ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Hedge Funds

Owing to the substantial risks involved, hedge funds are normally open only to professional, institutional or otherwise accredited investors. This paper outlines the structure of hedge funds, the investment strategies pursued and possible returns.

Hedge Funds

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Economic and Political WeeklyMarch 31, 20071148size of the hedge fund industry, fees from prime broking havebecome an increasingly important source of revenue for the majorinvestment banks. Such fees are estimated to have aggregatedas much as $ 10 billion last year.The third pillar is the fund administrator who does the account-ing, valuations and other back office functions. Fund adminis-trators are also paid a fee.The hedge fund industry also manifests the phenomenon ofindustry clusters (like information technology being clustered inBangalore or in Silicon Valley in California). Most hedge fundsare located in the states of Connecticut and New Jersey in theUS and the west end of London. Interestingly, neither Manhattannor “the city” seems to have attracted many hedge funds.Another feature of the hedge fund industry is worth noting.Perhaps several thousands, indeed a majority, die in the first yearitself – this is not a surprise given the high risk, high rewardnature of the business. However, what this also implies is thatthereisa great deal of “survivor bias” in the data on industry returns– those that die do not get captured in the returns data at all.In general, the industry is very lightly regulated in the US,but somewhat more rigorously in the other major centre, namely,London.IIInvestment StrategiesWhile both mutual funds and hedge funds are investmentpartnerships, there are major differences in the investment strat-egies of the two. The mutual fund industry is tightly regulatedand most regulators restrict short positions. Mutual funds are alsoliquid in the sense that, in the case of open ended funds, the funditself quotes the redemption and re-issue prices, while close-endfunds are traded in the secondary market.Given the relatively light regulation of hedge funds, the managerhas considerable, in fact unfettered, freedom in the investmentstrategies that can be adopted. However, one corollary of thisis that liquidity is limited to redemptions perhaps once a quarterand that too on specific dates and with significant notice periods:this allows the fund manager to make an orderly liquidation ofsometimes illiquid assets for the purpose of funding the redemption.Broadly speaking, the investment strategies followed by hedgefunds fall in two categories.Macro FundsThe so-called “macro” funds which take directional bets byway of unhedged positions in currency, interest rate and, lately,commodity markets, are based on a “top down” analysis of aneconomy or macro conditions in the market. The case of QuantumFund referred to above, in relation to the pound, is a typicalexample of a “macro” fund taking a directional bet. One Inter-national Monetary Fund report on hedge funds quoted a macrohedge fund manager describing the investment approach as being“based on an understanding of economic cycles across a largenumber of countries (with particular focus on the group of sevennations); an assessment of where we are in these cycles; and howfinancial markets are likely to behave at various points in thosecycles.” For macro funds, the liquidity of the instruments usedto take the bets is very important and constrains the activities.Sometimes macro funds also use derivatives, generally of the“plain vanilla” variety. The risks in macro funds are exemplifiedby the collapse of the Amaranth fund last year. Amaranth hadtaken a huge bet on the direction of oil prices. When its expec-tations proved wrong and prices moved the other way, it incurreda loss of as much as $ 6 billion, or two-thirds of its capital, withina few weeks.One strategy currently very popular is the so-called “carry”trade. This involves borrowing in a low interest currency – yenis the most popular currency at present – buying a higher yieldcurrency like the dollar or pound, and investing in debt securitiesin that currency. The bet is that the yen would not appreciateagainst the dollar or pound, to the extent of the interest differ-entials. (The bet has necessarily to be unhedged, as the hedgingcost would neutralise the interest differential advantage.) Whileprecise numbers are not available, such carry trade is believedto be responsible for the current weakness of the Japanese currencyvis-a-vis the dollar, pound and euro.Relative Value StrategiesIn effect, these are arbitraging strategies between two typesof assets. However, the arbitrage is not completely risk-free,which is the traditional definition of arbitrage. Firstly, thearbitrageis between two assets, going long in one and short inthe other, which reduces some of the risk but not the entire risk.Indeed, attractive returns would not be possible unless risks aretaken. Some of the relative value strategies are discussed below.Yield curve misalignment: An example would be that a particularmaturity security (say three years) is overpriced in relation tothe rest of the yield curve. One strategy would be to short thatsecurity, and go long in a portfolio of shorter and longer maturitysecurities with duration similar to the three-year security. Theduration matching would immunise the overall interest rateexposure. The fund would make a profit when the three-yearsecurity reverts to its normal place on the yield curve.Equity market investing: An example is to buy underpricedsecurities and short the index in the derivatives market. Whilethis immunises the portfolio to some extent from the generaldirection of equity price movements, clearly a major “basis risk”is being taken: the possibility of a change in the correlationbetween the index and bought equities.Equity convertible arbitrage: A convertible bond can be con-sidered a portfolio of a straight bond and an option to buy equity.Where the fund manager believes that the option embedded inthe convertible bond is either over- or underpriced, he wouldtry to make a profit by taking one position in the convertiblebond, and the opposite in the equity or options market.Arbitrage between the price of a complex derivative and the pricesof the individual elements in it: It is interesting that, while hedgefunds that are perhaps the most sophisticated players in thefinancial markets often use only plain vanilla derivatives fortaking directional bets, many Indian companies seem to be usingcomplex derivatives for the purpose without fully appreciatingthe pricing, the complexities or the cost of exiting.Arbitrage between treasury and corporate securities: Suchopportunities arise when the yield differences between treasurysecurities and corporate bonds of a given credit rating are misalignedin relation to historical relationships. The arbitrage would be toshort the overpriced security and go long in the underpriced one.This portfolio would eliminate most of the interest rate exposurebut result into a profit when the historical yield differences arerestored (the principle of “reversion to mean”).
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