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Hedge Funds

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Hedge Funds Summary

Hedge funds can use a wide array of assets to earn more return for those willing to adjust their risk profile. There are hedge funds for capturing profit from virtually any instrument, creating vast combinations of risk and return profiles for prospective investment. Hedge funds typically attempt to acquire higher return with less risk. Risk can never be completely eliminated, and the manager’s investment skill is determined by their ability to earn profit while reducing risk. This is known as their “alpha”, the return generated beyond an expected level for an asset, or in this case a collection of assets. 

Major Economic Analysis

Economic Summaries
Statistical Currency Projections
Large Speculator Sentiment
Technical Signals Lists

American Equity Markets

Economic Performance Index
US Dollar Projections
Market Sentiment Tracking
Sector Strength Tracking
Consensus Estimate Rankings
Fundamental Firm Analysis

Hedge Fund Basics

Hedge funds can use a wide array of assets to earn more return for those willing to adjust their risk profile. There are hedge funds for capturing profit from virtually any instrument, creating vast combinations of risk and return profiles for prospective investment. Hedge funds typically attempt to acquire higher return with less risk. Risk can never be completely eliminated, and the manager’s investment skill is determined by their ability to earn profit while reducing risk. This is known as their “alpha”, the return generated beyond an expected level for an asset, or in this case a collection of assets. 

Hedge Fund Basics

Hedge Fund Basics

Hedge funds can use a wide array of assets to earn more return for investors willing to accept their risk profile. There are hedge funds which capture profit from virtually any instrument, creating vast combinations of risk and return profiles for any prospective investment. Hedge funds typically attempt to acquire higher return with less risk. Risk can never be completely eliminated, and the manager’s investment skill is determined by their ability to earn profit beyond what a level of risk typically delivers. This is known as their “alpha”, the return generated beyond an expected level for an asset, or collection of assets.

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Accredited Investor Requirements

Accredited Investor Requirements

Hedge fund managers cannot accept any potential investor. This limitation is a requirement of their light regulatory status. Only certain investors should apply to hedge funds. Hedge funds are limited to high net worth individuals only; other applicants from other economic classes will be rejected. The specific financial requirement is set by the Securities and Exchange Commission in Rule 501, Regulation D. In order to accept investors without oversight, the hedge fund can only accept accredited investors, which are defined here.

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Hedge Fund Partnership Structure

Hedge Fund Partnership Structure

Hedge funds are comprised of various titles and roles for employees and investors. These title and operational deviations are required to ensure the fund’s legal and investment function. Hedge funds divide into many roles: General Partner, Limited Partner, Portfolio Manager, Analyst, Trader, and Consultant.

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Hedge Fund Value

Hedge Fund Value

Hedge fund values are based on Book or Net Asset valuations. The value of the assets and liabilities must be accurate in order to determine the book value. Assets and liabilities must be marked to current value as often as Net Asset Value is accessible to the fund’s investors. The fund achieves value calculation by marking assets and liabilities to market. Typically, Net Asset Value is updated at the end of each close.

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Hedge Fund Fees and Expenses

Hedge Fund Fees and Expenses

Hedge funds are expensive operations. The expenditures incurred range from typical business outlays (Office costs, Utilities, Salaries) and fund specific costs like research and consulting fees. These fees are paid from investor deposits and returns earned by trading.

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Selecting Hedge Funds

Your hedge fund selection should be based on your portfolio’s needs. They should be excess capital filling blank spaces in your portfolio. If you’re in need of coverage in specific asset classes, you can use these funds which manipulate that asset class for profit. The same is true for investment regions and market sectors. 

Picking Hedge Funds

Picking Hedge Funds

Your hedge fund selection should be based on your portfolio’s needs. These funds should be excess capital filling blank spaces in your constructed portfolio, and not large percentages. If you’re in need of coverage in specific asset classes, you can use these funds which manipulate that asset class for profit. The same is true for investment regions and market sectors.

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Researching Hedge Funds

Researching Hedge Funds

You need to be well informed before investing. Your entire investment is essentially given to general partners to control. It’s vital that you comprehend exactly how fund managers will earn return in relation to the risks they incur. The basis of general partner’s investment selection is vital to fund returns. All of these factors will be contrasted against your needs, and used to determine if investments within the fund are wise.

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Fund Agreements

Fund Agreements

Joining the hedge fund requires formalizing fund agreements between you and the general partners. Signing the agreements and depositing cash finalizes your entry into the fund. Within the limited liability partnership that constitutes the hedge fund your managers will be known as the general partners. You will be a limited partner. As a limited partner you will retain no control over operations, or investments your deposited currency purchases. Your vote on performance is the ability to withdraw your money from the fund. Due to your lack of control, you will be immune to civil or criminal prosecution resulting from the firm’s actions.

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Hedge Fund Deposits

Hedge Fund Deposits

After researching your potential hedge fund, checking general partner credentials, negotiating terms, and signing contracts, you’re finally ready to deposit money. The deposit will be routed to the fund’s brokerage accounts. It may not be instantly added to their active funds, many managers place your funds into a cash pool until it is needed, but you will still be counted as an investor. Funds may be added according to a set timeline.

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Hedge Fund Withdrawal & Ejection

Hedge Fund Withdrawal & Ejection

If you’re entering a hedge fund, be aware of your potential exits. There are three ways that you can exit the investment. The first is optional withdrawal from the fund. The second is selling your stake in the fund to other investors. The third is forcibly being ejected from the fund.

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Risks & Returns

Risks and performance amongst funds can differ widely since hedge funds can invest in varying amounts of instruments. Pay careful attention to risk and return figures when reviewing fund vehicles. Minor differences in structure can result in large diversions in risk adjusted performance. Two funds holding the exact same investment positions could widely vary based on leverage and investment entry or exit strategy. 

Hedge Fund Reporting

Hedge Fund Reporting

Hedge fund reporting functions differently than mutual fund reporting. Dissimilarities are due to their unregulated status. Hedge funds should optimally release performance and risk reports once a quarter. Funds often choose to release reports biannually, with some only releasing one report a year. Funds which release no reports at all should be concerning.

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Alpha & Performance

Alpha & Performance

Hedge fund performance is determined by the manager’s skill. In order to determine this attribute, you need to separate the manager’s return from the standard return anyone could earn from the same basket of assets. The difference between the standard expected return and the manager’s return is known as the “alpha”. A manager’s alpha is determined by the hedge fund’s performance beyond or below the market rate. This accurately implies alpha can be positive or negative.

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Hedge Fund Return Analysis

Hedge Fund Return Analysis

A common calculation method of investment return (within hedge funds) is the compound average growth formula, abbreviated to CAGR. Note that the Compound Average Growth Rate states “Value”, but is not specific as to which valuation system calculates that value. It can be obtained using a variety of methods. Market value, discounted cash flow, dividend discount model, adjusted present value, Black-Scholes-Merton, and other valuation models are all options for determining value.

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Returns and Taxation

Returns and Taxation

Please note that this section was written specifically for the United States. While certain underlying principles will apply to investing in general, please check your local nation’s tax regulations if you live outside of the US. Once invested, your return divides into the two typical divisions of capital gains and income. Your distributions change depending on your hedge fund’s policies and strategy. These divisions matter, tax treatments change based on the income type. The taxable responsibility generated by a hedge fund is passed on to the investors within the fund. Investors pay tax bills based on the categorization of hedge fund returns.

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Hedge Fund Risks

Hedge Fund Risks

Hedge funds are investment vehicles comprised of the assets which they hold as a basis for investment earnings. Hedge funds’ risks are not uniform since their perils are derived from the financial assets held. Assets are not the only basis of risk: funds derive further risk from strategic choices they make, an easy example being the amount of leverage.

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Hedge Fund Risk Measurement

Hedge Fund Risk Measurement

Hedge funds can create a large variety of risks for their investors which vary with their target market and trading strategies. Hedging reduces losses incurred below certain investment levels, while hopefully maintaining decent levels of investment performance. Funds with skilled managers will reduce or eliminate risks using hedging techniques, which is where the name hedge fund arises. Funds can use options, futures, custom derivatives, or investments with opposing correlations to achieve this goal. Options will secure a sale or purchase price when investment market values reach a specific level. Futures will secure a price for an investment in the future. Instruments with opposing correlation will move upward the price of opposing investments move downwards in an unequal fashion, and vice-versa.

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Hedge Funds Strategies

Hedge fund managers can use a variety of tactics and strategies in their attempt to acquire profit. As a hedge fund investor, you will relinquish control over the fund’s individual investments to the manager and their staff. It is required that you understand the strategy used by the manager and how it fits your greater financial objective. 

Classifying Fund Strategy

Classifying Fund Strategy

Hedge fund managers chose a research model and appropriate investment approach. These selections can have strategic impacts, and the strategy pursued may be based on these selections, or vice-versa. Managers can research actual investments in two differing directions: Top Down research methods or Down Up research methods.

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Arbitrage: Basics

Arbitrage: Basics

Arbitrage divides into multiple strategies based on the target asset. All of these strategies divide into in risk and riskless arbitrage. The execution of the arbitrage strategies changes based on which type of arbitrage is being used. Understanding the differences between the two types of arbitrage first requires understanding the situations which give rise to arbitrage opportunities. Arbitrage opportunities occur when the same or substitutable assets have pricing differences in two or more markets. The spread can widen if the barriers which created the difference in asset prices remain in place.

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Capital Structure Arbitrage

Capital Structure Arbitrage

Among the most obvious places to find arbitrage opportunities is within a firm’s capital structure. Firms usually have many differing assets which use the firm’s value as the underlying investment. The value differences aren’t always held on a correct ratio to the firm’s value or other capital instruments. Differences in these values give traders potential arbitrage opportunities.

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Convertible Arbitrage

Convertible Arbitrage

Convertible Arbitrage exploits price differences among assets which can be converted into other investment instruments. These instruments maintain the same source of underlying value, usually the issuing firm. Convertible arbitrage usually consists of convertible bonds or preferred shares, which can be converted to common shares. Arbitrage requires knowing the conversion ratio, the convertible asset’s price, and the price per common share. The price of purchasing convertible assets and changing them into common shares must be cheaper on a per share basis than open market purchases of those shares. If this is true, the convertible asset is undervalued compared to the common shares. If the convertible asset is undervalued, arbitrage strategies are viable. It is fairly easy to see pricing inefficiencies in the market, and capitalize on their differences. Most plays purchase the convertible asset, and short sell the common shares to seize profit from converging prices.

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Depository Receipt Arbitrage

Depository Receipt Arbitrage

A depository receipt is a vehicle representing firm shares in a firm’s domestic market. It is issued by banks, which purchase a specific number of foreign shares and sell depository receipts claiming ownership of those shares to investors. Each depository receipt represents a specific number of common or preferred shares from a share issuer. Depository receipts split into two categories: American Depository Receipts, labeled ADR and Global Depository Receipts, labeled GDR.

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Holding Company Arbitrage

Holding Company Arbitrage

An investment holding company owns and controls many other investments. Holding companies usually produce no product or services, existing only to own shares of other companies. They can also hold other assets or investments, such as real estate and intellectual property. Holding companies are protected from the liabilities created by their subsidiary firms, but can still appoint and control chairmen or executive management who are responsible. They also add another layer of separation between holding company owners and liabilities or responsibility for created legal or criminal risks.

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Merger Arbitrage

Merger Arbitrage

Merger arbitrage strategies revolve around the world of confirmed or rumored mergers and acquisitions (commonly called M&A). Hedge funds specializing in this strategy look at many factors of M&A which determine success. Managers can either wait for firms to announce mergers or acquisitions, or attempt to anticipate mergers and create positions in advance. The success of merger arbitrage strategies is based on the buyer’s ability to complete the purchase, and partially based on the underlying quality of the company being purchased. Hedge fund managers must think carefully before pulling the trigger on M&A arbitrage strategies, since a constant risk exists that mergers or acquisitions will fail. They must also ensure that firms are committed to the deal, since rumors and lies are commonly planted in the market to earn profits for their originators.

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Event Driven

Event Driven

Event-driven hedge fund strategies seek to profit from major business situations. Funds place themselves in positions to gain profits based on confirmed or rumored events. This can be directional plays or arbitrage-driven plays. The positions taken are based on the likeliness that situations will occur, chances of varying outcomes, price direction implied by events, and investor reactions to all of the above.

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Fund of Funds

Fund of Funds

A Fund of Funds is a hedge fund which purchases stakes in other hedging funds. Managers divide money entrusted to them to investments based on their diversification benefits, risk levels, and anticipated performance. The fund’s alpha is earned based on the manager’s ability to appropriately select investment vehicles.

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Global Macro

Global Macro

Global Macro Hedge Funds are directional and invest anywhere on the planet. They seek to capitalize on any possible positive or negative economic trend. The primary difference between Global Macro funds and other funds is the massive amount of freedom. They can use any accessible investment, in any available market, in any region. They can also select any available strategy. Their options are purchases, sales, short sales, swaps, arbitrage strategies, and even more. Funds may develop strategies using only investor’s funds or take highly leveraged positions. Thanks to low regulations on hedge funds, global funds are essentially limited only by restrictions stated in their prospectus.

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Long & Short Equity

Long & Short Equity

Long and short equity hedge funds trade shares for their profit. They use equity positions alongside equity targeted options and futures to profit from positive (long side) and negative (short side) price movements. During positive movements funds simply buy and gain profits. During negative movements funds sell and initiate short sales. Funds may mix long and short positions, to reduce risks stemming from market movements against certain trades. Even if they are engaged in hedging they will not perfectly reduce risks stemming from sectors, regions, and industries selected.

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Managed Futures

Managed Futures

A managed futures hedge fund focuses on securing profit from trading futures. Futures are used for varying assets, and managed futures funds can target any underlying futures target. Funds may diversify or solely trade one singular area. Hedge funds trading futures may rely on human or automatic trading, basing selection choices on economic outlooks, technical analysis, or other guidelines. Automated systems can trade day and night, as long as markets are open. They are not subject to human limits or desires.

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Multi-Strategy

Multi-Strategy

Many hedge funds regularly mix and match trading strategies, these are called Multi-Strategy funds. Hedge fund managers separate their staff into groups which handle each respective strategy, and distribute resources to each team based on expected market performance. Each group actively invests on behalf of the fund. Splitting the fund into smaller teams allows the funds to be well diversified. This also allows risk-adjusted performance to be easily identified by the strategy generating returns.

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Private Equity

Private Equity

Private Equity markets fund companies in of need financial backing while privately owned. Instead of entering the public financial exchanges, these firms choose private equity funders. They may not be ready for public trading, or simply do not wish for the reduction in control which occurs after an initial public offering. Private Equity Hedge funds deliver cash acquired from investors to firms seeking funding. Delivery occurs via loans or direct purchases of a firm’s equity. In both cases, the firm receives capital and the hedge fund plans to receive its money back, either by repayment of the loan or capital gains after the sale of equity.

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Private Lending

Private Lending

Many firms need to acquire business funding for expansionary projects. These firms need capital for their company projects, and happily seek either loans or investments to fund them towards completion. Hedge funds which actively loan or invest in firms to complete these needs are known as project financing hedge funds.

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Hedge Funds

International Economic Analysis:

  • Major Currency Economic Summaries
  • Performance of Major Imports and Exports
  • Mandates of Central Banks versus Expectations
  • Performance Indexes of Major Economies
  • Economically Correlated Currency Projections
  • Large Funds Currency Sentiment Readings
  • List of Technical Indicators to Look For
  • Occasional: Foregin Exchange Technicals Markups

Hedge Funds

American Markets Analysis:

  • Summaries of American Economic Structure
  • Performance of Major
  • Imports/Exports
  • Federal Reserve Mandate versus Expectations
  • Performance Indexes of U.S Economy
  • Economically Correlated U.S Dollar Projections
  • Large Trading Fund Index Sentiment Readings
  • Market Wide Earnings Versus Valuations
  • Fundamental Ranking of U.S Business Sectors
  • Best and Worst Future Consensus Estimates
  • Occasional: Firm Fundamental Strength Report
  • List of Technicals to Look for While Trading

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