Hedges on Hedge Funds: How to Successfully Analyze and Select an Investment

Overview

Hedges onHedge Funds

It's all about hedge funds—what they are, why they are so successful, and how you can become a hedge fund investor for as little as $25,000

Hedge funds are among today's most controversial investment vehicles. They are also among the most successful, significantly outperforming the S&P 500 since 1989 on both an average-return and risk-adjusted basis.

And hedge funds aren't just for the...

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Overview

Hedges onHedge Funds

It's all about hedge funds—what they are, why they are so successful, and how you can become a hedge fund investor for as little as $25,000

Hedge funds are among today's most controversial investment vehicles. They are also among the most successful, significantly outperforming the S&P 500 since 1989 on both an average-return and risk-adjusted basis.

And hedge funds aren't just for the super-wealthy anymore. Hedges on Hedge Funds takes an inside look at hedge funds, helping investors of virtually every size understand:

  • How a hedge fund works, including what a hedge fund is and what it is not
  • The three categories of hedge funds, and how to use them to actually reduce portfolio risk
  • Funds of hedge funds, which make theselucrative vehicles available to more investors than ever before

Investors in today's tumultuous markets can't afford to overlook any possibilities, especially those with proven track records of success. Hedges on Hedge Funds removes the veil of secrecy from hedge funds, revealing how and why they consistently outperform markets—and how to make them a valuable component of your investment portfolio.

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Editorial Reviews

From the Publisher
“…the book is to be praised for its emphasis on the need for thorough due diligence before entrusting one’s money to a hedge fund…” (Professional Investor, May 2005)
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Product Details

  • ISBN-13: 9780471625100
  • Publisher: Wiley
  • Publication date: 11/28/2004
  • Series: Wiley Finance Series , #254
  • Edition number: 1
  • Pages: 232
  • Product dimensions: 6.32 (w) x 9.35 (h) x 1.04 (d)

Meet the Author

James R. Hedges IV is the founder, President, and CIO of LJH Global Investments, which has offices in Florida, New York, and London. LJH is an investment advisory firm that helps clients select and invest in hedge funds. James is recognized as a pioneer in the hedge fund industry for his efforts to monitor and review funds and fund managers for performance and transparency. His efforts to advocate for investors have made LJH a watchdog for the industry—so much so that the SEC asked him to participate in their Hedge Fund Roundtable in May of 2003. James is often quoted in such publications as Forbes, Institutional Investor, Barron's, the New York Times, and the Wall Street Journal. He appears regularly on CNN, CNBC, Bloomberg, and Wall $treet Week.

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Table of Contents

Foreword.

Preface.

Acknowledgments.

CHAPTER 1: The Hedge Fund Alternative.

CHAPTER 2: Cutting through the Black Box: Transparency and Disclosure.

CHAPTER 3: The Operational Risk Crisis.

CHAPTER 4: Best Practices in Hedge Fund Valuation.

CHAPTER 5: Does Size Matter?

CHAPTER 6: Directional Investing through Global Macros and Managed Futures.

CHAPTER 7: Profiting from the Corporate Life Cycle.

CHAPTER 8: Evaluating Arbitrage and Relative Value Strategies.

CHAPTER 9: The Time Is Now for Equity Market Neutral.

CHAPTER 10: Long-Short Strategies in the Technology Sector.

CHAPTER 11: The Expansion of European Hedge Funds.

CHAPTER 12: The Dynamic World of Asian Hedge Funds.

CHAPTER 13: Hedge Fund Indices: In Search of a Benchmark.

GLOSSARY.

ABOUT THE AUTHORS.

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First Chapter

Hedges on Hedge Funds

How to Successfully Analyze and Select an Investment
By James R. Hedges, IV

John Wiley & Sons

ISBN: 0-471-62510-8


Chapter One

The Hedge Fund Alternative

SUCCESSFUL INVESTING REQUIRES KNOWLEDGE

The first step in being a successful investor in hedge funds or other types of investments is getting in the driver's seat and learning everything you can about timely opportunities and how they mesh with your objectives. Cruising along, pursuing the same investment philosophy that you have used for years, is certainly an option, and if you are achieving the returns you want, that is a wise road to follow. However, if you are like most investors, it is likely your investment process could use a boost. Exploring the addition of hedge funds to your portfolio is a good use of your time and effort, and you are smart to learn everything you can about this asset class.

What exactly is a hedge fund? For years, hedge funds have been the subject of cocktail party talk and an oft-discussed subject for news articles and business shows. Unfortunately, most investors do not really understand hedge funds or how they differ from traditional stock and bond investments. One of the common comments is that hedge funds are risky, a belief fueled by misconceptions and a lack of understanding in the area. For instance, the very meaning of "hedge" implies reducing risk. Hedge funds continue to spark the curiosity of investors, yet with that curiositycomes a need to better understand the industry and its respective strategies. Before thinking about whether to invest in hedge funds, investors need a clear understanding of what a hedge fund is, what it is not, and how it works. (See Table 1.1.)

Basically, hedge funds are considered to be a type of alternative investment, along with venture capital and private equity funds, real estate, and commodities. (See Figure 1.1.) The term "hedge fund" is derived from the practice of investment managers who took long positions in various securities and then hedged against the risk of a general market decline by taking short positions in other securities. In practice, the term has a much broader usage, generally referring to private investment vehicles that, by availing themselves of certain exemptions allowed in current securities laws, may utilize a wide range of investment strategies and instruments.

In the simplest, formal terms, hedge funds are little more than commingled pools of capital structured as limited partnerships, limited liability corporations, or offshore investment companies, offered exclusively via private placements to a relatively limited number of accredited investors who meet certain predetermined qualifications set forth in federal securities laws. These laws provide strict criteria for those eligible to invest in hedge funds. Hedge funds require that at least 65 of their 99 allowed investors be accredited, as defined as an individual or couple with a net worth of at least $1 million, or an individual who had an annual income in the previous two years of at least $200,000 ($300,000 for a couple). In reality, a potential hedge fund investor needs more than that to be fully diversified and qualify to meet the fund's minimum investment requirements. Minimum requirements range from $250,000 to $10 million, and the most common ones range between $500,000 and $1 million. New regulations allow for up to 499 investors per hedge fund as long as all the investors are qualified purchasers, which are defined as individuals with at least a $5 million liquid net worth. (See Table 1.2.)

Securities laws also regulate how hedge funds may obtain assets. Hedge funds are not allowed to engage in any form of public solicitation of funds but can acquire funds only through means of completely private introductions or existing relationships. The thinking behind these regulations is that such investors are sophisticated enough to understand the kinds of investment techniques a hedge fund manager may employ and thus appreciate and withstand the kinds of risks being taken. However, these two components of the regulatory structure help to foster an image of the industry as exclusive, elite, and secretive. The Securities and Exchange Commission (SEC) currently is reviewing the subject of hedge fund marketing as part of its ongoing review of hedge funds; investors may see changes to these rules in the coming years.

Another significant defining attribute of hedge funds deals with the fees charged. In contrast to traditional long-only investment managers, most hedge fund managers charge their clients an incentive fee in addition to a standard management fee. The most common fee structure includes an annual management fee of 1 percent of assets under management and 20 percent of the net annual return. Much of the continued strong growth of the hedge fund industry stems from this factor alone. Because of the potential to earn significantly more money as a hedge fund manager than as an employee of a large financial institution, the motivation to start and manage a hedge fund is compelling. Indeed, large, successful hedge fund managers can earn multimillion-dollar salaries, and clients typically do not mind paying high performance fees when the manager is achieving strong, justifiable results.

The investment industry has come to use the term "alpha" (in distinction to "beta," referring to the normal return of any given market or security) to refer to both the ability of a manager to outperform a benchmark and to the degree of outperformance itself.

Thus, it is helpful to think of a hedge fund as an investment vehicle where the preponderance of the return comes from the skill of the trader rather than the return of the markets. Although not without disadvantages, this arrangement is generally accepted as an essential dynamic of hedge fund performance and worth the price for superior investment returns.

HEDGE FUND DISTINCTIONS

Several other attributes differentiate hedge funds from other investment vehicles.

Investment Strategies

Traditional investment advisors are limited in their investment options, whereas alternative investment advisors are opportunistic. Alternative investment managers can take larger position sizes, invest across asset classes and security types, and employ strategies whose returns generally come from the exploitation of market inefficiencies, not market movements. Alternative investment strategies are also dynamic by nature. Fund managers can use leverage and sell securities short to vary market exposure actively. Alternative investment returns are therefore a product of how the manager invests, not just where the manager invests.

Return Objectives

The concept of absolute versus relative returns is central to the alternative investment sector. Unlike traditional investment managers driven by index weightings, nontraditional managers invest for absolute returns, not returns relative to the broad market. Most of the returns from alternative investment strategies come from the skill of the manager rather than the returns of an asset class. Table 1.3 presents characteristics of hedge fund strategies.

Minimum Investment Requirements

For the most part, due to the limited number of clients who can be invested in a fund, the minimum investments steadily increase as the years go by. A manager's initial minimum may be as low as $250,000 or $500,000, but can quickly increase by a multiple. There is no short-age of tier 1 investment managers who have minimum requirements in excess of $10 million. As institutions play an increasing role in the alternative investment arena, fund managers often are induced to take on as clients institutions rather than private individuals who, in most cases, allocate substantially smaller amounts.

Coinvestment Opportunities

Hedge fund managers tend to invest a significant portion of their own capital in their partnerships, thereby reinforcing their commitment to their fund's performance. This aspect differs greatly from the world of traditional investment advisors where, for regulatory reasons, managers often are discouraged from purchasing their own proprietary product.

Liquidity

Unlike managed accounts or mutual funds, alternative investment vehicles may typically require a lock-up of 12 months before withdrawals are permitted. Some offshore funds offer liquidity as frequently as weekly, but certain onshore long-term investment pools may require commitments of up to 4 years. It is important to make sure that the fund's liquidity constraints are in keeping with industry norms for the strategy employed.

Access and Transparency

The limited partnership format provides the manager with flexibility to deliver returns that would not be possible through other formats, but it also obscures a client's ability to monitor investment activities. Furthermore, many managers are hesitant to allow clients to second-guess their judgment in short-term increments. Without special considerations, it can be exceedingly difficult to monitor whether a manager is diverging from the stated strategy, inappropriately using derivatives or leverage, or engaging in other unacceptable behavior.

Beyond the formal characteristics of what defines a hedge fund, how do hedge funds actually attempt to pursue their investment objectives? Although there are several competing ways to classify and name the many hedge fund styles and strategies, three broad categories should be useful for introductory purposes: (1) directional, (2) nondirectional, and (3) event-driven/opportunistic.

DIRECTIONAL STRATEGIES

This category includes those funds seeking returns based on trend-following trades or market directional investments that may be hedged or unhedged. Global macro, long/short strategies, and short selling are typical directional strategies.

Global Macro

Perhaps the most prominent of the directional strategists are the global macro managers. These institutional managers run large and highly diversified portfolios designed to profit from major shifts in global capital flows, interest rates, and currencies. Commodity trading advisors also are placed into this category if they are running a nondiscretionary, or systems trading, program. Global macro funds represent the purest form of a top-down approach to hedge fund investing. The primary strategy of the macro fund managers is an opportunistic approach based on shifts in global economies. Global macro managers speculate on changes in countries' economic policies and shifts in currency and interest rates via derivatives and the use of leverage. Portfolios tend to be highly concentrated in a small number of investment themes, and typically place large bets on the relative valuations of two asset categories. Global macro managers structure complex combinations of investments to benefit from the narrowing or widening of the valuation spreads between these assets in such a way as to maximize the potential return and minimize potential losses. In some instances, the investments are designed specifically to take advantage of artificial imbalances in the marketplace brought on by central bank activities.

Long/Short Strategies

Long/short funds constitute in aggregate the largest single approach to hedge fund investing. This strategy involves investing in equity and/or bond markets combining long investments with short sales to reduce, but not eliminate, market exposure and isolate the performance of the fund from the performance of the asset class as a whole. Returns can be more correlated with other asset classes due to bias toward long market exposure. Hedged equity funds invest both long and short and adjust the ratio of the long and short positions to capitalize on market trends. Financial leverage is used to varying degrees depending on the manager's investment process. Options, futures, and derivative securities also can be used either to hedge (i.e., control risk) or to enhance returns by providing additional leverage. Long/short funds can be categorized further by geography or sector, although due to particularities of either certain geographies or industry sectors, they also might be more appropriately considered opportunistic.

Short Selling

Short sellers are the ultimate directional managers because they take bets on a market downturn. This strategy is based on the sale of securities that are believed to be overvalued from either a technical or a fundamental viewpoint. The investor does not own the shares sold, but instead borrows them from a broker in anticipation that the share price will fall and that the shares may be bought later at a lower price to replace those borrowed from the broker earlier. Short sellers typically focus on situations in which they believe stock prices are being supported by unrealistic expectations. Misleading accounting practices and managerial fraud result in some of the most profitable investments. One risk unique to short selling is the short squeeze, in which buyers drive prices up to force the short sellers to cover their positions.

NONDIRECTIONAL STRATEGIES

Nondirectional strategies are not dependent on the direction of any specific market and are commonly called specific forms of arbitrage, market-neutral, or relative value investing. In other words, these strategies seek to effectively neutralize market influences and to profit only from capturing the difference in price between two related securities. Because the price discrepancies these funds seek to capture are generally quite small, these funds often can involve the use of large amounts of financial leverage. Some of the principal strategies in this category include:

* Convertible arbitrage

* Fixed-income arbitrage

* Income arbitrage

* Closed-end fund arbitrage

* Equity market neutral

Convertible Arbitrage

Convertible arbitrageurs are simultaneously long the convertible securities and short the underlying equities of the same issuer, thereby working the spread between the two types of securities. Returns result from the difference between cash flows collected through coupon payments and short interest rebates and cash paid out to cover dividend payments on the short equity positions. Returns also can result from the convergence of valuations between the two securities. Risk originates from the widening of the valuation spreads due to rising interest rates or changes in investor preference. The focus of investments can be nation-specific or global in nature. Convertible arbitrage generally is considered a relatively conservative strategy with moderate expected volatility. Certain managers, however, have chosen to enhance the expected return by leveraging their holdings, which also can increase volatility, depending on how the positions are structured.

Fixed-Income Arbitrage

Fixed-income arbitrage involves taking long and short positions in bonds and other interest-rate-sensitive securities.

Continues...


Excerpted from Hedges on Hedge Funds by James R. Hedges, IV Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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  • Anonymous

    Posted December 10, 2004

    Best education available from a guy who's been around

    this book is a fast paced multi-faceted intro to the complex hedge fund world. Hedges gives readers a lots of helpful tips on due diligence

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