Insider view of the Hedge Funds Industry

TJC: Thanks for joining in. How do you define a Hedge Fund? And how do you see the current state of the Hedge Fund Industry?

Industry Exec: Hedge funds are pooled investment funds with relatively less SEC regulation (in the US), and are therefore different mutual funds. Certain hedge funds are required to register with SEC as investment advisers under the Investment Advisers Act.  The Act does not require an adviser to follow or avoid any particular investment strategies, nor does it require or prohibit specific investments. Hedge funds typically charge a fee greater than 1%, plus a “performance fee” of 20% of a hedge fund’s profits. There may be a “lock-up” period, during which an investor cannot cash in shares.

Some people break the hedge fund universe into seven broad classifications: (1) event driven, (2) fixed-income arbitrage, (3) global convertible bond arbitrage, (4) equity market-neutral, (5) long/short equity, (6) global macros, and (7) commodity trading. We will discuss two of them in more detail.

Regarding the Flow of Funds, assets under management of the hedge fund industry totaled $1.225 trillion at the end of Q2 2006 according to data by Hedge Fund Research Inc. (HFR). This was up 19% on the previous year and nearly twice the total three years earlier. Because hedge funds typically use leverage/gearing or debt to invest, the positions they can take in the financial markets are larger than their assets under management. The number of hedge funds increased 10% during the past year to reach around 9,000 according to HFR. Research conducted by TowerGroup predicts that hedge fund assets will grow at an annualised rate of 15% between 2006 and 2008 while the actual number of hedge funds is likely to remain relatively flat.

TJC: Which are the key locations from where the Hedge Fund Industry is operating from?

Industry Exec: A large number of hedge funds are registered offshore (with respect to US). The most popular offshore location has been the Cayman Islands followed by British Virgin Islands and Bermuda. The U.S. is the most popular onshore location accounting for 34% of the number of funds and 24% of assets. Onshore locations are far more important in terms of the location of hedge fund managers. New York City, Stamford and Greenwich, Connecticut together are the world’s leading location for hedge fund managers with about twice as many hedge fund managers as London, which is the next largest centre. Its not surprising as the US is the source of the bulk of hedge fund investments. London is Europe’s leading centre for the management of hedge funds. Australia has been the centre for Asia-Pacific hedge funds.

TJC: How do you go about your investments? Can you share some of the key investment strategies used by Hedge Funds?

Industry Exec: The bulk of hedge fund assets are invested in funds that employ “long / short” equity strategies. Other hedge funds use alternative strategies such as short bias, arbitrage, trading options or derivatives, using leverage, investing in seemingly undervalued securities, trading commodity and FX contracts, and attempting to take advantage of the spread between current market price and the ultimate purchase price in situations such as mergers. Many strategies acquire the risk of catastrophic losses as in the case of Long-Term Capital Management.

Lets first consider the Equity Long Short Strategy, which is currently the most ubiquitous hedge fund strategy globally representing some 27% of North American hedge fund assets, 38% in Europe and 69% in Asia. Equity long short investing involves buying long equities that are expected to increase in value and selling short equities that are expected to decrease in value either in absolute terms or in relative terms.

Typically equity long short investing is based on what is termed ‘bottom up’ fundamental analysis of companies driving the decisions whether to hold a stock long or sell it short. There is usually also a ‘top down’ basis for risk managing the equity portfolio to diversify risk by geography, industry, sector and macroeconomic factors. With time various evolutions of this strategy have emerged. Within equity long short managers there are those who specialize in a value approach or a growth approach. Similarly there are a variety of trading styles where a manager may be a more frequent or dynamic trader or a more long term investor. There are managers who focus on certain industries and sectors or certain regions.

The other prominent strategy is Risk Arbitrage Strategy, which is to buy shares of a company that has announced it is being purchased. When a merger or acquisition is announced, the target company and the acquirer disclose deal terms, or the premium that the acquirer will pay for the target. In almost all cases, the target’s current share price is below the premium that will be paid for it at the completion of the merger, so arbitragers will buy the target company’s now undervalued shares. As the announced merger’s effective date gets closer and the more approval the merger gains, the closer the target’s share price will get to the premium offered, so every detail of the merger process is very important. When the acquiring company is offering to buy the target for cash and its own stock, the trader will short sell the stock of the acquiring company, the appropriate number of shares being decided by cash/stock ratio of the deal terms, in addition to buying the stock of the target in order to lock in the spread between the target’s current price and the deal terms. We call this process as “setting a spread”. This strategy is very risky; hence the name. There is no assurance the merger will be finalized and several factors such as regulatory approval, shareholder approval, and the possibility of other acquiring companies entering the picture account to this.

TJC: Many thanks for this, and we look forward to another round of chat with you in the near future.

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