Submitted By: Nirdesh Mann Bhupesh Gupta Nitin Sharma Kumar Abhisekh Kewat Namit

Submitted To: Tushar Tantia

What is Hedge Fund? Strategies of Hedge Fund Mutual Fund v/s Hedge Fund Fund of Hedge Fund Hedge Fund Risk Advantages & Disadvantages Important Data Measuring the performance of Hedge Fund Examples

 A hedge fund is a fund that can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk. Hedge fund strategies vary enormously -- many hedge against downturns in the markets -- especially important today with volatility and anticipation of corrections in overheated stock markets. The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions.

 Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded.

Hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as puts, calls, options, futures, etc.). Hedge funds benefit by heavily weighting hedge fund managers remuneration towards performance incentives, thus attracting the best brains in the investment business.

There are approximately 14 distinct investment strategies used by hedge funds, each offering different degrees of risk and return.

1. Aggressive Growth
Invests in equities (often smaller or micro cap stocks for rapid growth) Hedges by shorting equities where earnings disappointment is expected. Expected Volatility: HIGH

2. Distressed Securities
Buys equity, debt, or trade claims at deep discounts of companies in or facing bankruptcy or reorganization. Profits from the markets lack of understanding of the true value of the deeply discounted securities and because the majority of institutional investors cannot own below investment grade securities. Expected Volatility: LOW-MODERATE

3. Emerging Markets:
Invests in equity or debt of emerging (less mature) markets which tend to have higher inflation and volatile growth. Expected Volatility: VERY HIGH

4. Fund of Funds
Mixes and matches hedge funds and other pooled investment vehicles. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds. Returns, risk, and volatility can be controlled by the mix of underlying strategies and funds. Capital preservation is generally an important consideration. Expected Volatility: LOW-MODERATE

5. Income
Invests with primary focus on yield or current income rather than solely on capital gains. May utilize leverage to buy bonds and sometimes fixed income derivatives in order to profit from principal appreciation and interest income. Expected Volatility: LOW

6. Macro
Aims to profit from changes in global economies, typically brought about by shifts in government policy which impact interest rates, in turn affecting currency, stock, and bond markets. Invest in equities, bonds, currencies and commodities. Expected Volatility: VERY HIGH

7. Market Neutral Arbitrage

Taking offsetting positions, often in different securities of the same issuer. (may use futures also. to hedge out interest risk) Example: Long Convertible bonds and Short on underlying equity Focuses on obtaining returns with low or no correlation to both the equity and bond markets. Expected Volatility: LOW

8. Market Neutral- Securities Hedging

Invests equally in long and short equity portfolios generally in the same sectors of the market. Sometimes uses market index futures to hedge out systematic risk. Relative benchmark index usually T-bills. Expected Volatility: LOW

9. Market Timing
Allocates assets among different asset classes depending on the managers view of the economic or market outlook. Expected Volatility: HIGH

10. Opportunistic
Changing its strategy as different opportunities arises such as IPO, sudden prices change due to interim earnings, hostile bids etc. Expected Volatility: VARIABLE

11. Multi Strategy

This style of investing allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities. Expected Volatility: VARIABLE

12. Short Selling:

Sells securities short in anticipation of being able to rebuy them at a future date at a lower price due to the managers assessment of the overvaluation of the securities, or the market, or in anticipation of earnings disappointments often due to accounting irregularities, new competition, change of management, etc. Expected Volatility: VERY HIGH

13. Special Situations

Invests in event-driven situations such as mergers, hostile takeovers, reorganizations, or leveraged buy outs. May involve simultaneous purchase of stock in companies being acquired, and the sale of stock in its acquirer, hoping to profit from the spread between the current market price and the ultimate purchase price of the company. Results generally not dependent on direction of market. Expected Volatility: MODERATE

14. Value
Invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth. Such securities may be out of favour or underfollowed by analysts. Long-term holding patience required untill the value is recongized by the market. Expected Market: LOW-MODERATE

A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors and invests typically in investment securities (stocks, bonds, short-term money market instruments, other mutual funds, other securities, and/or commodities such as precious metals). The mutual fund will have a fund manager that trades (buys and sells) the fund's investments in accordance with the fund's investment objective.

Mutual Funds

Hedge funds

A mutual fund is a company, which takes money in from investors and then purchases investments with that money. Investors are given shares in the fund in exchange of their money and there is no limit to the number of investors. Each person who invests in the mutual fund participate in either positive or negative growth in the overall performance of all the investments in the fund.

A hedge fund is a form of mutual fund. It is a much used phrase that has no real definite meaning. It is often a mutual fund that makes more esoteric (Likely to be understood by only a small number of people with a specialized knowledge) investments. Hedge funds are only available to a specific group of sophisticated investors with high net worth.

The overall value of the fund, called the net asset value (NAV), is usually determined daily, weekly or monthly and then divided into equal parts and distributed among all the shares in the mutual fund. They are regulated. A mutual funds ability to leverage or borrow against the value of securities in its portfolio is usually very restricted.

A minimum investment of $250000$500000 is often required of hedge fund investors. They are not regulated. Hedge funds often use sophisticated trading methods, such as short selling(the practice of selling securities that are not owned), trading options(an option is a contract between two parties giving right to buyer, but not the obligation, to buy or sell a parcel of shares at a predetermined price on or before a pre-determined date) and using leverage(e.g.a strategy that uses borrowed money to purchase financial assets with the objective of increasing returns)

 mutual funds pay their financial managers according to the volume of assets managed, regardless of performance. Mutual fund manager may or may not need to invest in the basket created by them.

To increase the potential reward of the investments. "Incentive fees" remunerate hedge fund managers only when returns are positive. Hedge fund managers are usually heavily invested in a significant portion of the funds they run and shares the rewards as well as risks with the investors.

 A fund of hedge funds is an investment company that invests in hedge funds -- rather than investing in individual securities. A diversified portfolio of generally uncorrelated hedge funds. May be widely diversified, or sector or geographically focused. Seeks to deliver more consistent returns than stock portfolios, mutual funds, unit trusts or individual hedge funds. Preferred investment of choice for many pension funds, endowments, insurance companies, private banks and high-net-worth families and individuals.

Provides access to a broad range of investment styles, strategies and hedge fund managers for one easy-to-administer investment. Provides more predictable returns than traditional investment funds. Provides effective diversification for investment portfolios. So, If you invest in hedge funds through a fund of hedge funds, you will pay two layers of fees: the fees of the fund of hedge funds and the fees charged by the underlying hedge funds.

 Provides an investment portfolio with lower levels of risk and can deliver returns uncorrelated with the performance of the stock market. Delivers more stable returns under most market conditions due to the fund-offund managers ability and understanding of the various hedge strategies. Significantly reduces individual fund and manager risk.

Eliminates the need for time-consuming due diligence otherwise required for making hedge fund investment decisions. Allows for easier administration of widely diversified investments across a large variety of hedge funds. Allows access to a broader spectrum of leading hedge funds that may otherwise be unavailable due to high minimum investment requirements. Is an ideal way to gain access to a wide variety of hedge fund strategies, managed by many of the worlds premier investment professionals, for a relatively modest investment.

at Dec 2010

at Dec 2010

Although leverage is used in many hedge fund strategies, some do not use it at all

 Funds can increase their leverage in 3 ways:

Borrow external funds to invest more or sell short more than the equity capital they put in
Borrow through a margin account

Use financial instruments and derivatives that require posting margins (and a smaller cash outlay) rather than purchasing the underlying securities.

Leverage can run anywhere from 2:1 ratio up to as high as 500:1 with arbitrage strategies using the most leverage because the trading profits are so narrow.

 Liquidity risk - Occurs in very thin or illiquid securities. In extreme market conditions, liquidity problems can cause the collapse of the entire fund. Pricing risk - Some of the assets in which a hedge fund invests can be very complicated, making it very difficult to price the securities properly.

Counterparty risk - Hedge funds tend to deal with broker/dealers. As such, there is always the risk that a particular broker/dealer may fail or simply cut off the hedge fund. In these situations, the downside risk for the hedge fund and all its participants is extremely serious.

 Settlement risk - Failure to deliver the securities by one or more parties to the transaction.

Short Squeeze risk - A short squeeze occurs when you have to purchase the securities you sold short before you want to. This can occur because the investors from whom you borrowed the security need it earlier than anticipated.
Financial squeeze - Occurs when companies find themselves unable to borrow or unable to borrow at acceptable rates. Overextended credit lines, defaults and other debt issues can cause a financial squeeze. Margin calls and mark to market positions may also result in financial issues.

.of hedge funds

 The investment manager gets paid a huge performance fee for successfully turning large profits on the fund, therefore he is highly motivated to make the investment flourish Hedge funds bank on the prosperity of only one investment and are not overly diversified investments

 Aggressive investment strategies such as short-selling or using borrowed money to buy more assets (leverage buying) can legally be utilized Huge gains in the millions are the potential reward for investing in hedge funds

 Only the wealthiest individuals can participate in hedge funds Hedge funds are extremely risky and millions of dollars can be lost in the blink of an eye The performance fee for the investment manager may encourage them to take bigger risks with your money There are very few government regulations overseeing hedge fund investments

 As above-mentioned, hedge funds are not subject to periodic requirements. This implies less transparency and less available information that potential investors can use to assess hedge funds' performance, credibility and potential. Hedge funds' managers are not limited in the amount of money they can borrow. Thus, one wrong decision by the general manager can bring down an entire hedge fund and its investors. Finally, the lack of regulation also means that it's left to investors to assess whether or not hedge fund share prices are fair.

HEDGE FUND PERFORMANCE

For some hedge funds, the ability to find their returns can be difficult because of the nature of the industry. However, studies have presented strong cases for investing in hedge funds biased on the following:
They tend to have a net return that is higher than equity and bond markets. They tend to have lower risks than equities when measured by the volatility of their returns.

 Sharpe ratios tend to be higher than those of equities and bonds. The Sharpe ratio is the reward to risk measured as the mean return in excess of the risk-free rate divided by the standard deviation. Correlation of hedge funds with conventional investment is generally low but still positive.

The tendency for hedge funds with poor performance to be dropped by mutual fund companies, generally because of poor results or low asset accumulation. This phenomenon, which is widespread in the fund industry, results in an overestimation of the past returns of hedge funds.

For example, a hedge fund company's selection of funds today will include only those that have been successful in the past.

Many losing funds are closed and merged into other funds to hide poor performance. This is an important issue to take into account when analyzing past performance.

Founded in 1994 by: 1. John Meriwether ( former Vice chairman & head of Bond trading at Salomon Brothers) 2. Myron Scholes Nobel Prize winners for Black-Scholes-Merton model 3. Robert C. Merton

Great Leverage ratio: $125 Billion of assets with $4.8 Billion of equity. (near to 30/1) Initially great return: 40% annual after deducting fees. Their investment strategies were based on a fairly regular range of volatility in foreign currencies and bond.

Using 'black-box' computer models to generate low-risk, but high rates of return.

 When Russia declared it was devaluing its currency and basically defaulting on its bonds, it moved beyond the regular range that LTCM had counted on. In response, the U.S. stock market dropped 20%, while European markets fell 35%. Investors sought refuge in Treasury bonds, causing interest rates to drop by over a full point. As a result, LTCMs highly leveraged investments started to crumble. By the end of August 1998, it lost 50% of the value of its capital investments. The fund was closed in early 2000.

John Alfred Paulson is the founder and president of Paulson & Co., a New York based hedge fund. He bet against the U.S. housing bubble. U.S. Housing Markets Collapse: Year No Down Payment Cases In 2001 3% In 2005 24% In 2007 43%

So he decided he wanted to bet that House prices would regress to the mean;

But how to find the right instrument to allow him to do that????

That instrument is

Credit-default Swaps

 CDS are working as Insurance on risky home mortgages. These were traded at Dirt-cheap prices. When home owners defaulted in their mortgages , this insurance would rise in value. Due to collapse; his firm, Paulson & Co., had made $15 billion in 2007.(a figure that topped the gross domestic products of Bolivia, Honduras, and Paraguay).
Paulsons personal gain was about to $4 billion (more than the earnings of J.K. Rowling, Oprah Winfrey, and Tiger Woods put together).