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LeoGlossary: Hedge Fund

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An actively managed fund for high net worth investors.

A pooled investment fund that trades in liquid assets. Hedge funds can engage in more complex strategies, including trading, portfolio-construction, and risk management techniques than other funds. They can improve performance by engaging in short selling, leverage, and derivatives.

Mutual Funds and Exchange Traded Funds (ETFs) have to avoid leverage and operate within simpler strategies. Hedge funds differ from Private Equity and closed ended funds due to the fact they invest in liquid assets and tend to be open ended.

Hedge fund managers use a range of strategies to beat the average returns. They will invest in esoteric asset classes along with using borrowed assets.

There is a difference between different funds. Not all will operate in the same manner. The profiles of risk, volatility, expected return, and asset focus are unique. How the managers choose to approach the markets is based upon what the fund is designed for. The constant is that all are trying to generate a return regardless of what the markets are doing in terms of direction.

These are considered risky hence usually only open to accredited investors. They are also known to carry some high fees. Typically, one will pay a base management fees, such as 2%, along with a commission on the growth in net asset value (20%). This is known as 2/20.

Best Known Hedge Fund Managers (With their firms)

  • George Soro - Quantum Group
  • Ray Dalio - Bridgewater Assets
  • John Paulson - Paulson & Co
  • John Merriweather - Long Term Capital Management (until it collapsed)
  • David Tepper - Appaloosa Management
  • Steven Cohen - Point72 Asset Management; formerly SAC Capital Advisors
  • Leon Cooperman - Omega Advisors
  • Paul Tudor Jones - Tudor Investment Corporation
  • David Einhorn - Greenlight Capital
  • Bill Ackman - Pershing Square Capital Management
  • Paul Singer - Elliott Management Corporation
  • Michael Hintze - CQS
  • Michael Platt - BlueCrest Capital Management

Strategies

The strategies employed tend to fall into these categories.

They are:

  • global macro
  • directional
  • event driven
  • arbitrage

Each has its own risks and characteristics. Some funds will employ just one, or utilize multiple. There can be overlap among the strategies themselves.

A hedge fund will spell out the details in the prospectus. Here is where the different asset classes employed are listed.

The list can include:

It will also alert investors to the instruments used such as options, futures, forwards, or swaps.

Many will opt to focus upon a specific sector such as energy or healthcare.

Market neutral strategies seek to make a return regardless of direction of the market. Hence, it is not impacted by the overall moves.

Global Macro

Under this strategy, the management of a fund is takes positions based upon a macro outlook. This is based upon the general economy and how it is viewed. Thus, by definition, a global macro is a directional strategy since it seeks to gain a return in alignment with market moves.

Once the direction is figured out, the fund will take large positions in stocks, bonds or currencies to seek a risk adjusted return. All of this includes the timing element. Deciding upon a direction is only a part of the analysis. Seeing the entire picture also means sizing up the time frame and aligning the acquisition of assets based upon that.

Global macro investing can be broken down even further. There is the discretionary approach where managers identify and select specific investment that fit into the fund. This contrasts with the systemic approach which uses mathematical models and software carries out the trades. This reduces the human element in the management of the fund, at least as it relates to the individual trades.

Directional

This is a strategy based upon a conclusion about where markets are going. Like most aspect of the hedge fund world, there are many different categories this can be broke into. There are ones that are domestic in focus while others incorporate international assets. It can be further reduced to things such as emerging markets.

We can also see a short or long bias. This could be coupled with specific sectors in addition to market focus. It can even be drilled down further to employ growth or value strategies.

Event Driven

Here is a strategy that seeks to take advantage of mismatches in value. This is why institutions employ this more than regular funds. They have the resources to go through the corporate transactions to find inconsistencies.

The events in this instance can be bankruptcies, mergers, consolidations, or acquisitions. Basically the fund is looking at the transactional data to find inconsistencies with what is being stated to the general public. If something is found, a few options are presented:

  • Distressed securities: here is where a bankruptcy or liquidation opens up the opportunity to buy bonds or loans in the company at a large discount. This can often prevent the bankruptcy given the fund a chance to profit handsomely off the bonds.

  • Risk arbitrage: done when mergers or acquisitions. This employs the buying and selling of stocks in the two companies to take advantage of the price differences.

  • Special situations: spin-offs, stock buybacks, and other one off events that a hedge fund manager can take advantage of.

Arbitrage

A strategy to take advantage of relative discrepancies in price between securities. This can occur due to mispricing of securities compared to related securities, the underlying security or the market overall.

Portfolio Managers

Hedge fund management firms are typically owned by the portfolio manager. The fees charged to clients is meant to cover the cost of operations. This means the payments tied to the increase in net asset value is the profit for the firm. It is usually paid to the owner of the management firm.

There is a large difference between the compensation for the top hedge fund managers and those who are much further down. This is why some of the wealthiest in this industry are on the billionaires list. The names listed above are the elite, pulling in hundreds of millions (some billions) each year.

General:

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