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Hedge Funds

Alternative Investments

Hedge Fund Investment Features

Learning Outcome Statement:

explain investment features of hedge funds and contrast them with other asset classes

Summary:

Hedge funds are private investment vehicles that utilize a variety of strategies including leverage, derivatives, and short selling to achieve high returns. They are distinguished by their flexible investment approaches and often do not track traditional benchmarks, instead using absolute return standards. Hedge funds are less regulated, have higher fees, and offer diversification due to low correlation with traditional assets. They are available only to institutional and accredited investors and are characterized by less liquidity and higher risk compared to mutual funds and ETFs.

Key Concepts:

Investment Strategies

Hedge funds employ diverse strategies such as equity hedge, event-driven, relative value, and opportunistic strategies to maximize returns. These strategies involve combinations of long and short positions, arbitrage, and leverage.

Fee Structure

Hedge funds typically charge both a management fee and a performance-based incentive fee. Some also use a high-water mark to ensure managers only receive performance fees on new profits.

Regulation and Accessibility

Hedge funds are less regulated and are not available to the general public. They are restricted to accredited or institutional investors due to their complex strategies and higher risk profiles.

Liquidity and Lockups

Hedge funds often have lockup periods during which investors cannot redeem their investments. This allows managers to pursue strategies that require longer time horizons.

Use of Leverage

Hedge funds often use borrowed money to amplify potential returns. While this can increase gains, it also raises the potential for significant losses, especially in volatile markets.

Hedge Fund Investment Forms

Learning Outcome Statement:

describe investment forms and vehicles used in hedge fund investments

Summary:

Hedge funds are typically structured as private investment partnerships or limited liability companies, often set up in tax-advantaged locations. They can be invested in directly through structures like master-feeder setups or indirectly via funds of hedge funds or exchange-traded products. Direct investments often involve complex structures like master-feeder arrangements for tax efficiency, while indirect investments provide accessibility and diversification at the cost of higher fees and potentially lower performance.

Key Concepts:

Master Feeder Structure

A master feeder structure involves an offshore feeder fund and an onshore feeder fund, both of which invest into a master fund. This structure optimizes tax efficiency and allows for global investment participation.

Two and Twenty Fee Structure

A common hedge fund fee arrangement where the managing partner charges a 2% management fee on assets and a 20% performance fee on the fund's profits.

Separately Managed Accounts (SMAs)

SMAs offer customizable portfolios with specific investment mandates, providing better transparency, efficient capital allocation, and higher liquidity. They are suitable for larger investors due to their operational complexity and governance requirements.

Funds of Hedge Funds

These funds invest in a diversified portfolio of hedge funds, offering direct diversification benefits. They typically have lower minimum investments and better liquidity but come with higher fee structures due to additional layers of management fees.

Hedge Fund ETFs

Exchange-traded products that seek to replicate hedge fund investment styles without directly investing in hedge funds. They offer greater liquidity and lower fees but may underperform compared to direct hedge fund investments due to regulatory constraints and inability to use leverage extensively.

Hedge Fund Investment Risk, Return, and Diversification

Learning Outcome Statement:

analyze sources of risk, return, and diversification among hedge fund investments

Summary:

This LOS explores the unique characteristics of hedge funds in generating returns, managing risks, and providing diversification benefits compared to traditional investment portfolios. Hedge funds aim to generate alpha through idiosyncratic returns by exploiting market inefficiencies and leveraging the skills of the manager. The content also discusses the biases and challenges associated with hedge fund indexes and the evolving nature of hedge fund strategies for diversification.

Key Concepts:

Sources of Hedge Fund Returns

Hedge funds generate returns through market beta, strategy beta, and alpha. Alpha is derived from the manager's ability to select unique positions and time the market effectively, often using leverage.

Hedge Fund Indexes

Hedge fund indexes, used for performance comparison, are often based on self-reported data, leading to biases such as survivorship, selection, and backfill biases. These indexes are non-investable and may not accurately reflect the hedge fund universe.

Diversification Benefits

Hedge funds originally aimed to be market-neutral, offering diversification by being uncorrelated with traditional asset classes. Over time, strategies have diversified across asset classes and strategies, providing institutional investors with risk mitigation and absolute returns.

Risk and Return Analysis

Hedge funds have historically shown higher returns and similar standard deviations compared to bonds, with modest correlations to global stock and bond returns, highlighting their role in portfolio diversification.

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