Tuesday, October 20, 2009

What is a hedge fund?

PFAEFFIKON, SWITZERLAND - OCTOBER 05: The offi...

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Definition

A hedge fund is an aggressively managed portfolio of securities set up for investors who have a net worth of over one million dollars. Investors who participate in a hedge fund must sign a letter of agreement specifying that they are knowledgeable investors and that they are aware of the risks. The hedge fund managers use advanced strategies to maximize the return on investment to the fund. The strategies employ highly leveraged positions in long and short derivative positions in both domestic and international markets. Derivatives include options (puts and calls), futures (contracts), and swaps, which they combine to protect the bulk of the portfolio. Most hedge funds (but not all) use sophisticated mathematical models to design protective “collars.” A normal requirement for hedge funds is that the investor must leave their investments in the fund for at least one year. To withdraw funds investors must notify the hedge fund manager within a narrow window (one or two months) and at no other time.

Regulation

Since hedge funds don’t deal with the regular public but with sophisticated “accredited” investors, they aren’t regulated. Therefore, managers have great flexibility in their choice of instrument. Although hedge funds resemble mutual funds, they aren’t considered mutual funds (which are regulated and banned from using derivatives). Yet, since hedge funds participate in organized and regulated markets they become subject to US law, and they may be scrutinized by the SEC and the Fed. In this respect, despite the fact that hedge funds aren’t regulated, “insider trader” laws and other laws also apply to them.

Return on investment

Because sophisticated investors demand higher returns for their investments, hedge funds are created to fill that need. Once a hedge fund can show a steady track record of high performance (much higher than the regular markets), money begins to flow in. The more explosive the return on investment the greater the allure of the hedge fund.

Cash Flow as a measure of liquidity, profitability, and future returns

No two hedge funds are alike; they all function independently and in general they become a reflection of the personality of their managers, but in particular of the personality of the general partner. Some general partners with cowboy personalities will ride over all open fields: buyouts, IPOs, stock splits, arbitrage, and foreign currencies. For many stock investors, the index “earnings per share” (EPS) is the absolute measure of profitability and an indicator of future corporate performance. For the hedge manager, however, a much better crystal ball is the corporation’s statement of cash flows. Why is the statement of cash flows preferred by the hedge fund managers over the EPS? Hedge fund managers know that EPS can be ‘doctored up,’ manipulated, disguised, and shaped to look good, when the underlying reality may be different—even grim. Cash flows on the other hand can be double checked with the banks that hold the cash accounts. The pieces that go into the preparation of the cash flows statement must fit perfectly and harmonize with the balance sheet and the income statement. From the top section of the statement we read the inflows and outflows from the main line of business—operations. From the middle section we read the investing activities: what cash was generated and used by non-current assets and non-current liabilities. From the third section we can see the inflows and outflows due to dividends, and bond and stock issues. The Statement of cash flows paints a detailed panorama of all the significant activities that management engaged in during the year. Of most importance are the clues that the figures give to hedge funds managers as to the direction of the company: what plant expansions are taking place, what restrictions are being placed on retained earnings, and so forth. And if the company is having difficulties with liquidity, this can be gleaned, too. Hedge fund managers value fresh, current, timely, and accurate information. Not only do they value information, but they also cultivate good sources of information and connections. In this respect, hedge fund managers must tread lightly so as not to become prey to “insider trading.”

Multiple Brokers and Arbitrage

To squeeze the maximum return on investment, hedge fund managers employ several brokers, always seeking to make economies on broker fees and commissions. Given the volume and large amounts of money their savings can be significant, which in the end will add to the fund’s bottom line. Again, given the large investments hedge funds can dump on brokers, they aren’t too proud to engage in arbitrage. If they see that there’s a price disparity between exchanges, they will capitalize on it by crossing markets. Of course, most of these mispricing can be detected by computer programs that crawl the internet, pouncing on every opportunity and thus eke out gains with no labor investment.

Conclusion

Investors with cold blood in their veins, strong hearts, and strong stomachs will entrust —risk, may be a better word— their money to hedge funds. Is there any protection? None. They go into the funds with open eyes, trusting only the personality of the general partner. May universities, hospitals, museums, art organizations, and other non-for profit organizations invest in hedge funds? Yes, they may. The overseers, trustees, directors, and in particular those in finance and investment committees will be considered ‘accredited’ investors. And in keeping with their fiduciary responsibility they will follow the “prudent man” philosophy of diversification, investing only a fraction of their endowments.
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