Absolute Returns

The Risk and Opportunities of Hedge Fund Investing

Focus Take-Aways

Leadership & Mgt. • Sociologist Alfred Winslow Jones set up the fi rst hedge fund in 1949. Strategy • Warren Buffett set up a fund that fi ts today’s perception of a hedge fund in the 1950s. Sales & Marketing • Absolute return money managers play both the long and short side of the market. Corporate Finance • Good hedge fund managers specialize. Analyzing their motivation and performance Human Resources is diffi cult. Technology & Production • Markets are never completely effi cient, and active managers can beat them sometimes. Small Business

Economics & Politics • Arbitrage traders take offsetting positions in related instruments whose performance is fairly predictable. Industries & Regions • Market neutral strategies are a form of arbitrage that seeks to exploit market Career Development inefﬁ ciencies by holding roughly equivalent long and short positions. Personal Finance • These strategies have been quite proﬁ table. Concepts & Trends • One investor’s risk is another’s opportunity. • Hedge fund investing may represent a paradigm shift or it may be a bubble.

Rating (10 is best)

Overall Applicability Innovation Style 8 8 8 7

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What You Will Learn In this Abstract, you will learn: 1) The history and track record of hedge funds; 2) All of the basic investment questions about hedge funds; and 3) Numerous possible answers to each one. Recommendation Hedge funds burst into the headlines in the early 1990s, when George Soros became a household name — at least in Europe, where many people blamed him and his hedge fund for wrecking the European exchange rate mechanism. Similarly, a U.S. hedge fund called Long Term Capital Management (LTCM) began with an aura of investing invincibility, only to fail dramatically. Hedge fund investing is sometimes, but not always, high risk and high return. Once limited to a privileged elite group of investors, hedge funds are now opening their rosters to less sophisticated, less wealthy speculators. But hedge funds are not just like any other funds, and anyone contemplating an investment needs a solid, comprehensive guide, such as this book. Author Alexander M. Ineichen, neither a salesman nor an alarmist, pulls no punches when discussing the risks of hedge funds. He is quite straightforward about the sometimes astonishing success of some hedge fund managers, but careful to point out the common misconceptions about them. Without hedging our bets, getAbstract.com ﬁ nds this book a valuable addition to every investor’s library.

Abstract

A Half Century of Hedge Fund History The fi rst hedge fund made its debut in 1949, when sociologist Alfred Winslow Jones started a general partnership, later changed to a limited partnership, to trade equities. In his stock trades, Jones sometimes went long and sometimes sold short. Short sellers borrow a stock and sell it, expecting to buy it back at a lower price and then return it to the lender. Traders who “go long” expect the price to go up; those who sell short expect the price to fall. Jones’s ability to profi t both ways was extraordinary. Other hedge funds followed. “Don’t lose money. In 1956, Warren Buffett established a partnership which resembled a hedge fund in most If you don’t know the facts, don’t ways; the difference was that Buffett did not sell short. From 1956 to 1969, his returns play. I just wait were 29.5% compounded. Buffett’s compensation depended on the fund’s performance. until there is His investors received a 6% return plus 75% of any profi ts above a 6% “hurdle rate.” money around the corner, and all I Buffett himself received 25% of profi ts above the 6% rate. Buffett was a contrarian, and have to do is go specialized in fi nding and buying stocks that he thought were undervalued. When the over there and pick market soared in the late 1960s, he couldn’t fi nd enough undervalued stocks to practice his it up.” traditional approach and he dissolved the partnership instead of changing his approach. George Soros, another renowned hedge fund investor, may be even greater at it than Buffett. His compound annual return from 1969 to 2001, after deducting fees, was 31.6%. During the fi rst decade of that period, the 1970s, only a few other, mostly small, hedge funds were in the market. A handful of prominent money managers set up funds during the 1980s, but hedge funds proliferated in the 1990s, as money managers left big fi nancial institutions and set up shop on their own. Not only did hedge funds multiply during this period, but a wide range of investment approaches appeared.

Absolute Returns © Copyright 2004 getAbstract 2 of 5 Absolute Return Most investment managers have some sort of benchmark. Many measure themselves against “Irrespective of the the S&P 500 index, for example. If the index goes down, but their funds go down less, they history of hedge have succeeded. If their funds earn more value than the index, they have succeeded. funds or whether hedge funds are “Absolute return” managers do not measure themselves against an index. They aim to leading or lagging make money no matter what the overall market is doing. They may use derivatives the establishment, and other tools or techniques to exploit a downward trend. They may go long or short. the pursuit of absolute returns is Contrary to popular misconception, these managers are not cowboys. They tend to be probably as old as extremely conservative, and they often use sophisticated fi nancial instruments, not to civilization and speculate, but to hedge. Their Ten Commandments are ten iterations of: “Thou shalt not trade itself. How- ever, so is lem- lose.” Absolute return managers are more sensitive to risk and more apt to manage it than ming-like trend long-only investors. following.” The Hedge Fund Industry Reliable information about the hedge fund industry is hard to get. Some observers say that there are as few as 2,500 hedge funds in the world, others estimate there are as many as 6,000. Numbers fl uctuate as new funds form and old ones dissolve. Hedge funds, collectively, probably manage between $500 and $600 billion in assets. This is minuscule compared to the $15.9 trillion 1999 asset base of pension funds. European hedge funds account for about 11% of total managed assets for the industry. Hedge funds achieved an important landmark in 1999 when the California Public Employees’ Retirement System (CalPERS) announced that it would invest in such funds, among other “hybrid investments.” Funds of funds, corporations, pension funds and individuals all invest in hedge funds now. “Capitalism is the The success of hedge funds in attracting new investors is rather surprising given their astounding belief that the most wick- generally negative press. Hedge funds are open to some justifi ed criticism on several counts: edest of men will do the most wick- • Magnitude — Once hedge funds get really big, they have trouble delivering superior, edest of things for or even positive, returns. the greatest good • Leverage — Highly leveraged hedge funds have sometimes threatened the stability of everyone.” of the entire fi nancial system. The most notable example was Long Term Capital Management (LTCM). • Transparency — Transparency allows third parties to monitor risk, but hedge funds are quite secretive and it is diffi cult to know exactly what they are doing. • Stability of funding — A “run on the bank” scenario can cause serious market disrup- tion. Hedge funds need stable fund sources. Many LTCM trades were actually good trades and might have scored if investors had not rushed to pull out their capital. • Pride — As the proverb has it, pride goeth before a fall. Hedge fund managers need a great deal of self-confi dence, because they receive rich compensation when they are right. Being right made them managers in the fi rst place, and betting on their convictions is a sine qua non of further success. Such confi dence can easily evolve “Risk control and into arrogance and lead to disastrous missteps. capital preserva- tion are among the The top three hedge fund investment styles, measured by their outcomes in the third main areas where quarter of 2001, were: the best hedge funds consistently • Equity Long/Short — $228 billion in assets, roughly 46% of total hedge fund assets. excel.” • Event — $108 billion, roughly 22% of total. • Macro, global — $40 billion, 8% of total.

Absolute Returns © Copyright 2004 getAbstract 3 of 5 The average age of hedge funds has declined as more and more new hedge funds have emerged. This means, of course, that evaluating and selecting good managers is getting “Either the con- more diffi cult. The fi eld is so crowded that you may easily confuse luck with skill. Even vertible was too so, several myths about hedge funds should be debunked, including: cheap or equity was too expen- • Hedge funds are high-risk investments — In fact, any investment may be high-risk sively valued by when it is not diversifi ed. Hedge funds are inherently no riskier than technology or the market. To exploit this ineffi - transportation stocks. Diversifi cation is important in every case. ciency, convertible • Hedge funds are gambles — Although hedge funds speculate, they are not necessar- arbitrageurs sold expensive equity ily speculative. Every investment is a speculation, but hedge funds may be more pro- and bought the tective of principal than other types of funds, precisely because they often hedge. comparably cheap • Hedge funds do great regardless of market moves — In fact, like other investments, convertible bonds.” hedge funds have good years and bad years. • Hedge funds always hedge — Hedge fund managers choose when to hedge and when not to, and take risks when they judge the risks to be good investments. • Short and long are opposites — In fact, in an investing context, short and long are not the mirror image of each other. Short positions have a different risk profi le than long positions and need to be handled with greater caution. However, most long/short investors consider a pure long strategy to be quite speculative compared to a strategy that balances long and short positions. Hedge funds usually, but not always, outperform mutual funds — in the aggregate. This makes sense since most mutual funds cannot exploit a down market or defend against one effectively. Hedge funds do not aim at a benchmark; by and large, the only measure “Buy and sell deci- of hedge fund success is cash won in the markets. A good benchmark of hedge fund sions are based on performance is unlikely to be developed because such a metric would have to be: expectations about future prices, and • Refl ective of the range of hedge fund styles and approaches. future prices, in turn, are contin- • Clear and subject to measurement. gent on present • Capable of being replicated passively. buy and sell deci- sions.” Hedge fund styles are too diverse and idiosyncratic to fi t a benchmark. The best funds do well because they are run by superlative risk managers. Investing in hedge funds has disadvantages, most notably the relative absence of transparency. But fees seem to be money well spent — hedge funds are no costlier than other investments when the costs are viewed in the context of performance. To some extent, hedge fund success fl ies in the face of effi cient market theory, but effi cient market theory itself often fl ies in the face of plainly observable facts. Styles Some of the main hedge fund styles include: • Convertible arbitrage — Most managers in this area buy bonds, warrants or convertible bonds and hedge away the market exposure. A formula allows them to calculate “Hedge fund managers, especially a fair value relationship between the stock and the convertible. When the convertible in the relative- is under-priced relative to the stock, they buy. value arena, make • Fixed income arbitrage — This school applies a similar arbitrage approach to bonds money by ex- ploiting objective and other fi xed income investments. market ineffi cien- • Market-neutral equity — These funds aim to exploit ineffi ciencies in the equity cies.” market by holding roughly equivalent long and short positions. Managers take a sta- tistical approach to historical price analysis to discern good potential trades.

Absolute Returns © Copyright 2004 getAbstract 4 of 5 • Risk arbitrage — Risk arbitrageurs essentially bet on a merger, acquisition or spin-off, usually buying the stock of the target and shorting the acquirer to capture the spread. “A small, well- Robert Rubin, former U.S. Treasury Secretary, was one of the best risk arbitrageurs. performing fund • Distress — Managers in the distressed securities business take positions in bankrupt attracts assets. Unlike mutual or otherwise troubled companies. These securities often trade at a discount off of funds, many abso- their fundamental value because so many investors avoid them. This leads to oppor- lute return strate- tunities since the various classes of securities that these companies issue generally gies have limited don’t follow rational pricing relationships. capacity.” • Equity long/short — This approach has many variations but, in general, managers take a directional view on securities, buying the ones they expect will appreciate and selling short the ones they expect will depreciate. This is not quite the same thing as market neutral. Market neutral players do not take a general market view; in fact, they seek to eliminate any suggestion of such a view from their portfolios. • Sector specialization — Managers apply a long/short approach to a particular sub- class of securities, for example, technology stocks, health care stocks and so on. • Macro — These funds are utterly unrestrained and completely ﬂ exible. • Short — Short managers aim to ﬁ nd overvalued securities, borrow them, sell them

“Active funds for what the market thinks they’re worth, buy them back when the market recognizes underperform what they’re really worth and make money doing it. passive funds • Emerging markets — Emerging market managers trade the securities of less devel- because active money manage- oped countries or markets, for instance, Latin America, Africa, Southeast Asia and ment is more Eastern Europe. costly than passive money man- • Fund of funds — This is not precisely an investment style but rather is a way of invest- agement.” ing in hedge funds. A fund of funds invests in funds managed by a number of managers, mixing and matching to achieve a certain overall balance of risk and return.

Some say hedge funds represent a paradigm shift in investing. Others suggest that hedge funds are a bubble waiting to pop. The truth is probably somewhere between these extremes. Hedge funds are neither extremely risky nor sure things. The most important advice to prospective investors is to know what risk you are taking before you take it, and if you aren’t sure, don’t.

About The Author

Alexander M. Ineichen, CFA, is Managing Director and Head of Equity Derivatives Research at UBS Warburg in London.

Buzz-Words

Absolute return / Arbitrage / Convertible / Emerging markets / Hedge fund / Hybrid investments / Leverage / Market neutral / Stability / Transparency