FTSE Guide to Hedge Funds

Contents

Background Hedge Funds A New Asset Class Investment Strategy Overview Performance and Returns The Evolution of the Hedge Index Glossary

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Background
Hedge funds are not for the faint-hearted. Or are they? Hedge funds are not regulated. Or are they? Hedge funds are more volatile than more traditional investments. Or are they? Hedge funds are not accessible for small investors. Or are they? Hedge fund performances are not measurable. Or are they? Just a few observations that illustrate the mystique behind one of the most talked about, but least understood areas in the investment community. By way of an illustration, the answers to the four opening statements is that they could all be perceived to be correct by investors, which goes some way towards explaining the nature of these phenomena of the fund management industry. By investment standards hedge funds are relative newcomers on the block. The first hedge fund is accredited to Alfred Winslow Jones who decided in 1949 that he had a better system of managing money than traditional fund managers. His novel approach, discovered while researching an article for his employers at Fortune Magazine, was to hedge potential risk in his long stock positions by selling other stocks to offset the impact on his portfolio of any wider market reversal. However, like many successful investors before him and since, he kept his new techniques to himself. It was not until he was finally outed in 1966 that investors woke up to the delightful simplicity of what the by now extremely wealthy Mr Jones had been doing. Once the news article pointed out that

in the past year Jones funds had outperformed the best performing mutual fund by 44% and that over the previous five years had a return 85% better than its nearest traditional rival, it wasnt long before others were rushing to copy him. Within two years over 200 new hedge funds were launched including ones by several individuals set to become legends of the industry, including George Soros, Warren Buffet and Michael Steinhardt. However, many of these new hedge fund managers quickly drifted away from Jones original principles when they found that allocating a portion of their assets to short sales weighed heavily on performance returns during the boom markets of the late 1960s. This lack of insurance began to be exposed as markets turned in 1969/70 and eventually saw many simply close their doors as the bear market turned into a rout in 1973. This shakeout served to discourage many new entrants to this sector, even as markets began to improve towards the end of the 1970s and by the mid1980s research indicated that less than 70 funds were operating with any conviction. But the early 1990s brought its rewards for the survivors, most spectacularly George Soros Quantum Fund and its forays into the currency market particularly its aggressive short stance on sterling that eventually accelerated sterlings exit from the European Exchange Rate Mechanism in 1992.

The ability of hedge funds to diversify into new markets and the advent of new trading tools, combined with the favourable press the hedge funds were starting to attract, saw a re-birth of the industry. By the end of that decade there were an estimated 4,000 hedge funds in operation. The onset of another bear market shortly into the new Millenium once again produced turmoil in the industry. But the experience of past mistakes, combined with much more widely diversified investment strategies both in terms of markets and more sophisticated instruments/techniques limited the fallout. Today there are an estimated 7,000 hedge funds. Clearly that is too many for the individual to research and to identify opportunities or risks even if they had money to invest in these funds. More recently, fund of funds have been developed as a means of encouraging smaller investors to invest in the hedge fund market. We will look at more specific details of how these funds operate and their different trading strategies a little later. However FTSE, a leading index provider, has launched FTSE Hedge, a hedge fund index that tracks the investable opportunity as it exists today and in the future. This index provides investors with a low cost and transparent tool to facilitate hedge fund investing.

Hedge Funds A New Asset Class

The specialist nature of hedge funds, in terms of their relative freedom from regulation, their exclusive investor profile and the diverse nature of their investments are the main factors that set them aside from mutual funds. The other defining difference is leveraged investment, with hedge funds openly borrowing (sometimes as much as 10 times the pledged investment capital) in order to be able to dominate some of the investment opportunities they identify. A key factor differentiating hedge funds from their publicly traded mutual counterparts is the remuneration of the funds partners or managers. Typically they will keep 20% of the profits, as well as a management fee that is often 1% or more annually of the assets under management. Huge potential rewards, but it also ensures a commitment to maximise returns for the other investors. Many classify hedge funds as alternative investments, in that a typical portfolio looks for alternatives to traditional long-only positions in stocks and bonds. However, while popular perceptions of hedge funds present them as high risk high return initiatives, only a small percentage fit this profile. Many are more conservative entities looking to maximise only better than market returns.

Given the scope available to fund managers a wide range of strategies are used. Some of the more popular include: Equity Hedge, Commodity Trading Association (CTA) / Managed Futures, Global Macro, Merger Arbitrage, Distressed & Opportunities, Convertible Arbitrage, Equity Arbitrage and Fixed Income Relative Value. Of course, many will be multiples of these and one individual investment could be defined under several of the listed headings. One way for an investor to access a cross section of hedge fund management strategies is to follow the fund of funds route, effectively specialist hedge funds that invest in other individual specialist funds. More difficult to follow is the way some hedge fund managers drift away from their original stated investment mandate, potentially exposing investors to risk they would prefer to avoid or duplicating investments held elsewhere. In a mutual fund these developments would be quickly identified through the much more transparent nature of the industry imposed by strict regulatory control. A fund of funds manager will be better positioned to keep closer scrutiny on these possible developments.

Investment Strategy Overview

FTSE Hedge comprises twelve indices with Net Asset Value (NAV) and Gross Asset Value (GAV) for each. The indices are the FTSE Hedge Index, three Management Style Indices and eight Trading Strategy Indices:
FTSE Hedge Index

Directional (47%)*

Event Driven (23%)*

Non-Directional (30%)*

Equity Hedge (30%)*

CTA/MF (9%)*

Global Macro (8%)*

Merger Arb (11%)*

Dist & Opps (12%)*

Convertible Arb (7%)*

Equity Arb (8%)*

Fixed Income (15%)*

*As at Februaury 2005

As already identified, hedge funds are primarily private partnerships to provide maximum flexibility in constructing a portfolio. They can take both long and short positions, make concentrated investments, use leverage, use derivatives, and invest in many markets. This is in sharp contrast to mutual funds, which are highly regulated and do not have the same breadth of investment instruments at their disposal. In addition, most hedge fund managers commit a portion of their wealth to the funds in order to align their interest with that of investors. Thus the objectives of managers and investors are the same, and the nature of the relationship is (intended to be) one of true partnership. Here are some examples of the trading tactics employed.

Global Macro
Macro funds make leveraged investments on anticipated price movements of stock markets, fixed interest securities, interest rates, foreign exchange and physical commodities and derivatives on such instruments. Macro managers employ a top-down global approach to forecast shifts in world economies, political fortunes or global supply and demand for resources, both physical and financial. They may invest in any markets using any instruments to participate in expected market movements.

Equity Hedge
These hedge funds consist of a core holding of long equities hedged at all times with tactical short sales of stocks and/or stock index options. In addition to equities, some hedge funds may have limited assets invested in other types of securities.

Commodity Trading Association (CTA) / Managed Futures

Managed futures funds take long and short positions in liquid financial futures such as currencies, interest rates, stock market indices and commodities.

Merger Arbitrage
Merger Arbitrage involves investments in eventdriven situations such as leveraged buy-outs, mergers and hostile takeovers. Normally, the stock of an acquisition target appreciates while the acquiring companys stock decreases in value. These strategies generate returns by purchasing stock of the company being acquired and in some instances, selling short the stock of the acquiring company.

Distressed & Opportunities

Distressed Securities strategies invest in, and may sell short, the securities of companies where the securitys price has been, or is expected to be, affected by a distressed situation. This may involve reorganisations, bankruptcies, distressed sales and other corporate restructurings. Depending on the managers style, investments may be made in bank debt, corporate debt, trade claims, common stock, preferred stock and warrants.

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Opportunities involve investing in opportunities created by significant transactional events, such as spin-offs, mergers and acquisitions, bankruptcy reorganisations, recapitalisations and share buybacks. Instruments include long and short common and preferred stocks, as well as debt securities and options.

Fixed Income Relative Value

Fixed Income Relative Value is a market neutral hedging strategy that seeks to profit by exploiting pricing inefficiencies between related fixed income securities while neutralizing exposure to interest rate risk. Managers attempt to exploit relative mispricing between related sets of fixed income securities. The generic types of fixed income hedging trades include: yield-curve arbitrage, corporate versus Treasury yield spreads, municipal bond versus Treasury yield spreads and cash versus futures.

Convertible Arbitrage
Convertible Arbitrage involves purchasing a portfolio of convertible securities and hedging a portion of the equity risk by selling short the underlying common stock. Managers may also seek to hedge interest rate exposure under some circumstances.

Equity Arbitrage
The Equity Arbitrage strategy is a market neutral strategy that seeks to profit by exploiting pricing inefficiencies between related equity securities, neutralising exposure to directional market risk by combining long and short positions in broadly equal amounts.

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Performance and Returns

Spectacular is a word used regularly when discussing hedge funds performance, both on the upside and the reverse. Certainly the long-term performance of the entire hedge fund universe stands up to scrutiny when compared with Equity Mutual Funds or for equity benchmarks. But it is also well known that there have been some high profile failures, often with far-reaching consequences as in Long Term Capital Managements demise in 1998. According to some estimates around a fifth of all hedge funds failed in 2002. However, this does not seem to have deterred those who specialise in the industry with the total number of funds

continuing to grow. It should also be remembered that spectacular failure is not something unique to hedge funds in the financial services universe, as all investment styles have been subject to their share of unwanted scrutiny in recent years. Total funds under management in hedge funds are now estimated to exceed $750 billion worldwide (though by comparison little more than 10% of that in mutual funds) in some 7,000 funds. In fact at the current rate of expansion growing more than sixfold in Europe in the past 5 years the total under management will exceed $1 trillion by the end of this decade. For example, new legislation became law in Germany from the start of 2004 and many expect this to herald a new wave of hedge fund expansion in Europe. The different strategies outlined in the previous section are obviously weighted to encompass completely different investment scenarios and will therefore mirror risk to reward. This is another reason why some of these specialist funds are left to specialist or professional investors who have the supporting capital to absorb downside risk. Evening out returns across the hedge fund investment spectrum leads back to the fund of funds approach, something which an investable index like FTSE Hedge is aiming to approximately replicate. These fund of funds broadly fall into three categories: Very Conservative, Moderately Conservative and More Aggressive.

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A very conservative fund of funds will target returns of 8-12% and will contain many market neutral hedge funds that exhibit a very low correlation to the underlying markets. In other words the investment intention is to remove market volatility. A moderately conservative fund of funds will target 12-17% returns over a pre-determined multi-year strategy. These will combine a selection of market neutral funds with a smattering of other higher risk strategies. A more aggressive fund of funds will still only aim for returns of 15-20% as it will still be aiming to have a lower-than-market statistical risk. However, it will contain a higher weighting of funds that are more closely correlated with the markets. Something to take into consideration when examining hedge fund performance is whether returns are net of fees, or calculated prior to fees. Many funds report performance numbers before fees are extracted, which can distort numbers greatly in the funds favour. This is key, as a positive month can instead turn negative when fees are factored in and we have already emphasised the much higher level fees awarded. The next factor when judging hedge fund performance is how returns are classified, with some of the basic breakdowns used in the industry being: pro forma, managed account, estimated, confirmed, and audited.

Hedge fund performance that is pro-forma basically means the numbers have one or more assumptions or hypothetical conditions built into the data. So if in a fund of funds there are ten funds that are planned to be invested in, and the data is compiled for the last year from those funds, the numbers would be classified as pro-forma. These are not actual returns, just hypothetical ones generated through a test. This is just one example of where the lack of transparency in the hedge fund sector places a much greater onus on the individual investor than he would have to be aware of if purely investing in traditional markets. For this reason, many consider the fund of funds route as the most accessible. Due diligence, allocation of percentages, monitoring of existing investments and searching for new opportunities becomes a full time job and a difficult one. Most investors are not able to perform all these tasks and that is why the fund of funds phenomenon has grown significantly over recent years.

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The Evolution of the Hedge Index

Hedge funds might have been conceived in the late 1940s and seen a boom in interest in the late 1960s, but there hadnt been much of an attempt to measure them as an industry until the 1980s. Research became more sophisticated over the next decade, by which time some rudimentary regular analysis and specialised indices started to emerge. It was well into the early part of the new Millennium before investable indices arrived. The launch of FTSE Hedge brings not only the experience of the worlds leading index provider to this sector, but also a discipline in index management that prevents style drift and enables accurate tracking. The design of FTSE Hedge provides investors with a low cost, transparent view of the investable hedge fund market by presenting a series that reflects the aggregate risk and return characteristics of the open, investable hedge fund universe. To ensure the highest quality funds are included there is daily risk monitoring and evaluation of underlying funds, as well as a qualitative due diligence overlay process. The aim of these activities is to improve transparency and increase investor confidence.

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In the absence of more formal regulatory stipulations, FTSE sets the following criteria for index eligibility: Have independent audited financial statements Have at least $50 million of unleveraged assets under management Have a minimum 2-year track record at the time of the annual review Have monthly reporting with a minimum of quarterly liquidity screening Be open to new investor subscriptions as well as having significant remaining investment capacity The methodology behind construction of the index include: Base universe of 6,000 funds established from various databases and industry sources Classification on basis of strategy and other criteria down to 250 funds Constituent selection using mathematical sampling to reduce to 75 funds Final committee due diligence to filter to eventual 40 constituents Apart from full scale annual reviews, including background checks and interviews, there is daily monitoring of each constituent hedge fund for the purposes of portfolio risk, position risk and most importantly, for any breaches of individual fund investment restrictions and guidelines.

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Glossary
All industries have a range of specialist language, or jargon, used to denote specific terms or actions. It is partly an industry shorthand and partly maintains a feeling of exclusivity. The hedge fund sector is no different. Here are a few of the key words and phrases, with the restatement of a few others in context which can also be used in the hedge fund industry. We have excluded those that specifically refer to investment strategies mentioned earlier. Alpha Measures the value a fund manager produces, by comparing performance to that of a risk-free investment (Treasury bills). For example, if a fund had an alpha of 1.0 during a given month, it would have produced a return during that month that was one percentage point higher than the benchmark Treasury. Alpha can also be used as a measure of residual risk, relative to the market in which a fund participates. Gauges the risk of a fund by measuring the volatility of its past returns in relation to the returns of a benchmark. A fund with a beta of 0.7 has experienced gains and losses that are 70% of the benchmarks changes. A beta of 1.3 means the total return is likely to move up or down 30% more than the index. A fund with a 1.0 beta is expected to move in tandem with the index. A hedge fund or open-end mutual fund that has at least temporarily stopped accepting capital from investors, usually due to rapid asset growth. Not to be confused with a closed-end fund.

Beta

Closed fund

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Drawdown

The percentage loss that a fund incurs from its peak net asset value to its lowest value. The maximum drawdown over a significant period is sometimes employed as a means of measuring the risk of a vehicle. Usually expressed as a percentage decline in net asset value. An investment vehicle consisting of shares in hedge funds and private equity funds. Some of these multi-manager vehicles limit holdings to specific managers or investment strategies, while others are more diversified. Investors in funds of funds are willing to pay two sets of fees, one to the fund of funds manager and another set of (usually higher) fees to the managers of the underlying funds. The individual or firm that organises and manages a limited partnership, such as a hedge fund. The general partner usually assumes unlimited legal responsibility for the liabilities of a partnership. A provision to ensure a fund manager only collects incentive fees on the highest net asset value previously attained at the end of any prior fiscal year - or gains on actual profits for each investor. For example, if the value of an investors contribution falls to $750,000 from $1 million in the first year and then rises to $1.25 million in year two, the manager would only receive incentive fees from that investor on the $250,000 that represented actual profits in year two. The minimum return necessary for a fund manager to start collecting incentive fees. The hurdle is usually tied to a benchmark rate such as Libor or the one-year Treasury bill rate plus a spread. If the manager sets a hurdle rate equal to 5% and the fund returns 15%, incentive fees would only apply to the 10% above the hurdle rate.

Fund of funds

General partner

High-water mark

Hurdle rate

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Incentive/Performance fee

The charge - typically 20% - that a fund manager assesses on gains earned during a given 12 month period. For example if a fund posts a return 40% above its hurdle rate, the incentive fee would be 8% (20% of 40%) - provided that the high-water mark does not come into play. The borrowed money that an investor employs to increase buying power and increase its exposure to an investment. Users of leverage seek to increase their overall invested amounts in hopes that the returns on their positions will exceed their borrowing costs. The extent of a funds leverage is stated either as a debt-to-equity ratio or as a percentage of the funds total assets that are funded by debt. Leverage can also come in the form of short sales, which involve borrowed securities. Many hedge funds are structured as limited partnerships, organisations managed by one or more general partners who are liable for the funds debts and obligations. The investors in such a structure are limited partners who do not participate in day-to-day operations and are liable only to the extent of their investments. The period of time - often one year - during which hedge fund investors are initially prohibited from redeeming their shares. The charge that a fund manager assesses to cover operating expenses. Investors are typically charged separately for costs incurred for outsourced services. The fee ranges from an annual 0.5-2.0% of an investors entire holdings, usually collected quarterly.

Leverage

Limited partnership

Lock-up

Management fee

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Master-feeder fund

A common hedge fund structure through which a manager sets up two separate vehicles - one based in the U.S. and an offshore fund - which serve as the only investors for a third non-U.S. fund. The two smaller entities are known as feeder funds, while the large offshore vehicle acts as the master fund. The purpose of this is to create a single investment vehicle for both U.S. and non-U.S. investors. A large bank or securities firm that provides various administrative, back-office and financing services to hedge funds and other professional investors. Prime brokers can provide a wide variety of services, including trade reconciliation (clearing and settlement), custody services, risk management, margin financing, securities lending for the purpose of carrying out short sales, record keeping, and investor reporting. A prime brokerage relationship doesnt preclude hedge funds from carrying out trades with other brokers, or even employing others as prime brokers. To compete for business, some prime brokers act as incubators for funds, providing office space and services to help new fund managers get off the ground. A measure of the degree to which a hedge funds returns are correlated to the broader financial market. A figure of 1 would be a perfect correlation, while 0 would be no correlation and minus 1 would be a perfect inverse correlation. Any figure below 0.3 is considered noncorrelated. The result is used to determine whether a hedge fund follows a market-neutral investment strategy. This is sometimes referred to as R2.

Prime broker

R-squared (R2)

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Regulation D

A provision in the Securities Act of 1933 that allows privately placed transactions to take place without SEC registration and prohibits hedge funds from advertising themselves to the general public. It also outlines which parties qualify as insiders. An approach in which the fund manager provides financing to publicly traded companies, usually in exchange for a privately placed convertible note issued at a discount. It is also known as PIPES (private investments in public entities). A measure of how well a fund is rewarded for the risk it incurs. The higher the ratio, the better the return per unit of risk taken. It is calculated by subtracting the risk-free rate from the funds annualised average return and dividing the result by the funds annualised standard deviation. A Sharpe ratio of 1:1 indicates that the rate of return is proportional to the risk assumed in seeking that reward. Developed by Prof. William R. Sharpe of Stanford University. Also called the upside potential ratio. Similar to the Sharpe ratio, it was developed by the Pension Research Institute to determine the amount of good volatility that a funds investment portfolio possesses that is, it seeks to define the amount by which the investment pools value may increase, based on expected pricing fluctuations. Money given to corporate start-ups and other new high-risk enterprises by investors who seek above average returns and who are often willing to take illiquid positions. The likelihood that an instruments value will change over a given period of time, usually measured as beta.

Regulation D investment strategy

Sharpe ratio

Sortino ratio

Venture capital

Volatility

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