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June - July 2006

Business Forum

Hedge Fund Strategies …because all hedge funds are not the same

by Jateen Patel, Director, Berkeley Capital

Neither any information nor any opinion contained in this paper constitutes an offer to buy or sell or a solicitation by or on behalf of Berkeley Capital and/or any of its affiliates (together “BCR Groupl”) of an offer to buy or sell any security, product, service or investment. Any opinions expressed in this site do not constitute investment advice and independent advice should be sought where appropriate.

Hedge funds have become an increasingly popular asset class during the 1990s and early 2000s. Amounts invested in global hedge funds have risen from approximately $50 billion in 1990 to over a trillion by the end of 2005. Because these funds characteristically employ substantial leverage, they play a far more important role in global securities markets than the size of their net assets indicates. Market makers on the floor of the New York Stock Exchange have estimated that during 2005, trades by hedge funds have often accounted for more than half of the total daily number of shares changing hands. Moreover, investments in hedge funds have become an important part of the asset mix of institutions and even wealthy individual investors.

The term “hedge fund” is applied to a heterogeneous group of investment funds. To the extent that they share any common characteristic it is that, unlike the typical equity mutual fund, they tend to employ substantial leverage, they usually hold both long and short positions, and they often employ complex investment instruments such as derivative securities in their portfolios. It is important to understand the differences between the various hedge fund strategies because all hedge funds are not the same — investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds.

Much of the nostalgia is for an era of spectacular returns. Last year, overall returns in hedge funds were modest at best (although 2006 is off to a stronger start). But something more profound is going on: hedge funds are growing up. What once was a cottage industry is being institutionalised. The mix of investors has changed dramatically in the past five years, and that has led to big shifts in everything from fund size to competition, risk profiles, transparency and—horrors!—regulation.

Key Characteristics of Hedge Funds

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.

Facts about Hedge Funds
Estimated to be a trillion plus industry and growing at about 20% per year, with approximately 8350 active hedge funds.

Includes a variety of investment strategies, some of which use leverage and derivatives while others are more conservative and employ little or no leverage. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or derivatives.

Most hedge funds are highly specialized, relying on the specific expertise of the manager or management team.

Performance of many hedge fund strategies, particularly relative value strategies, is not dependent on the direction of the bond or equity markets — unlike conventional equity or mutual funds (unit trusts), which are generally 100% exposed to market risk.

Many hedge fund strategies, particularly arbitrage strategies, are limited as to how much capital they can successfully employ before returns diminish. As a result, many successful hedge fund managers limit the amount of capital they will accept.

Hedge fund managers are generally highly professional, disciplined and diligent. Their returns over a sustained period of time have outperformed standard equity and bond indexes with less volatility and less risk of loss than equities.

Beyond the averages, there are some truly outstanding performers.

Investing in hedge funds tends to be favoured by more sophisticated investors, including many Swiss and other private banks, which have lived through, and understand the consequences of, major stock market corrections. Many endowments and pension funds allocate assets to hedge funds.

Hedge Fund Strategies: Popular Misconception
The popular misconception is that all hedge funds are volatile — that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds. Most hedge funds use derivatives only for hedging or don’t use derivatives at all, and many use no leverage.

Aggressive Growth: Invests in equities expected to experience acceleration in growth of earnings per share. Generally high P/E ratios, low or no dividends; often smaller and micro cap stocks which are expected to experience rapid growth. Includes sector specialist funds such as technology, banking, or biotechnology. Hedges by shorting equities where earnings disappointment is expected or by shorting stock indexes. Tends to be “long-biased.” Expected Volatility: High

Distressed Securities: Buys equity, debt, or trade claims at deep discounts of companies in or facing bankruptcy or reorganization. Profits from the market’s 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. (This selling pressure creates the deep discount.) Results generally not dependent on the direction of the markets. Expected Volatility: Low - Moderate
Emerging Markets: Invests in equity or debt of emerging (less mature) markets which tend to have higher inflation and volatile growth. Short selling is not permitted in many emerging markets, and, therefore, effective hedging is often not available, although Brady debt can be partially hedged via U.S. Treasury futures and currency markets. Expected Volatility: Very High

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. Volatility depends on the mix and ratio of strategies employed. Expected Volatility: Low - Moderate

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

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. Participates in all major markets — equities, bonds, currencies and commodities — though not always at the same time. Uses leverage and derivatives to accentuate the impact of market moves. Utilizes hedging, but leveraged directional bets tend to make the largest impact on performance. Expected Volatility: Very High

Market Neutral - Arbitrage: Attempts to hedge out most market risk by taking offsetting positions, often in different securities of the same issuer. For example, can be long convertible bonds and short the underlying issuers equity. May also use futures to hedge out interest rate risk. Focuses on obtaining returns with low or no correlation to both the equity and bond markets. These relative value strategies include fixed income arbitrage, mortgage backed securities, capital structure arbitrage, and closed-end fund arbitrage. Expected Volatility: Low

Market Neutral - Securities Hedging: Invests equally in long and short equity portfolios generally in the same sectors of the market. Market risk is greatly reduced, but effective stock analysis and stock picking is essential to obtaining meaningful results. Leverage may be used to enhance returns. Usually low or no correlation to the market. Sometimes uses market index futures to hedge out systematic (market) risk. Relative benchmark index usually T-bills. Expected Volatility: Low

Market Timing: Allocates assets among different asset classes depending on the manager’s view of the economic or market outlook. Portfolio emphasis may swing widely between asset classes. Unpredictability of market movements and the difficulty of timing entry and exit from markets adds to the volatility of this strategy. Expected Volatility: High

Opportunistic: Investment theme changes from strategy to strategy as opportunities arise to profit from events such as IPOs, sudden price changes often caused by an interim earnings disappointment, hostile bids, and other event-driven opportunities. May utilize several of these investing styles at a given time and is not restricted to any particular investment approach or asset class. Expected Volatility: Variable

Multi Strategy: Investment approach is diversified by employing various strategies simultaneously to realize short- and long-term gains. Other strategies may include systems trading such as trend following and various diversified technical strategies. This style of investing allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities. Expected Volatility: Variable

Short Selling: Sells securities short in anticipation of being able to re-buy them at a future date at a lower price due to the manager’s 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. Often used as a hedge to offset long-only portfolios and by those who feel the market is approaching a bearish cycle. High risk. Expected Volatility: Very High

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. May also utilize derivatives to leverage returns and to hedge out interest rate and/or market risk. Results generally not dependent on direction of market. Expected Volatility: Moderate

Value: Invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth. Such securities may be out of favor or under followed by analysts. Long-term holding, patience, and strong discipline are often required until the ultimate value is recognized by the market. Expected Volatility: Low – Moderate

Concluding Comments
Hedge funds have attracted close to a trillion dollars of investment capital, with most of the growth occurring during the early 2000s. They have been marketed as an asset class that has provided generous returns during all stock market environments and thus as excellent diversifiers to an all equity portfolio.

Reported hedge fund results are substantially upward biased. The practice of voluntary reporting (and backfilling only favorable past results) causes some reported hedge fund indexes to be substantially upward biased. Moreover, the substantial attrition that characterizes the hedge fund industry results in substantial survivorship bias in the returns of indexes composed of any currently existing funds. Correcting for such bias we find that hedge funds have lower returns and are riskier than is commonly supposed. Moreover, the reported low correlations of hedge fund returns with standard equity indexes is at least in part an artifact of hedge fund asset pricing that may sometimes rely on stale or managed prices. Even after correcting for such bias, however, hedge funds do appear to offer investors an asset class that is less than perfectly correlated with standard equity indexes.

Nevertheless, hedge funds have been shown to be extremely risky in another dimension. The cross-sectional variation and the range of individual hedge fund returns are far greater than is the case for traditional asset classes. Investors in hedge funds take on a substantial risk of selecting a very poorly performing fund or worse, a failing one. The industry is characterized by substantial numbers of failures. Moreover, while selection risk can be somewhat mitigated by investing in a diversified “fund of funds,” these diversified funds perform much less well than the industry as a whole.

Finally, I wonder whether the substantial flow of funds into the hedge fund industry will reduce returns significantly in the future. When only a limited amount of capital is pursuing arbitrage opportunities between about to merged corporations or between different securities of an individual company, even believers in reasonably efficient markets can image that limited profit opportunities may exist. But as enormous streams of investment funds enter the field, it is reasonable to assume that such opportunities will be attenuated. Thus, the very success of the hedge fund industry in attracting funds is likely to make hedge fund investing a less profitable investment strategy in the future.

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