: Earlier the apprehension of foreign exchange movement or certain other market condition was so much that investor wanted to preserve their capital and they wanted to ‘hedge’ their profit. Now the goal of Hedge Fund is to earn a return exceeding that of S&P 500 and Russell 3000. The ratios such as Jensen’s Alpha or Sharpe’s Ratios are used to gauge the performance of investment which will be further compared against the benchmark indexes.

Risk profile and the origin of Hedge Fund risk: The risk in the Hedge Fund is magnified due to the usage of derivatives and leverages. While there are differences in use of leverages in Fixed Income funds (with higher level) as compared to Equity funds, yet some funds can leverage upto 20 times of their capital base. This leveraging significantly effects and magnify the risk involved in the funds operation by enabling the fund managers use more capital than it is available and hence to take unreasonable risk. All hedge funds are not the same; investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds.

The prevalent usage of derivatives in the Hedge Funds are even a bigger risk, where some derivatives are having unlimited downside risk for the funds. Suppose a fund manager speculate that stocks of A ltd will fall in two weeks time and hence it sells the stock of the company without holding it in the portfolios.

In this scenario of short selling whereby the fund manager has to buy back the stock which it sold by borrowing, need to return back to the lender. What if the share price goes up in which case, the fund manager has to buy the share at a higher price which can go to any level. Similarly, usage of financial derivatives such as Mortgage & Assets Backed securities, options, SWAPS, Future, Swaptions, Futions, CFD, CDS and forwards all expose the hedge funds to an unquantifiable risk. Going further in this argument, it is important to note that the legendary investor Warren Buffet had once warned against the popularity of derivatives, saying that it is Financial Weapon of Mass Destructions. Quite correctly we have seen the implication of the failures of foreseeing the risk of MBS,ABS and other such complex financial products in 2007 when the Fannimae, Freidmac collapsed affecting the hedge funds worldwide and almost one third of Hedge Funds closed in 2007.

Legal & Operational Structure of the Hedge Fund and regulations around it: Typically Hedge funds are formed as Limited partnership for the US based investors where limited partners invest majority of the money, however, the general partner of the funds who are also the investment managers also invest into this to align their interest with limited partners. Non-US investors would form the Offshore Hedge Funds which are not subject to tax liability.

i. Hedge Fund is not for offering to the mass: Hedge Funds partnerships are available for handful of investors and not for the mass and hence it has a minimum amount of investments which comes from high net worth investors. Since it is not for public at large, it is exempted from registration with stock exchanges, not required to do many regulatory filings and lacks transparency which also contributes to manager specific idiosyncratic risks.

ii. Different degrees of Flexibility: In general, Hedge Funds are Open ended and closed ended. The Open ended funds allows the new investment and divestment any time and do not charge any penalty for that and hence offers flexibility, the close ended funds offers a limited number of shares to be transacted within its existing shareholder and capital can only be returned back at the end or liquidation of the fund. Most of the hedge funds are open ended funds.

iii. Multiple counterparties and stakeholders: Apart from the Investment managers, the operations of the hedge funds depend upon the prime brokers, custodian, administrators, legal counsel, auditors etc.

a. Prime brokers primarily do the trading & clearance of the trade orders, provides liquidity, acts as a counterparty and lends the securities. In many cases they act as custodians as well. Usually they are part of large investment banks.

b. Administrators: They distribute the new shares to the investors and perform the NAV valuations. Regulations around the worlds require the appointment of administrators to remove the potential conflict of interest arising from the valuation of NAV by the investment managers who are the direct beneficiary of the higher than reasonable valuation of the funds as it can increase their management and incentive fees.

Valuation: The Hedge Fund is valued on daily and monthly basis and it is stated as Net Asset Value or NAV which is (Asset – Liability). This valuation is prepared by the fund administrator and the data is provided by the market data providers such as Bloomberg and Reuters. The asset and liability of Hedge Funds are primarily the FX gain and loss, unrealized gain/loss of securities and financial derivatives and securities. The expenses are primarily the operating expenses which include the administration, audit, incentive and management etc. Similarly its income depends on the sale of securities and derivatives and FX gain/loss. Before the valuation is done, the trade cycle should be completed. Trade settlement is an important activity and without accounting for it, the NAV valuation can not be completed. Trade settlement is the act of exchanging securities and cash between buyer and sellers.

Investment Strategies: The Hedge Funds are using four main types of strategies for its investment, while some are more popular than others.

Long-Short Funds: This is the largest segment of the hedge funds which invests worldwide in every market with aim to take long & short positions to take advantage of the speculated increase and/or decrease of share prices of stocks. This strategies use high level of leverages.

Market Neutral Funds: This strategy could be mix of many other strategies i.e. it could take long/short position in stocks while using extensively derivatives too and on the same time it could use leverages. The aim of this strategy is to remain unaffected of market moves and hence it is called market neutral. Example of a market neutral strategy would be to invest in precious commodity based investment product such as oil & gold Exchange Traded Fund which will be safe from market movements and will give a return or retain the value of investment regardless of the market condition.

Global Macro Funds: This bet on the macro economic factors and uses derivatives to exploit the moves of market and economies in areas of interest rate, currency, commodity etc. This is also leveraged. For example, speculating a stronger INR, a Global Macro Fund could enter into a long position of a put option to sell the INR six months from now; this will be purely based on macro-economic conditions.

Event-driven Funds: This is purely opportunistic investment strategy. It heavily rely on some unique opportunity in the market which could be investment in a good potential or distressed company to benefit from its growth & revival respectively. For an example, a hedge fund can invest in the distressed stocks for Kingfisher if it has firm evidence that it can come out of the trouble it is facing and thus it will try to make massive profit.

Some other key attributes and terms popular in Hedge Fund industry are:

1. Management Fees & Incentive Fees: The management fee is charged on quarterly or monthly basis and typically is 1 or 2% of the Asset Under Management. This will be paid to the Investment Manager or the General Partner regardless of the performance of the fund. Nevertheless, the Incentive Fee is paid to the Investment manage when the fund exceeds certain predefined return benchmark, which could be based on hurdle rate and/or high water mark (HWM). Incentive fee is generally around 20% of the generated profit and intended to motivate and incentivize the Investment Managers for a robust performance. The HWM clause also known as the loss carry forward provision ensures that incentive fee is only paid at the net profit and when all the previous losses are recovered.

A hurdle rate provision means that a fund pays an incentive fees only when a minimum percentage of the return is generated by the fund which can be based on the LIBOR rate and the duration since the last incentive fee was calculated. Also, there are two types of hurdle rates, soft and hard. The soft hurdle rate allows the incentive fee to be calculated on all the profit made once the hurdle rate is cleared, however, the hard hurdle rate means that the incentive fee will be calculated only on the performance exceeding the hurdle rate.

3. Risk Measurement: The risk of Hedge Funds are measured by VAR (Value at Risk) with a given standard deviation, of course. Value at risk, as the names suggests, provides for the amount of expected risk and its probability. A typical VAR would say that ‘there is a 90% that the fund will not lose more than 15%. Apparently, it is stating the risk at the left tail of the bell curve and also the chances of it taking place. Since the VAR is calculated using historical data, it does not have much predictive value. Also it stands correct when the return distribution is normal, which is not the case as the Hedge Fund returns are not normally distributed.

Another way of measuring the risk is the maximum drawdown, which states the maximum loss an investor can expect from the funds, however, it does not quote the probability of that loss. Thus, a maximum drawdown of 15% is better than 25%, only in case of their probability are the same. Since, this information is not part of this risk measurement tool, this is also not very reliable on its own.

4. Side Pockets: When the funds invests into an asset which can not be valued reliably, it creates a side pocket where the shares are issued only to specified investors and as the investment is very illiquid, the side pocket share can not be redeemed before the whole asset is sold.

The best strategy of Hedge Fund is debatable and it is subject to various underlying expectations from the fund by the investors, nevertheless, it will be one which will minimize the leveraged trading of derivatives and reckless trading which results in accumulation of various types of risks such as market risk and counterparty risk.