Certificate for Introduction to Securities & Investment (Cert.ISI) Unit 1 Lesson 60:  Hedge funds: basic characteristics  Risk and risk types  Cost and liquidity  Investment strategies 60cis

Hedge funds Why are they called “hedge” funds? Let’s go back to basics: the purpose of a hedge is to mark a boundary, or to form a barrier against something. Farmer plant and lay hedges to mark the boundaries of their fields and to prevent livestock from entering or escaping.

Hedge funds From that original concept derives the expression “to hedge against” something, meaning to guard against the risk of loss. To “hedge one’s bet” is to ensure you don’t lose everything if your instinct proves to be wrong: you are not committing yourself completely. Race-course book-makers will often hedge, or lay off, their bets by taking out smaller, opposite bets with other book-makers. This web-site calculates the amount you need to 'lay off' a bet made with a bookie. This will ensure that, whatever the outcome, you end up with the same profit or loss. This technique is extensively used by people who want to place qualifying bets with a bookie in order to earn free bets later.

Hedge funds In their original form, hedge funds sought to eliminate or reduce market risk They would do so by going both “long” and “short” the same or similar financial assets, or by using derivatives to lay off some of the investment risk.  To go “short” means selling a security that the investor does not at that time actually own, in the hope of buying them back more cheaply if (as the investors expects), the market subsequently falls.  To go “long” means buying a security  Hedge funds are “active” investors  They do not passively track an index The aim of most hedge funds is to achieve “absolute return” – a growth in their investment fund, regardless of whether the underlying market goes up or down.  They are not interested in “relative outperformance” of a stock market

Hedge funds Because most hedge fund aim for “absolute return”, they do not play safe like index-trackers. For this reason, hedge funds are seen as having higher risk. Some hedge funds do indeed adopt highly risky investment strategies. But some are very risk-averse. It is difficult to generalise about the sector.  Some hedge fund strategies are very complex  They place a greater emphasis on producing highly geared returns than on controlling market risk Ungeared investment strategy Geared investment strategy

Hedge funds Many hedge funds have high minimum investment levels. Access is therefore restricted to wealthy investors and institutions  Traditional hedge funds are open only to wealthy investors Small investors can gain access to hedge funds through funds of hedge funds  Most hedge funds require minimum investments in excess of £50,000  Some hedge funds are aimed at the very wealthy with at least £1 million in liquid net worth. Hedge fund manager Arki Busson Hedge fund manager Chris Hohn Hedge fund manager John Paulson

Hedge funds Most hedge funds are established as unauthorised collective investment schemes. Therefore, they are unregulated. Unauthorised investment schemes cannot be marketed to private individuals because they are considered too risky for the less financially sophisticated investor Because they are not subject to the same level of regulation as traditional investment schemes, hedge funds have much more flexibility on the type of investments they can make  To avoid regulation even further, some hedge funds limit the number of individual investors in their funds to 99 or less. LOTS OF MONEY  Long and short and derivative positions in…  Shares  Bonds  Commodities  Currencies  Interest rates  Property

Hedge funds Hedge funds charge their investors performance-related fees, in addition to the usual management fees charged by most growth funds. If the fund achieves certain levels of performance (i.e. growth in value from the previous high), these performance fees can be substantial To ensure liquidity, hedge funds will often impose an initial “lock-in” period before investors can cash in their investment  The lock-in period is usually one-to-three months after the initial investment Source: Eurekahedge.com  It is quite common for hedge funds to charge 20% of the “net new high”. Hedge Fund performance, 2010

Hedge funds Most hedge funds appoint a prime broker to handle their transactions. A prime broker is usually an investment bank. The investment bank will transact most of the buying and selling on behalf of the hedge fund, and act as custodian and settlement agent for the assets.  Prime brokerage can be very profitable business for an investment bank  The Prime Broker earns fees on financing the hedge fund’s long and short cash and securities positions, and by charging fees for settlement and custodian services. Large investment banks compete heavily to win prime brokerage mandates