vistatelier.

Hedge Fund Basics

Definition

A Hedge Fund is an investment vehicle that aims to produce the maximum return irrespective of market conditions, normally utilising hedging techniques to eliminated specific risks

Legal Structure

Hedge funds may take several legal forms, including limited partnership and limited companies.

Fee Structures

Fees normally come in two parts:

• Base Fee: A standard asset management charge irrespective of outcome
• Incentive Fee: Additional fee based on performance

Types of Hedge Funds

• Long/Short Funds: Take speculative position on direction market will move in and use leverage to increase gains
• Market Neutral Funds: Aim to offset systemic risk and profit from picking underperforming/ overperforming assets
• Global Macro Funds: Take speculative positions on currency, interest rate and global securities
• Event-driven Funds: Use the principles of traditional hedge funds to take advantage of other mis-priced assets (e.g. merger speculation, bond rating upgrade/ downgrade)
• Fund of Funds: A portfolio of hedge fund investments may be put together to gain the same diversification benefits of traditional portfolio investment.

Fund of Funds Advantages & Disadvantages

Advantages:

• Allow investor with small capital access to this vehicle
• Provides risk diversification
• Avoids exclusion of funds that limit no. of investor
• Uses experts to select funds to invest in

Disadvantages:

• Fees – fund manager and fund-of-funds manager!
• Lack of transparency of what investor invests in

Hedge Fund – Risk

• Illiquidity of assets reduce flexibility
• Potential for mispricing. Investments in esoteric, infrequently traded securities may lead to difficulty determining true value, and causing large margin requirement
• Counterparty credit risk on non-marketable assets
• Settlement errors. Risk of counterparty failure to deliver security as agreed on settlement day.
• Short covering. Risk that managers who short sell as a strategy will have to cover their shorts and repurchase securities at price higher than where they originally sold.
• Margin calls. Can result in forced selling of assets, possibly at a loss, on an already highly leverage position.

-END-