hi everyone in today's video we will
talk about hedge funds an exciting and
fascinating topic provided that hedge
funds are in the business of making
money out of thin air figuratively
speaking before we start we'll make some
clarifications regarding the common
legal and fee structures of alternative
investments both hedge and private
equity funds are usually set up and run
as limited partnerships or LP this type
of legal structure includes general
partners or GPS and limited partners LPS
GPS are responsible for managing a given
investment fund they have unlimited
liability LPS on the other hand are the
investors in the fund they have limited
liability and a profit share
proportionate to their investment
limited partnerships are usually based
on tax efficient locations they aren't
subject to strict regulations as they
are not typically offered to the general
public
instead LPS are restricted to qualified
investors such as institutions and high
net worth individuals these investors
are generally expected to be more
knowledgeable and able to take higher
risks the common fee structure of
alternative investment funds includes a
management or base fee and an incentive
or performance fee the management fee is
calculated annually on assets under
management or AUM the incentive fee also
known as a hurdle rate is usually
calculated on profits above a certain
level of return another widely used
feature is the so called high watermark
this is the highest net asset value or
nav that a fund has reached and for
which a performance fee is paid setting
a high watermark protects investors from
paying fees on downside out performance
it also ensures that they won't pay
twice for the same increase in net asset
value or nav in other words when high
watermarks are in place fund managers
must recover any losses before charging
a performance fee on newly generated
profits that said we can now start
examining hedge funds in more detail in
trying to beat the market these
investment vehicles deploy a variety of
strategies such as the use of leverage
Rivet ifs and taking short positions
hedge fund performance is measured
either in terms of an absolute return
for example 15% or on a relative basis
versus a benchmark index for example 10%
above
S&P 500 redemption turns include a
lock-up period during which investors
cannot withdraw the money they have put
in a given hedge fund the notice period
is also part of the redemption terms it
usually lasts between 1 and 3 months
this restriction is posed for a reason
it often happens that hedge fund
managers need to exit illiquid positions
and convert holdings into cash the
notice period gives them time to do that
in an orderly manner
hedge funds may have redemption fees
intended to offset any transaction costs
incurred in this process ok before
moving on it is worth mentioning the so
called funds of hedge funds they provide
access to a diversified portfolio of
hedge funds and allow smaller investors
to participate great now let's take a
look at some of the typical hedge fund
strategies more precisely
we'll discuss four main categories of
hedge funds these are the event-driven
relative value global macro and equity
hedge funds
event-driven strategies are based on
various corporate actions such as
mergers acquisitions or restructuring
they entail taking long or short
positions in equity or debt securities
of the companies involved here we have a
couple of subcategories merger arbitrage
involves buying the shares of an
acquisition target company and selling
short the shares of the buyer this
strategy is expected to profit from the
spread between prices of the respective
shares or from potential overpayment by
the acquirer the main risk involved here
is that the deal may not close
distressed or restructuring strategies
involve investing in companies in
financial distress or in other words
firms that are about to file or have
already filed for bankruptcy in such
cases fund managers may choose to take
it long or short position in the debt or
equity securities of the distressed
company when taking a long position they
bid on a successful restructuring thus
they buy the company's securities at a
discount and expect a profit from a
price recovery on the other hand a short
position is expected to be profitable in
case of an unsuccessful restructuring
when going short fund managers usually
pick securities with lower investor
protection such as junior debt or common
stock these two approaches can also be
combined by simultaneously taking a long
position in senior debt and a short
position in junior debt or equity in
this case the hedge fund manager expects
to profit from an increase in the price
spread between the two classes of
securities activist
investing is another strategy based on
triggering corporate actions activist
hedge funds buy a sufficiently large
shareholding in a company with the
intention to influence its management
they would require the implementation of
various corporate actions and strategies
to increase the company's value these
may include divestitures restructuring
capital distribution or changes in
management activist investing resembles
the approach of private equity funds in
trying to gain control over a company
however the key difference here is that
activist investors focus on public
companies lastly special situations
funds invest in companies that are
undergoing
sort of restructuring other than mergers
acquisitions in bankruptcy
these include spin-offs asset sales and
share buybacks okay great
as we've seen event-driven strategies
can be quite interesting now let's
consider the relative value strategies
they focus on taking long and short
positions in related securities and
profiting from a temporary discrepancy
in their perceived price relationship
again we have several subcategories here
the first one is called fixed income
convertible arbitrage it exploits any
miss pricing of convertible bonds this
strategy involves taking a long position
in a convertible bond in a short
position in the common stock of the same
company asset-backed fixed income is
another relative value strategy it uses
opportunities that arise from mispriced
asset backed securities or abs and
mortgage-backed securities or MBS
general fixed income strategies exploit
various pricing discrepancies within
fixed income markets
these may include relative value
positions between two different
companies or between various securities
of the same company we also have
volatility strategies they typically use
various derivative financial instruments
to go long or short on market volatility
in a single asset class or across
different classes multi-strategy funds
as the term suggests deploy various
existing strategies to use relative
value opportunities across asset classes
great we're moving on to the third
category of strategies used macro hedge
funds rather than analyzing specific
companies they look for opportunities
arising from global economic and
political events macro hedge funds bet
on global market trends by taking long
or short positions across equities
derivatives fixed income currencies and
commodities
and finally we have equity hedge fund
strategies that involve taking long and
short positions in public equities in
related derivatives they differ from the
event-driven or macro strategies by
using a bottom-up rather than a top-down
approach here are the most common
variations of the equity hedge fund
strategies market neutral strategies
focus on selecting undervalue securities
to buy and overvalued ones to sell short
hedge fund managers do that by using
quantitative technical or fundamental
analysis the overall goal is to keep a
net neutral market position and profit
from individual securities movements
next we have the fundamental growth
strategies they use fundamental analysis
to identify and take long positions and
companies with high growth potential on
the other hand fundamental value
strategies take long positions in
various undervalued companies including
non high-growth firms quantitative
directional strategies use technical
analysis to select undervalued stocks to
buy and overvalued ones to sell short
net market exposure may vary depending
on the relative size of long and short
positions taken short by a strategies as
the term suggests take predominantly
short market exposure in companies that
are considered as overvalued and finally
sector specific strategies focus on a
specific sector of expertise and use
quantitative and fundamental analysis to
identify different investment
opportunities a lot of strategies right
in practice many hedge funds begin by
employing only one of them over time
they develop additional expertise and
expand to become multi strategy funds
well done our next task is to examine
the potential benefits and risks of
hedge funds the benefits are most
visible in down equity markets where
hedge funds typically perform better
than global equity markets long-term
correlation with equities can also
provide diversification benefits of
course these benefits vary according to
the specific hedge fund strategy because
of the great variety of hedge fund
strategies and the tendency for
correlations to increase
during periods of market turmoil we
should be careful when generalizing
about the diversification benefits of
hedge funds
moreover doing due diligence on hedge
funds can be quite challenging overall
these investment vehicles have light
regulatory disclosure requirements and
this potentially makes them less
transparent to sum up when assessing
hedge funds we need to focus on the
following questions what are the
strategy and investment processes they
use what are their historical returns
longevity amount of assets under
management valuation and returns
calculation methods what are their
management styles key person risks and
risk management systems and what are
their sources of competitive advantage
reputation and growth plans some of
these factors are difficult to quantify
even the ones that seem more
straightforward like returns for example
can present challenges to investors
for instance strategies that have been
successful in the past may decrease in
effectiveness as more funds begin to use
them okay great this is the end of
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so much for sticking till the end I'll
see you in our next episode