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An Introduction to Hedge Funds

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Pictet Alternative Advisors SA An introduction to hedge funds April 2018 Hedge funds gained a reputation for preserving investors’ capital and generating relative outperformance in market crises. Carefully selected hedge funds provide an alternative investment exposure with diversification and enhanced return potential over the long term. Contents 2 Executive summary 3 Part I - Hedge funds in perspective The beginning of hedge funds Definition of hedge funds The hedge fund industry today Hedge fund strategies Arbitrage Equity hedge Tactical trading 8 Part II - Investing in hedge funds The case for hedge funds Investors’ concerns Myth and reality The value-added of hedge funds Fund of hedge fund model 12 Part III - Pictet: a strategic partner for hedge funds Pictet Group Pictet Alternative Advisors SA Investment philosophy Portfolio construction – Manager selection – Strategy allocation – Risk management 14 Glossary An introduction to hedge funds 1 Executive Summary Hedge funds gained a reputation for preserving understand the manager’s investment strategy and investors’ capital and generating relative outper- assess whether it is likely to be successful in a given formance in market crises. Carefully selected hedge macroeconomic environment. funds provide an alternative investment exposure Our team of hedge fund investment professionals with diversification and enhanced return potential helps clients to understand these demanding aspects over the long-term. and offer a set of hedge fund investment solutions. At Pictet Alternative Advisors SA, in addition to Clients may choose from Pictet’s various commingled an extensive know-how of other alternative assets funds of hedge funds, diversified across several pro - such as private equity and real estate, we have been minent managers, or opt for a tailor-made mandate. selecting hedge funds for private and institutional In each case, our investment philosophy is based clients since the 1990s. on the same key investment principles and rules, Selecting the best hedge fund managers means derived from best industry practices and our long ex - that we invest in only a small portion of all the funds perience. We search for the best talents and allocate we screen worldwide. Finding hedge fund managers capital according to our macroeconomic views. Our who are able to achieve genuine, provable and repea - portfolio construction integrates the three main ele - table performance requires extensive research and ments of our investment process: strategy allocation, skill, as well as careful qualitative and quantitative manager selection and risk management. monitoring. Correctly assessing sources of risk is perhaps even more important than analysing sources of per - formance. Operational, credit and market risks are just a few aspects that need to be grasped before any investment in a hedge fund. Investors need to fully An introduction to hedge funds 2 Part I Hedge funds in perspective The beginnings of hedge funds In addition, hedge funds often It is generally said that the first share the following characteristics: known hedge fund was an investment — They are often formed as an unre - partnership established more than gulated investment pool and are 60 years ago by Alfred Winslow Jones. generally domiciled offshore. He sought to separate the two risks inherent in investing in stocks: — They measure their performance in 1) Market risk defined as the general absolute terms (i.e., independent of change in stock prices due to market market direction and uncorrelated influences and 2) Specific risks related to any benchmark). to factors particular to each individual — They usually charge a performance stock. fee. The first hedge fund was launched Jones’ partnership held a short in 1949 position in a basket of stocks as — They require high minimum in- insurance against a downturn in the vestments. market, “hedging” to some extent — Their subscription and redemption the systematic risk. Jones’ fund was policies are fairly restrictive and unique in that it combined unconven- may even impose lock-up periods tional characteristics such as market or gates. neutral exposure and incentive fees. According to Warren Buffett, — Hedge fund managers usually in- however, the first person to manage vest their own capital along with a hedge fund was none other than their clients. Benjamin Graham, who used long, as well as short positions and charged an incentive fee as early as the mid-1920s. Benjamin Graham is considered by many to be the father of financial ana - lysis and value investing. Definition of hedge funds There are various definitions in use, but broadly speaking, a hedge fund is any type of investment company or private partnership that uses the fol- lowing instruments and techniques: — Long or short positions across asset classes. — Derivatives, such as options (call or put), futures, swaps, etc. — Financial leverage. An introduction to hedge funds 3 The industry has grown more than The hedge fund industry today growth, rising from around 500 hedge 20-fold in the past decade The hedge fund industry is generally funds in 1990 to approximately 8,335 estimated to have grown from about at the end of December 2017. USD 40 billion in assets under mana - So far, the number of new funds has gement in 1990 to over 3.0 trillion in continued to grow despite approxima- December 2017. tely 10% of hedge funds closing each However, it is believed that the year because of their inability to raise amount of assets actually managed far sufficient assets or deliver satisfactory exceeds the figures officially reported. performance. No standard classification of Nevertheless, although assets continue hedge fund strategies to grow significantly, the size of the hedge fund industry remains small compared to the mutual fund industry and global financial markets. In terms of the number of funds, the industry has experienced similar HEDGE FUND INDUSTRY GROWTH 3500 9000 8000 3000 7000 2500 6000 2000 5000 4000 1500 3000 1000 2000 500 1000 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Number of Funds (ex FoFs) Assets Source: HFR Global Hedge fund industry report - Q4 2017 An introduction to hedge funds 4 Hedge fund strategies Arbitrage There are many ways of classifying the Relative value investment strategies of hedge fund Relative value is an investment strate - managers. Moreover, some managers gy that aims to exploit pricing inef - combine several strategies in what are ficiencies between related financial instruments such as stocks or bonds. AUM BREAKDOWN BY HEDGE FUND STRATEGIES Relative value managers will value the fundamentals of related instruments and go long and/or short expecting prices to converge towards a norm. As managers profit from the convergence 1990 2017 of relatively small differentials, this strategy can be leveraged in order to enhance returns. Relative Value (15%) Relative Value (26%) Volatility arbitrage Equity Hedge (41%) Equity Hedge (29%) Volatility arbitrage trades the implied Event Driven (26%) Event Driven (11%) volatility versus the historical volati- Macro (33%) Macro (19%) lity on the same asset across different strike prices or maturities expecting Source: HFR Global hedge fund report - Q4 2017 an increase in the fluctuations of the underlying security’s price. often referred to as “multi-strategy funds”. The table illustrates the three Statistical arbitrage broad strategic approaches of hedge Managers using this strategy seek funds and the underlying investment to profit from pricing inefficiencies strategies. identified using mathematical models. Statistical arbitrage strategies are HEDGE FUND STRATEGIES based on the premise that prices will return to their historical norms. Arbitrage Equity Hedge Tactical Trading Fixed-income arbitrage Relative Value Long Short Equity Global Macro This strategy seeks to exploit mis- – Volatility Arbitrage – Market Neutral pricings developed between related – Statistical Arbitrage – Short Sellers classes of fixed income securities such as yield curve and credit spread trading, often neutralising exposure Fixed Income Distressed Commodity Trading to interest rate risk. – Credit Arbitrage Advisors (CTA) – Capital Structure Arbitrage – Convertible Arbitrage Credit arbitrage Credit arbitrage seeks to take advan- Event Driven Emerging Markets tage of pricing inefficiencies between – Merger Arbitrage the credit sensitive securities of diffe - – Special Situations rent issuers. Instruments commonly traded in- clude CDOs (collateralised debt obliga- tions) and CDSs (credit default swaps). Source: Pictet Alternative Advisors SA An introduction to hedge funds 5 Capital structure arbitrage an undervalued stock. A manager can Capital structure arbitrage aims to either be a generalist or focused on profit from the pricing inefficien- specific regions, sectors, industries or cies across the issuing firm's capital market capitalizations. They can also structure with the expectation that specialize in types of stocks such as the pricing disparity between the two value and growth. securities will converge. Market neutral Convertible arbitrage Market neutral managers seek to ex- This strategy captures inefficiencies ploit investment opportunities unique in the pricing of convertible securities to some specific group of stocks while relative to its underlying stocks. maintaining a neutral exposure to Typically, a manager goes long broad groups of stocks defined for the convertible
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