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IFT Notes for Level I CFA® Program
IFT Notes for Level I CFA® Program

R47 Introduction to Alternative Investments

Part 2


4. Hedge Funds

4.1 Characteristics of Hedge Funds

History: Alfred Winslow Jones created a “hedged” fund in 1949. The purpose of this fund was to hedge long-only stock portfolio. The fund followed three key principles:

  • Always maintain short positions.
  • Always use leverage.
  • Only charge an incentive fee of 20% of the profits with no fixed fees.

Over time, the principles have changed. The following are the characteristics of hedge funds today:

  • Aggressively managed portfolios of investments across asset classes and regions use leverage, take long/short positions, and/or use derivatives.
  • Generate high returns: either absolute or over a specified benchmark with minimal restrictions.
  • Set up a private investment partnership with a limited number of investors who are willing to make a large initial investment.
  • Investors are required to keep the money with the fund for a certain period – lockup period. Redemptions are not immediate. Usually, require a minimum notice period of 30 to 90 days.
  • Invest anywhere there is a high return opportunity as restrictions are less.

A diversified portfolio of hedge funds is often referred to as a fund of funds. This instrument makes hedge funds accessible to smaller investors or to those who do not have the resources, time, or expertise to choose among hedge fund managers. Other benefits include:

  • Better redemption terms;
  • Due diligence expertise;
  • More diversification as they invest in hedge funds across geographies and strategies

However, fund of funds may charge an additional 1% management fee and 10% incentive fee on top of the fees charged by the underlying hedge funds. This double layer of fees can significantly reduce the after fee returns to the investor.

4.2 Hedge Fund Strategies

There are several hedge fund strategies. These fall in four major categories:

  • Event-driven: A short term, bottom-up strategy that aims to profit from pricing inefficiencies before a major potential corporate event. Ex: bankruptcy, acquisition, merger, restructuring of a company, asset sale (large pocket of land in a prime location).
  • Relative value: A strategy that seeks to profit from price discrepancy between related securities such as stocks and bonds.
  • Macro: Uses a top-down approach to identify trends based on changes in economic policies across the globe. The strategies could focus on currency markets, fixed income markets, or based on changes in interest rates. Trades are based on expected movement in economic variables.
  • Equity hedge: Bottom-up strategy. Not focused on event-driven or macro strategies. Take long and short positions in equity/equity derivative securities.

The sub-classifications under each category are listed below:

Sub-classification under event-driven category
Merger Arbitrage
  • Go long (buying) on the stock of the company being acquired and go short on the stock of the acquiring company.
  • Risk: many corporate events such as merger do not occur as planned and if the fund has not closed its positions on time, it may incur losses.
Distressed/restructuring
  • Purchase and profit from debt securities of companies that are either in bankruptcy or near bankruptcy.
  • Strategy: the fixed income securities would be priced at a significant discount to their par value; these can be sold later at a profit at settlement (liquidation or equity stake)
  • Other complicated strategies: Buy senior debt/short junior debt.
  • Buy preferred stock/short common stock.
Activist
  • Purchase a managing equity stake in a public company that is believed to be mismanaged, and then influence its policies.
  • May advocate restructure, changes in strategy, hiving off non-profitable units, etc.
Special Situations
  • Purchase equity of companies engaged in restructuring activities other than merger/bankruptcy.
Sub-classification under relative value category
Fixed-Income Convertible Arbitrage
  • A market neutral strategy to exploit mispricing in convertible bond and issuer’s stock.
  • Long position in convertible debt + short position in issuer’s common stock.
  • As the name implies, it has a theoretical zero-beta portfolio.

Note: A convertible bond is a bond (hybrid security) that can be converted into common stock at a pre-determined price at a pre-determined time. Usually, the yield is lower than a comparable bond.

Fixed-Income Asset Backed
  • Exploit mispricing of asset-backed securities.
Fixed-Income General
  • Exploit mispricing between two corporate issuers (i.e. long/short trades), between corporate and government issuers, or between different parts of the same issuer’s capital structure.
Volatility
  • Go long or short market volatility within a specific asset class.
Multi-Strategy
  • Generate consistently absolute positive returns irrespective of how the equity, debt, or currency markets are performing.
  • Does not focus on one strategy, but allocates capital across different strategies where investment opportunities exist. Ex: equity long/short, convertible arbitrage, merger arbitrage, etc.
  • Unlike funds of funds, multi-strategy funds execute strategies within one fund group and they do not have the extra layer of fees associated with a fund of funds.
The curriculum does not present any sub-classifications under the macro category.
Sub-classifications under the equity hedge category
Market Neutral
  • Uses quantitative/fundamental analysis to identify undervalued/overvalued securities.
  • Strategy: buy (long) undervalued securities and sell (short) overvalued securities. Hold equal dollar amounts in both positions.
  • Neutral with respect to market risk, i.e., the portfolio beta is close to zero.
Fundamental Growth ·         Uses fundamental analysis to identify companies with high growth potential and capital appreciation.

·         Strategy: long position in such stocks.

Fundamental Value Uses fundamental analysis to identify undervalued companies.

Strategy: long position in such stocks.

Short Bias
  • Uses quantitative/fundamental analysis to identify overvalued securities.
  • Strategy: short position in overvalued securities.
Sector Specific
  • Uses quantitative/fundamental analysis to identify mispricing in a specific sector.
  • Strategy: long on undervalued securities/short on overvalued securities.

4.3 Hedge Funds and Diversification Benefits

Due to different strategies across hedge funds, the diversification benefits associated with every hedge fund is not necessarily meaningful. It is believed that less-than-perfect correlation of hedge funds with stocks provides diversification benefit.

However, for the period since 2000, the low correlation claim holds only for 2000-02; between 2003 and 2009, there was a high correlation between stocks and hedge funds. This implies that during financial crisis periods, the correlation between hedge fund performance and stock market performance may increase. However, the losses for hedge funds may be less than for the equity markets.

Between 2009 – 2019, most hedge funds failed to beat the performance of equity and bonds. However, they were still a part of institutional asset allocations because of their risk-diversification properties.