This book tells all. It explains how [hedge funds] work. THIS

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3 Praise for the First Edition INVESTING IN HEDGE FUNDS: STRATEGIES FOR THE NEW MARKETPLACE by Joseph G. Nicholas This book tells all. It explains how [hedge funds] work. THIS IS A SERIOUS AND IMPORTANT BOOK ON THE SUBJECT AND MUST BE READ BY ANY SERIOUS INVESTOR. TradersWorld Magazine NICHOLAS HAS DONE AN INVALUABLE SERVICE in laying out exactly how hedge funds work, who runs them, how they incorporate, their benefits and risks, and how to go about selecting one. THE STREET.COM I have yet to find a book THAT DOES SUCH A GOOD JOB of demystifying an area that has been kept deliberately opaque (with good reason) by its players. AIMA (Alternative Investment Management Association) Newsletter In light of the dramatic increase of investments in hedge funds, the recent media attention, and the widespread need to better understand these complex strategies, JOE NICHOLAS HAS CREATED A KEY INVESTOR GUIDE TO HEDGE FUNDS, including the unique and valuable perspective of having top hedge fund managers describe what they do in their own words. TIMOTHY J. LEACH Former Chief Investment Officer U.S. Trust Corporation

4 Investing in Hedge Funds is the first comprehensive study of what hedge funds are and how they work. THIS IS AN ESSENTIAL BOOK FOR ALL INVESTORS CURIOUS ABOUT ALTERNATIVE INVESTMENT STRATEGIES. Joseph Nicholas details the range of investment strategies pursued by hedge fund managers and writes in a clear, lucid style. I HIGHLY RECOMMEND THIS BOOK TO ACADEMICS AND PROFESSIONALS WHO WANT TO LEARN ABOUT HEDGE FUNDS. PROFESSOR WILLIAM N. GOETZMANN Director, International Center for Finance Yale School of Management JOSEPH NICHOLAS PROVIDES AN EXTRAORDINARY ANALYSIS OF HEDGE FUNDS THAT CLEARLY EXPLAINS WHAT THEY ARE AND HOW THEY WORK. This book is a must-read for anyone looking to reduce investment risks and increase performance. WILLIAM B. NICHOLSON Former Chairman and Chief Executive Officer Capital Resource Advisors

6 INVESTING IN HEDGE FUNDS

7 ALSO BY JOSEPH G. NICHOLAS Hedge Fund of Funds Investing: An Investor s Guide Market-Neutral Investing: Long/Short Hedge Fund Strategies ALSO AVAILABLE FROM BLOOMBERG PRESS Investing in REITs: Real Estate Investment Trusts Third Edition by Ralph L. Block The Money-Making Guide to Bonds: Straightforward Strategies for Picking the Right Bonds and Bond Funds by Hildy Richelson and Stan Richelson The Trader s Guide to Key Economic Indicators by Richard Yamarone A complete list of our titles is available atwww.bloomberg.com/books ATTENTION CORPORATIONS This book is available for bulk purchase at special discount. Special editions or chapter reprints can also be customized to specifications. For information, please Bloomberg Press, press@bloomberg.com, Attention: Director of Special Markets, or phone

8 INVESTING IN HEDGE FUNDS REVISED AND UPDATED EDITION JOSEPH G. NICHOLAS B L O O M B E R G P R E S S N E W Y O R K

9 2005 by Joseph G. Nicholas. All rights reserved. Protected under the Berne Convention. Printed in the United States of America. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher except in the case of brief quotations embodied in critical articles and reviews. For information, please write: Permissions Department, Bloomberg Press, 731 Lexington Avenue, New York, NY 10022, U.S.A. or send an to press@bloomberg.com. BLOOMBERG, BLOOMBERG LEGAL, BLOOMBERG MARKETS, BLOOMBERG NEWS, BLOOMBERG PRESS, BLOOMBERG PROFESSIONAL, BLOOMBERG RADIO, BLOOMBERG TELEVISION, BLOOMBERG TERMINAL, and BLOOMBERG TRADEBOOK are trademarks and service marks of Bloomberg L.P. All rights reserved. This publication contains the author s opinions and is designed to provide accurate and authoritative information. It is sold with the understanding that the author, publisher, and Bloomberg L.P. are not engaged in rendering legal, accounting, investment-planning, or other professional advice. The reader should seek the services of a qualified professional for such advice; the author, publisher, and Bloomberg L.P. cannot be held responsible for any loss incurred as a result of specific investments or planning decisions made by the reader. All charts, graphs, and illustrations contained herein were created from data provided by Hedge Fund Research, Inc. All rights reserved. Reprint by permission only. Revised and updated edition published ISBN-13: Library of Congress has cataloged the earlier printing as follows: Nicholas, Joseph G. Investing in hedge funds / Joseph G. Nicholas. -- Rev. and updated ed. p. cm. Summary: Overview of the hedge fund industry and various hedge fund investment strategies. Includes industry data, graphs, and manager examples - Provided by publisher. Includes bibliographic references and index. ISBN (alk. paper) 1. Hedge funds--united States. II. Title: Hedge funds. II. Title. HG4930.N dc

10 To my parents, Diana and George Nicholas

11 INTRODUCTION 1 PART I Keys to Understanding 8 CHAPTER 1 What Is a Hedge Fund? 10 CHAPTER 2 The Hedge Fund Investment Structure 30 PART II Investing with Knowledge 50 CHAPTER 3 Hedge Fund Strategies 52 CHAPTER 4 Fixed-Income Arbitrage 80 CHAPTER 5 Equity Market Neutral 98 CHAPTER 6 Convertible Arbitrage 112 CHAPTER 7 Merger (Risk) Arbitrage 126 CHAPTER 8 Distressed Securities 138 CHAPTER 9 Event-Driven Strategies 154

12 CHAPTER 10 Macro Investing 166 CHAPTER 11 Sector Funds 180 CHAPTER 12 Equity Hedge 196 CHAPTER 13 Emerging Markets 212 CHAPTER 14 Short Selling 228 PART III Making an Investment 240 CHAPTER 15 Investing in Hedge Funds 242 CHAPTER 16 After the Initial Allocation 260 APPENDICES A. Calculation Methodology 274 B. Resources for Investors 276 C. Hedge Fund Research Performance Indices 278 GLOSSARY 300 NOTES INDEX

14 ACKNOWLEDGMENTS i thank the following: Ben Borton, Scott J. Esser, Patrick Kenary, Ken Heinz, and William Bock. For their insightful help and comments, in good times and bad, on the various strategy chapters we would like to thank the following managers and their staffs: Dan Adler, Ray Dalio, Karen Finerman, David Fink, Kent Fleming, J.C. Frey, Richard Giacomo, Mickey Harley, Jeff James, John Kerschner, Odell Lambroza, Sam Nathans, and Seth Washburne. SOURCE: BPTHESANS-PLAIN 5/12 SMALLCAPS TRACK 50

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