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HEDGE FUNDS
1. Arbitrage Strategies
Risk based Inve stment Strate gie s accentuate the impact of market moves. The leveraged
directional investments tend to make the largest impact
on performance.
The five risk based strategies, have their own risk,
and return characteristics. [2] High Risk Strategies
[1] Very High Risk Strategies 2.1 Aggressive Growth
A primarily equity-based strategy whereby the
1.1 Emerging Markets manager invests in companies, with smaller or micro
Invests in equity or debt of emerging (less mature) capitalization stocks, characterized by low or no
markets that tend to have higher inflation, volatile dividends, but experiencing or expected to
growth and the potential for significant future experience strong growth in earnings per share. The
growth. Examples include Brazil, China, India, and manager may consider a company's business
Russia. Short selling is not permitted in many fundamentals when investing and/or may invest in
emerging markets, and, therefore, effective hedging stocks on the basis of technical factors, such as
is often not available. This strategy is defined stock price momentum. Managers employing this
purely by geography; the manager may invest in any strategy generally utilize short selling to some
asset class (e.g., equities, bonds, currencies) and degree, although a substantial long bias is common.
may construct his portfolio on any basis (e.g. value, This includes sector specialist funds such as
growth, arbitrage) technology, banking, or biotechnology.
5.4 Market Neutral – Arbitrage In particular, Steven Cohen's SAC Capital Partners
The manager seeks to exploit specific inefficiencies charges a 3% management fee and a 35-50% performance
in the market by trading a carefully hedged portfolio fee, while Jim Simons' Renaissance Technologies Corp.
of offsetting long and short positions. By pairing charged a 5% management fee and a 44% incentive fee in
individual long positions with related short positions, its flagship Medallion Fund.
market-level risk is greatly reduced, resulting in a
portfolio that bears a low correlation to the market. Performance fees are intended to align the interests of
manager and investor better than flat fees that are payable
even when performance is poor.
For Example
Long convertible bonds and short underlying However, many people, including notable investor Warren
issuer’s equity. For example, can be long Buffett, for giving managers an incentive to take excessive
convertible bonds and short the underlying issuers risk rather than targeting high long-term returns, have
equity. It may also use futures to hedge out interest criticized performance fees. In an attempt to control this
rate risk. These relative value strategies include problem, fees are usually limited by a high water mark and
fixed income arbitrage, mortgage backed securities, sometimes limited by a hurdle rate. Alternatively, a "claw-
capital structure arbitrage, and closed-end fund back" provision may be included, whereby the investment
arbitrage. manager might be required to return performance fees
when the value of the fund drops.
For example
Fe es S tr u cture Suppose at the beginning of year 1 a hedge fund has
A hedge fund manager will typically receive both a a net asset value of 100, and throughout the year the
management fee and a performance fee (also known as an fund realizes a 25% return, raising the net asset
incentive fee). value to 125. Then if an investor entered the fund
with a $1,000,000 investment at the beginning of
Fees are payable by the fund to the investment manager. year 1 then his or her "shares" would be worth
They are therefore taken directly from the assets that the $1,250,000 gross of fees. If the benchmark was cash,
investor holds in the fund. say 5%, then the fees would be paid on the $200,000
upside in excess of cash. That is, the first 5% of the
Management fees return would not have to have fees paid on it. If the
As with other investment funds, the management fee is fees were 2 and 20, then the investor would pay
calculated as a percentage of the fund's net asset value (the $20,000 in fixed fee (2%) and 20% of the upside
total of the investors' capital accounts) at the time when the above cash, that is, an additional $40,000 for a total
fee becomes payable. Management fees typically range of $60,000 in fees. This would make the investment
from 1% to 4% per annum, with 2% being the standard value, gross of fees, equal to $1,190,000.
figure. Therefore, if a fund has $1 billion of assets at year-
The performance fee is sometimes calculated net of a Hurdle Rates
benchmark. That is, the returns that fees are paid on are Some managers specify a hurdle rate, signifying that they
sometimes only those returns in excess of some benchmark. will not charge a performance fee until the fund's
Sometimes the benchmark is a risk-free interest rate such annualized performance exceeds a benchmark rate, such as
as LIBOR (often called the cash benchmark, meaning T-bill yield, LIBOR or a fixed percentage. This links
performance fees are paid on the profit that would be made performance fees to the ability of the manager to do better
in excess of an investment in cash) and other times it is a than the investor would have done if he had put the money
market index such as the MSCI World Index or the S&P elsewhere.
500 index.
Because demand for hedge funds has outstripped supply,
High Water marks most managers do not now need hurdle rates in order to
A high water mark (also known as a loss carry forward attract investors. For this reason, hurdle rates are now rare.
provision) is often applied to a performance fee calculation.
This means that the manager only receives performance Withdrawal/Redemption Fees
fees on the value of the fund that exceeds the highest net Some managers charge investors a withdrawal/redemption
asset value it has previously achieved. fee (also known as a surrender charge) if they withdraw
money from the fund before a certain period has elapsed
The high water mark is an important concept: investors in since the money was invested.
hedge funds enter the fund at a certain net asset value,
which we will call the entering NAV. If the fund loses The purpose is to encourage long-term investment in the
money in a given year and then makes back that money in fund: as a fund's investments need to be liquidated to raise
a subsequent year, the investor is usually not required to cash for withdrawals, the fee allows the fund manager to
pay a management fee on any portion of the upside in the reduce the turnover of its own investments and invest in
subsequent year that was below the entering NAV. more complex, longer-term strategies. The fee also
dissuades investors from withdrawing funds after periods
For example of poor performance.
Suppose an investor enters a hedge fund with a $1,000,000
at the beginning of year 1, and in that year the fund is The fee is typically known as a "withdrawal fee" where the
down 20%, that is, the value of the investment drops to fund is a limited partnership and a "redemption fee" where
$800,000 gross of fees. the fund is a corporate entity.
1. http://www.hedgefundworld.com/forming_a_hedge_fund.htm
2. Hedge Funds Do About 60% Of Bond Trading, Study Says", The Wall Street Journal
5. Hedge Fund Math: Why Fees Matter (Newsletter), Epoch Investment Partners Inc.