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Hedge Funds explained

November 20, 2006

 

It can seem like an alphabet soup sometimes for those trying to move away from the staid world of individual stocks and mutual funds. Hedge Funds, Fund of Funds, CPOS, CTAs....exactly what are these different alternative investments?

With over $1 Trillion dollars now under management, most of us have heard of "Hedge Funds" by now. Indeed, hedge funds have been all over the news in the last few years, most recently with negative press for the collapse of the Amaranth fund, which lost several billion betting the wrong way on Natural Gas futures. But despite the huge growth and recent press, the term hedge fund is still shrouded in some mystery and is usually defined somewhat oddly in the financial press.

Hedge Fund:

So what is a hedge fund? The American Heritage Dictionary defines a hedge fund as: "An investment company that uses high-risk techniques, such as borrowing money and selling short, in an effort to make extraordinary capital gains."

This definition leaves a little to be desired, as it requires the further explanation of an investment company and misrepresents hedge funds as high-risk and going for big gains.

First, an investment company is merely a partnership, LLC, or similar legal entity formed for the purpose of investing. The money of multiple investors is pooled together in order for those investors to realize the benefits of a larger total pool of capital (such as more diversification) and allowing the same strategy to be employed simultaneously for all of the company members. The most well known investment companies are mutual funds. With a mutual fund, thousands of investors each invest a relatively small sum of money ($10,000 to $100,000), and participate in the gains and losses of the company (of the fund) as it buys and sells different stocks according to its investment strategy.

A hedge fund is nearly identical to a mutual fund in its general premise of pooling the money of multiple investors, but unlike mutual funds, hedge funds purposely keep the number of investors in the company(fund) under 100 people. This allows hedge funds to qualify for an exemption under the Investment Company Act of 1940 by which they do not have to register as an investment company and undergo rigorous regulatory and reporting requirements. While the laws require a company investing on behalf of greater than 100 people to be registered, there is no restriction on the total amount of money that is pooled together, thus hedge funds usually set their minimums at $1 Million and higher so they can still manage a significant amount of money while staying under the 100 investor limit.

Because of this exemption, hedge funds are not required to redeem investor's money within 7 days or report their positions like mutual funds must. As practically unregulated entities, they have much greater freedom in their investments and how they fund those investments. They can borrow money, do short sales, invest in complex derivatives, and more in their search for higher returns.

There's one downside to hedge fund's unregulated nature, and that is the regulations prohibit unregistered firms from advertising or soliciting new clients. That is why you don't see advertisements for big hedge funds right next to the Fidelity and Vanguard ads in the Wall Street Journal, and one of the reasons hedge funds are surrounded by so much mystique.

The last unique characteristic of hedge funds is their fee structure. Unlike mutual funds which generally charge annual fees of under 1% of assets with that fund, hedge funds generally charge an annual management fee of 1% to 2% and a performance fee of 20%. That's right, hedge funds take up to 20% of the profits. The performance fee is usually on realized and unrealized appreciation of the fund's assets and is payable on a yearly or quarterly basis. Many funds require the fund's assets to surpass the old "high water mark" before taking profits, thus the manager is only rewarded when the fund hits new all time highs.

Types of Hedge Funds:

Hedge funds usually focus on one area of expertise, which can generally be split up into the following categories (listed alphabetically)

Convertible Arbitrage: Convertible bonds are loans made by publicly traded companies which can be exchanged for common stocks at a certain price. This type of fund attempts to profit from the inefficient pricing of the convertible bonds versus the underlying stock by usually buying the bond and shorting the stock. By shorting one security and being long another of the same company, these funds are theoretically protected from a sharp move in one direction or the other. However, much of the recent news and rumors of hedge fund "blow ups" have centered around convertible "arb" funds which were long GM bonds and short the stock. In a move no one saw coming, the bonds sold off and the stock rallied as GM"s debt rating as downgraded and a tender offer for the common stock was made at a healthy premium in the same week.

Dedicated Short: Just like its name implies, these types of funds attempt to profit from declines in individual stocks and the overall market. Dedicated short funds usually attempt to be neutral or flat in upwards trending markets, then use leverage to accelerate profits when markets are in a down trend.

Emerging Markets: Another strategy aptly named, these types of funds invest in the stock, indices, and bonds of emerging markets. Examples of emerging markets include China, India, South Korea, Brazil, Malaysia, countries in Eastern Europe, and parts of Africa.

Equity Market Neutral: These types of funds are the closest thing to a "hedged" fund as you get in the different hedge fund strategies, as they attempt to remove market risk by going long and short similar securities simultaneously. By attempting to remove the risk of a falling or rising market, profits come from exploiting the inefficiencies between the pricings of "pairs" of stocks. A typical trade would be going long Fed Ex and short UPS.

Event Driven (Special Situation): These types of funds invest in the equity, stock, bonds, or legal claims of companies facing a special event driven situation such as a merger, takeover, bankruptcy. The two most common type of event driven funds are risk (or merger) arbitrage and distressed. Risk (merger) arbitrage deals in merger activity, usually by being long the stock of the company to be taken over and shorting the stock of the acquirer. The long/short profile theoretically hedges away market risk, and profits come from successful deal completions. Distressed hedge funds invest in companies in bankruptcy, facing legal trouble, or lagging their industry peers or market in general. The recent revival of Kmart and its merger with Sears was the result of hedge fund ESL Investments buying up Kmart's debt , and thus controlling interest, for pennies on the dollar in bankruptcy.

Fixed Income Arbitrage: This style looks to profit from the pricing inefficiencies between related interest rate securities (bonds). A common trade among this style of funds (and the trade that took down Long Term Capital Management) is selling on the run (just released) Treasury Bonds and buying off the run (Treasury Bonds released in the past) when the off the run treasuries are cheaper than the on the run treasuries. The bonds are the same exact asset, just released at different dates, thus in theory should be priced the same. A global liquidity crisis brought on by Russia defaulting on its debt caused a flight to not just quality, but on the run quality, shooting those prices up and off the run prices down and sinking LTCM.

Global Macro: These types of funds invest in broad reaching macro economic trends in markets around the globe, such as betting US interest rates will rise, the Japanese Yen exchange rate will fall, or Crude Oil will be at $100 in five years. The most famous Global Macro example is George Soros, who "broke the bank of England" by profiting from the Bank's stubborn reluctance to either raise its interest rates to levels comparable to those of other European countries or to float its currency. Finally, the Bank of England was forced to devaluate the Pound Sterling, and Soros earned an estimated US$ 1.1 billion in the process.

Long/Short Equity: Just like the name implies, these types of funds focus on the stock market by picking stocks and either buying (long) or selling them short. Many of these type of funds focus on specific sectors (like financials, health care, technology), market capitlizations (small, mid, & large cap), and pricing (value, growth) just like mutual funds - and do extensive research within that sector to determine which stocks are undervalued and which are overvalued. The difference is these funds can go short and can use leverage to multiply returns.

Managed Futures: Our favorite category at Attain, this style of hedge fund refers to products offered by registered Commodity Trading Advisors, or CTAs. In effect, these types of strategies are similar to global macro hedge funds except they operate exclusively in listed futures and commodities markets. Most managed futures programs are systematic in nature (using trading systems just like you and me), while some rely on the discretionary picks of its manager. Unlike hedge funds, where your funds are commingled into a partnership account, a CTA investment is usually held in a segregated account in the individual investor's name, meaning greater liquidity and transparency. To see a list of some of the top ranked managed futures programs we recommend, click the following link: http://www.attaincapital.com/cta-placement.php.

Fund of Funds: These types of funds invest in a diversified portfolio of other hedge fund strategies. With hedge fund minimums typically $1 MM to $5 MM, it is unrealistic for anyone but the insanely wealthy to be able to diversify into all of the different hedge fund types, and a fund of funds approach allows investors to get complete diversification with just one investment. One issue with fund of funds is the layering of fees, as the fund of funds manager usually charges fees on top of the steep fees already charged by the underlying managers.

Issues:

One problem many investors familiar with managed futures investments have with hedge funds is their fund structure. This requires the investor deposit the full amount of cash with the hedge fund advisor, and eliminates the possibility of cross-margining those funds with other investments. An investor holding $500,000 in T-Bills in an Attain account trading various CTAs and trading systems, for example, who has over $300,000 in available margin - could not simply add a $250,000 hedge fund allocation with those funds. The investor would have to physically wire the $250,000 to the hedge fund, sacrificing the ability to earn interest on that amount and ability to "share" that capital across other futures based investments.

Because investors invest directly with a hedge fund - there is also a greater possibility of fraud than with a commodity trading advisor managing an individual account. Managed Futures investments are predominantly done in the individual investor's account held in a segregated account. So while extremely unlikely at 99.99% of hedge funds, a hedge fund advisor is in direct control of an investor's money while a managed futures advisor can not, by definition, gain access to a client's money - he or she can only trade it.

Another issue with many hedge funds is their lack of transparency. Transparency is just a fancy word for being able to see what positions are being taken by the manager, and hedge funds generally do not provide this data to their investors, while managed futures investors get to see their positions on a day to day basis, because the advisors are managing their individual account usually.

Finally, most hedge funds have poor liquidity, meaning its hard to get your money out in a timely fashion. Either requiring investors hold the investment for several months to a year - or only allowing redemption monthly or quarterly.

Conclusion:

While hedge funds are usually described as an alternative asset class, the descriptions above show that most hedge funds are actually heavily invested in the fate of publicly traded companies in one way or another. For that reason, we believe hedge funds should be viewed as alternative strategies instead of an alternative asset class, and great care should be taken if assuming hedge funds will protect you from another stock market downturn.

The only true alternative asset class investment among the hedge fund strategies is managed futures. A managed futures investment brings exposure to a truly different asset class in commodities, which provide economic value through being consumed or transformed - not on the basis of future cash flows like stocks and bonds.

But regardless of hedge fund's exposure to equity markets and some of the issues surrounding them such as poor transparency and liquidity, they are a valuable investment tool for those who can afford them in our opinion. The fund of funds approach is usually the best method, as the minimums are lower and the diversification better. For those interested in learning more about hedge funds and some of the funds brokers at Attain deal with, please contact us at invest@attaincapital.com.

Whether or not the "party is over" for hedge funds remains to be seen. The growth of assets under management has been staggering since the Internet bubble burst in 2000, but returns have been lagging behind the stock market and historical norms since the stock market lows in 2003. This may be caused by too much money fighting for too few opportunities. As an example, with a finite amount of stock and bonds outstanding for any one company - you can definitely see the case where several firms all recognizing a mispricing between the two would be removing the inefficiency in their very attempt to exploit it. Likewise, several firms seeing the value in a bankrupt airline, for example, would all start buying the airlines assets or debt simultaneously, thereby driving up the price of those distressed assets and cutting into the potential return.

There is a lot of validity to these arguments, but the financial markets still dwarf the amount of hedge fund assets, at many trillions of dollars to one. So in effect there is enough money to go around. Don't be surprised to see hedge fund returns a little lower than their historical norms, however.

- Jeff Malec

IMPORTANT RISK DISCLOSURE


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Feature | Week In Review: Energy Volatility benefits Phoenix program.

The US Stock market continued its bullish trend last week after more positive reports on inflation and lower energy prices. According to economic reports released last week inflationary pressures seem to be leveling off which should allow the FOMC to hold interest rates steady until at least 2007. For the week SP futures gained +1.44%, NASDAQ futures were up +2.76%, Russell 2000 futures rallied +2.60% higher, and SP Midcap 400 futures had gains of +1.75%.

In energy trading moderate temperatures across the Midwest and East Coast caused energy prices to fall last week due to speculation that the warmer temperatures would allow supplies to increase. Crude Oil futures led the downward move after falling -4.18%, Heating Oil futures were down -2.08%, and RBOB Gasoline futures fell -2.01%. Natural Gas futures did not follow suit however, gaining +3.40% for the week.

Trading in US Treasuries and Foreign Currencies continues to be slow and very choppy. Most traders are blaming the conditions on the Fed being too transparent in their potential future decisions and are hoping for more uncertainty in the New Year. US Bonds fell slightly last week while the US Dollar Index rose +0.48%.

Commodities picked up some of the slack as Metals, Grains, and Meats continue to provide a slew of good trading opportunities. Last week the metals markets moved lower with Gold falling -1.21%, Silver down -2.40%, Platinum off -1.48%, and Palladium moving -3.86% lower. Big movers in the grains included Corn which was up +3.06% and Wheat which fell -1.40%. Tropicals were even more active with Sugar falling -4.22%, Cotton down -3.73%, and Coffee losing -1.75%. Finally, in the meats - Lean Hog futures fell -2.66% while Live Cattle futures rallied +1.66%.

***CTA Trading***

Last week was a banner month for commodity traders, especially in the energies. On a huge market reversal Thursday, Attain's own Phoenix Energy program, which trades the Natural Gas, Crude Oil, Heating Oil and Unleaded Gas markets, entered short all 4 markets to produce its largest single day gain since inception, up approx. 5% on the day. The program was ahead approx. +6.26% for the month coming into today.

Elsewhere, for some Option selling CTAs last Friday's Index option expiration was a welcome event while a bit more challenging for others. With several profitable trades last week World Capital has seen the most progress MTD adding approx. +3.99% in November. Zephyr Asset is also having a solid month as their Moderate program is ahead +1.42% and their Aggressive is ahead +2.33%. On the other hand Argus Capital is continuing to struggle through the constant up trending market and is down approximately -11% for November.

As a reminder, Argus focuses on selling spreads on the S&P 500 which is a strategy for anticipating the market will fall, remain neutral, or only rise slightly. The fact that the market has seen an explosive upward trend is the underlying reason for the strategies recent drawdown. We expect to see Argus enter into a new December position sometime over the next week. Here is a link to an article we wrote on the strategy a few months back that describes his trading strategy: http://www.attaincapital.com/alternatives/alt_oct1606.htm#Topic.

To view the monthly performance on the CTAs we track and to see newly recommended strategies here is the link to our website:

***Day & Swing Trading***

We're getting to the time of year when markets start to slow down considerably with all of the holiday closures. Swing trading programs usually fare better with these conditions as the day trading systems tend to struggle with the smaller ranges and jittery markets due to a lack of market participants.

Last week's stock market rally brought with it fresh lows in volatility as measured by the VIX index at the CBOE. Once again it was the swing systems holding long positions and the most aggressive day trading programs that finished the week profitable.

Since the day trading programs usually get more press, swing programs will be highlighted first this week. Delphi eRL closed out a winning long trade for profits of +$2,517.50. SeasonalST eRL and ES have been holding long positions for the entire month of November and tacked on +$2,010 and +$1,000 respectively in open trade equity. Spartan ES has been holding a similar long position for several weeks and gained $1,000 as well in open trade equity. Axiom eMD reached its profit objective on Wednesday good for a gain of +$1,913 on the closed out trade.

Counter-trend systems such as Tzar struggled last week as the market pushed through to new highs. Tzar NQ, ES and SP continue to hold short while the eRL finally bailed on its short trade and reversed long for a loss of -$2,590 on the trade.

Profitable day trading systems were few and far between, but BWT Zones Classic continued its hot streak last week with profits of +$1,100 on four trades. Compass eRL had two trades for gains of +$940. Finally, Impetus eRL had one trade Tuesday that added +$310 to the profitable year for the program.

Two systems that struggled last week were Compass SP which lost -$2,050 on a pair of trades and Beta v2 which lost -$2,077.03 on 8 trades in the Dax.

***Long Term***

The Interest Rate sector was fixed in a sideways range during the past week, but the bias continued to favor the upside as ideas of a cooling economy in the coming months kept prices supported. The slew of economic reports last week did little to change the overall view that a cooling picture is coming into play as most markets sit near 1-year highs. Long term systems continue to have an upside bias with long positions held by Andromeda +$3,165.63 (open trade), Vivaldi +$1,512.50 (open trade) and Pegasus entering a new Long position with -$81.25 (open trade) in USZ. Axiom LT is Long TYZ with open trade equity of +$246.88 and Pegasus entered into a new Long position with -$34.38 (open Trade). Aberration is long TUZ with open trade equity of -$292.50.

Major currencies ended the week posting small losses ahead of a weekend G20 meeting that offered no surprises. The G20 financial leaders continue to sum up the situation with an eye on growing inflation risks, but insist b world economic growth could offset such worries. Systems with short positions in SFZ and JYZ include Andromeda making +$937.50 per contract (open trade) and +$2,468.75 per contract (open trade) and Aberration is short SFZ with an open trade loss of -$1,525.00. Pegasus exited short SFZ and JYZ making +$375.00 per contract and +$1756.25.

The energy sector again came under pressure during the past week sparked by pessimism that OPEC production cuts would in fact be carried out. Fresh forecasts for a warmer winter in the U.S. also added pressure sending Crude prices to new 17-month lows. Long term systems continue to have a downside bias with short Crude oil positions in Pegasus making $+18,090.00 per contract (open trade) and Trend Simplicity making +$16,530.00 (open trade). Systems with short mini-crude positions are Aberration making +$7,327.50 (open trade) and Vivaldi making $+2,140.00 (open trade).

Grains and Oilseeds again experienced plenty of volatility last week as corn continued to find support from favorable production reports in a recent USDA release. Soybeans and cotton prices ended lower, meanwhile, while wheat continued lower on ideas the upcoming U.S. crop will be large. Systems with long corn positions include Aberration making +$3,250.00 (open trade), Andromeda +$2,562.50 (open trade), Axiom LT +$4,187.50 (open trade), and Trend Simplicity +$2,450.00 (open trade). Vivaldi currently is long Soybeans making +$2,500.00 (open trade). Systems with short cotton positions are Andromeda +$2,180.00 (open trade), Axiom LT +$7,215.00 (open trade) and Vivaldi +$4,320.00 (open trade).

Please Login to: http://www.attainaccess.com for the latest updated statistics.

IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.

Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.

Please read carefully the CFTC required disclaimer regarding hypothetical results below.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.