UNDERSTANDING HEDGE FUNDS (A Brief Overview)

in the world of Finance there are certain terms that get thrown around frequently and often people within the industry just assume that everyone knows what they mean in fact sometimes people even assume that they themselves understand what it means but when they actually stop and think about it they really don't know at all one of these terms is the infamous hedge fund these types of companies gained a bit of notoriety thanks to their perceived involvement in some of the darkest days in the financial markets and with specific assets although we're all familiar with the term hedge fund it seems not everyone is familiar with what it actually means so in this video I'm going to be giving you a basic overview of hedge funds including their history how they've involved some of the key attributes of them their strategies and their role in the financial markets this will allow you to make more sense of when this term is used in the financial media and hopefully allows you to differentiate between other types of investment firm the birth of the hedge funds can be attributed to Alfred Winslow Jones who in 1949 took long positions of undervalued securities and short positions of overvalued securities as an insurance against the downturn in the market thus creating a hedge fund as he was hedging at the position however according to Warren Buffett the roots of the concept dates back to the mid 1920s Benjamin Graham who is widely known as the father of value investing used the same strategy to hedge his investments and also to charge an incentive fee to investors the strategy was to generate returns irrespective of the markets direction hence the name of the funds comes from the strategy itself the authorities have yet to assign the hedge fund a legal definition essentially many regard hedge funds as an alternative investment vehicle a pool of private funds managed by a sophisticated manager for a sophisticated and wealthy investors due to their requirements and the structure hedge funds unlike other funds such as mutual funds or ETFs are partially not regulated in addition to that hedge funds cannot seek funds from the general public they operate on a private investment partnership therefore they have more operational freedom and can aim to generate returns in any kind of market regardless of the market condition in general hedge funds and mutual funds fall under the same category of pooled investments however they're differentiated by the distinguishing attributes of the investor's requirements according to the SEC an investor is considered accredited when they have earned an income of $200,000 in the last two years and expects the same in the current and the future year or hold a net worth of more than a million dollars this is required to ensure that the investor is able to take on the risk of investing in these unregulated securities therefore the investor needs to be conscious of the uncertainties of taking such risk which in case of unexpected events could destroy their entire investment unlike the traditional mutual fund managers the managers of hedge funds are more diverse in nature and have the technical know-how to use exotic or complex instruments like derivatives to generate returns the ability to go long or short in an asset means they can make use of more complex strategies such as equity hedging tactical trading and arbitrage where they take advantage of pricing and efficiencies in an asset although this is not so common anymore with there being fewer opportunities due to the rise of high-frequency trading and the overall competitiveness of the market so basically the managers have the skill to formulate their own trading strategies depending on the market conditions therefore they can charge an extra incentive fee on top of the management fee for their performance the annual management fee ranges from 1 to 2 percent independent of the performance of the fund additionally the incentive fees typically range from 20 percent to a whopping 50 percent this fee acts as an incentive for the manager to outperform and generate better returns in the market there's been a lot of pressure on hedge fund managers to reduce their fees and in fact this year we have seen a low of capital being withdrawn from hedge funds particularly in Asia due to the excessive fees that they're charging and the availability of alternatives this also partly due to the relative underperformance of macro related funds this has led to a lot of money moving to private equity and real estate instead overall there's been a big rise in the number of hedge funds from a mere six hundred and ten in 1992 a phenomenal amount of 15,000 in 2017 the funds that practice automation in their investment procedure have seen enormous growth in the hedge fund segment Barclays claims that quants are now responsible for around 17% of the total hedge fund assets this past decade has seen a sharp rise in a technological fields such as machine learning and artificial intelligence in fact a new kind of hedge fund is now combining machine intelligence to manage the investment of an American hedge fund is believed by some that the high usage of technology might prove to be helpful in preventing the market from large shocks in the future as with time AI artificial intelligence will eventually exceed human abilities and perhaps get closer to solving the stability puzzle by Nature hedge fund managers tend to be secretive therefore transparency remains a big issue when considering investing in hedge funds the managers tend to be secret in their ways and the use of their strategies and may even keep the funds under a lock-up periods whereby investors can only take out their funds during specific intervals that are set by the manager this overall issue was heightened by the infamous Ponzi scheme run by Bernie Madoff Madoff took the money from investors and portrayed false returns to get away with it this multi-billion dollar scam affected many many investors and charities and Madoff was later sentenced to a hundred and fifty years in prison for various charges these events suggest that this level of secrecy might be wrong and pressure from institutional investors has compelled some of the hedge fund managers to present their financial reports on a regular basis hedge fund managers often use leverage to boost their returns and to make the fund more attractive while leverage has of course caused benefits it also has its downsides as it increases the volatile of the fund thereby making it much more vulnerable to downside risks this is illustrated in the case of long-term capital management LTCM LTCM was formed in 1994 and was highly publicized around the world due to the reputation of the founder and the board members John Merriweather the former vice chairman of bond trading at Salomon Brothers and Myron sculls and Robert Merton who both want a Nobel Prize for their work on a valuation of derivatives including their famous black scores options pricing model LTCM generates an average annual return of 30% after fees up until 1997 due to their reputation and popularity LTCM was able to obtain extremely high leverage from large banks and was in a position to enter large swaps contracts but soon disaster struck after the Russian crisis LTCM was hit by a loss of more than four billion dollars his loan to value had reached 250 to 1 as peak leveraged and ultimately the US Federal Reserve had to come in and bailout LTCM as this kind of event could have resulted in a complete financial meltdown however the blame for this does not solely fall with LTCM is also the fault of the banks that provided such ridiculous levels of leverage without fully assessing the risk in LTCM strategy nevertheless operating with such high levels of leverage is an invitation to a lot of trouble perhaps the most documented role of hedge funds was their involvement in the financial crisis now although this is something that does warrant a whole series of videos of its own let's just go over a very quick and brief overview so in response to the recession of 2001 the US Federal Reserve lowered its race down to 1.5% which also meant there were low returns on bonds hence the pension funds move their investments into hedge funds to earn greater returns this results dim manages generating riskier investments such as the mortgage-backed securities these were a pool of mortgages which at the time were really profitable due to the huge demand for mortgage-backed securities some of the larger institutions also starts to form their own hedge funds it was also at this time that the lowered interest rates resolved in large amounts of people opting for interest only mortgages homeowners would take a home loan from the lender who would then sell them on for a commission to investment banks the investment banks bundled these mortgages along with other debt such as student loans car loans and so on and created something called a collateralized debt obligation a CDO and then passed it on to the investors as it gave the investor a wide variety of choice in terms of risk however in order to tackle inflation the US Federal Reserve increased their interest rates as you can imagine this results in more defaults by homeowners and especially the subprime segments the wake of 2007 saw many of the eminent hedge funds collapsing due to their higher risk levels and finally when the housing bubble burst this whole chain was jolted and the markets collapsed hedge funds managed to avoid a low of the responsibility since these risky investments were also being used by banks insurance companies and other funds and the hedge funds were not directly responsible for the formation of these destructive securities however they did actually hold the largest amount of CEOs at the start of the crisis 47 percent and it can be argued that the hedge funds gave the CEOs the impetus which ultimately led to part of the crisis this suggests a strict regulation of hedge funds should be put in place to avoid these kinds of events happening in future although there has been a lot of skepticism about investing in hedge funds most of the criticism actually lies with their high fees and lack of transparency however there has been a gradual shift over time towards more transparency better regulation and lower fees and these issues are also expected to further improve in the future hedge funds are accessible to retail investors via funds of hedge funds and statistically speaking hedge funds have in general outperformed other asset while remaining relatively stable amidst various crises the structure of hedge funds gives the hedge fund manager the freedom to invest in any market using any kind of investment naturally giving them a wide variety of choices historically hedge funds have proved to reduce volatility and provide diversity in an investor's overall portfolio and with the advent of machine learning and AI we may even see better stability in the future in one of the most complex systems in the world the capital markets if you liked this video please hit the thumbs up button and don't forget to subscribe for more financial education videos covering the markets trading investing and much more thanks love watching see you soon

Channel: The Duomo Initiative - Trading & Investing

Views: 224,311

Rating: 4.8962779 out of 5

Keywords: hedge fund, hedge funds, hedge fund industry, financial, financial services, financial services industry, mutual fund, fund, funds, hedge fund manager, ltcm, long term capital management, bernie madoff, financial crisis, an introduction, overview, niki puri, nicholas puri, duomo, duomo initiative, the duomo initiative, duomo method, the duomo method, duomo financial, duomo trading, duomo courses, duomo economics, puricassar, puricassar ag, financial education, yt:cc=on

Id: 8SJw9SVw6CU

Length: 11min 56sec (716 seconds)

Published: Mon Aug 28 2017