hedge funds mii presentation september 17, 2002 priyanka chopra

Hedge FundsHedge Funds

MII PresentationMII Presentation

September 17, 2002September 17, 2002

Priyanka ChopraPriyanka Chopra

What is hedging?What is hedging?

Simplistic definition to get started:Simplistic definition to get started:

An investment made in order to An investment made in order to reduce the riskreduce the risk of adverse price movements in a security, of adverse price movements in a security, by taking an offsetting position in a by taking an offsetting position in a

related security, such as an option or a related security, such as an option or a short sale.short sale.

Trivia!Trivia!

The use of the term "hedge" in the US The use of the term "hedge" in the US originally was coined by the agriculture originally was coined by the agriculture industry. industry. Farmers were the first "hedgers" by selling crops or Farmers were the first "hedgers" by selling crops or

cattle yet to be harvested at a price for future cattle yet to be harvested at a price for future delivery. delivery.

In doing so, they locked in a price today and were In doing so, they locked in a price today and were "not exposed" to future market fluctuations. "not exposed" to future market fluctuations.

In essence, they "hedged" their market exposure for In essence, they "hedged" their market exposure for the period of time it took them to harvest and the period of time it took them to harvest and deliver their product. deliver their product.

What is a hedge fund?What is a hedge fund?

Hedge Fund- A fund that can Hedge Fund- A fund that can take both long and short positionstake both long and short positions use arbitrageuse arbitrage buy and sell undervalued securitiesbuy and sell undervalued securities trade options or bonds, and trade options or bonds, and invest in almost any opportunity in any invest in almost any opportunity in any

market where it foresees market where it foresees impressive impressive gains at reduced risk. gains at reduced risk.

Goal of the fund?Goal of the fund?

Let’s break it up…Let’s break it up…

The primary aim of most hedge funds is The primary aim of most hedge funds is toto Reduce volatility and risk Reduce volatility and risk while attempting to preserve capital, andwhile attempting to preserve capital, and deliver positive returns under all market deliver positive returns under all market

conditions. conditions.

Historic Hedging: LogicHistoric Hedging: Logic

Historically the hedging strategy centered Historically the hedging strategy centered around this logic:around this logic: Equities on the "long side" outperformed up Equities on the "long side" outperformed up

markets. At the same time, the equities on the markets. At the same time, the equities on the "short side" did not create a drag on performance, "short side" did not create a drag on performance, and possibly even added to the portfolio’s return and possibly even added to the portfolio’s return since there are always stocks that lose value, even since there are always stocks that lose value, even in a bull market. in a bull market.

In a market correction, the short portfolio would In a market correction, the short portfolio would outperform the long portfolio, or at least "hedge" outperform the long portfolio, or at least "hedge" or reduce the slide in the long portfolio’s value. or reduce the slide in the long portfolio’s value.

Hedging StrategiesHedging Strategies

There are approximately 14 distinct There are approximately 14 distinct investment strategies used by hedge investment strategies used by hedge fundsfunds

KeyKey: All hedge funds are not the same. : All hedge funds are not the same. The investment returns, volatility, and risk The investment returns, volatility, and risk vary enormously among the different vary enormously among the different strategiesstrategies

““Styles” of Hedge FundsStyles” of Hedge Funds

Aggressive Growth:Aggressive Growth: Invests in equities Invests in equities expected to experience acceleration in expected to experience acceleration in growth of earnings per sharegrowth of earnings per share

Hedges by shorting equities where Hedges by shorting equities where earnings disappointment is expected or by earnings disappointment is expected or by shorting stock indexesshorting stock indexes

Tends to be "long-biased." Tends to be "long-biased." Expected Volatility:Expected Volatility: HighHigh

Styles of Hedge Funds Styles of Hedge Funds (Contd.)(Contd.)

Distressed Securities:Distressed Securities: Buys equity, debt, or Buys equity, debt, or trade claims at deep discounts of companies trade claims at deep discounts of companies in or facing bankruptcy or reorganizationin or facing bankruptcy or reorganization

Profits from the market's lack of Profits from the market's lack of understanding of the true value of the understanding of the true value of the deeply discounted securities deeply discounted securities

Majority of institutional investors cannot Majority of institutional investors cannot own below investment grade securities. own below investment grade securities.

Results generally not dependent on the Results generally not dependent on the direction of the markets. direction of the markets.

Expected Volatility:Expected Volatility: Low - ModerateLow - Moderate


Emerging Markets:Emerging Markets: Invests in equity or Invests in equity or debt of emerging (less mature) markets debt of emerging (less mature) markets that tend to have higher inflation and that tend to have higher inflation and volatile growthvolatile growth

Short selling is not permitted in many Short selling is not permitted in many emerging markets, and, therefore, emerging markets, and, therefore, effective hedging is often not availableeffective hedging is often not available

Expected Volatility:Expected Volatility: Very HighVery High


Funds of Hedge Funds:Funds of Hedge Funds: Mix and match Mix and match hedge funds and other pooled investment hedge funds and other pooled investment vehiclesvehicles

Blend of different strategies and asset Blend of different strategies and asset classes aims to provide stable long-term classes aims to provide stable long-term return than any of the individual funds. return than any of the individual funds.

Returns, risk, and volatility can be controlledReturns, risk, and volatility can be controlled Capital preservation is generally important Capital preservation is generally important Volatility depends on the mix and ratio of Volatility depends on the mix and ratio of

strategies employedstrategies employed Expected Volatility:Expected Volatility: Low - Moderate - HighLow - Moderate - High


Income:Income: Invests with primary focus on yield Invests with primary focus on yield or or current incomecurrent income rather than solely on rather than solely on capital gainscapital gains

May use leverage to buy bonds or fixed May use leverage to buy bonds or fixed income derivatives, in order to profit from income derivatives, in order to profit from principal appreciation and interest income. principal appreciation and interest income.

Expected Volatility:Expected Volatility: LowLow


Macro:Macro: Aims to profit from changes in global Aims to profit from changes in global economieseconomies Typically brought about by shifts in govt. Typically brought about by shifts in govt.

policy that impact interest rates, in turn policy that impact interest rates, in turn affecting currency, stock, and bond marketsaffecting currency, stock, and bond markets

Uses leverage and derivatives to accentuate Uses leverage and derivatives to accentuate the impact of market movesthe impact of market moves

Uses hedging, but largest performance Uses hedging, but largest performance impact is from the leveraged directional impact is from the leveraged directional investmentsinvestments



Market Neutral - Arbitrage:Market Neutral - Arbitrage: Attempts to hedge Attempts to hedge out most market risk by taking offsetting positions, out most market risk by taking offsetting positions, often in different securities of the same issueroften in different securities of the same issuer

Eg. Can be long convertible bonds and short the Eg. Can be long convertible bonds and short the underlying issuers equity. underlying issuers equity.

Focuses on obtaining returns with low or no Focuses on obtaining returns with low or no correlation to both the equity and bond marketscorrelation to both the equity and bond markets

Relative value strategies include fixed income Relative value strategies include fixed income arbitrage, mortgage backed securities, capital arbitrage, mortgage backed securities, capital structure arbitrage, and closed-end fund structure arbitrage, and closed-end fund arbitragearbitrage

Expected Volatility:Expected Volatility: LowLow


Market Neutral - Securities Hedging:Market Neutral - Securities Hedging: Invests equally in long and short equity Invests equally in long and short equity portfolios generally in the same sectors of the portfolios generally in the same sectors of the marketmarket Market risk is greatly reducedMarket risk is greatly reduced Effective stock analysis and stock picking is Effective stock analysis and stock picking is

essential to obtaining meaningful resultsessential to obtaining meaningful results Leverage may be used to enhance returnsLeverage may be used to enhance returns Usually low or no correlation to the marketUsually low or no correlation to the market Expected Volatility:Expected Volatility: LowLow


Market Timing:Market Timing: Allocates assets among Allocates assets among different asset classes depending on the different asset classes depending on the manager's view of the economic or market manager's view of the economic or market outlook. outlook. Portfolio emphasis may swing widely Portfolio emphasis may swing widely

between asset classesbetween asset classes Unpredictability of market movements, and Unpredictability of market movements, and

the difficulty of timing entry and exit from the difficulty of timing entry and exit from markets increase volatilitymarkets increase volatility

Expected Volatility:Expected Volatility: HighHigh


Opportunistic:Opportunistic: Investment theme changes Investment theme changes from strategy to strategy as opportunities from strategy to strategy as opportunities arise to profit from events such as IPOs, arise to profit from events such as IPOs, hostile bids, etc.hostile bids, etc. May utilize several of these investing styles May utilize several of these investing styles

at a given timeat a given time Not restricted to any particular investment Not restricted to any particular investment

approach or asset classapproach or asset class Expected Volatility:Expected Volatility: VariableVariable


Multi Strategy:Multi Strategy: Investment approach is Investment approach is diversified by employing various strategies diversified by employing various strategies simultaneously to realize short- and long-term simultaneously to realize short- and long-term gainsgains

Other strategies: Systems trading such as Other strategies: Systems trading such as trend following and various diversified trend following and various diversified technical strategiestechnical strategies

Allows the manager to overweight or Allows the manager to overweight or underweight different strategies to best underweight different strategies to best capitalize on current investment opportunitiescapitalize on current investment opportunities

Expected Volatility:Expected Volatility: VariableVariable


Short Selling:Short Selling: Sells securities short, in Sells securities short, in anticipation of being able to repurchase them anticipation of being able to repurchase them at a future date at a lower priceat a future date at a lower price Result of anticipated overvaluation, Result of anticipated overvaluation,

earnings disappointments, new earnings disappointments, new competition, change of management, etc. competition, change of management, etc.

Often used as a hedge to offset long-only Often used as a hedge to offset long-only portfolios by those who expect bearish portfolios by those who expect bearish cycle. cycle.



Special Situations:Special Situations: Invests in event-driven Invests in event-driven situations such as mergers, hostile takeovers, situations such as mergers, hostile takeovers, LBO’s etc.LBO’s etc.

May involve simultaneous purchase of stock May involve simultaneous purchase of stock in companies being acquired, and the sale of in companies being acquired, and the sale of stock in its acquirer, hoping to profit from the stock in its acquirer, hoping to profit from the spread between the current market price and spread between the current market price and the ultimate purchase price of the companythe ultimate purchase price of the company

Results generally not dependent on direction Results generally not dependent on direction of marketof market

Expected Volatility:Expected Volatility: ModerateModerate


Value:Value: Invests in securities perceived to be Invests in securities perceived to be selling at deep discounts to their intrinsic or selling at deep discounts to their intrinsic or potential worthpotential worth

Such securities may be out of favor or Such securities may be out of favor or under-followed by analystsunder-followed by analysts

Long-term holding, patience, and strong Long-term holding, patience, and strong discipline are often required until the discipline are often required until the ultimate value is recognized by the marketultimate value is recognized by the market

Expected Volatility:Expected Volatility: Low - ModerateLow - Moderate

Things to Note:Things to Note: FICTION: “All hedge funds are volatile -- they all place “All hedge funds are volatile -- they all place

large directional bets on securities and commodities, large directional bets on securities and commodities, while using lots of leverage”while using lots of leverage” FACT: Less than 5% of hedge funds are global macro : Less than 5% of hedge funds are global macro

funds. Most hedge funds use derivatives only for funds. Most hedge funds use derivatives only for hedging or don't use derivatives at all, and many use hedging or don't use derivatives at all, and many use no leverage. no leverage.

Some “hedge funds” don't actually hedge against risk. Some “hedge funds” don't actually hedge against risk. The term is applied to a wide range of alternative The term is applied to a wide range of alternative funds, and encompasses funds that use high-risk funds, and encompasses funds that use high-risk strategies without hedging against risk of lossstrategies without hedging against risk of loss

Management of Hedge Management of Hedge fundsfunds

Most hedge funds are managed by experienced Most hedge funds are managed by experienced investment professionalsinvestment professionals

Highly specializedHighly specialized Trade only within their area of expertise and Trade only within their area of expertise and

competitive advantagecompetitive advantage Remuneration heavily weighted towards Remuneration heavily weighted towards

performance incentivesperformance incentives Usually have their own money invested in their Usually have their own money invested in their

fundfund

How is a Hedge Fund different How is a Hedge Fund different from a Mutual Fund?from a Mutual Fund?

Hedge funds traditionally reserved for clients Hedge funds traditionally reserved for clients with initial minimum investment of $1 million. with initial minimum investment of $1 million. Mutual fund companies beginning to offer Mutual fund companies beginning to offer hedge fund products to wider client basehedge fund products to wider client base

There are 5 key differences between them There are 5 key differences between them based on:based on:

1.1. Performance EvaluationPerformance Evaluation2.2. Level of regulatory controlLevel of regulatory control3.3. Basis for Remuneration of ManagementBasis for Remuneration of Management4.4. Portfolio ProtectionPortfolio Protection5.5. Dependence on MarketsDependence on Markets

Differences (Contd.)Differences (Contd.) Performance Evaluation:

Mutual funds are measured on relative performance compared to a relevant index or to other mutual funds in their sector

Hedge funds are expected to deliver absolute returns under all circumstances, even when the relative indices are down

Level of Regulation: Unlike hedge funds, mutual funds are highly regulated,

restricting the use of short selling and derivatives. Makes it difficult to outperform market, or protect assets in downturn.

Differences (Contd.)Differences (Contd.) Remuneration for ManagementRemuneration for Management

Mutual Fund managers are paid based on a % of AUM. Mutual Fund managers are paid based on a % of AUM. Hedge funds pay managers performance-related Hedge funds pay managers performance-related incentive fees plus a fixed feeincentive fees plus a fixed fee

Portfolio ProtectionPortfolio Protection Mutual funds are not able to effectively protect Mutual funds are not able to effectively protect

portfolios against declining markets other than by portfolios against declining markets other than by going into cash or by shorting a limited amount of going into cash or by shorting a limited amount of stock index futuresstock index futures

Hedge funds are often able to protect against declining Hedge funds are often able to protect against declining markets by using various hedging strategies, and can markets by using various hedging strategies, and can generate positive returns even in declining markets. generate positive returns even in declining markets.

Differences (Contd.)Differences (Contd.)

Dependence on MarketsDependence on Markets The future performance of mutual The future performance of mutual

funds depends on the direction of the funds depends on the direction of the equity markets. equity markets.

The future performance of many hedge The future performance of many hedge fund strategies tends to be highly fund strategies tends to be highly predictable and not dependent on the predictable and not dependent on the direction of the equity markets.direction of the equity markets.

Fund of FundsFund of Funds

A fund of funds mixes the most successful hedge funds and A fund of funds mixes the most successful hedge funds and other pooled investment vehicles, spreading investments other pooled investment vehicles, spreading investments among many different funds or investment vehiclesamong many different funds or investment vehicles

Hedge fund strategies are complex and varied in their Hedge fund strategies are complex and varied in their ranges of risk/return. Even within a particular style, two ranges of risk/return. Even within a particular style, two managers can apply different amounts of hedging or managers can apply different amounts of hedging or insurance and leverage to his/her portfolioinsurance and leverage to his/her portfolio

A fund of funds blends together funds of different strategies A fund of funds blends together funds of different strategies and asset classes in order to accomplish:and asset classes in order to accomplish: More consistent return (than any of the individual funds)More consistent return (than any of the individual funds) Spreading out the risks among a variety of fundsSpreading out the risks among a variety of funds Meeting a range of investor risk/return objectivesMeeting a range of investor risk/return objectives

Questions?Questions?

hedge funds mii presentation september 17, 2002 priyanka chopra

Documents

market exposure

market conditions

market correction

bull market

short portfolio

future market fluctuations

term hedge

long portfolios value