INTRODUCTION

DEFINITION:

Hedge Fund is:

“A private investment partnership limited to 99 high net-worth or institutional investors.

A hedge fund may take long and short positions in various types of securities and use

leverage. The investment managers are compensated by a percentage of the funds profits”

Hedge funds is a private investment fund charging a performance fee and typically open

to only a very limited range of qualified investors.

In the United States, hedge funds are open to accredited investors only.

A hedge fund's activities are limited only by the contracts governing the particular fund,

so they can follow complex investment strategies, being long or short assets and entering

into futures, swaps and other derivative contracts.

They often hedge their investments against adverse moves in equity and other markets,

because a common objective is to generate returns that are not closely correlated to those

of the broader financial markets.

As hedge funds are essentially a private pool of managed assets, and as their public

access is commonly restricted by the government, they have little to no incentive to

release their private information to the public.

Inarguably private entities, hedge funds have a corresponding reputation for secrecy, and

less is known about the methods and activities of hedge funds than about publicly-

accessible "retail" funds.

However, since hedge fund assets can run into many billions of dollars, and thus their

sway over markets—whether they succeed or fail—is substantial, there have been calls

for regulation of these private investment funds.

The funds, often organized as limited partnerships, typically invest on behalf of high-net-

worth individuals and institutions.

Their primary objective is often to preserve investors' capital by taking positions whose

returns are not closely correlated to those of the broader financial markets.

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HISTORY OF HEDGE FUNDS

The concept of “Hedge Funds” was found by Alfred Winslow Jones in 1949.

Mr. Jones was a graduate from Harvard University and a financial journalist.

While doing an article on financial forecasting he got captivated by the subject, dropped

journalism and decided to try finance himself.

He created A.W. Jones & Co., a partnership of four friends, and invested $100,000 in

stocks, using a mix of long and short positions.

Out of $100,000, Mr. Jones contributed $40,000

Jones was the first to combine short selling, leverage, limited partnership structure, etc.

and earn incentive fees as compensation for the managing partner.

He implemented a scheme to make the manager’s fee 20 percent of profits, thus merging

his incentives with those of investors.

In line with his share-the-profits-share-the-pain philosophy, he charged no fee unless he

created profit

That incentive structure remains typical of hedge funds even today.

A year after he formed the fund, it earned 17.3 percent.

During the next decade it outperformed every mutual fund by 87 percent.

However, as the stock market collapsed between 1969 and 1974 in two downward waves,

hedge-fund assets slid by 70 percent from losses and withdrawals.

Later in the 1990’s hedge funds came into limelight.

The high point arrived in September 1992, when Mr. Soros's Quantum Fund made $2

billion by profiting from the devaluation of the British pound.

Today hedge funds are gradually growing and making a place in the global scenario.

And so Jones is widely regarded as the father of the modern hedge fund industry

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ADVANTAGES OF HEDGE FUNDS

1. Focus on absolute versus relative returns

Hedge funds strive to meet 'absolute return' investment objectives as opposed to 'relative

return' objectives, meaning hedge fund managers don't just focus on beating an index -

they aim to deliver positive returns regardless of market direction.

2. Superior performance with lower volatility

Historically, long/short equity funds have consistently delivered superior risk-adjusted

returns with lower volatility than the returns of major stock market indexes.

Because of their ability to use leverage and short sell, hedge funds have a distinct

advantage. They can increase their long exposure to the market to generate additional

returns, or increase their short exposure when a more defensive stance is required

3. Strong performance in up and down markets

Hedge funds have the ability to protect capital in down markets and provide equity-like

returns when markets are rising. They have consistently out-performed traditional mutual

funds and are the investment of choice for wealthy investors.

4. Enhanced diversification & portfolio efficiency

Due to the low correlation to traditional investments, hedge funds can improve

diversification and enhance a portfolio's efficiency. The benefit to the investor is

increased return for the same or lower level of risk.

5. Limited asset size

Hedge funds typically become closed to new investors when they reach a predetermined

asset level. A reason for this capacity limit is that asset growth beyond certain levels is

often detrimental to hedge funds using strategies that require nimble trading in order to

react quickly to market events.

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6. Incentive based compensation

Unlike the fee structures of traditional mutual funds that focus on asset-gathering, hedge

fund fee structures reward managers for exceptional returns. Hedge funds attract top-tier

talent because the fee structure affords greater financial rewards and personal satisfaction

to managers who consistently deliver superior performance.

7. Manager's capital committed

Hedge fund managers generally have significant amounts of their own capital invested

alongside their clients, further ensuring everyone's interests are aligned. This alignment

of interests adds tremendously to credibility and speaks for itself in indicating where the

manager's focus and best investment ideas will be directed.

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DISADVANTAGES OF HEDGE FUNDS

1. Skill-based strategies  

Hedge funds require skill-based strategies. They depend upon the abilities of the fund

manager to add value that merits the higher level of fees charged and risks incurred. 

However, it takes considerable due diligence to determine whether the hedge fund

manager is smart or has just been lucky. 

2. Limited partnership

Only 99 investors can participate in any single hedge fund if the manager wants to

maintain the regulatory exemption. 

This means two things:- 

First, minimum requirement for hedge funds are high in order to produce a large enough

fund to make it worth the manager’s time.  Hence only rich investors can invest n this

fund.

Second, it may happen that an investor just finds a good fund to invest but realizes that he

is too late to invest as the 99 available slots have already been taken. 

3. High investment      

Because of the private nature of hedge fund investments, and the limitation on the

number of investors, it is very difficult to access managers with successful long-term

track records for less than $1 million.  In fact, many of the most successful hedge fund

managers require minimums of $5 million or even more.

4. Less numbers of managers 

Even if a large investor can meet the $1+ million minimums, he still may not be able to

access the best managers as they may only operate offshore funds.  Many talented

managers have chosen to operate funds offshore where the regulatory framework is more

favorable.

 

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5. Lack of data       

Hedge funds are not required to report returns monthly, so an investor only receives

information on a quarterly basis.  Redemptions are allowed only once per calendar

quarter.  Hence some hedge funds have “lock-up” provisions that require the investment

to stay with the manager for a year or more before redemption can occur.

6. Lack of transparency     

Transparency is the ability to see the individual investments making up the fund’s

portfolio. Since hedge fund managers usually try to take advantage of inefficiencies in the

market, they do not like to publish all of their positions for fear that other hedge funds

managers will use this information to trade against them. It becomes difficult to know, if

the hedge fund manager will show you their particular investments in their periodic

reporting, or not.  Many managers don’t and investors have no idea what they are

invested in.

7. Inexperienced managers     

Since many of the most successful managers are unavailable because of the 99 investor

rule, many investors are putting their money with managers who have limited experience

in managing hedge funds.

 

8. Competition

Since many hedge fund managers try to take advantage of temporary market

inefficiencies, the rapid increase in funds means more and more fund managers are trying

to do the same things.  With more managers chasing the same types of trades, the returns

on these trades are likely to suffer over a period of time.

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WHY HEDGE FUNDS?

1. Hedge funds have the ability to earn superior risk-adjusted returns in bear and bull

markets

2. Hedge funds have low to moderate correlation to traditional asset classes

3. The distribution pattern on returns of hedge funds is asymmetric. It helps an

investor to get downside protection

4. An investor can have access to some of the best talent in financial markets

5. Hedge funds are only for high net worth individuals. Hence they are highly

sophisticated and have unbiased investing

6. Because of increase in popularity of hedge funds the transparency and regulation

are improving

7. Hedge funds belong in every diversified investment portfolio and it has the ability

to earn even in the poorest of times

8. Hedge funds are focused on absolute return rather than relative return.

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WHO CAN INVEST IN HEDGE FUNDS?

Individuals

For an individual to invest in an unregistered investment company, the SEC must deem

an individual to be an accredited investors (a defined by SEC rule 501 of Regulation D).

The rule includes the following points for an individual:

a. The individual must have at the time of investment a net worth (or joint net worth

with spouse) exceeding $1,000,000, or

b. The individual must have individual income exceeding $200,000 in each of the

two most recent years or joint income with spouse exceeding $300,000 in each of

the two most recent years, and must have a "reasonable expectation" of reaching

the same level in the coming year.

Organization

For an organization to invest in hedge funds it must satisfy the following requirements:

a. The organization must have total assets in excess of $5,000,000, or

b. The organization's owners must be accredited investors.

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HOW TO INVEST?

1. With an estimated 6000 hedge funds managing in excess of $550 billion, most

investors are questioning where to begin.

2. Many investors attempt to conduct their own due diligence and invest directly

with specific managers, while others take advantage of professional hedge fund

consultant firms to research, advice and monitor their investments.

3. Investing with a hedge fund manager involves a complex evaluation process.

Identifying the best managers can be very difficult.

4. Hedge fund managers are not required, and in many cases not allowed, to

advertise or report performance data to any central authority. As a result, many of the top

hedge fund managers are not listed in commercially available databases.

5. Hedge fund consultants greatly assist in this process. Research specialists, with

access to this data, screen the universe of hedge funds in search of high quality candidates

for further analysis.

6. They perform qualitative, on-site evaluations and review a manager's

background, financial statements and corporate documentation in an attempt to identify a

competitive advantage.

7. This process often includes a quantitative review focused on the performance

statistics related to volatility, consistency, and peer comparisons.

8. Consultants’ help investors define their investment profile and offer their clients a

unique range of comprehensive hedge fund solutions.

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9. They then help clients monitor their investments to compare performance with their

original investment parameters. They may advise a client to redirect their investment

allocations as a result of changing market conditions, some asset classes outperforming

others, or a change in the investor's objectives.

10. As the hedge fund business is very large and the investors are generally high net

worth individuals’ managers are generally appointed. In some cases managers of

investors themselves invest with the investor

11. The money invested by an investor is very huge and hence the investor has to take

care that the managers he/she is appointing is at most qualified and efficient for doing the

job.

Thus if an investor is qualified to invest in hedge funds he/she an do so either by

themselves or appointing managers or by taking help of research specialist and

consultants.

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CLASSIFICATION OF HEDGE FUNDS

Hedge funds are generally classified according to the type of investment strategy they

run. Following are the types of hedge funds.

1. Market Neutral (or Relative Value) Funds

Market neutral funds attempt to produce return series that have no or low correlation with

traditional markets such as the fixed income markets. Market neutral strategies are

characterized less by what they invest in than by the nature of the returns. They often are

highly quantitative in their portfolio construction process, and market themselves as an

investment that can improve the overall risk/return structure of a portfolio of investments.

The key feature of market neutral funds is the low correlation between their returns and

the traditional asset's.

2. Event Driven Funds

Event driven funds seek to make profitable investments by investing in a timely manner

in securities that are presently affected by particular events. Such events include

distressed debt investing, merger arbitrage (risk arbitrage) and corporate spin-offs and

restructuring.

3. Long/Short Funds

Funds employing long/short strategies generally invest in equity and fixed income

securities taking directional bets on either an individual security, sector or country level.

Long/Short strategies are not automatically market neutral. That is, a long/short strategy

can have significant correlation with traditional markets.

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VARIOUS HEDGE FUND STRATEGIES

1. Arbitrage Strategies

Arbitrage is the exploitation of observable price inefficiency. Pure arbitrage is always

considered risk less.

Example: If a particular stock currently trades at Rs.10 and a single stock futures contract

due in six months is priced at Rs.14. The futures contract is a promise to buy or sell the

stock at a predetermined price. So by purchasing the stock and simultaneously selling the

futures contract an investor can without taking on any risk lock in an Rs.4 gain before

transaction and borrowing costs.

In practice, arbitrage is more complicated, but three trends in investing practices have

opened up the possibility of all sorts of arbitrage strategies:

a. Derivative instruments

b. Trading software, and

c. Various trading exchanges

Only a few hedge funds are pure arbitrageurs. But, because observable price

inefficiencies tend to be quite small, pure arbitrage requires large, usually leveraged

investments and high turnover. Further, arbitrage is perishable and self-defeating i.e. if a

strategy is too successful, it gets duplicated and gradually disappears.

Most arbitrage strategies are better labeled "relative value". These strategies do try to

capitalize on price differences, but they are not risk free.

2. Event-Driven Strategies

Event-driven strategies take advantage of transaction announcements and other one-time

events. Various event driven strategies are:

a. Merger arbitrage: It is used in the event of an acquisition announcement and

involves buying the stock of the target company and hedging the purchase by

selling short the stock of the acquiring company. Usually at announcement, the

purchase price that the acquiring company will pay to buy its target exceeds the

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current trading price of the target company. The merger arbitrageur bets the

acquisition will happen and cause the target company's price to rise to the

purchase price that the acquiring company pays. This also is not pure arbitrage. If

the market happens to frown on the deal, the acquisition may unravel and send the

stock of the acquirer up (in relief) and the target company's stock down (wiping

out the temporary bump) which would cause a loss for the position.

b. Distressed securities: It which involves investing in companies that is re-

organizing or has been unfairly beaten down.

c. Event-driven fund: It is an activist fund, which is predatory in nature. This type

takes sizeable positions in small, flawed companies and then uses its ownership to

force management changes or a restructuring of the balance sheet.

3. Directional or Tactical Strategies

The largest group of hedge funds uses directional or tactical strategies. They make "top-

down" bets on currencies, interest rates, commodities or foreign economies. Because they

are for "big picture" investors, these funds often do not analyze individual companies.

Various types of directional or tactical strategies are:

a. Long/short strategies: It combine purchases (long positions) with short sales.

b. Market neutral strategies are a specific type of long/short whose goal is to negate

the impact and risk of general market movements, trying to isolate the pure

returns of individual stocks. This type of strategy is a good example of how hedge

funds can aim for positive, absolute returns even in a bear market.

c. Dedicated short strategies specialize in the short sale of over-valued securities.

Losses on short-only positions are theoretically unlimited (because the stock can

rise indefinitely). But these strategies are particularly risky.

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Hedge Fund Capital Structure By Strategy

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PRINCIPLES OF INVESTING IN HEDGE FUNDS

1. Liquidity

a. Liquidity dates refer to pre-specified times of the year when an investor is

allowed to redeem shares.

b. Hedge funds typically have quarterly liquidity dates

c. Some hedge funds even have yearly liquidity dates

d. Investors have to give advanced notice if he wants to redeem. These redemption

notices are often required 30 days in advance of actual redemption.

2. Lockup

a. Lockup refers to the initial amount of time an investor is required to keep his or

her money in the fund before redeem shares.

b. Lockup therefore represents a commitment to keep initial investment in a fund for

a period of time.

c. Once the lockup period is over, the investor is free to redeem shares on any

liquidity date.

d. The length of the lockup period represents a cushion to the hedge fund manager.

e. If the hedge fund is unlucky enough to experience a drawdown (a sharp reduction

in net asset value) after the launching of his or her fund, then the lockup period

will force investors to stay in the fund rather than bail out.

f. The ability for a hedge fund to demand a long lockup period and still raise a

significant amount of money depends a great deal on the quality and reputation of

the hedge fund as well as the market savvy of the marketers of the fund.

3. Minimum investment

a. Hedge funds require a $10 million minimum investment - one of the highest in the

industry.

b. The fee structure is also very high. It includes an annual management charge of

2% of assets, plus 25% of profits, compared with 1% and 20% respectively, for

most of the industry.

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COMPARISON BETWEEN A HEDGE FUND AND A MUTUAL

FUND

There are five key distinctions between hedge funds and mutual funds. They are as

follows:

1. Mutual funds are measured on relative performance .Their performance is compared

to a relevant index that is comparison of one mutual fund with another mutual fund of

similar portfolio. Hedge funds are expected to deliver absolute returns. They attempt

to make profits under all circumstances, even when the relative indices are down.

 

2. Mutual funds are highly regulated, restricting the use of short selling and derivatives.

These regulations serve as handcuffs, making it more difficult to outperform the

market or to protect the assets of the fund in a downturn. Hedge funds, on the

other hand, are unregulated and therefore unrestricted - they allow for short selling

and other strategies designed to accelerate performance or reduce volatility. However,

an informal restriction is generally imposed on all hedge fund managers by

professional investors who understand the different strategies and typically invest in a

particular fund because of the manager's expertise in a particular investment strategy.

These investors require and expect the hedge fund to stay within its area of

specialization and competence. Hence, one of the defining characteristics of hedge

funds is that they tend to be specialized, operating within a given niche, specialty or

industry that requires a particular expertise.

 

3. Mutual funds generally remunerate management based on a percent of assets under

management. Hedge funds always remunerate managers with performance-related

incentive fees as well as a fixed fee. Investing for absolute returns is more demanding

than simply seeking relative returns and requires greater skill, knowledge, and talent.

Not surprisingly, the incentive-based performance fees tend to attract the most

talented investment managers to the hedge fund industry.

 

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4. Mutual funds are not able to effectively protect portfolios against declining markets

other than by going into cash or by shorting a limited amount of stock index futures.

Hedge funds, on the other hand, are often able to protect against declining markets by

utilizing various hedging strategies. The strategies used vary tremendously depending

on the investment style and type of hedge fund. But as a result of these hedging

strategies, certain types of hedge funds are able to generate positive returns even in

declining markets.

 

5. The future performance of mutual funds is dependent on the direction of the equity

markets. It can be compared to putting a cork on the surface of the ocean - the cork

will go up and down with the waves. The future performance of many hedge fund

strategies tends to be highly predictable and not dependent on the direction of the

equity markets. It can be compared to a submarine traveling in an almost straight line

below the surface, not impacted by the effect of the waves.

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Comparison between hedge funds and mutual funds in terms of performance and

numbers between 1990-2005

  Hedge Fund IndexAverage Equity Mutual Fund

1Q90 2.20% -2.80%

3Q90 -3.70% -15.40%

2Q91 2.30% -0.90%

1Q92 5.00% -0.70%

1Q94 -0.80% -3.20%

4Q94 -1.20% -2.60%

3Q98 -6.10% -15.00%

3Q99 2.10% -3.20%

2Q00 0.30% -3.60%

3Q00 3.00% 0.60%

4Q00 -2.40% -7.80%

1Q01 -1.10% -12.70%

3Q01 -3.80% -17.20%

2Q02 -1.40% -10.70%

3Q02 -3.60% -16.60%

3Q04 1.40% -1.70%

1Q05 .10% -2.20%

Total -10.30% -115.70%

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Comparison of hedge funds with mutual funds with regards to their individual

features, market trends, fee structure etc.

Comparison of Hedge and Mutual Funds

Characteristic Hedge Fund Mutual Fund

Expected returns Higher Lower

Risk of investment Higher Lower

Fees charged Higher Lower

Leverage Higher Lower

Trading volume Higher Lower

Secondary market Limited Widely available

Transfer and withdrawal rules Very restrictive Not generally restrictive

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VARIOUS INVESTMENT APPROACHES FOR HEDGE FUNDS

1. Aggressive Growth:

a. Hedge funds invest in equities which are expected to experience acceleration in

growth of earnings per share.

b. Generally they have high P/E ratios, low or no dividends; often smaller and micro

cap stocks which are expected to experience rapid growth.

c. Here hedge funds invest in sector such as technology, banking, or biotechnology.

d. It hedges by shorting equities where earnings disappointment is expected or by

shorting stock indexes.

e. Tends to be "long-biased."

f. Expected Volatility: High

2. Distressed Securities:

a. Managers buy equity, debt, or trade claims at deep discounts of companies in or

facing bankruptcy or reorganization.

b. As a result they make profits from the market’s lack of understanding of the true

value of the deeply discounted securities and because majority of institutional

investors cannot own below investment grade securities. (This selling pressure

creates the deep discount.)

c. Results generally not dependent on the direction of the markets.

d. Expected Volatility: Low - Moderate

3. Market Neutral - Securities Hedging:

a. Managers invest equally in long and short equity portfolios generally in the same

sectors of the market.

b. Market risk is greatly reduced, but effective stock analysis and stock picking is

essential to obtaining meaningful results.

c. Leverage may be used to enhance returns.

d. Usually low or no correlation to the market. Sometimes they use market index

futures to hedge out systematic (market) risk.

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e. Relative benchmark index usually T-bills.

f. Expected Volatility: Low

4. Market Timing:

a. Assets are allocated assets among different asset classes depending on the

manager’s view of the economic or market outlook.

b. Portfolio emphasis may swing widely between asset classes.

c. Unpredictability of market movements and the difficulty of timing entry and exit

from markets add to the volatility of this strategy.

d. Expected Volatility: High

5. Opportunistic:

a. Investment theme changes from strategy to strategy as opportunities arise to profit

from events such as IPO’s, sudden price changes often caused by an interim

earnings disappointment, hostile bids, and other event-driven opportunities.

b. Managers may utilize several of these investing styles at a given time and is not

restricted to any particular investment approach or asset class.

c. Expected Volatility: Variable

6. Emerging Markets:

a. Investment is done in equity or debt of emerging (less mature) markets which

tend to have higher inflation and volatile growth.

b. Short selling is not permitted in many emerging markets, and, therefore, effective

hedging is often not available.

c. Expected Volatility: Very High

7. Fund of Funds:

a. Manager’s mixes and matches hedge funds and other pooled investment vehicles.

b. This blending of different strategies and asset classes aims to provide a more

stable long-term investment return than any of the individual funds.

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c. Returns, risk, and volatility can be controlled by the mix of underlying strategies

and funds.

d. Capital preservation is generally an important consideration.

e. Volatility depends on the mix and ratio of strategies employed.

f. Expected Volatility: Low - Moderate

8. Income:

a. Mangers invest with primary focus on yield or current income rather than solely

on capital gains.

b. Managers may utilize leverage to buy bonds and sometimes fixed income

derivatives in order to profit from principal appreciation and interest income.

c. Expected Volatility: Low

9. Macro:

a. Aims to profit from changes in global economies typically brought about by shifts

in government policy which impact interest rates, in turn affecting currency,

stock, and bond markets.

b. They participate in all major markets equities, bonds, currencies and

commodities, though not always at the same time.

c. Uses leverage and derivatives to accentuate the impact of market moves.

d. Utilizes hedging, but leveraged directional bets tend to make the largest impact on

performance.

e. Expected Volatility: Very High

10. Market Neutral - Arbitrage:

a. Attempts are made to hedge out most market risk by taking offsetting positions,

often in different securities of the same issuer.

b. They may use futures to hedge out interest rate risk.

c. Here, focus is on obtaining returns with low or no correlation to both the equity

and bond markets.

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d. These relative value strategies include fixed income arbitrage, mortgage backed

securities, capital structure arbitrage, and closed-end fund arbitrage.

e. Expected Volatility: Low

11. Multi Strategy:

a. Here, investment approach is diversified by employing various strategies

simultaneously to realize short- and long-term gains.

b. Other strategies may include systems trading such as trend following and various

diversified technical strategies.

c. This style of investing allows the manager to overweight or underweight different

strategies to best capitalize on current investment opportunities.

d. Expected Volatility: Variable

12. Short Selling:

a. Managers sells securities short in anticipation of being able to rebuy them at a

future date at a lower price due to the manager’s assessment of the overvaluation

of the securities, or the market, or in anticipation of earnings disappointments

often due to accounting irregularities, new competition, change of management,

etc.

b. It is often used as a hedge to offset long-only portfolios and by those who feel the

market is approaching a bearish cycle.

c. Here the risk level is very high.

d. Expected Volatility: Very High

13. Special Situations:

a. Investment in this case is event-driven

b. Event driven situations are mergers, hostile takeovers, reorganizations, or

leveraged buy outs.

c. Mangers may simultaneously purchase a stock in companies being acquired, and

the sell the stock to its acquirer, hoping to profit from the spread between the

current market price and the ultimate purchase price of the company.

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d. Managers may also utilize derivatives to leverage returns and to hedge out interest

rate and/or market risk.

e. Results generally not dependent on direction of market.

f. Expected Volatility: Moderate

14. Value:

a. Managers here, invests in securities perceived to be selling at deep discounts to

their intrinsic or potential worth.

b. Such securities may be out of favor or under followed by analysts.

c. Long-term holding, patience, and strong discipline are often required until the

ultimate value is recognized by the market.

d. Expected Volatility: Low - Moderate

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HEDGE FUNDS DISTRIBUTION ACCORDING TO INDUSTRIES

1. Like all investments, hedge funds are also invested in many sectors.

2. Hedge funds managers believe in the philosophy that “Don’t put all your eggs in one

basket” i.e. they generally don’t invest in just one sector.

3. Hedge fund investments are generally diversified.

4. At any point of time it can be seen that the investment pattern is more or less the

same.

5. Hedge funds investments do not vary much unlike mutual funds.

6. Mutual fund investments go up and down daily according to current market trends.

7. But hedge funds are not like that.

8. They are generally long term and don’t go up and down frequently.

9. As the hedge fund industry is growing at a very fast rate its investments are also

diversifying and growing a lot with time.

10. The technology sector is booming at a very fast rate and hence the investment of

hedge funds in technology is also the highest.

11. It is followed by financial services, transportation, etc

12. Every hedge fund manager wants a diverse portfolio.

13. The average hedge fund clients in the year 2006 are represented in the pie chart.

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Hedge fund clients in the year 2006

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HEDGE FUND INDICES

There are a number of indices that track the hedge fund industry. These indices come in

two types, Invest able and Non-invest able, both with substantial problems. There are also

new types of tracking product, called as "clone indices" that aim to replicate the returns

of hedge fund indices without actually holding hedge funds at all.

Invest able indices are created from funds that can be bought and sold. Only Hedge Funds

that agree to accept investments on terms acceptable to the constructor of the index are

included. Invest ability is an attractive property for an index because it makes the index

more relevant to the choices available to investors in practice. In some ways these indices

are similar to Fund of hedge funds. However, such indices do not represent the total

universe of hedge funds and may under-represent the more successful managers, who

may not find the index terms attractive. Fund indexes include Hedge Fund Research,

CSFB Tremont and FTSE Hedge.

The index provider selects funds and develops structured products or derivative

instruments that deliver the performance of the index with a small tracking error. These

indices allow access to alternative investment strategies at low cost, providing liquidity

but sacrificing some representatively as a result.

Non-invest able indices are indicative in nature, and aim to represent the performance of

the universe of hedge funds using some measure such as mean, median or weighted mean

from some hedge fund database. There are diverse selection criteria and methods of

construction, and no single database captures all funds. This leads to significant

differences in reported performance between different databases.

Non-invest able indices inherit the databases' shortcomings in terms of scope and quality

of data. Funds’ participation in a database is voluntary, leading to “self reporting bias”

because those funds that choose to report may not be typical of funds as a whole. For

example, some do not report because of poor results or because they have already

reached their target size and do not wish to raise further money.

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The short lifetimes of many hedge funds means that there are many new entrants and

many departures each year, which raises the problem of “survivorship bias”. If only funds

that have survived to the present are examined it will overestimate past returns because

many of the worst-performing funds have not survived, and the observed association

between fund youth and fund performance suggests that this bias may be substantial

Database providers have differing selection criteria, so their data does not represent the

same universe of hedge funds.

When a fund is added to a database for the first time, all or part of its historical data is

recorded ex-post in the database. It is likely that funds only publish their results when

they are favorable, so that the average performances displayed by the funds during their

incubation period are inflated. This is known as "instant history bias” or “backfill bias”.

In traditional equity investment indices play a central and unambiguous role. They are

widely accepted as representative, and products such as futures and ETFs provide liquid

access to them in most developed markets. However, among hedge funds no index

combines these characteristics. Invest able indices achieve liquidity, at the expense of

representative ness. Non-invest able indices may be more representative, but their quoted

returns may not be available in practice. Neither is wholly satisfactory.

28

Hedge Funds Indexes At A Glance

Indices at a Glance

Index Jul 07(Est)

Jun 07 YTD06Return

Ann.Return

Hedge Fund Index 1.10 1.43 10.05 14.16 13.41

North American Hedge Fund Index -0.04 0.62 6.40 12.08 12.04

European Hedge Fund Index -0.25 0.40 7.08 12.12 10.45

Asian Hedge Fund Index 3.37 2.34 16.02 16.46 13.16

Japan Hedge Fund Index -0.35 1.35 3.00 -3.29 8.87

Emerging Markets Hedge Fund Index 3.70 2.66 19.97 27.53 20.76

Latin American Hedge Fund Index 1.35 1.40 12.12 22.42 21.48

Long-Only Absolute Return Fund Index

1.31 1.96 14.63 20.02 13.82

 

29

LEVERAGE

Definition:

The degree to which an investor is utilizing borrowed money is known as leverage.

Investors/ Funds that are highly leveraged may be at risk if they are unable to make

payments on their debt. Leverage is not always bad, however; it can increase the

investors' return on their investment and often there are tax advantages associated with

borrowing.

Leverage may be presented in various forms:

Gross Leverage=(Longs+Shorts)/Net Asset Value

Net Leverage=(Longs-Shorts)/Net Asset Value

Gross Longs=(Longs)/Net Asset Value

Many hedge fund strategies are “not leveraged” or “only moderately leveraged”.

1. No leverage (0 - 1: 1)

a. High yield funds

b. Distressed securities funds

c. Short-biased equity funds

d. Some long/short equities funds

2. Low leverage (1.1 - 2 : 1)

a. Most long/short equities funds

b. Merger arbitrage

3. Moderate leverage (2 - 7 : 1)

a. Convertible arbitrage

b. Statistical arbitrage

c. Mortgage-backed securities arbitrage

4. High leverage (8 - 20: 1)

a. Fixed income arbitrage

30

BIASES IN HEDGE FUNDS

Hedge funds aren't required to contribute their performance data to anyone. Hence for an

investor to measure a managers performance through past data becomes very difficult as

there are no past records. If an investor asks a manger to make their performance chart

then most hedge fund managers make their performance chart in favor of their

performance. Their records are subject to some biases so as to enable them to make their

performance look good. Following are the various biases:-

1. Backfill bias:

a. When a hedge fund is added to an index, the fund's past performance may be

"backfilled" into the index.

b. For example, if the fund has been in business for two years at the time it is added

to the index, past index values are adjusted for those two years to reflect the

fund's performance during that period.

c. Not all indexes backfill, but those that do introduce a bias.

d. Usually, a hedge fund will start contributing data to an index to draw attention to

recent strong performance.

e. One of the oldest tricks in investment management is to launch multiple

investment funds and then market those that happen to perform well.

f. The practice is also common among hedge funds, who report the winners to

indexes while closing down the losers.

g. Also, index providers generally have criteria for adding a new fund to an existing

index.

h. This may include minimum assets under management requirement, and successful

funds are more likely to satisfy these criteria than unsuccessful ones.

i. In summary, successful funds are more likely to be added to an index than

unsuccessful ones, so this biases indexes that backfill.

j. While backfilling is obviously a questionable practice, it is also quite

understandable.

31

k. When a provider first launches an index, they have an understandable desire to go

back and construct the index for the preceding few years. If a look is taken at time

series of hedge fund index performance data, it will be noted that indexes have

very strong performance in the first few years, and this may be due to backfilling.

2. Survivorship bias:

a. When a fund is dropped from an index, past values of the index may be adjusted

to remove that dropped fund's past data.

b. Inevitably, a fund will be dropped from an index if it stops providing its

performance data to the index provider, and a fund will be more likely to do so

following poor performance than good.

c. Also, providers may have criteria for dropping a fund, and this may naturally

cause poor performers to be dropped more often than good performers.

3. Liquidation bias:

a. Due to considerable leverage, hedge funds can fail suddenly.

b. In the midst of such a calamity, the managers have more important things on their

minds than reporting their mounting losses to index providers.

c. An index provider will have little choice but to drop the fund from the index.

d. They may go back and purge the index of that fund's past performance or they

may not.

e. Either way, the index will not reflect the fund's staggering losses.

4. Fraud bias:

a. One hedge fund that misrepresents its performance can severely bias an index.

b. Suppose an index is based on 25 hedge funds. One is fraudulent and misrepresents

a 30% loss as a 20% gain. That one misrepresentation will bias the index return

by about 2%.

Thus it is seen that majority hedge funds indexes and performers charts show real

information and are generally biased.

32

MAJOR FRAUDS IN HEDGE FUND INDUSTRY

Since the hedge fund industry does not have lots of rules and regulations and governing

authorities there are many frauds happening in the industry. Major frauds in this industry

are:

David M. Mobley, Sr., manager of the Maricopa funds, invested fund assets in his own

businesses, most of which failed. He also tapped fund assets to make donations to

charities and to pay for a luxurious lifestyle for himself and his family. Between 1993 and

2000, he reported annual returns of about 50% after his 30% fee. In 2000, he claimed the

funds had assets of USD 450MM when they really had only USD 33MM. Authorities

intervened shortly thereafter.

Lipper & Co's Lipper Convertible Fund lost heavily in convertible arbitrage trading

between 1996 and 2002. The fund's manager, Edward Strafaci, falsified returns during

much of that period. He claimed a 7.7% return for 2001 when the fund actually lost 40%.

John D. Barry and the other managers of Beacon Hill Asset Management lied about

losses in their market neutral hedge funds during 2002. SEC filings claim they also

defrauded hedge fund investors by transacting trades at off-market prices between the

hedge funds and other accounts they managed. Between August and October 2002, the

hedge funds lost 54% of their value.

Michael Lauer's Lancer Offshore Fund invested in distressed small cap stocks. It was

successful for a while but suffered heavy losses during the bear market of 2000-2003.

Lauer reported gains to investors while the fund's capital plunged USD 571MM.

Above were the major frauds taken place in the hedge fund industry which was

identified. But even today many minor frauds take place in the industry every now and

then.

33

FAILURES IN HEDGE FUND INDUSRY

Hedge funds are like unregulated insurance companies writing insurance policies to other

market participants and pocketing the insurance premiums. When markets crash they tend

to lose money. Because they are highly leveraged, they can lose enormous sums of

money. It is not atypical for hedge funds to lose most, if not all their capital.

Long Term Capital Management (LTCM) in 1998 lost almost all its capital due to

excessive leverage. It was a massive failure.

David Askin's Granite Fund lost all its USD 600MM capital in February 1994 when the

Federal Reserve raised interest rates and the fund's leveraged CMO positions plummeted.

John Koonmen's Japan-based Eifuku Master Fund was heavily leveraged with just a few

concentrated positions and it lost essentially all its USD 300MM capital over a one week

period in 2002.

Nicholas Maounis' massive Amaranth Advisors fund folded after losing USD 6.5 billion

i.e. 70% of its capital betting on natural gas prices in 2006.

34

HEDGE FUND PORTFOLIO

35

LEGAL STRUCTURE (U.S)

Legal structure is usually determined by the tax environment of the fund investors. Many

hedge funds are domiciled i.e. have their legal residence offshore in countries unrelated

to either the manager, investor or investment operations of the fund, with the objective of

making taxes payable only by the investor and not additionally by the fund.

Funds ordinarily are run by hedge fund management companies, which may operate one

or many funds domiciled in multiple jurisdictions.

For U.S-based investors who pay tax, hedge funds are often structured as limited

partnerships because these receive relatively favorable tax treatment in the US. The

hedge fund manager (usually structured as a corporate entity) is the general partner or

manager and the investors are the limited partners or members respectively. The funds

are pooled together in the partnership or company and the general partner or manager

makes all the investment decisions.

Non-US investors and U.S. entities that do not pay tax (such as pension funds) do not

receive the same benefits from limited partnerships, and funds for these investors are

often structured as offshore or unit trusts or investment companies. Hybrid or "Master-

feeder " structures that contain both a US limited partnership and an offshore company

allows hedge funds to attract capital from several different tax regimes.

At the end of 2004, 55% of the number of hedge funds, managing nearly two-thirds of

total hedge fund assets, was registered offshore. The most popular offshore location was

the Cayman Islands followed by British Virgin Islands and Bermuda. The U.S. was the

most popular onshore location accounting for 34% of the number of funds and 24% of

assets. European countries were the next most popular location with 9% of the number of

funds and 11% of assets. Asia accounted for the majority of the remaining assets.

At end-2006, three-quarters of European hedge fund investments, totaling $400bn, were

managed within the UK, the vast majority from London. Assets managed out of London

36

grew more than fourfold between 2002 and 2005 from $61bn to $225bn. Australia was

the most important centre for the management of Asia-Pacific hedge funds. Managers

located there accounted for around a quarter of the $115bn in Asia-Pacific hedge funds’

assets in 2005.

Indian hedge fund industry has nearly 1% of the total hedge fund assets and is growing at

an alarming rate.

37

REGULATORY ISSUES (U.S)

Part of what gives hedge funds their competitive edge, and their cachet in the public

imagination, is that they straddle multiple definitions and categories; some aspects of

their dealings are well-regulated, others are unregulated or at best quasi-regulated.

The typical investment company in the United States is required to be registered with the

U.S. Securities and Exchange Commission (SEC). Aside from registration and reporting

requirements, investment companies are subject to strict limitations on short-selling and

the use of leverage. There are other limitations and restrictions placed on investment

company managers, including the prohibition on charging incentive or performance fees.

Funds that trade in commodities, which include many of the largest funds engaged in

"macro" strategies, are registered with the Commodity Futures Trading Commission as

commodity pools and as commodity trading advisors, or CTAs.

In 2004, 65 of the top 100 funds in 2003 were commodity pools, and 50 out of the 100

largest hedge funds were CTAs in addition to being commodity pools.

Although hedge funds fall within the statutory definition of an investment company,

hedge funds elect to operate pursuant to exemptions from the registration requirements.

The two major exemptions are set forth in Sections 3(c)1 and 3(c)7 of the Investment

Company Act of 1940. Those exemptions are for funds with fewer than 100 investors (a

"3(c) 1 Fund") and funds where the investors are "qualified purchasers" (a "3(c) 7 Fund").

[5] A qualified purchaser is an individual with over US$5,000,000 in investment assets.

(Some institutional investors also qualify as accredited investors or qualified purchasers.)

[6] A 3(c)1 Fund cannot have more than 100 investors, while a 3(c)7 Fund can have an

unlimited number of investors. Both types of funds can charge performance or incentive

fees.

In order to comply with 3(c)(1) or 3(c)(7), hedge funds are sold via private placement

under the Securities Act of 1933. Thus interests in a hedge fund cannot be offered or

38

advertised to the general public, and are normally offered under Regulation D. Although

it is possible to have non-accredited investors in a hedge fund, the exemptions under the

Investment Company Act, combined with the restrictions contained in Regulation D,

effectively require hedge funds to be offered solely to accredited investors.

An accredited investor is an individual with a minimum net worth of US$1,000,000 or,

alternatively, a minimum income of US$200,000 in each of the last two years and a

reasonable expectation of reaching the same income level in the current year.

The regulatory landscape for Investment Advisors is changing, and there have been

attempts to register hedge fund investment managers. There are numerous issues

surrounding these proposed requirements. One issue of importance to hedge fund

managers is the requirement that a client who is charged an incentive fee must be a

"qualified client" under Advisers Act Rule 205-3. To be a qualified client, an individual

must have US$750,000 in assets invested with the adviser or a net worth in excess of

US$1.5 million, or be one of certain high-level employees of the investment adviser

.

For the funds, the tradeoff of operating under these exemptions is that they have fewer

investors to sell to, but they have few government-imposed restrictions on their

investment strategies. The presumption is that hedge funds are pursuing more risky

strategies, which may or may not be true depending on the fund, and that the ability to

invest in these funds should be restricted to wealthier investors who are presumed to be

more sophisticated and who have the financial reserves to absorb a possible loss

In December 2004, the SEC issued a rule change that required most hedge fund advisers

to register with the SEC by February 1, 2006, as investment advisers under the

Investment Advisers Act. The requirement, with minor exceptions, applied to firms

managing in excess of US$25,000,000 with over 15 investors. The SEC stated that it was

adopting a "risk-based approach" to monitoring hedge funds as part of its evolving

regulatory regimen for the burgeoning industry. The rule change was challenged in court

by a hedge fund manager, and in June 2006, the U.S. Court of Appeals for the District of

Columbia overturned it and sent it back to the agency to be reviewed.

39

SEC currently has neither the staff nor expertise to comprehensively monitor the

estimated 8,000 U.S. and international hedge funds The SEC is forming internal teams

that will identify and evaluate irregular trading patterns or other phenomena that may

threaten individual investors, the stability of the industry, or the financial world

In February 2007, the President's Working Group on Financial Markets rejected further

regulation of hedge funds and said that the industry should instead follow voluntary

guidelines.

40

PAY STRUCTURE FOR HEDGE FUND MANAGERS

A hedge fund manager generally earns two types of fee

Management fees are generally according to assets for managing them and performance

fees is for the actual performance of the manger which is very high. This type of

performance fees exists only in the hedge fund industry and not the mutual fund industry.

Management Fees

Usually the hedge fund manager will receive both a management fee and a performance

fee. As with other investment funds, the management fee is computed as a percentage of

assets under management. Management fees might typically be 1.5% or 2.0%.

Performance fees

Performance fees, which give a share of positive returns to the manager, are one of the

defining characteristics of hedge funds. The performance fee is computed as a percentage

of the fund's profits, counting both paper profits and actual realized trading profits.

Performance fees exist because investors are usually willing to pay managers more

generously when the investors have themselves made money. For managers who perform

well the performance fee is extremely lucrative.

Typically, hedge funds charge 20% of gross returns as a performance fee, but again the

range is wide, with highly regarded managers demanding higher fees. There are two

terminologies relating to performance fee. They are:-

High water marks

a. A "High water mark" is often used in regards to performance fees.

b. This means that the manager does not receive incentive fees unless the value of

the fund exceeds the highest net asset value it has previously achieved.

c. For example, if a fund was launched at a net asset value (NAV) of 100 and rose to

130 in its first year, a performance fee would be payable on the 30% return. If the

next year it dropped to 120, no fee is payable. If in the third year the NAV rises to

41

143, a performance fee will be payable only on the 13% return from 130 to 143

rather than on the full return from 120 to 143.

d. This measure is intended to link the manager's interests more closely to those of

investors and to reduce the incentive for managers to seek volatile trades.

e. If a high water mark is not used, a fund that ends alternate years at 100 and 110

would generate performance fee every other year, enriching the manager but not

the investors.

f. However, this mechanism does not provide complete protection to investors: a

manager that has lost money may simply decide to close the fund and start again

with a clean slate, provided that he can persuade investors to trust him with their

money.

g. A high water mark is sometimes also referred to as a "Loss Carryforward

Provision".

Hurdle rates

a. Some funds also specify a 'hurdle', which signifies that the fund will not charge a

performance fee until its annualized performance exceeds a benchmark rate, such

as fixed percentage, over some period.

b. This links performance fees to the ability of the manager to do better than the

investor would have done if he had put the money in a bank account.

c. Though logically appealing, this practice has diminished as demand for hedge

funds have outstripped supply and hurdles are now rare.

This was the typical pay structure for a hedge fund manager. However the

performance fees vary for one manger to another and one investor to another.

42

NET ASSET VALUE (NAV)

The net asset value of a fund is the cumulative market value of the assets fund net of its

liabilities. In other words, if the fund is dissolved or liquidated, by selling off all the

assets in the fund, this is the amount that the investors would collectively own.

This gives rise to the concept of net asset value per unit, which is the value represented

by the ownership of one unit in the fund. It is calculated by dividing the net asset vale of

the fund by the number of units. However, in general terms many people refer net asset

value per unit as net asset value, ignoring per unit.

Calculation of net asset value (NAV)

Market Value of the Schemes Investment + Other Assets (Including Accrued Interest) –

All Liabilities except Unit Capital and Reserves

Number of Units Outstanding

The most important part of the calculation is the value of assets owned by the fund. Once

it is calculated, NAV is simply net value of the assets divided by the number of units

outstanding.

The detailed methodology for the calculation of asset value is as under:-

Asset Value = Sum of Market Value of Funds + Liquid Cash/ Asset Held, If Any +

Dividends/ Interest Accrued

For liquid shares/ debentures, valuation is done on the basis of the last or closing market

price on the principle exchange where the security is traded

For illiquid and unlisted and/or thinly traded shares or debentures, the value has to be

estimated.

43

For shares it is the book value per share or an estimated market price if suitable

benchmarks are available.

For debentures and bonds, value is estimated on the basis of yields of the comparable

liquid securities after adjusting for illiquidity. The value of the fixed interest bearing

securities moves in opposite direction to the interest rate changes.

Valuation of debentures and bonds is a big problem since most of them are unlisted and

thinly traded. This gives considerable leeway o the managers and investors and some of

them take advantage of this and adopt flexible valuation policies depending on the

situation.

Interest is payable on debentures and bonds on a periodic basis say every six months. But

with every passing day interest is said to be accrued. This difference in daily interest rate

is calculated by dividing the periodic interest payment with the number of days in each

period. Thus, accrued interest on a particular day is equal to the daily interest rate

multiplied by the number of days since the last interest payment date.

Expenses include management fees, performance fees, custody charges etc. are calculated

on daily basis.

Thus The Net Asset Value (NAV) of a hedge fund is calculated.

44

HEDGE FUND STRUCTURE

1. A hedge fund structure always starts with an investor

2. He is the person who decides how much has to be invested and who is going to help

him.

3. Depending upon the capital to be invested by him he decides the investment structure

of the fund

4. The structure can be LP or LLC.

5. LP earns liberty post and LLC means Limited Liability Company.

6. The investor then appoints a fund manager who will decide upon the allocation of

investments.

7. Various hedge fund strategies like arbitrage, short selling, etc will be applied by the

fund manager.

8. Fund manager allocates the funds in various sectors using various hedge fund

strategies.

9. After a period of time the investment earns returns

10. These returns are distributed among the investors

11. A hedge fund manager generally earns performance fees on investment. Generally it

is 20%

12. Depending on the investors needs the returns on investment is either returned to him

or reinvested in the hedge fund market.

13. This is the basic structure of a hedge fund.

45

Basic hedge fund structure

46

TYPICAL OFSHORE STRUCTURE OF HEDGE FUNDS

INVESTOR

AUDITOR

ADMINIS- TRATOR

PRIME BROKER

EXECUTION BROKER

SECURITIES

HEDGE FUND LTD.

INVESTMENT MANAGER/ SPONSOR

INVESTMENT ADVISOR

47

The role of the different parties

Hedge Fund Ltd

They are the offshore company i.e. the company which has decided to invest in an

offshore location.

They hold the articles of association

They comprise of directors, and two groups of shareholders

Investor

Investor is the holder of the non-voting, participating shares

Sponsor

Sponsor is the holder of the voting, non-participating shares

Investment Manager

Investment manager is discretionary portfolio manager

There are generally different mangers specialized in typically offshore funds

Investment Advisor

They are non-discretionary ‘advisor’, typically onshore

Auditor

Auditor is the one who records all the transactions and financial expenses i.e. all

functions performed by the hedge fund company financially.

Their main function is to audit the balance sheet and P&L once per annum

Prime broker

A prime broker performs the following transactions:

Stock lending

Leverage

Custody of portfolio securities and cash

48

Trade execution and settlement

Back office facilities

Office space

Legal assistance for set up

Marketing support

Administrator

Administrator handles independent NAV calculation

They also perform the function of handling of subscriptions and redemptions

49

HEDGE FUNDS IN INDIA

1. Technically India is out of bounds for the hedge fund industry

2. However many hedge fund investors invest hedge funds in the Indian markets

indirectly through the participatory notes (PN) route

3. As a result the SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI)

have agreed to allow foreign individuals, corporate and other investors of hedge funds to

register directly as FOREIGN INSTITUTIONAL INVESTORS(FII) — a move designed

to increase transparency and reduce transaction costs for these investors

4. At least four foreign funds i.e. Milan, Italy-based Aletti Gestielle Societa,

Toronto-based DGAM Emerging Markets Equity Fund, Karma Capital Management and

Blackrock Advisors, all known for using hedge fund investment strategies, have been

granted FII registration by the regulator, triggering speculation that SEBI is slowly

allowing hedge funds an entry into the domestic markets.

5. In 2006, portfolio inflows of hedge funs investment through PN route was

aggregated to around $8 billion

6. It is expected to be even higher in 2007.

7. According to a recent study conducted by Eureka Hedge, Indian exposure by the

hedge funds accounted for accounted for one per cent of total global hedge fund assets.

8. Various companies carrying out hedge funds in India are:

a. Amoeba Capital Partners

b. Atyant Capital India Fund

c. Boyer Allan India Fund

d. Avatar India Opportunities Fund

9. India’s hedge fund market is growing at a rate of 40%

10. Hedge funds contributed to about 30-40 per cent of the inflow into the Indian equities

in 2006

11. With $35 billion in investment capital, DE Shaw and Co, the world’s fourth-largest

hedge fund, has set its eye firmly on India. It has been reported that in September, DE

Shaw will open its second office in India, just 14 months after it started off in Gurgaon,

outside New Delhi

50

HEDGE FUNDS WORLD DISTRIBUTION

Hedge funds were introduced in USA. Even today most of the hedge fund business is carried out in USA. But other countries are also not far behind in the world of hedge funds.

The distribution of the hedge fund business and its activities is as follows:

Country % of hedge fund businessUSA 50%SWITZERLAND 25%UK 5%JAPAN 5%OTHER 15%

51

TOP EARNERS

Earnings from a hedge fund are simply 100% of the capital gains on the manager's own

equity stake in the fund plus 20% to 50% (depending on policy) of the gains on the other

investors' capital.

The 2004 top earner was Edward Lampert of ESL Investments Inc. who earned $1.02

billion during the year (PR Newswire link).

The 2005 top earner was T. Boone Pickens with an estimated earning of over $1.5 billion

during the year.

The full top 10 list of hedge fund earners in 2005 are:

1. T. Boone Pickens - $1.5bn +

2. Steven A. Cohen, SAC Capital Advisers - $1bn +

3. James H. Simons, Renaissance Technologies Corp. - $900m - $1bn

4. Paul Tudor Jones, Tudor Investment Corp. - $800m - $900m

5. Stephen Feinberg, Cerberus Capital Management - $500 - $600m

6. Bruce Kovner, Caxton Associates - $500m - $600m

7. Eddie Lampert, ESL Investments - $500m - $600m

8. David E. Shaw, D. E. Shaw & Co. - $400m - $500m

9. Jeffrey Gendell, Tontine Partners - $300m - $400m

10. Louis Bacon, Moore Capital Management - $300m - $350m

10. Stephen Mandel, Lone Pine Capital - $300m - $350m

52

HEDGE FUNDS- A BOOMING INDUSTRY

1. The demand for hedge funds is exploding in the past few years. 

2. There were only about 600 funds with $38 billion in 1990.

3. Today there are between 6,000 and 7,000 active hedge funds in the U.S. with

approximately $650 billion in assets.

4. This does not include thousands of offshore hedge funds.  Numbers are estimated

because exact figures are hard to come by since reporting is voluntary, and most hedge

funds do not have to register with the SEC

5. Worldwide there are about 10,000 hedge funds with almost $1,500 billion capital

as of December 2006 an

6. However, it is easy to see that interest in hedge funds is fueling a lot of growth in

the industry. 

7. Part of this growth can be attributed to the ability of certain hedge fund managers

to consistently beat the stock market indexes, sometimes with less risk. 

8. However the success of these relatively few individual fund managers has now

been attributed to the entire hedge fund industry, resulting in hedge funds being the latest

“darlings” of the investment industry.

9. The interest in hedge funds has even infected the mutual fund industry. 

10. How this latest hedge fund “knock-off” is going to work (if it does) is not at all clear

as yet.

11. In addition, there are many mutual funds that have now incorporated both leverage

and short trading in an effort to look more like hedge funds and make money in any kind

of market. 

12. Time will only tell whether or not these recent arrivals to the hedge fund arena will be

successful

53

FACTORS CONTRIBUTING TO THE GROWTH OF HEDGE FUND

INDUSTRY

Lower Fees

The standard hedge-fund fee structure consists of a 1–2 percent asset-based fee and at

least a 20 percent profit participation fee. Many funds charge much higher rates. Hedge

fund investors are glad to pay fees when returns are high. But in a muddled market

environment with more middling returns and less overall volatility in the equity markets,

these fees will simply become too large a percentage of the total fund returns, thus

dragging down returns to investors to unattractive levels.

In addition, given the proliferation of new managers entering the space, and the intense

competition that will ensue, it is inevitable that the average hedge fund fee will have to

come down in order to attract investors. In addition, with much of the new money coming

into hedge funds being contributed by institutional investors who have more buying

leverage, and who are not accustomed to paying rack retail rates, it is inevitable that they

will not demand fee concessions from many hedge funds in return for large capital

commitments. While established “star” managers may be immune from this fee pressure,

it is all but certain that emerging managers will have to succumb to fee compression,

thereby creating a trend toward a new and lower fee structure with which those who

follow will have to comply. This was the trend in the institutional money management

business that saw fees decline precipitously over the past 15 years as increased

competition and consolidation created a more efficient market. This was also the trend in

the mutual fund business where high loads and high internal fees were the norm a mere

ten years ago. The hedge fund business will follow this trend as it matures. It is not a

question of if, but when, and by how much.

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Increased Liquidity

Most hedge funds have a one-year lockup provision and advance notice of 90 days before

any capital withdrawal. Some private investment funds, such as those making venture

capital investments in developmental-stage firms, have a clear and valid need for such

long-term lockup arrangements. But the underlying instruments in most hedge funds are

sufficient for 30-day-or-less liquidity. Other than the desire to earn fees for a longer

period of time, it is hard for the average hedge fund to argue that it is absolutely

necessary to hold client funds beyond 30 days. From the investor’s perspective, all else

being equal, one does not want to be a year away from accessing his or her money.

Investors want to be able to withdraw their money in the event they see something with

the fund they do not like, or simply if they need the liquidity. Since most hedge funds do

not “need” to have these lockup provisions, as the industry matures, this will be one easy

way for managers to distinguish themselves and accommodate client needs. Thus, we see

increased liquidity becoming the norm of hedge fund investing, not the exception.

Increased Transparency

Investing on faith was once accepted as part of the “price of admission” into the hedge

fund industry. Indeed, the cachet of an exclusive or closely guarded strategy may have

been a positive. Then came Long-Term Capital Management (LTCM)—the most

spectacular of all hedge fund blowups. Clearly there has been a movement toward

increased “factor transparency” in the post-LTCM era, which calls for the disclosure of

the macro characteristics of a fund at month’s end such as the percentages of long and

short exposure. In our view, factor transparency does not meet the due-diligence

requirements of most sophisticated retail or institutional investors. Investors have a right

to know exactly what they own and how returns were generated. More investors will

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make these demands on their hedge fund managers in the face of misleading, and in some

cases fraudulent, activity, news of which finds its way into the popular press on a regular

basis. As such, many funds, especially newer emerging funds, will be forced to deliver

full transparency if they wish to raise substantial assets. Indeed, institutional investors

often demand that their hedge fund investments be located in a managed account vehicle

(that by definition offers complete transparency) with the hedge fund company’s

traditional partnership structure. To preserve strategy confidentiality, non-disclosure

agreements with “teeth” may have to be signed and enforced in return for transparency.

Furthermore, mandated hedge fund registration for advisors with more than $25 million

under management will ensure increased operational transparency.

Focus on Emerging Managers

Size may be a disadvantage to certain hedge fund strategies at high levels of assets. In

their later years, some of the top performing hedge funds, had difficulty in replicating the

spectacular performance of their earlier years. Part of the reason for diminished

performance may be due to the difficulty in putting large sums of capital to work

profitably. Other reasons are some managers’ inability to build a scalable business, either

due to limitations on their strategy or the simple fact that some hedge fund managers are

great investors, but poor businesspeople who function more efficiently in smaller

environments devoid of bureaucracy.

In other cases, successful funds attract competition and suffer from key staff defections,

as star analysts who have been major contributors to performance leave to create their

own funds—often running a similar strategy. A certain amount of size is necessary to

ensure critical mass and organizational viability. But there is no free lunch, as smaller

fund management firms require extra due diligence and monitoring. Hence, hedge fund

investors in present carefully weigh the balance between confidences in delivering alpha

relative to operational risk. Also, Securities and Exchange Commission’s registration

requirements provide many investors with a fair amount of comfort (akin to investing in a

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non-household “name” mutual fund) and tip the balance in favor of those firms that are

able to deliver investment performance in highly competitive markets.

Focus on Niche Strategies

Although this trend is clearly related to the prior trend, there are some subtle differences.

For example, the bulk of the 8,000 hedge funds are following traditional strategies such

as long/short fundamental equity, event-driven, statistical arbitrage, global macro, merger

arbitrage, and so forth. But not many funds use esoteric forms of technical analysis and

combine them with option overwrites to earn extra income and reduce risk. The key take-

away is that as more managers flock to the hedge fund space, investors are seeking out

those funds with a definable niche and run a strategy that is not easy to replicate and this

superior performance will be more likely to persist.

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CONCLUSION

Hedge funds are a private investment partnership limited to 99 high net-worth or

institutional investors. A hedge fund may take long and short positions in various types of

securities and use leverage. The investment managers are compensated by a percentage

of the funds profits.

Hedge funds represent a diversification opportunity for those investors who are

sophisticated enough to investigate them thoroughly before investing, and wealthy

enough to meet the high minimum investment requirements.  The record is clear that

some of these funds have been able to deliver above-market returns.

However, as with any investment, due diligence is the key to success.  If an investor is

interested in participating in a hedge fund, he needs to be familiar not only with the hedge

fund terminology, but also with the various advanced trading strategies employed by

different types of managers such as the use of derivatives, options, short trades, etc.

As a practical matter, hedge funds are out of reach for most investors, but this doesn’t

mean that the average investor cannot access active management strategies similar to

those employed by hedge fund managers.  The mutual fund industry is already starting to

roll out funds that are touted to emulate hedge funds.

The hedge fund industry is growing day by day. SEBI is now allowing hedge funds to

participate in the Indian financial market as FII’s and it has been said that India will

sooner or later open its door to Hedge Funds.

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BIBLOGRAPHY

The following books were referred for doing the project:

1. ALL ABOUT HEDGE FUNDS - ROBERT A JAEGER

The following magazines and newspapers were referred for doing the project:

1. Business Today

2. Economic Times

3. Times Of India

The following websites were referred for doing the project:

1. www.hedgefund.com

2. www.hedgefundindia.com

3. www.riskglossary.com

4. www.msnbc.com

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GLOSSARY

Accredited investor

A person is an accredited investor if:

He has an individual net worth, or if he and his spouse have a combined net worth, in

excess of $1 million.

He has an individual income, excluding any income attributable to his spouse, of more

than $200,000 in the previous two years, and he reasonably expects to do the same this

calendar year.

He and his spouse had joint income of more than $300,000 in the previous two years and

reasonably expect to do the same in this calendar year.

Bear market

A long term downtrend (a downtrend lasting months to years) in any market, especially

the stock market, characterized by lower intermediate lows (those established in a time

frame of weeks to months) interrupted by lower intermediate highs is known as a bear

market.

Bull market

A long term uptrend (months to years) price movement in any market, characterized by a

series of higher intermediate highs (those established within weeks to months) interrupted

by higher consecutive intermediate lows is known as a bull market.

Correlation

Correlation measures the degree to which two series of returns move together.

Correlations range from -1 to 1. A correlation close to 1 means that those two assets or

two managers tend to move up and down together and vice versa. A correlation close to

zero means two series of returns move independently of each other.

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Hedge funds

Hedge funds are an actively managed investment fund whose objective is to earn positive

rate of return that does not depend on the return of standard market indices.

Liquidity

A liquid market is a market where willing buyers and willing sellers can find each other

relatively easily

Short selling

Short selling is a way to profit from the decline in price of a security, such as a stock or a

bond. To profit from the stock price going down, short sellers borrow a security and sell

it, expecting that it will decrease in value so that they can buy it back at a lower price and

keep the difference.

Volatility

Volatility is the measure of the state of instability.

Volatility refers to the standard deviation of the change in value of a financial instrument

with a specific time horizon. It is often used to quantify the risk of the instrument over

that time period. Volatility is typically expressed in annualized terms, and it may either

be an absolute number or a fraction of the initial value.

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