activeallocator insights are hedge funds.pdf · this presentation is intended only as an...

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© 2016 Active Allocator, Inc.

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Insight

What are Hedge Funds?


Basics of Hedge Funds

Non-Traditional vs. Traditional Assets

Investment Universe

Alternative/Non-Traditional Assets

Private Equity/Debt Venture Capital

Real Estate

Private stake in companies or real

assets

Commodities and Managed Futures

Ownership of commodities or listed

commodity derivatives

Hedge Funds and Liquid Alternatives

Long & short positions in publicly listed securities and

their derivatives

Traditional Investments

Stocks

Long positions in publicly listed stocks

Bonds

Long positions in publicly listed bonds

Introduction

Hedge funds have unique return drivers and characteristics that differ from traditional

investments. In most cases, the primary source of return is from manager skill and security

selection, rather than just from directional asset class exposure.

Hedge funds are an investment structure for:

• Managing private, loosely regulated, investment pools

• Investing in physical securities and derivative markets on a leveraged basis

• Being active on both the "long" and "short" sides of markets

In general, hedge funds:

• Compensate the fund manager with performance related fees in addition to asset-based

fees

• Allow the fund manager flexibility in investment style and approach


Hedge funds are defined by their

investment technique (i.e., use of

shorting, leverage and derivatives) ...to

arbitrage credit and market risks as well

as their limited partnership structure

Hedge Fund Industry Size

Over 9000 funds, $3 trillion AUM

In 2000, assets under management were less

than $500 billion. Hedge funds are now seen

as an integral component in balanced

portfolios

Hedge fund assets rebounded sharply after

the global financial crisis

Historically, high net worth individuals have

been significant investors in hedge funds

In recent years, the mass affluent using

alternative mutual funds have been a growing

presence

Estimated growth of assets in hedge fund industry

39 58 96168 167 186

257

368 375456 491

539626

820

973

1,105

1,465

1,868

1,407

1,6001,6681,648

1,769

1,917

0

500

1,000

1,500

2,000

2,500

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Q1 2010 Q3 2010

Asse

ts ($

MM

)Estimated Assets

61%

39%

Institutional

High Net Worth

Clients

Source: HFR Industry Reports, www.hedgefundresearch.com

Hedge Fund Investor Base

Source: HFR Industry Reports, www.hedgefundresearch.com© 2016 Active Allocator, Inc.

Industry Consolidation

By # Firms

52%

15%

9%

8%

11%

5%

< $100 Million $100 - $250 Million

$250 - $500 Million $500M - $1 Billion

$1 - $5 Billion > $5 Billion

By Firm AUM Size

2%2% 3%5%

25%

63%

Source: HFR Industry Reports, www.hedgefundresearch.com

The Top Firms Tend To:

• Be larger and better organized

• Have longer track records

• House multiple managers and decision makers

• Offer diversified trading approaches

• Have developed improved systems and risk management

processes; and,

• Are more transparent and better understood by their clients,

partly due to their high visibility

The industry, in terms of AUM, remains very concentrated

Distribution of industry assets by firm AUM tier


Heterogeneity in Trading Strategies

Market Direction

Non-Directional

Strategies

• Combination of convertible arbitrage, distressed securities, event-driven, risk arbitrage, equity market-neutral,

relative value arbitrage and statistical arbitrage

• Should not be viewed solely as diversification vehicles because the correlation between absolute non-directional

return strategies and equity markets is not zero

Semi-Directional

Strategies

• Include those with ‘long’ and ‘short’ positions

• Manager aims to maintain some limited, but varying exposure to the underlying market direction

Directional Strategies • Hedged investments with exposure to major market movements (equity or global macros).

• Involves concentrated portfolios together with strategies using macro bets


There are over 20 hedge fund strategies

Examples of Hedge Fund Trading Strategies

Convertible Arbitrage • Extract value by purchasing convertible securities while hedging the equity, credit, and interest rate exposures with

"short"

Long/Short Equity • Funds exposed to a long-short portfolio of equities with a long bias

Equity Market Neutral • Funds typically trade long-short portfolios of equities with little directional exposure to the stock market

Event Driven • Funds specialize in trading around corporate events, such as mergers or corporate restructuring

Fixed Income Arbitrage • Funds typically trade long-short portfolios of bonds

Macro Funds • Funds bet on directional movements in stocks, bonds, FX rates and commodity prices

Hedge Funds vs. Alternative Mutual

Hedge Funds Alternative Mutual Funds

• Manager receives a management fee and who also participates in

investor’s profits

• Managed by a fund manager, who does not charge performance fees

• The fund manager's assets are more likely to be a significant

percentage of the fund

• The fund manager’s assets are less likely invested in the fund

• Available only to qualified investors, high-net worth individuals and

institutions by a confidential offering memorandum and a

partnership agreement

• Available to the general public by prospectus

• Typically not allowed to advertise • Allowed to advertise

• Limited by SEC to “limited partners“ investing in a fund • Available to retail investors

• Minimal limited by the SEC in the securities or strategies they may

use

• Subject to SEC regulations by way of strategies they can use and

underlying instruments that they can invest in

• Entry is significant–$250K to $1MM+ • Entry is usually from a few thousand dollars

• Illiquid, may not be able to redeem at any time • Redeemed daily on the open markets

• Usually a lock-in period • Sometimes a fee to redeem early; shares can be bought or sold daily


Same same, but different

Industry Regulation and Investor Suitability

Regulation

• The exclusions from registration under the Federal Securities laws that apply to hedge funds and their securities offerings are central to hedge

funds' ability to operate in their current form

• Typically offered in private placement transactions which rely on the “safe harbor“ provisions of Regulation D, or the "safe harbor" for offerings

outside the United States contained in Regulation S

• Hedge Funds are able to avoid certain regulations by meeting criteria that is laid out in four general exclusions or exceptions:

1. Exclusion under Investment Company Act of 1940

2. Exemption under Securities Act of 1933

3. Exception from registration of fund manager under Investment Advisers Act of 1940

4. Exception from reporting requirements under Securities Exchange Act of 1933

• Exclusions define:

• Investment strategies

• Types of investors

• How they may be sold

• Changes in government regulation and legislation remain a threat to HFs’ status as stateless entities


Securities of hedge funds are typically offered in private placement transactions

Hedge Funds in Alternative Mutual Fund wrappers are governed by regular mutual fund regulations under ‘40 Act

Risks of Hedge Fund Investing

Risks

• They can be highly illiquid (AMFs by comparison are liquid and may not invest more than 15% in illiquid securities)

• Hedge fund managers may limit the ability of investors to withdraw funds. (AMFs may not restrict redemptions)

• This limitations are in themselves a potential source of risk because they constrain the ability to rebalance investor portfolios,

meet liquidity events, or react to manager underperformance

• Not required to provide valuation or periodic pricing (AMFs are valued daily)

• May involve complex tax structures (AMFs structures are simple)

• Delays in distributing important tax information

• Not subject to similar regulatory requirements as mutual funds (AMFs are mutual funds)

• Higher fees – management and incentive fee (AMFs charge only management fees)

• May have volatile performance

• No secondary market (AMFs do not need a secondary market)

• Restrictions on transferring interests in the fund (AMFs can be redeemed daily/bought and sold as mutual funds)


Not all hedge fund strategies may be appropriate even for sophisticated investors

Benefits of Hedge Fund Investing

Benefits

• Have an absolute performance objective

• May use leverage to enhance returns (AMFs can leverage only 1/3 of their equity. No limits on synthetic leverage using derivatives)

• Performance dependent primarily on advisor skill

• Low correlations with market indices

• Invest opportunistically in strategies where they see value

• Short-sell securities (AMFs may not derive more than 30% of profits from short selling and short term trading)

• May use derivatives to protect downside

• Access to information due to large research teams

• Can often invest based on a negotiated price


Hedge funds managers have more flexibility when defining and executing on

investment strategies

In Summary:


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