Visual Guide to Hedge Funds

Richard C. Wilson

• Publisher: Bloomberg Press
• Year: 2014
• ISBN:
  9781118421338
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Negocios en general

Vivid graphics make hedge funds, how they work and how to invest in them, accessible for investors and finance professionals

Despite the recent wave of scandals related to the hedge fund industry, interest in hedge funds as a relatively safe alternative investment remains high. Yet details about how the industry operates and the strategies employed by different types of hedge funds is hard to come by. With increasing calls from lawmakers and the media for industry reform, it is incumbent upon finance professionals and high-net-worth individuals to take a good look before leaping into hedge funds. That's where the Bloomberg Visual Guide to Hedge Funds comes in. It provides a graphically rich, comprehensive overview of the industry and its practitioners, zeroing in on how different types of hedge funds work.

• Based on extensive interviews with hedge fund managers, analysts and other industry experts, the book provides a detailed look at the industry and how it works
• Outlines investment strategies employed by both long and short hedge funds, as well as global macro strategies
• Arms you with need-to-know tips, tools and techniques for success with all hedge fund investment strategies
• Provides a highly visual presentation with an emphasis on graphics and professional applications
• Real-life examples take you inside how hedge funds illustrating how they operate, who manages them and who invests in them

CHAPTER 1
Hedge Fund Daily Operations

Hedge funds have become a powerful force in finance. There are thousands of hedge funds operating today; an incredible expansion for an industry that was only in its infancy half a century ago. If the hedge fund industry was crawling and learning how to walk in the 1960s and 1970s, it is now fully grown, at times running circles around its more traditional peers in the investment world. In this chapter, you will learn how these alternative funds operate and how these vehicles have become ever more complex and sophisticated over the years.

As you will learn in this book, the hedge fund has evolved greatly in recent years and differs in many ways from its peers in traditional investment vehicles. Hedge funds are private investment partnerships, with only a couple exceptions where the fund is sponsored by a publicly traded investment firm. Hedge funds often employ significant leverage to maximize profits on investments (with increased risks to the portfolio and investors), and managers run many exotic and complex strategies from convertible arbitrage to quantitative-driven investments executed in the blink of an eye.

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DEFINITION:

Hedge Fund

An alternative investment fund, typically structured as a private investment partnership, that is restricted to accredited investors (investors with significant means and sufficient sophistication). Hedge funds are actively managed, invest in a variety of securities—sometimes highly complex or exotic ones—and typically operate with greater flexibility, higher leverage, more complicated strategies, and with less regulatory oversight than a traditional investment fund.

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One common misconception is that hedge funds are “just another type of mutual fund.” I asked Paul Udall, Investment Director at GAM, to share how he explains what separates a hedge fund like his from a mutual fund. “Very simply, a ‘hedge’ fund hedges the risk in the portfolio by taking short positions to offset the long positions. The aim of this is simply to reduce the risk of general market moves.” There are many other attributes that separate hedge funds as a unique alternative investment class, but the core concept to understand, as Paul explained, is that hedge funds seek to limit risk with short positions.

Hedge funds are often described along two extremes: one stereotype is of the so-called “masters of the universe, ” hedge fund managers who occupy lavish offices all over Manhattan and employ hundreds of traders and analysts, all earning millions in compensation on the billions that the hedge fund earns in profits. This depiction resembles Michael Douglas’s famous Gordon Gekko character from the movie Wall Street. The other caricature is a lone trader, executing massive trades in his garage, reaping huge rewards while assuming equally huge risks. The truth, as is often the case, lies somewhere in the middle, and there is some truth in both extreme stereotypes.

Many hedge funds manage well over $1 billion in assets under management. These funds often occupy large Manhattan office spaces (as seen in Figure 1.1), run hugely complex trading operations, and many of these hedge fund employees will earn $1 million or more in compensation on a good year (and even on a bad year, for some funds). However, not all hedge funds are created equal and there are thousands of hedge funds that manage “mere” millions in assets under management and grind out modest gains for a small number of investors.

Figure 1.1 Successful Hedge Fund Titan, Leon Cooperman, founder of Omega Advisors, Inc., Manages Billions from His New York Office

Photographer: Mackenzie Stroh/Bloomberg Markets.

A sub-$1 billion dollar fund might be a startup with just $1 to $10 million under management or emerging managers who have been around a few years and have yet to hit it out of the park with returns big enough to attract institutional capital en masse. In The Big Short (Norton/Allen Lane), a terrific account of the financial crisis and the hedge funds that succeeded during that time, author Michael Lewis profiles a few managers in this low-to-middle tier of hedge funds. Michael Burry is a hedge fund manager and one of the characters in Lewis’s nonfictional story. Burry managed to make a killing shorting the financial crisis and housing bubble, but for years he was just trading during the night and in his spare time. He didn’t fit the stereotype of a Wall Street titan, not with his shorts and informal style, but he possessed exceptional analytical skills.

As we explore in the next chapter, the size of a hedge fund determines the complexity and vastness of its resources and operations. Hedge funds range from the giant firms like Bridgewater Associates (which manages over $100 billion in AUM) to modest trading outfits that most investors have never heard of. The single-trader hedge fund may only have an analyst and an assistant on staff and the rest of the services, like auditing, accounting, legal, and so on, are out-sourced to industry service providers. More established, large firms will typically handle a lot of operational functions in-house and may employ dozens, even hundreds of employees. It is best to think of a hedge fund as a financial company, with all the day-to-day responsibilities and activities of a small to medium-sized business.

A hedge fund is a cohesive business with many moving parts that require numerous individuals to perform specific daily activities to allow the firm to generate returns and profit from management and performance fees. Each employee, from portfolio to risk managers, plays an important role in helping the firm operate on a daily basis. This chapter describes the roles in a hedge fund organization and how each role plays a part in the operation of a hedge fund.

Hedge Fund Manager

The principal of a hedge fund usually wears many hats. These include portfolio manager, asset allocation specialist, supervisor of portfolio managers, and sales representative. Each of these roles is important to the operation of a hedge fund.

Generally, when a hedge fund hangs out its shingle to start its business, the hedge fund manager is the key driver of returns. This person is usually the portfolio manager who is creating the investment strategies and the risk level associated with the fund. This portfolio manager is generally responsible for generating the hedge fund’s past returns that create the bulk of the fund’s track record. The hedge fund manager has a robust understanding of how to invest and how to manage the risks to the portfolio.

As the hedge fund expands, the fund manager’s responsibilities grow, requiring that individual to play a more versatile role within the firm. Hedge fund managers supervise and meet with the other portfolio managers on a daily basis to discuss strategy as well as their profits and losses. Risk is another issue for the hedge fund manager as he or she needs to be abreast of the potential losses his/her firm could incur if the market takes a swing that negatively affects the position.

Asset allocation is a key ingredient to generating the most efficient risk-adjusted returns. If the firm is set up so that there is only one strategy and one manager, then asset allocation is more linear and easier to manage. For funds that have multiple managers and multiple strategies, this quantitative issue is key to performance. A hedge fund manager needs to allocate capital to the managers and strategies that are going to produce the best risk-adjusted returns. A combination of certain types of market environments and trader underperformance can create a situation where a hedge fund manager reallocates capital to a different portfolio. Some managers use qualitative allocation methods while others use quantitative methods.

Marketing and selling the services of a hedge fund is another role the hedge fund manager handles. As a hedge fund grows, the investor-relations team is formed, which removes some of the initial introductions that take place when marketing a firm. Most of the time, closing the deal is still left up to the hedge fund manager.

In summary, the principal of a hedge fund is involved in almost every aspect of the business—much like the CEO of a small business understands everything about his business. Most successful hedge fund managers that I have met were knowledgeable about every part of the firm, from the day-to-day portfolio management to how the reporting is distributed to investors by the investor relations team.

Portfolio Managers

Po...