CHAPTER 1

INTRODUCTION TO HEDGE FUNDS

DEFINITION:

“An aggressively managed portfolio of investments that usesadvanced investment strategies such as leveraged, long, short andderivative positions in both domestic and international marketswith the goal of generating high returns (either in an absolutesense or over a specified market benchmark).

Legally, hedge funds are most often set up as private investmentpartnerships that are open to a limited number of investors andrequire a very large initial minimum investment. Investments inhedge funds are illiquid as they often require investors keeptheir money in the fund for at least one year.”

MEANING:

For the most part, hedge funds (unlike mutual funds) areunregulated because they cater to sophisticated investors. In theU.S., laws require that the majority of investors in the fund beaccredited. That is, they must earn a minimum amount of moneyannually and have a net worth of more than $1 million, along witha significant amount of investment knowledge. You can think ofhedge funds as mutual funds for the super rich. They are similarto mutual funds in that investments are pooled and professionallymanaged, but differ in that the fund has far more flexibility inits investment strategies.

It is important to note that hedging is actually the practice ofattempting to reduce risk, but the goal of most hedge funds is tomaximize return on investment. The name is mostly historical, asthe first hedge funds tried to hedge against the downside risk ofa bear market by shorting the market (mutual funds generallycan't enter into short positions as one of their primary goals).Nowadays, hedge funds use dozens of different strategies, so it

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isn't accurate to say that hedge funds just "hedge risk". Infact, because hedge fund managers make speculative investments,these funds can carry more risk than the overall market.

Hedge funds are privately-owned companies that pool investors'dollars and reinvest them into all kinds of complicated financialinstruments. Their goal is to outperform the market -- by a lot.Unlike mutual funds, whose owners are public corporations, theyare not regulated by the SEC (Securities and ExchangeCommission). For this reason, and many others, hedge funds arevery risky. However, it is exactly this risk that attracts manyinvestors who believe higher risk leads to higher return.Hedge funds offer more financial reward because of the way theirmanagers are paid, the types of financial vehicles they caninvest in, and their lack of financial regulation.

1. Hedge fund managers are compensated as a percent of the returnsthey earn. This attracts many investors who are frustrated by thefact that mutual funds are paid fees, regardless of fundperformance. Thanks to this compensation structure, hedge fundmanagers are driven to achieve above-market returns.

2. Hedge fund managers are very good at usingsophisticated derivatives, such as futures contracts, optionsand collateralized debt obligations. Derivatives allow hedge fundmanagers to profit even when the stock market is going down.Hedge fund managers can use put options, or cansell stocks short. Basically, these products all do two things:they use small amounts of money, or leverage, to control largeamounts of stocks or commodities. Second, they pay out by aparticular point in time. The combination of leverage and timingmeans that managers make outsize returns when they correctlypredict the market's rise or fall.

3. Since hedge funds aren't regulated, they have free rein toinvest in these high return, but speculative, financialvehicles.

There are two basic reasons for investing in a hedge fund: toseek higher net returns (net of management and performance fees)and/or to seek diversification. But how good are hedge fund atproviding either? Let's take a look. At it as follows;

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1.Potential for Higher Returns, Especially in a BearMarket: 

Higher returns are hardly guaranteed. Most hedge funds invest inthe same securities available to mutual funds and individualinvestors. You can therefore only reasonably expect higherreturns if you select a superior manager or pick a timelystrategy. Many experts argue that selecting a talented manager isthe only thing that really matters. This helps to explain whyhedge fund strategies are not scalable, meaning bigger is notbetter. With mutual funds, an investment process can bereplicated and taught to new managers, but many hedge funds arebuilt around individual "stars", and genius is difficult toclone. For this reason, some of the better funds are likely to besmall. 

A timely strategy is also critical. The often-cited statisticsfrom CSFB/Tremont Index in regard to hedge fund performanceduring the 1990s are revealing. From January 1994 to September2000 - a raging bull market by any definition - the passive S&P500 Index outperformed every major hedge fund strategy by awhopping 6% in annualized return. But particular strategiesperformed very differently. For example, dedicated shortstrategies suffered badly, but market neutral strategiesoutperformed the S&P 500 Index in risk-adjusted terms (i.e.underperformed in annualized return but incurred less than one-fourth the risk). If your market outlook is bullish, you willneed a specific reason to expect a hedge fund to beat the index.Conversely, if your outlook is bearish, hedge funds should be anattractive asset class compared to buy-and-hold or long-onlymutual funds. Looking at the period up to the middle of 2009, wecan see that the Credit Suisse/Tremont Hedge Fund Index made upground on the S&P 500 with net average annual performance of8.93% versus 6.46% for the S&P 500 (since January 1994). Thedivergence of performance between these two periods shows thattiming is critical when investing in hedge funds.

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2. Diversification Benefits: 

Many institutions invest in hedge funds for the diversificationbenefits. If you have a portfolio of investments, addinguncorrelated (and positive-returning) assets will reduce totalportfolio risk. Hedge funds - because theyemploy derivatives, short sales or non-equity investments -tend to be uncorrelated with broad stock market indexes. Butagain, correlation varies by strategy. Historical correlationdata (e.g. over the 1990s) remains somewhat consistent.Hedge fund investors are exposed to multiple risks, and eachstrategy has its own unique risks. For example, long/shortfunds are exposed to the short-squeeze. 

The traditional measure of risk is volatility, or theannualized standard deviation of returns. Surprisingly, mostacademic studies demonstrate that hedge funds, on average, areless volatile than the market. For example, over the periodfrom 1994 to 2009 we referred to earlier, volatility(annualized standard deviation) of the S&P 500 was about 15.5%while volatility of the aggregated hedge funds was only about8%. In risk-adjusted terms, as measured by the Sharperatio (unit of excess return per unit of risk), some strategiesoutperformed the S&P 500 Index over the bull market periodmentioned earlier.

The problem is that hedge fund returns do not follow thesymmetrical return paths implied by traditional volatility.Instead, hedge fund returns tend to be skewed. Specifically,they tend to be negatively skewed, which means they bear thedreaded "fat tails", which are mostly characterized by positivereturns but a few cases of extreme losses. For this reason,measures of downside risk can be more useful than volatility orSharpe ratio. Downside risk measures, such as value atrisk (VaR), focus only on the left side of the returndistribution curve where losses occur. They answer questionssuch as, "What are the odds that I lose 15% of the principal in

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one year?" 

CHAPTER 2

EVOLUTION OF HEDGE FUNDSFamed hedge fund manager Mario Gabelli in 2002: "Today, ifasked to define a hedge fund, I suspect most folks wouldcharacterize it as a highly speculative vehicle for unwitting fatcats and careless financial institutions to lose theirshirts." This characterization stems from the hedge fund's recenthistory, which began with the headline-making collapse of LongTerm Capital Management in 1998 and continued with thesensational meltdown of the Tiger Funds in March of 2000,followed by the reorganization of the once high-flying QuantumFund in April of 2000. These high-profile incidents overshadowmore than half a century of hedge fund history that began whenAlfred Winslow Jones launched the first hedge fund in 1949. 

The Father of the Hedge Fund: 

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Alfred Jones was born in Melbourne, Australia in 1901 to Americanparents. He moved to the United States as a young child,graduated from Harvard in 1923 and became a U.S. diplomat in theearly 1930s, working in Berlin, Germany. He earned a PhD insociology from Columbia University and joined the editorial staffat Fortune magazine in the early 1940s. 

It was while writing an article about current investment trendsfor Fortune in 1948 that Jones was inspired to try his hand atmanaging money. He raised $100,000 (including $40,000 out of hisown pocket) and set forth to try to minimize the risk in holdinglong-term stock positions by short selling other stocks. Thisinvesting innovation is now referred to as the classic long/shortequities model. Jones also employed leverage in an effort toenhance returns. 

In 1952, Jones altered the structure of his investment vehicle,converting it from a general partnership to a limitedpartnership and adding a 20% incentive fee as compensation forthe managing partner. As the first money manager to combine shortselling, the use of leverage, shared risk through a partnershipwith other investors and a compensation system based oninvestment performance, Jones earned his place in investinghistory as the father of the hedge fund. 

The Rise of the Industry:

When a 1966 article in Fortune magazine highlighted an obscureinvestment that outperformed every mutual fund on the market bydouble-digit figures over the past year and by high double-digitsover the last five years, the hedge fund industry was born. By1968, there were some 140 hedge funds in operation. 

In an effort to maximize returns, many funds turned away fromJones' strategy, which focused on stock picking coupledwith hedging, and chose instead to engage in riskier strategiesbased on long-term leverage. These tactics led to heavy losses in1969-70, followed by a number of hedge fund closures during thebear market of 1973-74. 

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The industry was relatively quiet for more than two decades,until a 1986 article inInstitutional Investor touted the double-digitperformance of Julian Robertson's Tiger Fund. With a high-flyinghedge fund once again capturing the public's attention with itsstellar performance, investors flocked to an industry that nowoffered thousands of funds and an ever-increasing array of exoticstrategies, including currency trading and derivatives suchasfutures and options. 

High-profile money managers deserted the traditional mutualfund industry in droves in the early 1990s, seeking fame andfortune as hedge fund managers. Unfortunately, history repeateditself in the late 1990s and into the early 2000s as a number ofhigh-profile hedge funds, including Robertson's, failed inspectacular fashion. 

The Hedge Fund Today:

With media attention still focused on the recent failure of somehedge funds, there has been an increasing move towards theirregulation. In 2004, the Securities and Exchange Commissionadopted changes that require hedge fund managers and sponsors toregister as investment advisors under the Investment Advisor'sAct of 1940. This greatly increased the number of requirementsplaced on hedge funds, including keeping up-to-date performancerecords, hiring a compliance officer and creating a code ofethics. This was seen as an important move in protectinginvestors.

Despite troubles in the last few years, the hedge fund industrycontinues to thrive. The development of the "fund of funds",which is simplistically defined as a mutual fund that invests inmultiple hedge funds, provided greater diversification forinvestors' portfolios and reduced the minimum investmentrequirement to as low as $25,000. The introduction of the fund offunds not only took some of the risk out of hedge fund investing,

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but also made the product more accessible to the averageinvestor. 

The very first hedge fund was started by Alfred W. Jones in 1949.By using leverage and short selling, he effectively "hedged" riskin the marketplace. Though his hedge fund greatly outperformedmutual funds of that time, hedge funds really didn't feign muchinterest until the 60's. Big names like Warren Buffet and GeorgeSoros took an interest in Jone's strategy, and over the next theyears, 130 hedge funds were born. 

Hedge funds, like other alternative investments such as realestate and private equity, are thought to provide returns thatare uncorrelated with traditional investments. This attracted anincreasing number of individual and institutional investors.However, while Alfred Jones' strategy employed short selling andleverage, there are a multitude of different strategies used byhedge fund managers today, and the term "hedge" doesn't alwaysapply, since many of these funds are not hedged at all. In fact,many hedge funds attempt to capture absolute returns and takepositions that are often highly speculative. 

In 2008, the hedge fund industry faced one of its worse years inhistory as markets across the globe crumbled. Many of the bestand brightest managers and investors faced losses of 30 percentor more, and assets under management decreased as investors optedinto treasury bills and cash investments. Still, many of thestrategies utilized by hedge fund managers capture greaterreturns in a volatile market, and some of the hedge funds foundways to make investors money despite the financial crisis. 

In the first half of 2009, the industry as a whole has bouncedback in dramatic fashion and seen its popularity rise among many

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investors. What does the future hold for this often misunderstoodinvestment class? Only time will tell. 

CHAPTER 3

HEDGE FUND STRATEGIES

1.Hedge Fund Strategy - Equity Long-Short:An equity long-short strategy is an investing strategy, usedprimarily by hedge funds, that involves taking long positions instocks that are expected to increase in value and short positionsin stocks that are expected to decrease in value.

You may know that taking a long position in a stock simply meansbuying it: If the stock increases in value, you will make money.

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On the other hand, taking a short position in a stock meansborrowing a stock you don’t own (usually from your broker),selling it, then hoping it declines in value, at which time youcan buy it back at a lower price than you paid for it and returnthe borrowed shares.

Hedge funds using equity long-short strategies simply do this ona grander scale. At its most basic level, an equity long-shortstrategy consists of buying an undervalued stock and shorting anovervalued stock. Ideally, the long position will increase invalue, and the short position will decline in value. If thishappens, and the positions are of equal size, the hedge fund willbenefit. That said, the strategy will work even if the longposition declines in value, provided that the long positionoutperforms the short position. Thus, the goal of any equitylong-short strategy is to minimize exposure to the market ingeneral, and profit from a change in the difference, or spread,between two stocks.

That may sound complicated, so let’s look at a hypotheticalexample. Let’s say a hedge fund takes a $1 million long positionin Pfizer and a $1 million short position in Wyeth, both largepharmaceutical companies. With these positions, any event thatcauses all pharmaceutical stocks to fall will lead to a loss onthe Pfizer position and a profit on the Wyeth position.Similarly, an event that causes both stocks to rise will havelittle effect, since the positions balance each other out. So,the market risk is minimal. Why, then, would a portfolio managertake such a position? Because he or she thinks Pfizer willperform better than Wyeth.

Equity long-short strategies such as the one described, whichhold equal dollar amounts of long and short positions, are calledmarket neutral strategies. But not all equity long-shortstrategies are market neutral. Some hedge fund managers willmaintain a long bias, as is the case with so-called “130/30”strategies. With these strategies, hedge funds have 130% exposureto long positions and 30% exposure to short positions. Otherstructures are also used, such as 120% long and 20% short. (Fewhedge funds have a long-term short bias, since the equity marketstend to move up over time.)

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Equity long-short managers can also be distinguished by thegeographic market in which they invest, the sector in which theyinvest (financial, health care or technology, for example) ortheir investment style (value or quantitative, for example).Buying and selling two related stocks—for example, two stocks inthe same region or industry—is called a “paired trade” model. Itmay limit risk to a specific subset of the market instead of themarket in general.

Equity long-short strategies have been used by sophisticatedinvestors, such as institutions, for years.

They became increasingly popular among individual investors astraditional strategies struggled in the most recent bear market,highlighting the need for investors to consider expanding theirportfolios into innovative financial solutions. Equity long-short strategies are not without risks. Thesestrategies have all the generic hedge fund risks: For example,hedge funds are typically not as liquid as mutual funds, meaningit is more difficult to sell shares; the strategies they usecould lead to significant losses; and they can have high fees.Additionally, equity long-short strategies have some uniquerisks. The main one is that the portfolio manager must correctlypredict the relative performance of two stocks, which can bedifficult. Another risk results from what is referred to in theindustry as “beta mismatch.” While this is more complicated thatwe can explain in detail here, essentially, it means that

When the stock market declines sharply, long positions couldlose more than short positions.

In summary, equity long-short strategies may help increasereturns in difficult market environments, but also involve somerisk. As a result, investors considering these strategies maywant to ensure that their hedge funds follows strict rules toevaluate market risks and find good investment opportunities.

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2.Hedge Fund Strategy - Convertible Arbitrage:Convertible arbitrage is a type of equity long short investingstrategy often used by hedge funds.An equity long-short strategy is an investing strategy whichinvolves taking long positions in stocks that are expected toincrease in value and short positions in stocks that are expectedto decrease in value.

Instead of purchasing and shorting stocks, however, convertiblearbitrage takes a long position in, or purchases, convertiblesecurities. It simultaneously takes a short position in, orsells, the same company’s common stock.

To understand how that works, it is important to know whatconvertible securities are. A convertible security is a securitythat can be converted into another security at a pre-determined

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time and a pre-determined price. In most cases, the term appliesto a bond that can be converted into a stock. Convertible bondsare considered neither bonds nor stocks, but hybrid securitieswith features of both. They may have a lower yield than otherbonds, but this is usually balanced by the fact that they can beconverted into stock at what is usually a discount to the stock’smarket value. In fact, buying the convertible bond places theinvestor in a position to hold the bond as-is, or to convert itto stock if he or she anticipates that the stock’s price willrise.

The idea behind convertible arbitrage is that a company’sconvertible bonds are sometimes priced inefficiently relative tothe company’s stock. Convertible arbitrage attempts to profitfrom this pricing error.

To illustrate how convertible arbitrage works, a hedge fundusing convertible arbitrage will buy a company’s convertiblebonds at the same time as it shorts the company’s stock. If thecompany’s stock price falls, the hedge fund will benefit from itsshort position; it is also likely that the company’s convertiblebonds will decline less than its stock, because they areprotected by their value as fixed-income instruments. On theother hand, if the company’s stock price rises, the hedge fundcan convert its convertible bonds into stock and sell that stockat market value, thereby benefiting from its long position, andideally, compensating for any losses on its short position.

Convertible arbitrage is not without risks. First, it is trickierthan it sounds. Because one generally must hold convertible bondsfor a specified amount of time before they can be converted intostock, it is important for the convertible arbitrageur toevaluate the market carefully and determine in advance if marketconditions will coincide with the time frame in which conversionis permitted.

Additionally, convertible arbitrageurs can fall victim tounpredictable events. One example is the market crash of 1987,when many convertible bonds declined more than the stocks intowhich they were convertible, for various reasons which are nottotally understood even today. A more recent example occurred in2005, when many arbitrageurs had long positions in General Motors

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(GM) convertible bonds and short positions in GM stock. Theysuffered losses when a billionaire investor tried to buy GM stockat the same time its debt was being downgraded by credit-ratingsagencies.

Finally, convertible arbitrage has become increasingly popular inrecent years as investors have sought alternative investmentoptions. That has reduced the effectiveness of the strategy.

In summary, convertible arbitrage, like other long-shortstrategies, may help increase returns in difficult marketenvironments, but it isn’t without risks. As a result, investorsconsidering a hedge fund that uses convertible arbitrage may wantto carefully evaluate whether the potential return is balanced bythe potential risks.

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3.Understanding Fixed-Income Arbitrage:Fixed-income arbitrage is an investment strategy that exploitspricing differentials between fixed-income securities.

Before we explain that, let’s review the concept of arbitrage.Arbitrage, at its most simplest, involves buying securities onone market for immediate resale on another market in order toprofit from a price discrepancy. But in the hedge fund world,arbitrage more commonly refers to the simultaneous purchase andsale of two similar securities whose prices, in the opinion ofthe trader, are not in sync with what the trader believes to betheir “true value.” Acting on the assumption that prices willrevert to true value over time, the trader will sell short theoverpriced security and buy the underpriced security. Once pricesrevert to true value, the trade can be liquidated at a profit.(Remember, short selling is simply borrowing a security you don’town, selling it, then hoping it declines in value, at which timeyou can buy it back at a lower price than you paid for it andreturn the borrowed securities.) Arbitrage can also be used tobuy and sell two stocks, two commodities and many othersecurities.

Although many investors are unfamiliar with the term “fixed-income arbitrage” most have heard of one of its major users: LongTerm Capital Management, a hedge fund that in the 1990s realizedaverage annual returns of greater than 40%, then had to be bailed

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out by several Wall Street firms at the encouragement of the U.S.Federal Reserve Board.

To understand fixed-income arbitrage, it is important to havesome familiarity with fixed-income securities. At their mostbasic level, fixed-income securities are simply debt instruments,issued by private companies or public entities, which promise afixed stream of income. U.S. Treasuries, corporate bonds andmunicipal bonds bonds are examples. There are, however, moresophisticated fixed-income securities, such as credit defaultswaps.

Credit default swaps are complex financial instruments similar toinsurance contracts in that they provide the buyer withprotection against specific risks. So, for example, say you buy acorporate bond from Company ABC. You think the company will payyou back with interest, but it might default, and you invested alot of money, so you want some added protection. So, you callyour insurance company and ask it to sell you insurance againstthe possible default of Company ABC’s bonds. Your insurancecompany charges you a fee for that insurance, just as it would ifyou were buying car insurance or homeowner’s insurance. Buthere’s the catch: When it comes to credit default swaps, youdon’t have to actually own the asset in order to insure it. Yourinsurance company is selling insurance on Company ABC’s stock toanyone. In other words, it’s selling pieces of paper—securitiesthat fall into the “derivatives” category—called credit defaultswaps. And these pieces of paper are traded over-the-counter bysophisticated investors.

The reason for that detailed explanation of credit default swaps,as you might have guessed, is that they are often used in fixed-income arbitrage. In fact, one of the most popular fixed-incomearbitrage strategies is called “swap-spread arbitrage.” Whileswap-spread arbitrage is too complex a topic to explain in fullhere, it involves taking a bet on the direction of credit defaultswap rates and other interest rates, such as the interest rate ofU.S. Treasuries or the London Interbank Offered Rate (LIBOR,which is the interest rate banks charge each other for loans).

There are many other fixed-income arbitrage strategies, however.Another is called yield curve arbitrage. The yield curve is a

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graphical representation of how yields on bonds of differentmaturities compare. When the yield curve is flat, shorter- andlonger-term yields are close. When the yield curve is heavilysloped, there is a greater gap between short- and long-termyields. Yield-curve arbitrageurs seek to profit from shifts inthe yield curve by taking long and short positions in Treasuriesof various maturities.

Another fixed-income arbitrage strategy is capital structurearbitrage, which seeks to profit from the pricing differentialsbetween various claims on a company, such as its debt and stock.For example, a capital structure arbitrageur who believes acompany’s debt is overpriced relative to its stock might shortthe company’s debt and buy the company’s stock.

Fixed-income arbitrageurs must be willing to accept significantrisk. That’s because fixed-income arbitrage typically providesrelatively small returns, but can potentially lead to hugelosses. In fact, many people refer to fixed-income arbitrage as"picking up nickels in front of a steamroller."

Because of the limited returns and huge risks involved, largeinstitutional investors with significant assets—such as hedgefunds, private equity firms and investment banks—are the majorusers of fixed-income arbitrage.

In summary, then, fixed-income arbitrage could be a goodinvestment option, but it is best used by institutional investorswho have significant assets and are willing to accept the risks

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4.Hedge Fund Strategy - Emerging Markets Fund:An emerging market hedge fund is a hedge fund that specializesits investments in the securities of emerging market countries.

Although there is no exact definition of “emerging marketcountries,” these countries are in the process of developing.They typically have per-capita incomes on the lower to middle endof the world range, and are in the process of moving from aclosed market to an open market.

As a result, emerging market countries include a wide range ofnations. China and Russia, two of the world's economicpowerhouses, are lumped in the emerging market category withPeru, a much smaller country with fewer resources, because allhave recently embarked on economic development and reformprograms, and have thus “emerged” onto the global financialscene. In fact, while only around 20% of the world’s nations areconsidered emerging market countries, these countries constituteapproximately 80% of the global population.

Although emerging market stocks have been available for some timethrough emerging market mutual funds, earlier this decade,institutional investors such as pension funds and endowmentsstarted looking for alternative investment options and beganpouring money into emerging market hedge funds as well.

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Emerging market hedge funds offer one significant advantage overemerging market mutual funds. While mutual funds typically investonly in stocks and bonds, hedge funds can offer exposure to moresophisticated investments, including commodities, real estate,currencies and derivatives (which are contracts to buy or sellanother security at a specified price, and include futures andoptions). Emerging market hedge funds can also use leverage,which is essentially investing with borrowed money. Thesestrategies could significantly increase return potential. Along with the increase return potential, however, comesincreased risk potential. Emerging market hedge funds have allthe generic hedge fund risks: For example, hedge funds aretypically not as liquid as mutual funds, meaning it is moredifficult to sell shares; the strategies they use could lead tosignificant losses; and they can have high fees. Additionally,investing in the emerging markets has some unique risks,including a lack of transparency, which makes it hard to evaluateinvestment opportunities; relative illiquidity; and extremevolatility.

In fact, any downturn in these countries’ securities could beself-propagating: If hedge fund investors, faced with a downturnin one emerging market country demand their money back, hedgefunds could be forced to sell holdings in unaffected markets tomeet redemption requests, leading to a steep slide in regionsthat weren’t originally affected.

One final downside to emerging market hedge funds is that they,like all hedge funds, are not currently regulated by the U.S.Securities and Exchange Commission (SEC), a financial industryoversight entity. As a result, they are typically open only to alimited range of investors. Specifically, U.S. laws require thathedge fund investors be “accredited,” which means they must earna minimum annual income, have a net worth of more than $1million, and possess significant investment knowledge.

In summary, emerging market hedge funds may be a good choice forinvestors who want more access to the emerging markets thanemerging market mutual funds can offer—if they can meet thesuitability requirements and are willing to accept the increasedrisk.

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5.Hedge Fund Strategy - Fund of Hedge Funds:A fund of hedge funds is an investment vehicle whose portfolioconsists of shares in a number of hedge funds.

The fund of funds strategy can be applied to any type ofinvestment fund, from a mutual fund to a private equity fund. Thefund of funds – which may also be called a collective investmentor a multi-manager investment – simply holds a portfolio of otherinvestment funds instead of investing directly in securities,such as stocks, bonds, commodities or derivatives.

Funds of hedge funds simply follow this strategy by constructinga portfolio of other hedge funds. How the underlying hedge fundsare chosen can vary. A fund of hedge funds may invest only inhedge funds using a particular management strategy. Or, a fund ofhedge funds may invest in hedge funds using many differentstrategies in an attempt to gain exposure to all of them.

The benefit of owning any fund of fund is experienced managementand diversification. A portfolio manager uses his or herexperience and skill to select the best underlying funds based onpast performance and other factors. If the portfolio manager istalented, this can increase return potential and decrease riskpotential, since putting your eggs in more than one basket mayreduce the dangers associated with investing in a single hedgefund.

With funds of hedge funds, there is an additional benefit, giventhat most hedge funds have prohibitively high initial minimuminvestments. Through a fund of hedge funds, investors cantheoretically gain access to a number of the country’s best hedgefunds with a relatively smaller investment. For example,investing in five hedge funds with $1,000,000 minimums wouldrequire $5,000,000. Investing in a fund of hedge funds thatinvests in those same underlying funds may require just$1,000,000.

In fact, it may even require less. Sometimes a fund of hedgefunds will invest in only one hedge fund, but offer shares at amuch lower initial minimum investment that the underlying hedgefund does. This gives investors access to an acclaimed fund withless cash than would normally be required.

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One disadvantage of investing in a fund of hedge funds is thefees. These funds generally charge a fee for their services inaddition to the fees charged by the underlying hedge funds. Inother words, each underlying hedge fund might charge a fee of 1%to 2% of assets under management and an incentive fee of 15% to25% of profits generated. On top of that, a fund of hedge fundswill typically charge its own fees. While fund of hedge fundshave been criticized for this “incremental fee” structure,portfolio managers often argue that the fees are more than madeup for by potential higher risk-adjusted returns offered by fundsof hedge funds.

In summary, funds of hedge funds may be appealing to investorsseeking the high return potential of hedge funds along with alittle diversification to help manage risk and lower investmentminimums – but before investing, be sure you know how much feeswill cut into your returns.

CHAPTER 4

HEDGE FUND REGULATOTS IN INDIA

The Securities Exchange Board of India imposed rules onalternative investment funds in May 2012.

The capital markets regulator organizes alternative investmentfunds - such as venture capital, social venture funds, small andmedium enterprise funds and hedge funds - under three categories.

Hedge funds fall under a category that allows them to undertakeleverage and employ complex trading strategies.

Below are some of the rules set for this category:

* Such a fund must manage assets with a total value of at least200 million rupees.

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* An individual investor must contribute at least 10 millionrupees to the fund.

* The manager/sponsor must own a stake of 5 percent of the assetsunder management, or 100 million rupees, whichever is lower.

* No fund can have more than 1,000 investors.

* Funds may be open-ended or close-ended.

* Funds cannot invest more than 10 percent of assets in onecompany.

* Funds must disclose information regarding the overall level ofleverage.

* Foreign funds can apply for licenses, provided they establishor incorporate a fund locally.

* Funds can raise money from all investors, including foreigninvestors.

SEBI NOTIFIES SEBI (ALTERNATIVE INVESTMENT PLAN) REGULATION 2012:

1. The SEBI (Alternative Investment Funds) Regulations, 2012(“AIF Regulations”) have been notified today. The AIFRegulations are available on the SEBIwebsite http://www.sebi.gov.in/

2. AIFs Regulations endeavour to extend the perimeter ofregulation to unregulated funds with a view to systemicstability, increasing market efficiency, encouragingformation of new capital and consumer protection. Salient

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features of the AIF Regulations, inter alia, include thefollowing:

      Scope of the Regulations and applicability toexisting funds:

a. All AIFs whether operating as Private Equity Funds, RealEstate Funds, Hedge Funds, etc. must register with SEBIunder the AIF Regulations.

b. SEBI (Venture Capital Funds) Regulations, 1996 (“VCFRegulations”) have been repealed. However, existing VCFsshall continue to be regulated by the VCF Regulations tillthe existing fund or scheme managed by the fund is wound up.Existing VCFs, however, shall not increase the targetedcorpus of the fund or scheme as it stands on the day of  Notification of these Regulations. Such VCFs may also seekre-registration under AIF regulations subject to approval of66.67% of their investors by value.

c. Existing funds not registered under the VCF Regulations willnot be allowed to float any new scheme without registrationunder AIF Regulations. However, schemes floated by suchfunds before coming into force of AIF Regulations, shall beallowed to continue to be governed till maturity by thecontractual terms, except that no rollover/ extension orraising of any fresh funds shall be allowed.

d. Existing funds not registered under the VCF Regulationswhich seek registration but are not able to comply with allprovisions of AIF Regulations may seek exemption from theBoard from strict compliance with the AIF Regulations.

Categories of the funds:

               The Regulation seeks to cover all typesof funds broadly under 3 categories. An application can bemade to SEBI for registration as an AIF under one of thefollowing 3 categories:-

Category I AIF – those AIFs with positive spillover effects onthe economy,  for which certain incentives or concessions mightbe considered by SEBI or Government of India or other regulatorsin India; and which shall include Venture Capital Funds, SME

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Funds, Social Venture Funds, Infrastructure Funds and such otherAlternative  Investment Funds as may be specified. These fundsshall be close ended, shall not engage in leverage and shallfollow investment restrictions as prescribed for each category.Investment restrictions for VCFs are similar to restrictions inthe existing VCF Regulations.

 

Category II AIF – those AIFs for which no specific incentivesor concessions are given by the government or any otherRegulator; which shall not undertake leverage other than to meetday-to-day operational requirements as permitted in theseRegulations; and which shall include Private Equity Funds, DebtFunds, Fund of Funds and such other funds that are not classifiedas category I or III.  These funds shall be close ended, shallnot engage in leverage and have no other investment restrictions.

Category III AIF – those AIFs including hedge funds whichtrade with a view to make short term returns; which employsdiverse or complex trading strategies and may employ leverageincluding through investment in listed or unlistedderivatives.     These funds can be open ended or close ended.Category III funds shall be regulated through issuance ofdirections regarding areas such as operational standards, conductof business rules, prudential requirements, and restrictions onredemption, conflict of interest as may be specified by theBoard.

   Other salient features:

a. The Alternative Investment Fund shall not accept from aninvestor an investment of value less than rupees one crore.Further, the AIF shall have a minimum corpus of Rs. 20crore.

b. The fund or any scheme of the fund shall not have more than1000 investors.

c. The manager or sponsor for a Category I and II AIF shallhave a continuing interest in the AIF of not less than 2.5%of the initial corpus or Rs.5 crore whichever is lower and

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such interest shall not be through the waiver of managementfees.

d. For Category III Alternative Investment Fund, the continuinginterest shall be not less that 5% of the corpus or rupeesten crore, whichever is lower.

e. Category I and II AIFs shall be close-ended and shall have aminimum tenure of 3 years. However, Category III AIF mayeither be close-ended or open-ended.

f. Schemes may be launched under an AIF subject to filing ofinformation memorandum with the Board along with applicablefees.

g. Units of AIF may be listed on stock exchange subject to aminimum tradable lot of rupees one crore. However, AIF shallnot raise funds through Stock Exchange mechanism.

h. Category I and II AIFs shall not be permitted to invest morethan 25% of the investible funds in one Investee Company.Category III AIFs shall invest not more than 10% of thecorpus in one Investee Company.

i. AIF shall not invest in associates except with the approvalof 75% of investors by value of their investment in theAlternative Investment Fund.

j. All AIFs shall have QIB status as per SEBI (Issue of Capitaland Disclosure Requirements) Regulations, 2009.

k. The Regulations provide for transparency and disclosures andmechanism for avoidance of conflict of interest.

CHAPTER NO 5

HEDGE FUND MANAGEMENT

1.RISK MANAGEMENT BY ARBITRAGE PRICING THEORY:25

Over 80% of hedge funds believe risk management will become morecentral to raising assets in 2013, according to a survey by Prmiaand SunGard APT.

While the percentage is virtually unchanged from 2012, it doesshow a long-term trend for risk management to be viewed not justas a cost centre but as an essential function.

One chief risk officer (CRO) of a US hedge fund commented in thesurvey: "[Risk management] is viewed by the board as a costcentre. From my perspective as CRO, I measure my success based onour investors' view of the company and whether we can retaintheir assets and attract new ones."

At present hedge funds tend to put the emphasis on short-termdownside risk measures. "Things like expected shortfall andconcentration risk we found were more used by hedge funds thanconventional statistical measures like volatility," says LaurenceWormald, head of research at SunGard APT.

He thinks hedge funds should do more stress testing "because wethink that is the real way of improving downside performance".

Stress testing is about future risk while most hedge fundsconcentrate on backward looking risk analytics.

Although investment teams discuss potential tail risks such asinflation or a Chinese hard landing, such shocks to the systemare not quantified "well enough to help people consider how theycan protect themselves", says Wormald.

He predicts hedge funds will move towards stress testing andscenario analysis. "It will be very important that [hedge funds]talk more about effective management of the downside," he says.This, for Wormald, is "almost synonymous" with scenario analysisand stress testing.

Stress testing is one of the most frequently used measures acrossbuy-side companies. Just over 10% of those surveyed use value atrisk (VaR) measures, equal to those using stress testing only.Volatility (10%), counterparty risk (9%) and historical scenarios

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(9%) were the other most commonly used risk measures. Furtherdown the agenda were risk attribution, tracking error andexpected shortfall, each used by 6% of survey respondents.

Integration of risk management into the investment process isseen as the main challenge by risk managers at hedge funds. Thiswas the second priority for all buy-side respondents who putbetter risk culture top of the list.

Another area of concern for the hedge fund community isregulation, according to the survey. More than a third of allrespondents say regulatory uncertainty has made their companymore risk-aware. Almost one in two believe Dodd-Frank andSolvency II will increase the cost of doing business while only14% say regulation has improved risk processes.

In Europe the introduction of the alternative investment fundmanagers (AIFM) directive is pushing hedge funds and allalternative funds towards a uniform approach to risk managementand measurement. The directive is putting hedge funds "in a box"and forcing them to become more like retail Ucits funds inreporting to regulators and investors, according to Wormald.

There were 375 respondents to the survey, conducted jointly byPrmia and SunGard APT. All of the respondents were Prmia membersor buy-side risk manager clients or prospective clients ofSunGard APT. The survey was conducted in October and November2012.

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CHAPTER NO 6

HEDGE FUND PERFORMANCES IN PAST FIVE YEARS

The February 2013 edition of Bloomberg Markets Magazine featuresits ranking of the top 100 large hedge fund managers in theworld.Unlike last year when the most successful hedge funds were avariety of strategies — long/short, macro etc. — this year'ssuccess stories mostly come from the world of mortgage bonds.This strategy provided an average return of 20.2 percent in 2012,far outpacing the industry average of 1.3 percent.The tiny average return was also far worse than the performanceof the S&P 500, which provided a double-digit return in2012. Bloomberg reports 635 hedge funds closed due to these poorreturns through September.The hedge fund managers listed here, though, are far from closingup shop — some of them even manage multiple successful funds. In2012, they dominated the market with returns ranging from 9 to37.8 percent.Barclay Hedge Fund Index:

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The Barclay Hedge Fund Index is a measure of the average returnof all hedge funds (excepting Funds of Funds) in the Barclaydatabase. The index is simply the arithmetic average of the netreturns of all the funds that have reported that month.

The Barclay Hedge Fund Index is recalculated and updated real-time on this page as soon as the monthly returns for theunderlying funds are recorded. Only funds that provide us withnet returns are included in the index calculation. The number offunds that are currently included in the calculations for themost recent months can be found in the footnotes below. Pleasenote that the calculation for the number of funds is time-stampedand that the number of funds will continue to increase until allfunds categorized within the sector have reported monthlyreturns. The following given on next page explains in detail ofthe Barclay hedge fund index.

 

  2013 2012 2011 2010 2009

Jan 2.48% 3.10% 0.44% -0.41% -0.14%

Feb 0.28% 2.31% 1.16% 0.76% -1.46%

Mar 1.37% 0.03% 0.23% 2.82% 2.04%

Apr 0.54% -0.58% 1.14% 1.27% 4.27%

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May 0.87% -3.04%

Jun -1.52% 0.59%

Jul 1.62% 0.74%

Aug -0.61% 0.98%

Sep 2.03% 1.61%

Oct 1.75%§ 0.12%

Nov 0.22%† 0.53%

Dec - 1.70%

YTD 9.32%* 8.25%†Estimated performance for November 2013 calculated withreported data from 900 funds.

§Estimated performance for October 2013 calculated withreported data from 2740 funds.

*All estimates and 2013 YTD amounts are calculated withreported data as of December-8-2013 00:14 US CST.

INDIAN PERFORMANCE OF HEDGE FUNDS:

ARVIND JAYARAM BL RESEARCH BUREAU

October 18, 2013:  

India-focused hedge funds snapped their four-month losing streakin September this year, gaining 7.1 per cent. This was betterthan returns from hedge funds broadly focused on Asia and evenoutperformed Japanese hedge funds.

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But it was not sufficient to cover up slippages in previousmonths and India-focused funds were down 11.5 per cent in theJanuary-September period this year.

These funds are clearly not the best choice if you want to putyour money in a hedge fund. Indian hedge funds have posted lossesof 3.6 per cent for the July-September quarter. In contrast,Asia-focused hedge funds have delivered an average return of 9.9per cent for January-September 2013.

BACK TO EARNINGSGlobally, hedge funds were back to earning mode in September,thanks to rallies in underlying markets. North American hedgefunds were up 1.7 per cent during the month after losing 0.4 percent in August, while hedge funds targeted at emerging marketsbounced back by 2.1 per cent after shedding 0.7 per cent in theprevious month.

European hedge funds, too, posted a 2.5 per cent return forSeptember, compared with a 0.2 per cent decline in August.

But despite the gains, hedge fund performance was inferior to thereturns from equity markets. The Eureka. Hedge. Hedge FundIndex — which tracks the performance of 2,404 funds — was up 1.2per cent during September, whereas the MSCI World Index gained3.9 per cent.

SUSTAINED FUND INFLOWS:Positive investor sentiment in hedge funds drove up the totalassets under management of the sector to $1.9 trillion inSeptember, just 2 per cent shy of their historical peak. This wasthe eighth straight month of net inflows into global hedge funds,with $90 billion mopped up since January, according to financialdata from research firm Eurekahedge.

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Among the highlights of the month was that assets in long/shortequity hedge funds surpassed the $600-billion mark for the firsttime since 2008 after attracting fresh inflows of $1.3 billion.However, they remained below the peak of $756 billion reached inOctober 2007.

Multi-strategy funds witnessed healthy allocation activity inSeptember as well, with net positive inflows of $0.9 billion.These funds delivered a 6 per cent return for the 12 months toSeptember.

Fixed income funds, too, saw net inflows of $0.3 billion duringthe month under review, taking their total inflows in 2013 to$31.1 billion as of September. The total assets under managementby fixed income hedge funds now stand at a record $142.5 billion.They gained 7.1 per cent between September 2012 and September2013.

On the other hand, commodity trading manager (CTA)/managedfutures funds — which tracks funds that use futures contracts aspart of their overall investment strategy — witnessed net assetoutflows for the fourth consecutive month. Eurekahedge expectsfurther outflows from the strategy, as these funds have notdelivered the requisite performance in 2012 and 2013, even thoughthey attracted significant capital in 2011.

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CHAPTER NO 7

RISK MEASURMENT AND RISK MANAGEMENT

INTRODUCTION TO RISK:

Being financially secure is one of the most important things wehave to work for throughout our lives. While living out ourpassions and living in the moment are romantically essential toliving a meaningful life, we should not neglect the practicalside of things Let’s face it, we will eventually be too old towork and won’t be as healthy as we were 30 or 40 years ago. Beingpassionate about life and living in the moment knowing that youhave no financial debts to pay and have enough saved for therainy days are keys to not only a meaningful life, but a peacefulone.

An important aspect of a secured financial future is investments.We may invest in money, properties, precious metals, andbusiness, among others. But in seeking for rewards, there arealways risks involved. Especially when it comes to money matters.Being financially educated is the best way to avoid losses and tohave a clearer understanding of how your money should work foryou. After all, the years we spend working hard for a comfortablelife would all be put to waste if we are not able to get what wedeserve.

Systematic and Unsystematic Risks

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In finance, there are two types of risks – systematic risks andunsystematic risks and it would be very beneficial to be aware ofboth.

Unsystematic Risk

Are investment risks that come with having assets or putting up abusiness and the myriads of problems that you could possiblyencounter. Examples of these would be delay in product roll out,employees, or ultimately, financial loss. Further examples areliquidity and marketability risks (Are you putting up your hedgefunds the right way? Are your current assets well enough toappreciate instead of depreciate?); and credit risks (not beingable to pay on time thereby falling into debt).

 Systematic Risks

On the other hand, is a collapse of an entire financial system ormarket thereby not only caused by an individual, or a group or acertain element of the system. More specific examples of suchrisks would be recession, interest rates, and wars mostlysuffered by an entire country. As a system always works withfacets interdependent to one another, a certain failure in onemay cause a complete collapse leading to bankruptcy or a bringingdown of the market entirely.

RISK MANAGEMENT:

1.Hedge funds by the both alpha-generating potentialand better risk profile than equities or bondswhile being uncorrelated to both:

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Most hedge funds are self-described absolute return vehicles thatpromote their ability to produce superior alpha versus othertypes of investments. It was the allure of double-digit returnsfollowing the tech bubble collapse that sparked the explosion ofhedge funds in the early 2000s. 

Recent hedge funds returns have been lack lustre compared withequity investments. Moreover, the introduction of low-cost equityinvestments through the tremendous growth of exchange-tradedfunds (ETFs) coupled with disappointing returns has madeattracting and retaining investors a challenge, putting pressureon existing hedge fund fee structures. 

While many institutional investors are likely to take a longerview on hedge fund performance and benefits, not all investorshave such patience. As if these challenges were not enough, thepopular media portrayal of hedge fund managers as mavericks witha propensity for losing their investors’ capital is not aconfidence-winner. 

The reality of hedge fund returns tells a different story. Hedgefunds have much more to offer than pure outperformance.Historically they have marketed themselves using the ‘return’ in‘absolute return’ vehicle, citing outperformance of other assetclasses. 

However, the ‘absolute’ in ‘absolute return’ may be a morepowerful message in today’s market conditions and offers funds anopportunity to improve their perception among the largerinvestment community . Over the last five years hedge funds have had demonstrably lowervolatility than equities and offer returns that are uncorrelatedwith both equities and fixed income. These facts have a profoundeffect on how hedge funds perform when combined with atraditional equity and fixed income portfolio. They providesignificant diversification and risk reduction benefits. 

Hedge funds are acting as their name implies: funds that hedgeother investments. 

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The reversal of the ban on direct marketing under the Jobs Act bythe Securities and Exchange Commission offers a fresh opportunityto promote hedge funds as belonging in every investor’s portfoliobecause of their diversification and risk-mitigating propertiesin addition to being a source of alpha. 

Despite the statistics, most hedge funds now face an uphillstruggle. Over the past several years, inflows have mainly goneto the largest (and presumably safest) funds, leaving smallerfunds struggling for capital. 

At the same time investors have cited some hedge funds’ highcorrelation with the S&P, questioning the wisdom of paying suchhigh fees for what essentially amounts to equity beta even whenhedge fund returns have been a fraction of what investors havegained in stocks. However, our research indicates the majority ofhedge fund strategies remain largely uncorrelated with the equitymarkets, thus providing powerful risk reduction effects whencompared with additional equity investment. 

Most asset classes have been enjoying a loosening of correlationsrecently. Even within equities the various sectors are lesscorrelated with each other than at any point since the financialcrisis. 

To demonstrate the benefits of hedge funds when combined withtraditional investments, we analysed and characterised the recentreturns and risk profiles of a variety of alternatives for atypical long-term investor: equity, bond and hedge funds. 

Since most public funds and individual retirement accounts investheavily in equities, we constructed a ‘typical retirementaccount’ composed of 60% equities, 25% fixed income and 15% cash.We refer to this as the base portfolio. We then examined 13 PimcoBond Funds, 13 HFRX strategy indexes and 26 Vanguard equitymutual funds and analysed how different investments in thesefunds would affect the risk of the overall portfolio. 

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The equityfundsaveraged acompoundedreturn of8% overthe pastthree andfive yearswith

volatilities of around 20%. Unsurprisingly, correlations with thebase portfolio averaged nearly 0.8 over the past three years,showing that equity funds offered virtually no diversification. 

This lack of diversification, combined with high volatilityindicates they would materially add to the risk of the portfolioas a whole. An intuitive way to visualise the effect of thisinvestment on the portfolio is to use the VisualVaR technique.

If we were to start with the base portfolio and reinvest the 15%cash into a typical equity fund, the VisualVaR diagram would looklike that shown in Figure 1. The fact that the second arrowessentially points in the same direction as the base portfoliomeans that the additional equity investment materially adds riskto the total portfolio.Bond funds have behaved very differently. Over the past fiveyears, they have had volatilities of around 5% with almost nocorrelation to the base portfolio. Moreover, they have had lowreturns and prospects for that situation improving, giveninterest rate expectations are poor. 

Hedge funds in contrast offer significant alpha-generationopportunities in changing environments, such as interest rate

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increases, while having bond fund-like volatility. Also, theircorrelations with the base portfolio are only slightly higherthan bond funds’ correlations. 

Within the HFRX indexes, there is a range of correlation to baseportfolio by strategy. The one-year and three-year correlationsrange from a low of roughly zero for convertible arbitrage,systematic diversified and equity market neutral to a high of 0.4or 0.5 for market directional, merger arbitrage and event drivenstrategies. Hedge funds offer bond-like risk characteristics butwith significantly more alpha potential.Critically, hedge funds are also uncorrelated to bond funds; theyprovide a completely uncorrelated/orthogonal source of alpha forthe owners of the base portfolio. Investing in a hedge fundprovides complete diversification: uncorrelated to equities,bonds, and the existing base portfolio. This makes hedge funds anideal diversifying investment for the typical investor.

With the ability to market directly and advertise, hedge fundshave an opportunity to tap into a much larger investor base.However, given prevailing perceptions they will find limitedsuccess in the current environment if they do not augment theirmessage to include concepts beyond returns generation. Showing investors that they are simultaneously positioned todeliver alpha in the coming years while mitigating risk is apowerful combination that is appealing to institutional investorsand to less-sophisticated qualified investors. Marketing the funds as having alpha-generating potential inaddition to a more attractive risk profile than equities or bondswhile being uncorrelated to both could potentially attractinflows and improve the perception of the hedge fund industry inthe eyes of the investor community.

2.MENA PERFORMANCE REMAIN STRONG-INDIAN METHOD:

Hedge funds that specifically target the Indian market have faceda difficult operating environment during the last several months,making the universe one of the most volatile in the entire hedgefund industry.

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India-focused funds have lost an average of over 11% in the lastthree months bringing year-to-date (YTD) losses over 15%. In thepast three years the group has swung from being the worst to bestand back again to the worst-performing hedge fund segment.

Total assets allocated to India-focused funds fell below $6billion for the second time since the financial crisis began.Redemptions spiked in July following performance losses asinvestors withdrew nearly 7% of the group’s assets undermanagement (AUM) during the month.

The investment database contains 48 unique hedge funds thatspecifically target Indian markets.

Performance remains strong for Mena funds;Performance from funds with investments targeting the regions andcountries making up all of the Middle East and Africa hasremained strong while emerging markets have broadly declined inrecent months.

Investor interest in funds targeting the Middle East and NorthAfrica (Mena) region has been strong relative to other emergingmarket hedge fund universes. Estimated AUM in the group hasincreased in each quarter of 2013 from net investor flows.

South Africa-based hedge fund assets may have increased over 14%in the first six months of the year, according to eVestment’ssecond quarter 2013 administrator survey. With South Africa-focused fund performance averaging 6.3% YTD, it appears investorshave allocated heavily to the region.

Mena funds have outperformed South Africa and pan-Africa funds bynearly two times in 2013. The universes have returned an averageof 16.6% for Mena, 6.3% for South Africa and 8.5% for pan-Africafunds.Investment tracks nearly 100 funds with investmentstargeting Mena

Money flows into equity as con arb funds sufferredemptions;

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The universe of convertible arbitrage funds is up 4.04% year-to-date (YTD) through July, underperforming the hedge fund aggregateby 94 basis points and well shy of the BAML Investment GradeConvertibles 14.29% return during the same period.

Total assets under management for convertible arbitrage fundsstood at $52 billion at the end of July 2013. After seeingpositive flows in 2012, cumulative net investor flows have beennegative in 2013, despite being positive in four of seven monthsduring the year.

Recent outflows come against the backdrop of inflows for equitystrategies as a whole in both May and July, a rarity for theuniverse, which saw inflows in only two of the prior 22 months. 

This indicates an appetite for equity market exposure but perhapswithout the interest rate risks that come via exposures toconvertibles.

The inVestment research database contains 138 unique hedge fundswith a primary strategy of convertible arbitrage.

More specialised multi-strategy funds outperformgeneralist peers:Multi-strategy funds targeting capital structure opportunitieshave underperformed their more targeted peer universes in 2013,returning 4.81% compared with 7.83% for distressed, 6.38% forevent driven and 9.11% for long/short equity.

Estimated assets under management in multi-strategy hedge fundshave increased nearly 7% in 2013 to $318.7 billion. Investorinterest in the universe has been high relative to the rest ofthe hedge fund industry during the year.

investment tracks 565 unique multi-strategy funds comprised of acore set of four sub-classifications: multi-strategy capitalstructure that focuses on equity and corporate credit strategiesincluding event driven, distressed and long/short equity; multi-strategy relative value; multi-strategy macro/managed futures

40

that focus on macroeconomic trends or invest largely withinfutures markets; and multi-strategy fixed income.

CHAPTER 8

HEDGE FUND MANAGEMENT COMPANIES

There are many ways to rank a list of the top 10 hedge funds andother prominent investors, and in this iteration, we're going tolook at equity portfolio values.

1) Berkshire Hathaway Led by Warren Buffett, Berkshire has nearly$90 billion in the U.S. equity markets.

2) Citadel Investment Group Ken Griffin is the manager of Citadelwith a total equity portfolio value of $57.88 billion.

3) Fisher Asset Management Ken Fisher founded this fund in 1979,which isn't technically a hedge fund although we still track itdue to its prominent spot in the investing world. Fisher AssetManagement has been going strong ever since, reaching anequity portfolio value of $38.51 billion.

4) Renaissance Technologies Jim Simons is top dog at RenaissanceTechnologies, a hedge fund company with an equity portfolio valueof $38.14 billion.

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5) Millennium Management Although many are unfamiliar with thework of Israel Englander, Millennium Management continues to growand has an equity portfolio value of $32.62 billion.

6) Icahn Capital Lp Carl Icahn is one of the most well knownnames in the industry, and he oversees $21.51 billion in capitalinvested in the stock market.

7) SAC Capital Advisors A legendary trader and billionaire,Steven Cohen is the manager of SAC with an equity portfolio valueof $18.19 billion.

8) Paulson & Co John Paulson started this hedge fund in 1994 andthe rest is history. He now has over $14 billion invested in thestock market.

9) Bridgewater Associates Ray Dalio has a long history ofinvesting success, and Bridgewater has $11.4 billion in itsequity portfolio.

10) Pershing Square Bill Ackman believes in long term valueinvesting, and this has suited him well at Pershing Square. Thehedge fund has an equity portfolio value of $10.95 billion, andcloses out this list of top 10 hedge funds . Of course, thesetotals don't represent the actual sizes of the largest hedgefunds.

TOP 10 HEDGE FUNDS FIRMS IN INDIA:

HFG India Continuum Fund: 

Hudson Fairfax Group (HFG) is an investment partnership focusedon India’s aerospace, defense, homeland security and otherstrategic sectors. It is based in New York with an advisory

42

office in New Delhi. Its team has five decades of focusedexperience in the sector combining investment and industryexpertise. Hudson Fairfax Group, through its predecessor company,started as an investment advisory firm in 2005. It ran aninvestment fund, the HFG India Continuum Fund, which invested inpublicly traded Indian securities. During the operation of itsfund, HFG was a Registered Investment Advisor (RIA) with the U.S.Securities & Exchange Commission and a Foreign InstitutionalInvestor (FII) with the Securities & Exchange Board of India. 

Avatar Investment Management: 

Avatar Investment Management is the investment advisor to threefunds. Headquartered in Mauritius, the funds are focussed on theIndian public and private equity markets. In order to meet theapproval of various regulatory bodies around the world, onlyaccredited investors may apply to invest.

India Deep Value Fund:  

India Investment Advisors, LLC was founded by Robin Rodriguez andRaj Agarwal in 2006 topursue the number of significant investmentopportunities presented by the burgeoning Indian capital and realestate markets. As a result, the India Deep Value Fund waslaunched in April 2006. The Fund's Managers seek to achieve long-term capital gains by acting as pro-active deep value investorsin publicly-traded Indian stocks.

 Fair value: 

Fair Value Capital is a highly specialized and exclusiveInvestment Advisory Firm focused on Deep Value Investmentopportunities primarily in Indian equity markets. It seekabsolute, long-term returns for its investments while minimizinginvestment risks using a Value oriented approach towards our

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investments. Fair Value specializes in Deep Value Investments inthe Indian equity markets. 

INDEA ACAPITAL PTE LIMITED:  

Indea Capital Pte. Ltd (Indea) is a Singapore based investmentadvisor. Indea was formed in 2002 to provide boutique fundmanagement services to institutions, foundations, family officesand high net-worth individuals. In July 2003, Indea launched theIndea Absolute Return Fund (IARF), a directional fund investingin India and Indian companies globally. The principals have acombined over 30 years of experience in researching and investingin India. In addition to the Singapore office, Indea has aresearch presence in Mumbai, India.

India Capital FUND: 

India Capital FundSM is an open-ended Investment Companyincorporated in Mauritius which has invested in India since 1994.Shares of the India Capital FundSM 

Monsoon Capital Equity Value Fund:

India Capital FundSM is an open-ended Investment Companyincorporated in Mauritius which has invested in India since 1994.Shares of the India Capital Fund 

Karma Capital Management, LLC:

Monsoon Capital is the adviser to onshore and offshore privateinvestment partnerships and specializes in equity investments inIndia.

Atyant Capital :

Karma Capital Management LLC is an organization with dedicatedprofessionals engaged in providing specialist, fundamentally

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based, alpha-seeking India Focused products including long-onlyequity and long-short products. Our wealth of experience hasguided us in offering attractive risk-adjusted, performance-driven products that take advantage of market opportunities andmeet specific client objectives. From diversified proprietaryfund portfolios to customized programs for a full range of globalinstitutional investors, our capabilities and product offeringsaddress the various investment needs of investors around theworld.

Atlantis India Opportunities Fund :

Rahul leads Atyant Capital Advisors, advisor to the AtyantCapital India Fund. In the last 10 years he’s managed moneyexclusively in the Indian markets. His mission is to consistentlyidentify the best 10-15 investment ideas from among the thousandsof publicly-traded Indian corporations. Rahul’s value-basedinvestment philosophy stands apart due to his belief in theparamount importance of corporate governance, specifically howmanagement operates with its minority shareholders in mind.Priorto Atyant, Rahul spent four years leading Meridian Investments,generating a 430% absolute return for the firm’s high net worthclients.

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CHAPTER 9

ARTICLES AND CASESTUDY

DESTINATION INDIA GLOBAL HEDGE FUNDS.

What are hedge funds? Hedge funds are private investment funds that usually employhighly speculative techniques. Their aim is to earn maximumcapital gains. These funds ‘hedge’ or protect their investmentsfrom losses by making other safer investments that generateprofits or nullify losses. Since the number and category ofinvestors is specified, these funds are generally outside thescope of regulatory entities. However, hedge fund transactionshave to comply with the regulations of the individual funds theyinvest in – so their activities are not totally ungoverned. Is India lucrative for hedge funds?

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 Financial experts and analysts are unanimous in their opinionthat India has high potential and is an ideal market for allasset categories, for the following reasons:

Variety in investment options, excellent growth prospectsfor hedge funds and favorable variables are key attractionfactors.

India has maintained diversification in its internationalportfolio allotment – vital for hedge funds. 

Indian economy has been growing stronger each year and nowis almost indifferent to the fluctuations of othereconomies.

 Hedge funds – too hyped? Hedge funds have been a bone of contention in developed as wellas emerging markets worldwide. These funds are often viewed withskepticism as they are mostly recognized as privately run fundsthat make money through aggressive tactics! Moreover, hedge fundsare not governed stringently as they are professionally operatedfor distinguished individual investors and entities likecompanies, banks and universities.

In reality, according to Prof Subrahmanyam (Professor of Financeand economics, Stern School of Business, New York University),hedge funds simply employ complex strategies with a mathematicalapproach to balance their investments. He feels that regulationsmeant to curb exploitations by such funds might hamper capitalcreation and destroy incentives altogether. Instead, India shouldconsider such policies for hedge funds that are beneficial forall.Other than being an ‘emerging’ country in the global scenario,India has strongly displayed its independence and is no longersensitive to fluctuations in the U.S. market.

Hedge funds produces solid returnsSep 24, 2003, 12.22am IST

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Mad, bad and dangerous, hedge funds once offered cocktails ofstratospheric rewards and giddying risks to investors rich enoughto spare a million dollars or more. The industry has changed,although its rakish image remains. Since the bear market set in,hedge funds have produced solid rather than spectacular returns.And they are no longer the preserve of the very wealthy. Mainlythrough outfits known as funds of funds, institutional investorsand less rich (if, in the main, still pretty well-off)individuals are being offered a taste of the hedge funds'glamour.

As their name suggests, funds of funds spread their clients'money among several hedge funds. The idea is that investors willenjoy the fat returns that hedge funds can bring, but thatdiversification will diminish the risk. Not surprisingly, anincreasing number of investors are attracted by this notion.However, the rewards have so far been disappointing. To choosetheir hedge funds, managers of funds of funds go to remarkablelengths. They not only tour the world assessing funds, but alsomight hire private investigators and delve into the private livesof hedge-fund managers (might an impending divorce be adistraction?). After many months, they select a portfolio,usually of between five and 25 hedge funds.

Funds of funds now account for about 30% of the $650bn investedin hedge funds. According to Hedge Fund Research, a researchcompany, the value of assets in funds of hedge funds doubled lastyear. Inflows rose five-fold, to $103bn. The number of funds offunds increased from 550 in '01 to more than 780. Most offertailor-made funds for some clients — such as a Swiss private bank— as well as off-the-peg funds for less exalted investors.

European institutional investors already include a Swedish statepension fund and PGGM, a Dutch pension fund with $50bn undermanagement. In Britain, the pension funds of Shropshire countycouncil, Sainsbury's, a supermarket chain, and Pearson, part-owner of The Economist, are thinking about joining the trend. Ina recent survey of 341 European institutional investors by JPMorgan Fleming, 56% said that they were planning to invest morein hedge funds. Of these, nearly two-thirds would choose thefunds-of-funds route.

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In the US, hedge-fund investment, which among institutions usedto be largely confined to endowment funds, is spreading topension funds and insurers. The California Public EmployeesRetirement System, America's largest pension fund, is thinkingabout tripling the $1bn pledged for investment in hedge funds andfunds of funds. So alluring are funds of funds that investors arewilling to pay a double whack of fees to place their money. Theypay a management fee of between 1% and 3.5%, plus a performancefee (except at some funds where management fees are higher). Ontop of this, the underlying hedge funds charge management fees of2% and one-fifth, or more, of profits. Investors also have toaccept that they will never really hit the jackpot. One of thehedge-fund managers in their portfolio may be the new GeorgeSoros; but that means that the rest of the money is with peoplewithout the same golden touch.

So what do investors get for their fees? They hire funds-of-fundsmanagers' inside knowledge: these specialists know their waythrough the maze of hedge-fund strategies, from long-short equityfunds, which buy undervalued equities and short-sell those theydeem too dear, to "macro" funds, which bet on any security,anywhere. Investors also buy access that was once exclusive:people with as little as $1,000 can invest. Funds of funds aremore open with their clients, and more liquid, than hedge funds.At GAM, one of the biggest, investors can redeem their moneywithin five days. Hedge funds generally ask investors to lock intheir money for three months; some insist on a year.

All of this means that investors have to sacrifice the thought oftruly juicy returns, although such returns are precisely why manyare drawn to funds of funds in the first place. "The question ishow much of absolute returns are you willing to give up for afund of funds," says David Smith, chief investment director atGAM. In the first eight months of this year, says Hedge FundResearch, hedge funds returned 12.2% on average. Funds of fundsmade 6.5%. Last year was the only one of the past ten in whichfunds of funds did not trail the company's hedge-fund index.After taking such care to seek out the world's finest hedgefunds, funds of funds might have been expected to do better thanthis.

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Of course, some funds of hedge funds have done much better thanthe average. "The good ones definitely earn their fees," saysChris Woods, chief investment officer for hedge-fund strategiesat State Street Global Advisors. But most of them struggle tojustify the double layer of charges. With this performance, willinvestors keep pouring money into funds of funds?

INVESTORS PLEDGE $1.4 BILLION EVERBRIGHT BANK HONGKONG LISTING

REUTERS DEC 4,2013 2.55PM IST

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HONG KONG: Shanghai-listed China Everbright Bank Co Ltd hasreceived initial commitments worth nearly $1.4 billion from 10investors for an up to $1.8 billion listing in Hong Kong, IFRreported on Wednesday citing people familiar with the plans.

The group of so-called cornerstone investors includes US hedgefund DE Shaw & Co, China Shipping (Group) Co andZhongrongInternational Trust, reported IFR, a Thomson Reuters publication.China Shipping made the largest commitment at $800 million.

The final list and amount of investment may change, IFR reported.

Cornerstone investors receive a guaranteed allocation in exchangefor agreeing to retain their stakes for a set period.

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CASESTUDYToday we’re starting a multi-part series on hedge fund casestudies, and I’m going to give away for free more actionableinformation, tips, and real examples than what other trainingproviders would charge you $10,000+ for.As The Joker might say, “It’s not about money… it’s about sendinga message.”We’ll leave out the second part of that quote abouteverything burning, at least until we reach the end of thisseries.Our interviewee has had a ton of experience in the financeindustry, ranging from equity research to private equity to hedgefunds – and I convinced him to share all his best tips with you.He contributed the interviews on equity research over a year ago,and this series will be even better.Let’s jump right into it:Assumptions & Background InformationQ: So we haven’t sat down for an interview since that series onequity research. What’s new?A: Sure – since the last time we chatted, I’ve graduated frombusiness school and have been through the recruiting process athedge funds. I am currently an analyst at a long/short equityfund.I’m still helping clients break into equity research, privateequity, and hedge funds as well.In the past, I’ve worked in private equity, equity research, andhedge funds (both internships and full-time), and I’ve completedcase studies at every step along the way – so I wanted to sitdown with you and explain the process, why it’s so important forbuy-side recruiting, and how to make your own case studiessuccessful.

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Why Do Case Studies Matter So Much in Hedge Fund Interviews?Q: Well, sounds like you’ve been quite busy (to say the least).Let’s start from the beginning: why do case studies matter somuch in hedge fund interviews?A: Here are the top 3 reasons:

1. Case studies are what you really do on the job – you generateinvestment ideas, present them to the PM, and aim to profitfrom your ideas while mitigating risk. Often, you’re taskedwith analyzing an investment opportunity with minimal guidanceand hand-holding; therefore, it’s up to you to use yourintellectual horsepower and investment acumen to figure outwhether a particular asset is a good investment.

2. They’re a way to level the playing field and stand out againsteveryone else with high grades from Harvard/Wharton/Stanford.Lots of people have great pedigrees, but few can investsuccessfully.

3. You will get them as part of the recruiting process at everysingle hedge fund, guaranteed.

Also, very, very few candidates actually customize their stockpitch and/or case study to the specific strategy that a funduses… so even by using relatively simple strategies, you canstand out.As you always say, don’t overestimate the competition.Q: So it seems like these case studies could also be a way tobreak in if you’re coming from a very different or unconventionalbackground?A: Yes. Unlike large banks that run very standardized recruitingprocesses and look for very standard types of candidates, manyhedge funds are more open about who they’ll speak to… IF you canprove that you have solid investment ideas and that you’repassionate about investing.The industry has gotten super-competitive over the past 10-15years, and it is generally getting smaller – but if you can makea lot of money for a potential employer, there will always beroom for you.

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In practice, of course, most people at hedge funds still comefrom investment banking, equity research, or trading backgrounds– but especially at smaller funds, they care more about your P&Lthan your pedigree.What Are Hedge Fund Case Studies?Q: Yeah, that matches what I’ve seen from clients going throughthe HF recruiting process.Before we move on, can you tell us what exactly a “case study”is?A: Sure, I should probably define that one at some point…In hedge fund interviews, “case studies” are very informal. 90%of the time they will tell you:

Come up with an investment idea you think is interesting,present it to us, and back it up with quantitative andqualitative support.

And… that’s it.It’s up to you to come up with the structure, pick the industryand find the company, and anticipate their key questions inadvance.Unlike private equity case studies, these case studies are farless structured and they want to see how well you can functionwithout much direction.Occasionally, you will get case studies where they give you aspecific company and then give you a few hours to look at itsfinancial statements, filings, and industry research and formyour own opinion – but “open-ended” case studies tend todominate.Q: So unlike PE case studies, where you’re focused on IRR anddetermining whether or not buying out a company could generateyour targeted return, with HF case studies it sounds like it’smore about valuation.A: Partially, yes.Valuation is more important in these open-ended case studiesbecause you can pick pretty much any company – it’s not like a

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leveraged buyout case study where they’ll give you a company ordeal and you’re constrained by that.But the main difference is that HF case studies and publicmarkets investing in general are all about asymmetric riskprofiles: cases where the upside potential is significantlygreater than the downside potential.So you’re not necessarily targeting a certain IRR – instead,you’re thinking: “This stock is currently at $25.00 per share. Ithink there’s a 75% chance it could increase to $30.00, and onlya 25% chance that it will fall to $20.00, so I recommendinvesting because…”The other big difference is that catalysts are much moreimportant in these case studies – it’s not enough to estimate theprobabilities and argue what a stock’s “expected value” is.You need to say, “I think it will change because of Event X,”where Event X is something like a new customer, a new product,regulatory changes, a competitor’s strategy, a refinancing orchange in capital structure, or anything else you could think of.Finally, risk factors and mitigating risk are essential for hedgefund case studies: you still consider them in PE case studies,but often you can’t make extremely specific recommendations tomitigate the risk when you’re acquiring an entire company.Q: Awesome. We’re going to delve into the structure of thesestock pitches and case studies in Part 2.But just to get everyone thinking about it, can you explain howyou’d usually structure your recommendations?A: Sure… we’ll go into this in more detail in the next part ofthe series, but here’s what I usually use:1) Recommendation: ”Neutral” recommendations are not ideal, soare you long or short this stock? What do you think it’s worthand how much would you pay for it?2) Company Background: Introduce what the company does and statewhat its current market cap and valuation multiples are.3) Your Investment Thesis: Give 2-3 points about why you thinkthe stock is price imperfectly – these can be both quantitative

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and qualitative factors, but they must be specific to the company(i.e. don’t say, “Well, the economy could crash…”). This will bethe bulk of your presentation or write-up.4) Catalysts: So you think the stock is priced imperfectly and isworth $X when its current share price is $Y… but what will pushit to $X? Many people miss this part completely, which can sinkyour chances.5) Valuation: Support your view of what the company is worth byusing the standard methodologies: public comps, precedenttransactions, DCF or other intrinsic value analyses, and so on.6) Risk Factors and How to Mitigate Them: Remember that hedgefunds are always looking for investments with asymmetric riskprofiles. All investments have potential downsides as well, andin this section you discuss those and explain that, while theyexist, there’s still a greater chance of your own thesis beingtrue.In that last part on Risk Factors, you also explain howto hedge against the possibility that you’re wrong. Much of theQ&A that takes place after you make your pitch will revolvearound understanding potential sources of downside.

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CONCLUSION

Government authorities are moving cautiously as they considerwhether new policies or regulations are needed to control theactivities of hedge funds. Certainly, the record of the pastdecade suggests instances of large position taking, eitherdirectly by hedge funds, or by other investors with greatercapital at their command who may take their cues from hedge fundactivity. Yet this recent history is far from clear that hedgefunds, on balance, do more harm in precipitating the fall ofasset prices than they do good by helping break the free fallthat can afflict oversold markets, including markets forcurrencies. Thus, new restrictions on hedge funds may do as muchharm as good.

Hedge funds can be complicated investment vehicles that aredifficult to understand. This is due partly to the complexstrategies they use, and partly to the high level of secrecyinherent in trying to prevent others from copying your investmentmethodology. It doesn't help the industry that the media usuallyonly showcases hedge funds when there is a huge blow-up or, in afew cases, when a hedge fund has incredibly high returns.

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The truth of the matter is that there are hedge funds thatgenerate attractive (relative to expectations) returns, andsometimes the return pattern can be volatile while other timesthe pattern is very stable. There is a hedge fund to fit therisk/return guidelines of any investor and with proper education,evaluation, and familiarity with them, they become much lessintimidating.

This is not to say that anyone should take a hedge fundinvestment lightly. As I mentioned earlier, there are more risksto a hedge fund than the probability of losing money. Forexample, there is the risk that an investor may not have accessto their cash for extended periods due to lock-ups. And there isa much more subtle risk of a hedge fund having style drift andcausing the investor's portfolio allocation to become sub-optimal.

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