What Do Hedge Funds Actually Do? Introduction to Hedge Funds

hi everyone in today's video we will talk about hedge funds an exciting and fascinating topic provided that hedge funds are in the business of making money out of thin air figuratively speaking before we start we'll make some clarifications regarding the common legal and fee structures of alternative investments both hedge and private equity funds are usually set up and run as limited partnerships or LP this type of legal structure includes general partners or GPS and limited partners LPS GPS are responsible for managing a given investment fund they have unlimited liability LPS on the other hand are the investors in the fund they have limited liability and a profit share proportionate to their investment limited partnerships are usually based on tax efficient locations they aren't subject to strict regulations as they are not typically offered to the general public instead LPS are restricted to qualified investors such as institutions and high net worth individuals these investors are generally expected to be more knowledgeable and able to take higher risks the common fee structure of alternative investment funds includes a management or base fee and an incentive or performance fee the management fee is calculated annually on assets under management or AUM the incentive fee also known as a hurdle rate is usually calculated on profits above a certain level of return another widely used feature is the so called high watermark this is the highest net asset value or nav that a fund has reached and for which a performance fee is paid setting a high watermark protects investors from paying fees on downside out performance it also ensures that they won't pay twice for the same increase in net asset value or nav in other words when high watermarks are in place fund managers must recover any losses before charging a performance fee on newly generated profits that said we can now start examining hedge funds in more detail in trying to beat the market these investment vehicles deploy a variety of strategies such as the use of leverage Rivet ifs and taking short positions hedge fund performance is measured either in terms of an absolute return for example 15% or on a relative basis versus a benchmark index for example 10% above S&P 500 redemption turns include a lock-up period during which investors cannot withdraw the money they have put in a given hedge fund the notice period is also part of the redemption terms it usually lasts between 1 and 3 months this restriction is posed for a reason it often happens that hedge fund managers need to exit illiquid positions and convert holdings into cash the notice period gives them time to do that in an orderly manner hedge funds may have redemption fees intended to offset any transaction costs incurred in this process ok before moving on it is worth mentioning the so called funds of hedge funds they provide access to a diversified portfolio of hedge funds and allow smaller investors to participate great now let's take a look at some of the typical hedge fund strategies more precisely we'll discuss four main categories of hedge funds these are the event-driven relative value global macro and equity hedge funds event-driven strategies are based on various corporate actions such as mergers acquisitions or restructuring they entail taking long or short positions in equity or debt securities of the companies involved here we have a couple of subcategories merger arbitrage involves buying the shares of an acquisition target company and selling short the shares of the buyer this strategy is expected to profit from the spread between prices of the respective shares or from potential overpayment by the acquirer the main risk involved here is that the deal may not close distressed or restructuring strategies involve investing in companies in financial distress or in other words firms that are about to file or have already filed for bankruptcy in such cases fund managers may choose to take it long or short position in the debt or equity securities of the distressed company when taking a long position they bid on a successful restructuring thus they buy the company's securities at a discount and expect a profit from a price recovery on the other hand a short position is expected to be profitable in case of an unsuccessful restructuring when going short fund managers usually pick securities with lower investor protection such as junior debt or common stock these two approaches can also be combined by simultaneously taking a long position in senior debt and a short position in junior debt or equity in this case the hedge fund manager expects to profit from an increase in the price spread between the two classes of securities activist investing is another strategy based on triggering corporate actions activist hedge funds buy a sufficiently large shareholding in a company with the intention to influence its management they would require the implementation of various corporate actions and strategies to increase the company's value these may include divestitures restructuring capital distribution or changes in management activist investing resembles the approach of private equity funds in trying to gain control over a company however the key difference here is that activist investors focus on public companies lastly special situations funds invest in companies that are undergoing sort of restructuring other than mergers acquisitions in bankruptcy these include spin-offs asset sales and share buybacks okay great as we've seen event-driven strategies can be quite interesting now let's consider the relative value strategies they focus on taking long and short positions in related securities and profiting from a temporary discrepancy in their perceived price relationship again we have several subcategories here the first one is called fixed income convertible arbitrage it exploits any miss pricing of convertible bonds this strategy involves taking a long position in a convertible bond in a short position in the common stock of the same company asset-backed fixed income is another relative value strategy it uses opportunities that arise from mispriced asset backed securities or abs and mortgage-backed securities or MBS general fixed income strategies exploit various pricing discrepancies within fixed income markets these may include relative value positions between two different companies or between various securities of the same company we also have volatility strategies they typically use various derivative financial instruments to go long or short on market volatility in a single asset class or across different classes multi-strategy funds as the term suggests deploy various existing strategies to use relative value opportunities across asset classes great we're moving on to the third category of strategies used macro hedge funds rather than analyzing specific companies they look for opportunities arising from global economic and political events macro hedge funds bet on global market trends by taking long or short positions across equities derivatives fixed income currencies and commodities and finally we have equity hedge fund strategies that involve taking long and short positions in public equities in related derivatives they differ from the event-driven or macro strategies by using a bottom-up rather than a top-down approach here are the most common variations of the equity hedge fund strategies market neutral strategies focus on selecting undervalue securities to buy and overvalued ones to sell short hedge fund managers do that by using quantitative technical or fundamental analysis the overall goal is to keep a net neutral market position and profit from individual securities movements next we have the fundamental growth strategies they use fundamental analysis to identify and take long positions and companies with high growth potential on the other hand fundamental value strategies take long positions in various undervalued companies including non high-growth firms quantitative directional strategies use technical analysis to select undervalued stocks to buy and overvalued ones to sell short net market exposure may vary depending on the relative size of long and short positions taken short by a strategies as the term suggests take predominantly short market exposure in companies that are considered as overvalued and finally sector specific strategies focus on a specific sector of expertise and use quantitative and fundamental analysis to identify different investment opportunities a lot of strategies right in practice many hedge funds begin by employing only one of them over time they develop additional expertise and expand to become multi strategy funds well done our next task is to examine the potential benefits and risks of hedge funds the benefits are most visible in down equity markets where hedge funds typically perform better than global equity markets long-term correlation with equities can also provide diversification benefits of course these benefits vary according to the specific hedge fund strategy because of the great variety of hedge fund strategies and the tendency for correlations to increase during periods of market turmoil we should be careful when generalizing about the diversification benefits of hedge funds moreover doing due diligence on hedge funds can be quite challenging overall these investment vehicles have light regulatory disclosure requirements and this potentially makes them less transparent to sum up when assessing hedge funds we need to focus on the following questions what are the strategy and investment processes they use what are their historical returns longevity amount of assets under management valuation and returns calculation methods what are their management styles key person risks and risk management systems and what are their sources of competitive advantage reputation and growth plans some of these factors are difficult to quantify even the ones that seem more straightforward like returns for example can present challenges to investors for instance strategies that have been successful in the past may decrease in effectiveness as more funds begin to use them okay great this is the end of today's video if you are into educational investment and Finance videos make sure you subscribe to our Channel and hit the like button thanks so much for sticking till the end I'll see you in our next episode

Channel: 365 Financial Analyst

Views: 284,840

Keywords:

Id: r4roG2fcPXE

Length: 11min 19sec (679 seconds)

Published: Wed Feb 12 2020