courses and seminars jan 2009

EFG Bank 18/F, International Commercial Centre, 1 Austin Road West, Kowloon, Hong Kong. Tel: (852) 2298 3000 Fax: (852) 2298 3300

Hedge Funds

Various Strategies Explored

Richard Boutland ACA, [email protected]

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A brief background to hedge funds1949 and Alfred W Jones

The types of trades utilized by hedge funds have been in existence for centuries (for example the first short selling regulations were introduced in 1610 by the Amsterdam Stock Exchange), the first modern hedge fund is generally considered to date from 1949.

The fund was created by Alfred Winslow Jones, a sociologist and freelance writer of magazine articles. In March 1949 he wrote an article for Fortune magazine called “Fashions in Forecasting” which reported on the technical analysis employed by market forecasters. His research left him unconvinced of their ability to consistently predict the direction of the market. This led to his thinking about ways in which a fund could keep its capital fully invested while having a lower exposure to swings in the market.

Jones’s key insight was that a fund manager could combine two techniques to create a conservative investment scheme. He used leverage to buy more shares, and used short selling to avoid market risk. He bought as many stocks as he sold, so market-wide moves up or down would not affect the total value of such a portfolio. Performance would therefore not be determined by the overall movement of the market but whether the manager had picked the right stocks to buy and sell.

In 1949 he and four friends formed A.W. Jones & Co, a private partnership (thus avoiding the regulatory and disclosure requirements of the Investment Company Act of 1940 by limiting itself to 99 partners). Jones chose to take 20 percent of profits as compensation.

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A brief background to hedge funds - continued1966 and ‘The Jones that nobody can keep up with’

Although a small number of similar funds were created in the following years, the ‘hedged fund’ industry remained out of the public view until 1966 when Carol Loomis wrote an article called "The Jones Nobody Keeps Up With." Published in Fortune, Loomis' article lionized Jones and his approach. The article's opening line summarizes the results at A.W. Jones & Co.: "There are reasons to believe that the best professional money manager of investors' money these days is a quiet-spoken seldom photographed man named Alfred Winslow Jones." Coining the term 'hedge fund' to describe Jones' fund, it pointed out that his hedge fund had outperformed the best mutual fund over the previous five years by 44 percent, despite its management-incentive fee. On a 10-year basis, Mr. Jones's hedge fund had beaten the top performer Dreyfus Fund by 87 percent. Alfred Jones's investors lost money in only 3 of his 34 years. By contrast, the S&P500 had 9 down years in during a similar period.

Although hedge funds have evolved greatly since 1949, the philosophy of minimizing risk to create an absolute return remains central to the hedge fund industry.

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A brief background to hedge funds - continued1966 and ‘The Jones that nobody can keep up with’

The 1966 article led to a flurry of interest in hedge funds and within the next three years at least 130 hedge funds were started, including George Soros's Quantum Fund and Michael Steinhardt's Steinhardt Partners.

Jones’s original hedge fund is what is now termed an equity long/short fund, a hedge fund strategy that still remains the most. In contrast, both Soros and Stenhardt followed investment styles that are now called ‘global macro’, which means they aim to produce profits from major macro economic moves (such as currency, commodity and inflation and interest movements) rather than picking good and bad stocks.

Global macro was the second major hedge fund investment style to evolve and has subsequently been followed by a wide range of others, each with their own distinctive investment characteristics:

Breakdown of Industry AUM by Strategy

Macro6%

Event-Driven9%

Multi-Strategy21%

Long-Short Equities

35%

Fixed Income6%

Relative Value/Arbitrage

16%CTA3%

Distressed Debt4%

Source: EurekaHedge: Data as at 31st December 2006

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Short selling

Source: www.telegraph.co.uk

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Main strategies – Equity long/shortEquity long/short

This is what most people recognize as a hedge fund. It involves buying long equities that are expected to increase in value and selling short equities that are expected to decrease in value.

About 35% of all hedge funds are recognizable as equity long/short but they generally break into two approaches:

Fundamental

A fundamental manager is the classic Warren Buffett type of investor. Carefully analyzing the inherent value in an investment and then either buying it (going long) or going short (ie, borrowing the investment and selling it into the market).

Quantative

A quantative manager is one who invests purely on the basis of the movement of a security or market. They are looking for repeating patterns and invest accordingly.

They have little or no interest in understanding why the pattern occurs or in the fundamentals of the underlying investment (in fact they often invest into indices). They are however very interested in how reliably the pattern repeats and how durable it is.

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Performance:

Equity like performance during equity bull markets – which means that they have tended to have material levels of equity market risk (ie, as a group they are not always hedged).

Sources: Bloomberg, Credit Suisse/Tremont Data period from 31 Dec 1993 to 30 Nov 2008

Equity long/short

Hedge Fund IndexLong-Short Equity

Hedge Funds

Global Equities

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5.50

Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07

Credit Suisse/Tremont Hedge Fund Index Credit Suisse/Tremont HFI Long-Short Equity

MSCI AC World Index in USD

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Fundamental managers tend to differ from quantative managers in:

1. being more market directional,

2. having higher volatility,

3. being less liquid

However, they tend to be much less highly geared as they profit opportunities are ‘fatter’ and the scope for leveraging is lower.

Leverage is the Achilles heel of investors as it forces them to sell when the market moves against them:

“ the greatest threats to wealth are liquor and leverage.“

Warren Buffett

Main strategies – Equity long/short

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Performance

1. Generally has been uncorrelated with equity markets.

2. Macro has been more volatile

3. CTA’s has tended to perform well when the markets suffer major dislocations (an analogy with insurance brokers: they don’t suffer the loss, but everyone wants to buy insurance when disaster strikes).


Main strategies – Macro and CTA

Global Equities

Credit Suisse/Tremont HFI Managed Futures

Global Macro

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MSCI AC World Index in USD Credit Suisse/Tremont HFI Managed Futures

Credit Suisse/Tremont HFI Global Macro

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Global Macro and Managed Futures

These two strategies are often considered complementary in that their investment characteristics can be similar and the futures markets are strongly influenced by macro economic factors. Indeed many macro managers will actively trade in the futures markets.

However they differ in the way that they invest – using the analogy from equity long/short above; Managed Futures managers are ‘quantative macro’ and ‘global macro’ are ‘fundamental macro’

Global Macro

After equity long/short, the next major hedge fund strategy to evolve was global macro which started to appear in the mid to late sixties. During the 1970’s and early 1980’s the poor performance of the equity markets compared to the strong global macro economic changes benefited macro managers compared to equity long/short ones. Macro managers grew quickly and became the dominant strategy (estimated at 71% of hedge funds in 1990).

However the equity markets hit their lows in 1982 and have been on a long bull market since. At the same time the macro economic environment became more placid and opportunities for macro managers were reduced. They are now only a small proportion of hedge fund assets.

Marco managers have performed very well so far in 2008 (and performed well in 2007) and it is possible that macro may be making a comeback.

Macro managers position their portfolios in the expectation of some macro- economic change. For example they may believe that US interest rates will rise relative to European ones due to the differing levels of growth and inflation in those economies. They will then look for investment vehicles that they can combine together to capture profit from this change.

They’ll use whatever investment vehicle best fits their purpose – FX, equities, bonds and commodities can all be utilized. They are therefore amongst the most opportunistic and dynamic managers.


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Managed Futures

Although (often called CTA’s Commodity Trading Advisors) futures markets have been around for centuries, managed futures funds only started to appear in the late 1940’s. The ‘commodities’ name is somewhat misleading as the nature of the trading does not give much economic exposure to the commodity markets. Indeed as CTA’s trade in all futures markets much of what they do is in non-commodity (such as financial and currency futures) markets.

They make money by being prepared to take either side of a futures contract whenever they see an opportunity. They can therefore be viewed as providing temporary liquidity to the futures market and making it more efficient.

They are very quantative in approach and utilize computer screening techniques to identify repeating patterns within the futures markets. Managers that are completely driven by computer trading are termed ‘systematic’, those that involve human oversight are called ‘discretionary’


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Event driven

“We are ready for any unforeseen event that may or may not happen. “

Dan Quayle

These managers are investing on the expectation of a catalyst occurring that will realize profits for them.

There are two main types:

1. Merger Arbitrage

2. Distressed/High-Yield

Main strategies – Event Driven

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Merger Arbitrage – a bull market strategy

This strategy is often called ‘risk arbitrage’ and traditionally involves buying the stock of the target company and selling the stock of the buying company. As there is a degree of uncertainty as to whether or not the merger will go through there is an arbitrage opportunity between the current prices and the prospective merger price.

The hedge fund manager will carefully review the probability of the merger going through and will decide whether the merger premium is worth the risk.

This strategy naturally requires a strong flow of deals and therefore tends to be most profitable during equity bull markets. Additionally more managers are now pursuing profits by investing on the presumption of a merger (or demerger) and even pushing management to accept change (so called activist managers).

Distressed – a ‘bear’ market strategy

Contrary to popular opinion, distressed managers don’t tend to do well in times of economic hardship. They do however benefit from such periods as it provides an increased pool of attractively priced assets that will provide profits once the economy improves.

They receive quite a poor press, but actually they are providing a major economic benefit by purchasing assets when few buyers are available. They return economically viable assets back to the economy that would otherwise be scrapped.

As these managers wish to ensure that they are provided security for their risk they tend to invest into the debt of their target companies (and therefore have a superior claim to collateral and interest) rather than equity. This is why they are often termed distressed/high yield.

Main strategies – Event Driven

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Performance

Distressed has been:

1. more aggressive

2. more volatile

3. given higher returns

4. But with less liquidity and has been (potentially) more risky

Event Driven


Distressed Hedge Funds

Global Equities

Event-Driven Multi-Strategy Funds

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Credit Suisse/Tremont HFI Distress Securities MSCI AC World Index in USD

Credit Suisse/Tremont HFI Event-Driven Multi-Strategy

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Relative value

These managers are true arbitragers and seek to identify market mis-pricings. By hedging out all of the other risks they should be able to extract a risk free (or low risk) profit.

The problem is that such profits are hard to come by and there is a strong temptation to employ leverage to make competitive returns. Although the strategy may appear to be low risk the use of leverage reduces its attractiveness.

Convertible Bond Arbitrage – the most common strategy

A convertible bond is a hybrid instrument that can be thought of as combining a corporate bond with an embedded equity option. The combined theoretical value often differs from the market value and so can be released by talented arbitrage.

Relative Value


Convertible Arbitrage

Fixed Income Arbitrage


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Credit Suisse/Tremont HFI Convertible Arbitrage Credit Suisse/Tremont HFI Fixed Income Arbitrage


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Most hedge fund strategies are actually quite strait-forward (Jones’s original approach for example was strikingly simple). Their application however requires a high level of skill and expertise – managing a hedge fund is definitely something to be left to the experts.

Where hedge funds do differ greatly from conventional investments is the level of freedom given to the hedge fund manager. This can be seen by comparing the prospectuses of a hedge fund with that of a conventional fund (a bond fund for example):

Conventional Fund:

Investment flexibility: the difference between hedge funds and conventional Funds

Source: PIMCO Funds: Global Investors Series plc: Prospectus July 2003

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Contrast this with a Hedge Fund:

Investment Guidelines

The Company intends to have a diversified portfolio consistent with its investment objectives and

policies and will seek returns that are commensurate with the level of risk undertaken. The Articles

do not contain any restrictions on the investment powers of the Company. However, as a matter

of policy, the Manager intends to observe the following general guidelines in managing the assets

of the Company:

(a) the net exposure of the Company to the obligations of any one issuer will not normally exceed

10% of the Company’s gross assets, except for securities issued or guaranteed by government,

sovereign and quasi-sovereign entities, public or local authorities;

(b) the net exposure of the Company in relation to any one non-OECD country will not normally

exceed 30% of the Company’s gross assets (for this purpose, the People’s Republic of China

and Hong Kong will be considered as two separate countries);

(d) the value of securities sold short will not normally exceed 50% of the latest available Net Asset

Value of the Company;

Investment flexibility

Source: Asian Credit Hedge Fund, Prrivate Placing Memorandum, July 2007

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Hedge Fund:

Hong Kong: WARNING – THE CONTENTS OF THIS DOCUMENT HAVE NOT BEEN REVIEWED

BY ANY REGULATORY AUTHORITY IN HONG KONG. YOU ARE ADVISED TO EXERCISE

CAUTION IN RELATION TO THIS OFFER. IF YOU ARE IN ANY DOUBT ABOUT ANY OF THE

CONTENTS OF THIS DOCUMENT, YOU SHOULD OBTAIN INDEPENDENT PROFESSIONAL

ADVICE. This document is distributed on a confidential basis. No interest in the Company will be

issued to any person other than the person to whom this document has been sent. No person in

Hong Kong other than the person to whom a copy of this document has been addressed may treat

the same as constituting an invitation to him to invest. This document may not be reproduced in

any form or transmitted to any person other than the person to whom it is addressed. This

document has not been approved by the Securities and Futures Commission in Hong Kong, nor

has a copy of it been registered by the Registrar of Companies in Hong Kong and, accordingly,

Participating Shares may not be offered or sold in Hong Kong by means of this document or any

other document other than in circumstances which do not constitute an offer to the public for the

purposes of the Hong Kong Companies Ordinance or the Hong Kong Securities and Futures

Ordinance.

The downside– marketability is much more restricted


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Apart from flexibility, Hedge Funds are not so different from conventional managers

Most hedge fund strategies are actually quite strait-forward and easy to understand (Jones’s original approach for example was strikingly simple). Their application however requires a high level of skill and expertise – managing a hedge fund is definitely something to be left to the experts.

As stated above, where hedge funds do differ greatly from conventional investments is the level of freedom given to the hedge fund manager. The conventional fund will state that the manager must be fully invested into US large cap equities at all times, the hedge fund manager by comparison is able to invest into virtually any investment, can go long or short, and can even go completely into cash.

The Future

Hedge Fund Index

Global Equities

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US 3-month LIBOR Credit Suisse/Tremont HFI Long-Short Equity MSCI AC World Index in USD


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The Future

We can see that hedge funds would perform very similarly to a conventional manager who invested into equities during bull markets and then had the freedom to switch to bonds or cash during bear markets.

Although this is a great simplification and doesn’t apply to all hedge funds, it is useful to think hedge funds as pools of capital managed by entrepreneurial and talented investment managers.

Myth: Hedge Funds are always fully hedged

The only way to guarantee a return is to buy a high quality government bond. Any return above this low rate involves risk and therefore can’t be guaranteed. Hedge funds can only perform strongly by taking at least an element of downside risk.

What hedge funds can do is manage the downside risk by hedging against large market falls and by shifting away from risky assets (such as equities) when they feel the risks are not worth the returns. A conventional manager meanwhile would be obliged to remain invested in a falling market.

Myth: Hedge Funds are unregulated

Although hedge funds are private investment vehicles that do not openly publicise themselves in the way that conventional managers do, this is mainly due to the regulatory authorities who restrict investment into hedge funds to sophisticated investors. Therefore hedge can’t openly advertise or publicise themselves and remain very private.

Hedge funds though are regulated. Although the fund may be domiciled in an offshore location, such as Bermuda or the Cayman Islands, the actual investment management is usually carried out in one of the major onshore financial centers. For hedge funds, these centers are New York in the Americas, London in Europe, and Hong Kong, Singapore, Tokyo, and Sydney in Asia. The hedge funds are closely monitored and regulated by the authorities in these financial centres.

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The Future

If we don’t believe in the efficient market theory then hedge funds are the next logical evolution of the asset management industry:

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Manager Selection

Quantative Screening

“to a man with a hammer the whole world looks like a nail”

Warren Buffett

Statistics are like a drunk with a lampost: used more for support than illumination.

Sir Winston Churchill

Qualatitive Screening

Administrator of the Fund and Its Role

Regulator Overseeing the Fund Manager

Operational Infrastructure of the Fund Manager

Special Terms for Other Investors

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Risk Warning and Disclaimer

Nothing in this document constitutes an offer to buy or sell any hedge fund or investment described herein, and all expressions of opinion are subject to change without notice.

Each hedge fund is managed at the full discretion of the fund’s investment adviser(s), pursuant to the general investment strategy described in the fund’s prospectus.

EFG Funds are available only outside the United States to investors who are neither citizens nor residents of the United States. In addition, the hedge funds and any services offered in connection with them shall only be available in jurisdictions where it is lawful to do so. Thus, in certain jurisdictions, investors who have received this document may be prohibited from subscribing to any or all of the referenced hedge funds from EFG Bank.

If you have an account with EFG Bank, EFG Bank may provide you, from time to time, with advice or information on available investments. Any provision of such advice or information is provided at EFG Bank’s sole discretion, without obligation to update the information or advice provided. Further, the information provided will not contain an analysis of all material facts concerning any hedge fund or investment discussed, and while the information has been obtained from sources believed to be reliable, EFG Bank does not guarantee its accuracy or completeness and does not accept liability for any direct or consequential losses arising from its use.

You are solely responsible for your investment decisions, even if the decision is based on advice or information provided by us. Thus prior to making any investment decision you should fully understand the characteristics and risks associated with the investment and make your own determination that the investment is consistent with your objectives, that it is suitable for you and that you are able to assume the risks.

EFG Bank assumes no liability for any actions or omissions of the individual fund houses, in general or in connection with hedge funds referenced herein.

This information is confidential and intended solely for the use of EFG Bank and the client or prospective client to whom it has been delivered. It is not to be reproduced or distributed to any other person except to the client’s professional advisers, nor is it to be used or distributed by any other broker/dealer or investment bank.

Hedge funds and the securities they hold are not deposits; are neither obligations of, nor guaranteed by, EFG Bank or any of its affiliates; are not government insured; and are subject to investment risks, including possible loss of principal amount invested.

January 2009

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Hedge Fund:

Hong Kong: WARNING – THE CONTENTS OF THIS DOCUMENT HAVE NOT BEEN REVIEWED

BY ANY REGULATORY AUTHORITY IN HONG KONG. YOU ARE ADVISED TO EXERCISE

CAUTION IN RELATION TO THIS OFFER. IF YOU ARE IN ANY DOUBT ABOUT ANY OF THE

CONTENTS OF THIS DOCUMENT, YOU SHOULD OBTAIN INDEPENDENT PROFESSIONAL

ADVICE. This document is distributed on a confidential basis. No interest in the Company will be

issued to any person other than the person to whom this document has been sent. No person in

Hong Kong other than the person to whom a copy of this document has been addressed may treat

the same as constituting an invitation to him to invest. This document may not be reproduced in

any form or transmitted to any person other than the person to whom it is addressed. This

document has not been approved by the Securities and Futures Commission in Hong Kong, nor

has a copy of it been registered by the Registrar of Companies in Hong Kong and, accordingly,

Participating Shares may not be offered or sold in Hong Kong by means of this document or any

other document other than in circumstances which do not constitute an offer to the public for the

purposes of the Hong Kong Companies Ordinance or the Hong Kong Securities and Futures

Ordinance.

The downside– marketability is much more restricted


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