Hedge funds have acquired a fearsome reputation in recent years, largely because

people still remember how George Soros’s Quantum Fund helped to force the pound
out of the European exchange-rate mechanism in 1992.

The irony is that, despite their high-risk image, hedge funds were originally
designed to protect against risk, rather than maximise it.

So here is a quick explanation of what hedge funds are, how they operate and how
you can invest in them.

What is a hedge fund?

An investment that aims to make money year in, year out, no matter what the
financial climate (known as an absolute-return strategy). How to define hedge funds
is tricky because it is an umbrella term for a huge range of different investment
strategies and risk levels. One thing that they have in common is that wealth
preservation - not losing money - comes very high up the list of priorities.

Why do they seem so scary?

Their sheer size (many funds are worth billions of pounds) is enough on its own to
command attention, but it is the frequency with which they trade that gives them a
profile even bigger than their size alone would merit. Market experts reckon that
hedge funds account for as much as 50 per cent of all trades on the London Stock
Exchange.

When hedge funds combine to bet on a particular outcome, as they did with the
pound in 1992, even governments can find themselves powerless to resist the
momentum they generate.

How do hedge funds work?

They use a number of strategies to make money for investors. Perhaps the most
notable is the long-short equity strategy. This allows the fund manager both to "go
long" - the traditional approach of buying an asset in the hope that it will rise in
value - and to "go short". The latter is when the fund manager sells a borrowed
asset in the hope of buying it back more cheaply later.

Another approach is arbitrage, where the fund manager takes advantage of

anomalies in the pricing of assets. For example, when a company's shares are
quoted in two different countries, arbitrageurs may see a slight advantage in buying
the shares in one country rather than the other. To see arbitrage in action, use an
online calculator.

A third method of making money is to take a significant stake in a company in the

hope that a profitable takeover or management shakeout will follow.

Are hedge funds suitable for the man in the street?

There are a number of hurdles that a typical private investor needs to clear before
putting money in a hedge fund. The first is that the initial investment required is
usually very high. It is rarely less than £50,000 and can be £1 million or more, which
rules out all but the wealthiest investors.

Hedge funds are based offshore and are not regulated by the Financial Services
Authority, so the usual warning about seeking advice before buying applies with
extra force in this case.

Although not all hedge funds are high-risk, some of the strategies used by some of
the funds undoubtedly are. For example, the use of specialist instruments known as
derivatives offers highly geared bets on the future price of things such as shares or
commodities, and investors need to be sure that they appreciate the level of risk.
Hedge funds typically use leverage. This involves borrowing additional money to
increase the size of the bets they are taking.

How much does all this expertise cost?

Quite a lot. Hedge funds typically charge 2 per cent a year in annual fees, plus a
performance fee of 20 per cent or more of any rise in the fund’s value. Performance
fees are rewards to managers for achieving a certain level of return. The idea is that
by offering these incentives the fund ensures that both the managers and the
investors have a strong interest in the fund doing well.

Does the performance of these funds justify the high fees?

It is impossible to give a blanket answer to that question, but it is certainly fair to

say that the high charges act as a drag on performance.

For example the average return on European hedge funds in 2008 was a little less
than 10 per cent, according to HedgeFund Intelligence, the industry information
group. This compares with the return of 18.1 per cent posted by ordinary European
equity funds.

However, hedge funds fared much better in the bear market of 2001 and 2002.
While the stock market was down 45 per cent, hedge funds were up by between 1
per cent and 2 per cent. Because hedge funds aim for absolute returns, they tend to
perform better than the stock market in bad times but less well in good times.

How do you go about buying a hedge fund?

Your financial adviser should be able to point you in the right direction, but you will
need a substantial initial sum and could be buying into a very risky investment.

Charles Cade, of Winterflood Securities, the stockbroker, says that he would not
recommend direct investment in hedge funds. A better route would be a fund of
hedge funds. These invest in a number of different funds and there are more than
20 listed on the London Stock Exchange.
But these, too, have drawbacks. They usually charge another layer of performance
fees on top of those levied by the underlying hedge funds, and like hedge funds,
they are not regulated by the FSA, though the watchdog is thinking about bringing
some funds of hedge funds under its regulatory umbrella.

http://www.timesonline.co.uk/tol/money/reader_guides/article3034518.ece [hhedge
funds work]

Home Investing How hedge funds work

Michael Clarke, This is Money

12 July 2006

Deals

THE influence of hedge funds over the City has grown as quickly as investors'
money has flowed into the funds over the past 15 years.

UP OR DOWN: Hedge funds can make money regardless of which way the market
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These funds now reportedly manage over £750bn of clients' money and their highly-
paid managers can achieve remarkable returns.

Retail investors have so far been barred from investing in the funds, but that could
change next year. But what are these funds and what makes them so different to
normal collective investments? Read our report to find out.

What is a hedge fund?

Hedge funds are collective investments that aim to make money whether the
market is moving up, down or sideways. Unlike unit trusts, Oeics or investment
trusts, which tend to only grow when shares rise, hedge funds can make money
when share prices are falling.

They do this using a range of complicated specialist techniques. The most

commonly used is by going long or short on a share. Most private investors simply
go long on a share, buying it in the hope that the price will rise.

Where an investor goes short, they believe that the equity will fall in value. There
are two main ways that hedge funds can do this. The first is by 'shorting' the stock,
where the investor 'borrows' a stock to sell it, with the hope that it will decrease in
value so they can buy it back at a lower price and keep the difference.

For example, if an investor borrows 500 shares of X company at £10 each, they
would then sell those shares for £5,000. If the price then falls to £8 per share, the
investor would buy the shares back for £4,000, return them to the original owner
and make a profit of £1,000.
Another way of taking advantage of falling share prices is by dealing in 'contracts
for difference'. This allows the investor to make money on share price movements
without actually buying the shares. A CFD on a company's shares will specify the
price of the shares when the contract was started. The contract is an agreement to
pay out cash on the difference between the starting share price and when the
contract is closed.

However, hedge funds are not only restricted to equities. They will invest in
anything that will make them a profit, including foreign currency, bonds or
commodities. The return achieved by the fund is likely to be dependent on the skill
of the manager rather than underlying economic conditions and that is why they are
so well paid.

Can I invest in a hedge fund?

At the moment, hedge funds are only available to high wealth individuals who are
prepared to invest around £500,000 or to professional investors, such as pension
funds or insurance companies. Individual retail investors cannot buy directly into
hedge funds as the City watchdog, the Financial Services Authority, is concerned
about how the funds are operated and their risk. Plus, it is unclear whether the
hedge fund operators would welcome dealing with a large number of small
investors due to the costs involved.

However, the FSA will launch a consultation next year on whether it should increase
the scope of funds it authorises to include funds of hedge funds. Retail investors still
wouldn't be able to invest directly, but would be able to invest in an authorised
collective investment scheme that would put money into hedge funds.
Currently, if investors want exposure to hedge funds they can purchase shares in
the companies that operate funds, such as Man Group. It is also possible to buy into
foreign funds over the internet, although investors cannot expect the same financial
protection that they would receive in the UK.

Read more: http://www.thisismoney.co.uk/investing/article.html?

in_article_id=410685&in_page_id=166#ixzz0jSMwiYNz

http://www.thisismoney.co.uk/investing/article.html?
in_article_id=410685&in_page_id=166 [how hedge funds works and meaning ]

How do hedge funds work?

Hedge funds have the unusual characteristic of causing both anxiety and
excitement. Most investors remember the time that George Soros - probably the
most famous hedge fund manager - “broke the Bank of England” in 1992, and the
near-collapse of Long-Term Capital Management in 1998.

Friday, August 31st 2001, 4:20PM

But they also suspect that such funds offer ways to get spectacular returns which
are not available to the average person.

Hedge funds are essentially vehicles that use unconventional techniques to allow
them to prosper in all market conditions. For example, hedge funds can "short-sell"
or bet on falling markets or securities, and can therefore perform well even when
sharemarkets are falling.

The ability of hedge funds to grow, or at least fall less, even when markets are
falling is one of their main attractions. According to the weighted index calculated
by the Hedge Fund Research Institute, from January 1991 to May 2001 the average
returns of hedge funds on a global level were 13.67%, which is slightly less than the
14.84% of the S&P500 Index.
However, the average volatility of the hedge funds was 8.11%, compared with
14.9% for the S&P500. If the Sharpe ratio - which measures return relative to risk -
is taken into account, then hedge funds perform substantially better than the
S&P500.

A comparison of hedge fund performance with that of the S&P500 over four discrete
periods gives some insight into their relative performance: from February 1994 to
January 1995, July to October 1998, from March to December 2000 and the first five
months of this year. In all these intervals except the third, hedge funds increased
more than the S&P500. (It is important to note that the return of hedge funds is
uncorrelated with that of the stockmarket. In fact, the correlation between the
S&P500 and the average returns on hedge funds rarely exceeds 10%.)

These general results show the potential hedge funds can offer investors, but it is
useful to remember that these results represent an average for the sector as a
whole.

To properly understand hedge funds, it is important to classify them according to

the strategies that they follow.

•Long/short equity

•Short-selling

•Event Driven

•Distressed Securities

•Convertible arbitrage

•Fixed income arbitrage

•Equity Neutral

•Macro

Long/short equity

This strategy includes constructing a portfolio with a long position (buying) in

undervalued shares, and a short position (selling) in overvalued shares. The
difference between the long position and the short is the net exposure to the
market. The average return of this strategy from 1990 until today has greatly
exceeded both the S&P500 and the MSCI World Index. In addition, the average
volatility was lower than both of these indices, and accordingly these hedge funds
have had the best ratio of risk to returns.

The strategy is not risk-free. The hedge fund manager must not only be on top of
the individual share position, but must also decide on the net exposure to the
market. Investors should also remember that managers with a short position face
the possibility that the intermediaries may recall the borrowed shares.

Short-selling

This strategy is a more specialised version of the long/short strategy. It consists of

selling shares in companies with specific problems, or selling shares because of the
market sentiment. In other words, it means betting on falling markets or securities.

The stockmarket boom of the last few years has not benefitted this strategy. Short-
sellers tend to perform best when markets fall: between March and December of
last year, the short-selling hedge funds gained 60 percent compared to negative
returns for almost all the main world stockmarket indices. These funds are valid
instruments for hedging against a fall in the market, because they are characterized
by a strong negative correlation with stockmarket indices. But they are not free of
risk, as fund managers who pursue this strategy must get their timing right.

Event-driven

The event-driven strategies are focused on particular events, which can produce a
rise in the price of the shares. The underlying principles are represented by merger
arbitrage and distressed securities. The strategy of merger arbitrage is focused on
mergers and acquisitions. These hedge funds buy, after the announcement of
mergers, the shares of the company that is being acquired, and sell those of the
purchaser, in an amount that depends on the prefixed exchange rate between the
two sets of shares. The objective is to gain the spread between the market price
and the offer price (the premium). If the transaction proceeds without a problem,
the market quotes will reflect the offer price.

This strategy has generally attained positive returns in recent years, as the funds
have benefitted from a favourable market environment. The most common risk of
this strategy is that the mergers are not completed. The situation depends on many
factors: government disposition, willingness of the shareholders, the nature of the
operation - hostile or willing - and interests of other companies. There is also the
risk spread, that is, that the estimated premium is lower than it seems.

Distressed securities

Hedge fund managers which follow the 'distressed securities' strategy focus on the
opportunities that arise from situations of bankruptcy, liquidation, and restructuring.
These funds typically invest in different fixed income securities, such as high-yield
bonds or "junk bonds" (the debt of companies with a poor credit rating). The typical
risk for these hedge funds is that market conditions might move against them. An
economic downturn or an increase in interest rates typically hit the profit margins of
distressed companies.

Convertible arbitrage

This strategy consists of the acquisition of convertibles (bonds which can convert to
shares), and the sale of a specific amount of shares from the same company. The
hedge fund manager aims to take advantage of mispriced situations with relation to
the price between the convertible bonds and shares. These hedge funds have given
satisfaction to their investors in the 1990s, with a Sharpe ratio more than double
that of the S&P500 Index. But it is once again important to take into account the
specifics of this time period. This strategy does not generally benefit from changes
in interest rates or market volatility.

Fixed income arbitrage

There are numerous variables that exist within this strategy. In general, the short
position is composed of securities with the highest credit rating, such as Treasury
bills, while the long positions are corporate bonds or emerging markets debt. The
objective is to gain from the convergence of interest rates. Although this strategy
has not attained exciting results over the last years, it has enjoyed low volatility.

The risks characterising this strategy are those typical of bond investments: the
exposure to interest rate fluctuations and credit risk.

Equity market neutral

The portfolios of this strategy are composed of long positions in undervalued
shares, equally balanced with a short position in overvalued firms, to cancel the
fluctuations of the market. This method of investment is equivalent to the
long/short, with no market exposure. For the choice of shares in general, it uses
quantitative models to discover those that are inefficiently priced.

The strategy has produced optimum results over the 1990s, and has a low volatility.
It has also generated positive results in all of the four negative periods discussed
above. The returns of this strategy are almost completely attributable to the ability
of the manager, and/or to the quantitative methods, to support the share selection.
Therefore, the risk resides in these two factors, but also in the possible lack of
correlation between the long and short parts of the portfolio.

Macro

The macro funds take long and short positions in shares, bonds, options, futures,
and commodities, using high financial instruments. The name of the strategy
derives from the fact that these funds are not simply interested in the future
evolution of the companies, but of the entire country or sector. This strategy has
provided consistent returns with low volatility. It is important to note that compared
to other hedge fund strategies, macro funds are characterised by a strong
correlation with stockmarket indices.

http://www.goodreturns.co.nz/article/976486567/how-do-hedge-funds-work.html
[how does this work stretegies]