Hedge Fund Primer

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  • 1. GP Asset Management Hedge Fund Primer

2. GP Asset ManagementHedge Fund PrimerWhat is a Hedge Fund? Alfred Winslow Jones (a Ph.D. in sociology at Columbia University and writer for Fortune) is credited with developing the first hedge fund investment vehicle when he formed A.W. Jones & Co in 1949. Jones's strategy was to invest in individual stocks, taking both long and short positions.The term "hedge fund" has evolved to a point that no universally accepted definition exists. Some funds calling themselves hedge funds may not employ hedging techniques at all.The most common usage of the term is to describe an actively managed investment that seeks absolute returns independent of market conditions. This is typically achieved using one of a broad range of opportunistic investment or trading techniques. Hedge funds stand in contrast to mutual funds, which are long-only vehicles that must remain fully invested at all times.Hedge funds are often structured as limited partnerships, with the general partner being the portfolio manager who makes the investment decisions. How do hedge funds differ from mutual funds?Hedge FundMutual Fund Fees Asset and Asset based onlyperformance based TaxesPass throughNo tax at fund level Risk & returnManager and StrategyMarket Investment An Absolute returnA Relative return Objective LiquidityInvestment &Daily liquidityredemption limits Strategy Diverse, can useLimitations on leverageleverage and shortand short sellingselling MarketingMarketing and selling Access to retail marketlimitations StructureManager and clients Manager is agentare partnersfor clients FinancialStocks, bonds, options, Stocks, bonds, cash Instrumentsfutures, currencies, etc.Page 1 3. GP Asset ManagementWhat accounts for the growth of Hedge Funds? The primary factors that account for the growth ofNumber and assets under hedge funds are: management of hedge funds Recent bear markets enhance the attractiveness of Number (Line)Sbn assets (Bars)absolute return strategies9,000 900 Adding hedge funds to a portfolio of stocks and bonds 8,000 800improves the efficient frontier, producing more return7,000 700per unit of risk6,000 600 Hedge funds tend to be non-correlated with traditionalasset classes 5,000 500 Manager's compensation is tied to performance, so the 4,000 400 manager's interests are aligned with3,000 300those of investors2,000 200 Hedge funds provide a diverse array of strategies and1,000 100styles from which to choose0 0 1991 1993 199519971999 2001 2003Disadvantages of hedge funds often cited are:Source: Van Hedge Fund Advisors International Inc., MorganStanley, Hedge Fund Research May be less liquid than other investments Some have lock-up periods or other restrictive redemption terms May offer less transparency than other investments Tend to have higher minimums for initial investments Hedge Fund Strategies Hedge fund strategies are usually broadly divided into three major categories: Event Driven, Relative Value, & Opportunistic, and into sub-categories thereof.Following this is a brief description of each strategy type.Convertible Arbitrage: Convertible arbitrage is a relative value strategy. Convertible Arbitrage strategies attempt to exploit discrepancies in prices of corporate securities that are convertible into common stock.Dedicated short bias or short selling: This is a directional opportunistic strategy with a "bearish" focus. It involves short-selling securities in the hope of buying them back in the future at lower prices.Emerging Markets: This relative value strategy involves investing in equity and fixed-income instruments in emerging markets worldwide.Equity Market Neutral: This relative value strategy offsets long and short equity positions that are beta-neutral, currency-neutral, or both, with a view to minimizing the overall impact of the market on the portfolio.Page 2 4. GP Asset ManagementEvent Driven: These strategies try to profit from price anomalies resulting from corporate transactions and special situations. The focus is usually on distressed securities, high yield debt, Regulation D or risk arbitrage.Fixed Income Arbitrage: This relative value strategy tries to exploit price inefficiencies between related debt securities.Global Macro: Typifies strategies that try to profit from changes in global economies. These directional macroeconomic strategies may look at how a governmental policy change may impact interest rates and securities.Long-Short Equity: Typically directional equity and equity derivative strategies. They may switch from net long to net short and vice versa depending on the manager's outlook for the market.Managed Futures or CTA Global: These strategies invest in listed financial, commodity and currency markets. The strategies may be trend following or discretionary and use either quantitative fundamental or technical analysis.Multi-Strategy: Where a fund employs multiple strategy types to achieve a profit.Merger Arbitrage: As the title suggests this strategy invests in companies involved in a Merger or Acquisition. The strategy involves going long the targeted company and selling short the stock of the acquiring company.Hedge Fund performance Hedge fund performance tends to be assessed using a number of criteria:Sharpe ratio: The Sharpe Ratio measures the reward per unit of risk. It is calculated by finding the difference between an investment's average monthly performance and the monthly rate of return of a designated riskless alternative (usually the US Treasury Bill rate). This figure is then divided by the variability of the portfolio's returns (Standard Deviation). Other things being equal, an increase in the excess returns of an investment will result in a greater Sharpe Ratio. The Sharpe Ratio gives an idea of how efficiently excess returns have been achieved. A higher ratio indicates higher efficiency. The general rule of thumb is a Sharpe Ratio higher than 1 is desirable.Sortino ratio: Variance is commonly used to measure risk. Variance is the dispersion of an investment's returns from the mean. An investment with monthly returns of -2% and +2% will have the same variance as another investment that is 0% one month and +4% the next. Standard Deviation is the square root of Variance. The Sharpe Ratio uses a non-directionally based measure of volatility to adjust for risk. The result of this could be that if a fund has a month of exceptionally high performance its Sharpe Ratio is penalized. Obviously upside deviation is acceptable and even desirable. This is where the Sortino Ratio comes in. Instead of using Standard Deviation as the denominator, the Sortino Ratio uses downside semi-variance. Thus, the Sortino Ratio only penalizes downward volatility. The Sortino Ratio is therefore a measurement of return per unit of risk on the downside. Page 3 5. GP Asset ManagementTreynor ratio: (Sometimes called the Reward to Variability Ratio): Earlier it was explained how the Sharpe Ratio measures the reward per unit of risk. The Treynor Ratio also relates return to risk but instead of total risk the Treynor Ratio uses systematic risk. The Treynor Ratio helps analyze returns in relation to the market risk of the fund. The Treynor Ratio provides a measure of performance adjusted for market risk. Again, the higher the Treynor Ratio, the better the performance under analysis. The Treynor Ratio uses Beta as the volatility measurement. The Treynor Ratio divides the difference of the average return of the fund and the risk-free rate by Beta (market risk) of the fund. Therefore the Treynor Ratio illustrates the return over the risk-free rate per unit of market risk.Calmar ratio: The Calmar Ratio is another return versus risk ratio. The Compound Annualized Rate of Return (usually for the previous 3 years) is the numerator and the denominator is the Maximum Drawdown (again usually for the previous 3 years and given as an absolute value). The Calmar Ratio therefore measures the return versus the drawdown risk. This ratio can be useful to compare potential opportunity gain versus opportunity loss.Omega ratio: This new, increasingly popular ratio attempts to correct for the fact that distribution of hedge fund returns is often skewed. The Omega ratio measures probability of returns falling above a given a threshold. Often more than one threshold is used to reflect different risk profiles (the usual range is from 0% to the risk free rate). At a given return threshold, the Omega ratio specifies the likelihood of beating that return over the likelihood of failing to match it. The Omega is a series of numbers indicating the risk of an investment for different levels of return. An advantage of the Omega Ratio is that it considers all aspects of a probability distribution of returns, not just the mean and standard deviation, but the actual shape of the distribution curve.Hedge fund returnsHedge fund long-term returns Annual returns1988-2003, % compunded 35 annual return 30 20 25 20 15 15 1050 10 -5-10-15 5-20-25 2001 2002 20030Van Global Hedge MSCILehman BrothersVan Global MSCI WorldLehman Brothers Fund Index World Equity Aggregate Bond IndexHedge F. Ind.EquityAggreg. Bond Ind.Source: Van Hedge Fund Advisors International Inc.Source: Van Hedge Fund Advisors International Inc. Page 4 6. GP Asset ManagementOther performance related terms you may come across:Alpha: Alpha measures the excess returns over and above a benchmark produced by a fund manager. This is the portion of returns attributable to the manager's skill.Beta: Beta is a measure of the volatility or systematic risk of a fund in comparison to that of the market. A Beta of 1 indicates that the fund's volatility will move with the market. A Beta greater than 1 indicates that the fund's volatility will be more than that of the market. A Beta of less than 1 means the fund will be less volatile than the market.Volatility: Volatility is usually calculated by using Variance or Sta