Hedge Fund Stategies

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How to use hedge fund strategies to boost your portfolio's return and protect against the downside. The definitive guide for investors who want to use advanced hedge fund strategies without the disadvantages of actually using a hedge fund.

Transcript of Hedge Fund Stategies

  • 1.Hedge Fund StrategiesBoost Your PortfoliosPerformance! Thomas Kirchner is The Deal Sleuth

2. Hedge Fund Strategies 2008 by Thomas Kirchner Disclaimer: By reading this e-book you accept that: This e-book is educational and does not constitute an advertisement, offer to sell a security orother solicitation. Securities are mentioned in this e-book as examples only, are not recommended and may ormay not be suitable for you. The e-book has been made available for informational purposes only. It contains informationobtained from third party sources considered reliable but that may be inaccurate. Investment strategies mentioned herein may not be appropriate for your individualcircumstances. Always seek advice from your broker or investment adviser before investing. If you do not agree to these terms, please close the e-book now.Exit NowAcknowledgments: The idea for this e-book is Ron Charnocks, whom I also thank forhelping with its design. Many thanks to Anthony Von Mickle for giving me the opportunityto present its content at an event of The Investment Forum LLC. Thomas Kirchner is The Deal Sleuth 3. Hedge Fund Strategies Let's start with some name dropping. This is John Paulson, who runs a hedge fund firm by the name of you guessed it Paulson & Co. His claim to fame is his pay check for 2007: he is reported to have made $3.7 billion. That's billion with a b.He earned this payout by making a profit of $15 billion for his investors last year. His flagship fund generated a return of 599%. No wonder he looks happy. Thomas Kirchner is The Deal Sleuth 4. Hedge Fund StrategiesThis is George Soros, who runs a hedge fund firm by the name ofSoros Fund Management. He looks unhappy. Maybe because Paulson stole the #1 spot in paychecks for last year.Soros made $800 million less than Paulson, only $2.9 billion. But no worries. Soros became famous in 1992 when he broke thebank of England, netting him $1 billion.A billion dollars was considered a lot of money at thetime. Thomas Kirchner is The Deal Sleuth 5. Hedge Fund Strategies This is Christopher Hohn. He is a relative pauper, apparently worth only a few $100 million. Hegave away most of his money to a children charity. What makes him join the list of billionaires is not his income, but ratherhis losses. The hedge fund he manages reportedly lost $1 billion in a single month,June 2008. The size of his hedge fund went from $8 billion to $7 billion. Let's make clear that Hohn is a very smart guy. He graduated 5th in hisclass from Harvard Business School. But even smart people cangenerate spectacular losses. Just remember Long Term CapitalManagement. Not one, but two Nobel laureates ran this hedge fund thatcollapsed in 1998. Thomas Kirchner as The Deal Sleuth 6. Hedge Fund StrategiesHEDGE FUNDS ARE ALTERNATIVE INVESTMENT STRATEGIESHedge funds are generally associated with big amounts of money, big checks, and big bets. Hedge fundsare considered evil unregulated speculators who push stocks to highs, or crash them. In this e-book, we will take a different look at hedge funds. One of the best ways to look at them is toexamine the investment strategies that they employ.Chart 1 Source Most readers will be familiar with the style boxes. You have probably seen this in you 401(k) plan's literature or elsewhere. This is how investors traditionally have viewed the market. It is a very simple concept: You can invest in large, medium or small companies that either are cheap, grow quickly or are somewhere in between. It is not a very sophisticated approach to investing. It goes back to research done a good two decades ago by two academics and has not changed ever since. Arguably, the markets have changed. Hedge funds take a radically different view of investing. Rather than focusing on characteristics of thecompanies, they have completely different strategies, many of which are quite sophisticated. The chartbelow shows a classification of different hedge fund strategies. Unlike the style boxes of traditionalinvesting, there is no generally accepted standard classification for hedge fund strategies.Chart 2 Fuss, Kaiser and Thomas Kirchner is The Deal Sleuth 7. Hedge Fund StrategiesHEDGE FUNDS HAVE THREE DIFFERENT STYLES AND STRATEGIESThere are three different styles: arbitrage, event-driven and directional. Different strategies are part of eachstyle. ArbitrageBenefits from price discrepancies of otherwise similar securities Equity Market Neutral - Buy one stock and sell short another. For example, sell short an overvalued stock and buy an undervalued one Fixed-Income- Buy high yielding bonds and sell short similar bonds with low yields Convertible Arbitrage - Hedge convertible bonds with stock Event-Driven Takes advantage of mal pricing of corporate events Merger Arbitrage - Capture difference between market price and acquisition price Distressed Securities - Buy bonds of companies in bankruptcy and take ownership when a firm emerges from bankruptcy Special Situations - The above plus investments in other corporate events such as liquidations or spin-offs DirectionalTrade ups and downs in the market Equity Long-Short - Go long or short stocks Managed Futures - Invest in commodities Global Macro - Buy or sell short any asset anywhere in the world based on where the manager thinks the market is heading Although these strategies are usually referred to as hedge fund strategies, they are not only used byhedge funds. A better term is alternative investment strategies, to distinguish them from the traditionalinvestments that most 401(k) investors are limited to.Thomas Kirchner is The Deal Sleuth 8. Hedge Fund Strategies THE EVOLUTION OF HEDGE FUND STYLES OVER TIME If we look at which strategies most hedge funds were invested in in 1990, we see that (Global) Macroaccounted for almost three quarters of all hedge fund assets. If you recall, Global Macro is a directionalstrategy where the manager tries to anticipate the movement of different markets. The perception thatwe have today about hedge funds goes back to the early 1990s, when big trades on market directionwere what most hedge funds did all day long. Chart Thomas Kirchner is The Deal Sleuth 9. Hedge Fund Strategies The situation has changed significantly since then. In early 2007, (Global) Macro accounted for justunder 5% of all hedge fund assets. Hedge funds are now much more evenly spread out among thedifferent strategies. ChartSource of both charts: HSBC Private Hedge funds are now much more evenly spread out among all strategies Thomas Kirchner is The Deal Sleuth 10. Hedge Fund Strategies WHAT MAKES HEDGE FUNDS DIFFERENT If you ask a hedge fund manager about what they do, they will tell you theirstrategy, performance and one other aspect that sets them apart from traditionalmanagers: they depend little on the overall direction of the market. In financialparlance, they have a low correlation to the market. Most investors focus most and foremost on the return of an investment. However,1987-2006an increasing number ofAverage 1987-2006investors are looking toAnnualStandard find investments that notStyle ReturnDeviationonly have a decentMarket Neutral Index 7.954.86return, but also one thatFixed Income Index13.79 22.65 is independent of theConvertible Arbitrage Index9.667.35 market as a whole. OneEvent Driven Index16.02 12.46 that zigs when the marketMerger Arbitrage Index11.299.42Distressed Index16.52 12.38zags. The reason is thatOpportunistic Index 14.66 10.66such investments help toLong/Short Equity Index 13.649.01stabilize the overallGlobal/Macro Index14.8416.5portfolio and reduce theHennessee Hedge Fund Index13.599.28gyrations in the net worthS&P 5009.24 16.15that investors experienceDJIA 9.87 13.96whenever the market goesRussell 2000 9.518.19through a rough period. NASDAQ 10.1630.59 Lehman Brothers Int. Gov. Corp. Bond IndexThe table shows hedge 7.345.24fund returns for theperiod 1987-2006 collected by Hennessee. There are many firms that collecthedge fund data, and each has slightly different numbers; however, they all showthe same effect that we will see in the Hennessee data.Thomas Kirchner is The Deal Sleuth 11. Hedge Fund Strategies A convenient way to visualize the table is a risk/return chart. The best place to be is the top left of thediagram: produce a high return with little risk. This is the holy grail of investing, and as the chart shows,nobody has achieved it yet.Chart Thomas Kirchner is The Deal Sleuth 12. Hedge Fund StrategiesHEDGE FUND SIZE DOES MATTER Risk/return is just one of the tradeoffs of investing, For hedge funds, there is another dimension thatcomplicates the analysis. Larger hedge funds tend to have a lower performance than smaller ones. Chart The chart shows that large funds with more than $1 billion is assets have on average a return that is 2% lower than that of smaller funds with just a few million dollars in assets. This effect does not normally appear in traditional or index investments. In traditional investments, markets are very large and there is almost no practical limit to how much an investors can allocate. For alternative strategies, however, there is often a limit to how much can be invested in the most profitable opportunities. Or conversely, a limited number of very profitable investments is available and additional assets must be invested in lower yielding opportunities. Thomas Kirchner is The Deal Sleuth 13. Hedge Fund StrategiesHEDGE FUNDS ARE NOT FOR EVERYBODYSo why isn't everybody in hedge funds? There are many restrictions that keep most investors out. Most hedge funds are private partnerships that are not registered with the SEC and can not be offered tothe public. The SEC limits the sale of such risky structures to those who can afford to lose their entireinvestment. That means that you need at least $1 million in liquid assets, or an income of $300,000, if youwant to invest. (The SEC is looking at raising these limits) Another restriction c