About Hedge Funds
An Introduction to Hedge Fund Investing
Table of Contents
(Click on each subject title to go directly to the section below.)
DEFINITION AND INVESTMENT MERITS OF HEDGE FUND PRODUCTS
The term “Hedge Fund” is derived from the practice of investment managers who would take long positions in various securities and then “Hedge” against the risk of a general market decline by taking short positions in other securities. Today, the term usually refers to private investment vehicles that may utilize a wide range of investment strategies and instruments. These funds may use short positions and derivatives, utilize leverage and charge incentive based fees. Normally, they are structured as limited partnerships, LLCs (limited liability corporations) or offshore investment companies.
Hedge funds are a subset of the alternative investment asset class. Alternative investments play an increasingly important role for many investors. With typically low correlation to public security strategies, alternatives can add greater diversification and a wider range of return opportunities. Based on the current usage of the term, hedge funds are no more than commingled pools offered to a limited number of investors with the manager of the fund receiving an incentive fee based on the fund’s performance.
Investing a portion of one’s overall public securities portfolio in a variety of hedge fund strategies can reduce exposure to the market risk inherent in traditionally managed, long-only, U.S. equity and fixed-income portfolios. The primary benefit to hedge fund investing is the low correlation many hedge fund strategies maintain to traditional investment exposures. During periods of market volatility and decline, hedge fund strategies typically outperform their conventional, market-dependent counterparts. In addition, hedge fund strategies can provide highly diversified access to instruments, markets and investment techniques.
Hedge fund strategies can provide access to instruments, markets and investment techniques not typically used by traditional investment programs. In addition, hedge funds typically pursue positive absolute returns rather than seeking to outperform a benchmark. Consequently, hedge funds are also described as "absolute-return strategies."
Hedge funds include traditional stock and bond investments, but generally combine these with short sales, arbitrage and leverage not generally found in traditional stock and bond market strategies. When investing in hedge funds it is important to understand these three terms. 1) Short sales involve the sale of borrowed securities considered overvalued with the intent to purchase them later at lower prices to make a profit. 2) Arbitrage strategies attempt to exploit temporary price discrepancies between similar securities through buying the cheaper one and selling short the more expensive one. 3) Leverage involves borrowing money to increase the effective size of the portfolio. Leverage increases risk and profit potential.
There are four main types of hedge funds, each of which may employ sub-strategies or combinations of strategies:
Market neutral or relative value funds encompass a range of funds that invest in bonds and/or equity, but are not dependent on the direction of market movements. Managers seek to exploit market inefficiencies or mis-pricing and balance long and short market exposures. Returns are typically uncorrelated with other asset classes.
Event driven funds pursue strategies largely unaffected by the direction of equity and bond markets with investment based on the actual or anticipated occurrence of a particular event, such as a merger, bankruptcy or corporate re-organization. Returns tend to have low correlation with other asset classes.
Long/short strategies invest 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 towards long market exposure.
Tactical trading funds speculate on the direction of market prices of currencies, commodities, equities and/or bonds in the futures and cash markets. This is the most volatile hedge fund category in terms of performance. Correlation of returns with traditional asset classes is low.
Despite this variety, characteristics common to most hedge funds include:
- The objective of securing absolute returns – the achievement of a stipulated level of gain rather than relative performance to a benchmark.
- The ability to sell short.
- The goal of producing positive returns in all market conditions.
Investing a portion of one’s overall public securities portfolio in a variety of hedge fund strategies can reduce exposure to the market risk inherent in traditionally managed, long-only, U.S. equity and fixed-income portfolios. One of the main benefits to hedge fund investing is the low correlation many hedge fund strategies maintain to traditional investment exposures. During periods of market volatility and decline, hedge fund strategies can outperform their conventional, market-dependent counterparts. Incorporating absolute return funds into a traditional portfolio can provide added diversification and risk reduction.
Back to top ^
FUND-OF-HEDGE-FUNDS
A fund-of-hedge-funds (or multi-manager fund) will invest its capital in several unrelated hedge funds rather that allocate all assets to a single fund manager. This permits greater diversification with the same amount of dollars than could otherwise be attained by investing in a single fund. In addition, a fund-of-hedge-funds manager can perform the due diligence and fund monitoring on the individual managers that are critical to a successful hedge fund allocation.
Back to top ^
TAXATION
A major investor concern in the alternative investment sector has been the potentially significant tax liability created by hedge fund investments. As limited partnerships, investments in hedge funds produce taxable income every fiscal year, regardless of whether the fund made any distributions. The trading strategies employed by the majority of hedge fund managers are generally short-term in nature and, thus, taxable at the 40% short-term ordinary income tax rate regardless of how long the fund is held. As such, some investors have been leery to use alternative investment strategies as part of their long-term investment planning. Recent developments in the financial markets have, however, resulted in the creation of international insurance and swap contracts that could quell some of these concerns. These new contracts offer the maximum in tax efficiency, while enabling the investor to use hedge funds that engage in short-term trading strategies.
Back to top ^
TRANSPARENCY
The literal meaning of transparency is the state of being easily detected or seen through, readily understood, or free from pretense or deceit. But transparency of a different variety has become a central theme of discussions concerning alternative investments, and in particular, hedge funds. Transparency in this sense refers to the ability of the investor to look through a hedge fund to its investment portfolio to determine compliance with the fund’s investment guidelines and risk parameters. Transparency essentially allows investors to see what the manager is doing with their money.
More transparency is simply a better way to gauge if managers are performing well on a risk-adjusted basis. Transparency can also allow the investor to minimize exposures to certain investments made by the hedge fund manager. At first glance, the request for transparency seems like a reasonable one. After all, investors would certainly not engage in blind trust with hedge fund managers who are managing a sizable portion of their wealth. They would undoubtedly want to monitor not only the overall performance of the manager, but also the nature of the trading activity and the risks undertaken. In comparison, mutual funds are required by the SEC to offer total transparency.
Indeed, some of the smaller hedge fund managers are finding that they have to provide more information about where they are investing in order to attract capital.
While many smaller hedge fund managers are increasing the transparency they provide, some of the larger managers are taking the opposite approach. They do not necessarily need to attract more capital and, thus, are giving as little disclosure as possible. In essence, there is a selection bias that is taking place. Large hedge fund managers probably do not want to attract investors who are intent on scrutinizing the details of the portfolio. Rather than explicitly excluding these investors, the managers choose not to disclose information that these investors want, which results in the investors fleeing to another manager that will fulfill their requests.
Back to top ^
ACCREDITED INVESTOR
An Accredited Investor is: 1) an individual who has made $200,000 per year in income for the past two years and has a reasonable expectation of doing so in the future; 2) an individual and spouse with aggregate income of $300,000 per year, or 3) an individual with a net worth of $1 million or more, excluding home and automobile. Certain hedge fund structures require that investors be “Accredited.”
Back to top ^
QUALIFIED PURCHASER
A “Qualified Purchaser” as defined in Section 2(a)(51) of the Investment Company Act of 1940, is an individual with a $5 million investment portfolio or an institution with a $25 million portfolio. Certain hedge fund structures require that the investors be “Qualified Purchasers.”
Back to top ^
RISKS OF HEDGE FUND INVESTING
Alternative investment strategies can reduce portfolio risk, however the method of accessing these strategies can increase portfolio risk. The major risks include misrepresentation of investments, forbidden exposure (i.e. excessive leverage, position or sector overlap/concentration), strategy or style drift, and inappropriate valuation methods.
Back to top ^
SUMMARY
At the core of a non-traditional investment strategy is a compelling argument for hedge funds. Broadly defined, hedge funds are private partnerships wherein the investment manager/general partner is free to operate in a variety of markets, employ investment strategies with variable long/short positions, and augment their exposures through leverage. It is the hedge fund manager’s opportunistic approach, flexibility, responsiveness, and orientation toward producing absolute returns, which are derived from skill-based strategies rather than broad market movements that make these investment vehicles inherently attractive.
Since 1992, LJH has dispelled many popular misconceptions that all hedge funds are speculative and risky by successfully employing a diversity of hedged investment strategies that have earned its principals and clients attractive risk-adjusted rates of return. By strategically allocating assets to investment strategies that have the ability to profit under various market climates and generate returns that are low-to-negatively correlated with one another, LJH has constructed tailored portfolios that have time and again validated the attractiveness of alternative investments.
What distinguishes LJH from its peers is an approach that is founded on principal investing and a manager selection and portfolio management process that is based on thorough, unmatched due diligence.
The hedge fund industry tends to be somewhat of a closed society, based on long standing personal relationships. And while LJH subscribes to the leading third party subscription data services, professional guidance that is generated by primary research from an insider is a prerequisite to achieving a successful outcome. As a recognized long-term consumer within the industry, LJH is always privy to the best information available.
Once a prospective strategy or manager has been identified, LJH performs comprehensive due diligence procedures to fully understand the strategy and manager’s background. The specialized nature of alternative investments requires a specialized due diligence process. The four main elements of LJH’s evaluation process are the collection and analysis of partnership documents, quantitative analysis of returns, background and reference checks, and lastly, on site interviews. After the initial due diligence and manager selection is complete, on going monitoring is imperative. This process includes monthly calls to manager, evaluation against peers and the extent that the manager is meeting expectations set during due diligence.
Back to top ^
|
