Hedge Funds. DUMmIES. by Ann C. Logue FOR

Size: px

Start display at page:

Download "Hedge Funds. DUMmIES. by Ann C. Logue FOR"

Susanna Baker
6 years ago
Views:

1 Hedge Funds FOR DUMmIES by Ann C. Logue

3 Hedge Funds FOR DUMmIES by Ann C. Logue

4 Hedge Funds For Dummies Published by Wiley Publishing, Inc. 111 River St. Hoboken, NJ Copyright 2007 by Wiley Publishing, Inc., Indianapolis, Indiana Published by Wiley Publishing, Inc., Indianapolis, Indiana Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, , fax Requests to the Publisher for permission should be addressed to the Legal Department, Wiley Publishing, Inc., Crosspoint Blvd., Indianapolis, IN 46256, , fax , or online at Trademarks: Wiley, the Wiley Publishing logo, For Dummies, the Dummies Man logo, A Reference for the Rest of Us!, The Dummies Way, Dummies Daily, The Fun and Easy Way, Dummies.com and related trade dress are trademarks or registered trademarks of John Wiley & Sons, Inc. and/or its affiliates in the United States and other countries, and may not be used without written permission. All other trademarks are the property of their respective owners. Wiley Publishing, Inc., is not associated with any product or vendor mentioned in this book. LIMIT OF LIABILITY/DISCLAIMER OF WARRANTY: THE PUBLISHER AND THE AUTHOR MAKE NO REP- RESENTATIONS OR WARRANTIES WITH RESPECT TO THE ACCURACY OR COMPLETENESS OF THE CONTENTS OF THIS WORK AND SPECIFICALLY DISCLAIM ALL WARRANTIES, INCLUDING WITHOUT LIMITATION WARRANTIES OF FITNESS FOR A PARTICULAR PURPOSE. NO WARRANTY MAY BE CRE- ATED OR EXTENDED BY SALES OR PROMOTIONAL MATERIALS. THE ADVICE AND STRATEGIES CON- TAINED HEREIN MAY NOT BE SUITABLE FOR EVERY SITUATION. THIS WORK IS SOLD WITH THE UNDERSTANDING THAT THE PUBLISHER IS NOT ENGAGED IN RENDERING LEGAL, ACCOUNTING, OR OTHER PROFESSIONAL SERVICES. IF PROFESSIONAL ASSISTANCE IS REQUIRED, THE SERVICES OF A COMPETENT PROFESSIONAL PERSON SHOULD BE SOUGHT. NEITHER THE PUBLISHER NOR THE AUTHOR SHALL BE LIABLE FOR DAMAGES ARISING HEREFROM. THE FACT THAT AN ORGANIZATION OR WEBSITE IS REFERRED TO IN THIS WORK AS A CITATION AND/OR A POTENTIAL SOURCE OF FUR- THER INFORMATION DOES NOT MEAN THAT THE AUTHOR OR THE PUBLISHER ENDORSES THE INFORMATION THE ORGANIZATION OR WEBSITE MAY PROVIDE OR RECOMMENDATIONS IT MAY MAKE. FURTHER, READERS SHOULD BE AWARE THAT INTERNET WEBSITES LISTED IN THIS WORK MAY HAVE CHANGED OR DISAPPEARED BETWEEN WHEN THIS WORK WAS WRITTEN AND WHEN IT IS READ. For general information on our other products and services, please contact our Customer Care Department within the U.S. at , outside the U.S. at , or fax For technical support, please visit Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Library of Congress Control Number: ISBN-13: ISBN-10: Manufactured in the United States of America B/RS/RQ/QW/IN

5 About the Author Ann C. Logue is a freelance writer and consulting analyst. She has written for Barron s, the New York Times, Newsweek Japan, Compliance Week, and the International Monetary Fund. She s a lecturer at the Liautaud Graduate School of Business at the University of Illinois at Chicago. Her current career follows 12 years of experience as an investment analyst. She has a BA from Northwestern University, an MBA from the University of Chicago, and she holds the Chartered Financial Analyst designation. Dedication To Rik and Andrew, for their love and support. Author s Acknowledgments So many wonderful people helped me with this book! I talked to many hedge fund managers and others in the investment business, including Cliff Asness, Catherine Cooper, Beth Cotner, Nancy Fallon-Houle, Marshall Greenwald, Steve Gregornik, Anil Joshi of NuFact, Russ Kuhns, Alecia Licata of the CFA Institute, Dan Orlow, Tino Sellitto, Lisa Springer, Ryan Tagal at Morningstar, Scott Takemoto, and Gary Tilkin and Kelly Quintanilla at Global Forex Trading. I also talked to a handful of other hedge fund managers who asked to remain anonymous; they know who they are, and I hope they also know how much I appreciate their help. The CFA Society of Chicago put on a great conference entitled New Considerations in the Quest for Alpha, which took place in the middle of writing this book and gave me some valuable insights. I m grateful to the volunteers and presenters who made the day so productive for me. I want to thank a few friends who helped give me direction on writing this and who pointed me to friends of theirs who work in the hedge-fund business. Bev Bennett, Lisa Duffy, Mary Richardson Graham, and Erik Sherman all were wonderful help. I also need to acknowledge Jennie Phipps, the proprietor of Freelance Success ( one of the best resources out there for professional writers. As for the mechanics of putting together the book, Natalie Harris, Stacy Kennedy, and Josh Dials of Wiley were fabulous to work with. Their patience and good humor got me through a tough schedule. Marcia Layton-Turner gets kudos for introducing me to her agent, Marilyn Allen, who became my agent and made the book possible. Thanks, everyone!

6 Publisher s Acknowledgments We re proud of this book; please send us your comments through our Dummies online registration form located at Some of the people who helped bring this book to market include the following: Acquisitions, Editorial, and Media Development Project Editor: Natalie Faye Harris Acquisitions Editor: Stacy Kennedy Assistant Editor: Courtney Allen Copy Editor: Josh Dials Editorial Program Coordinator: Hanna K. Scott Technical Editor: Russell Rhoads Editorial Manager: Christine Beck Editorial Assistants: Erin Calligan, David Lutton Cartoons: Rich Tennant ( Composition Services Project Coordinator: Adrienne Martinez Layout and Graphics: Claudia Bell, Carl Byers, Lavonne Cook, Barry Offringa, Laura Pence, Julie Trippetti Proofreaders: Jessica Kramer, Christy Pingleton, Christine Sabooni Indexer: Techbooks Publishing and Editorial for Consumer Dummies Diane Graves Steele, Vice President and Publisher, Consumer Dummies Joyce Pepple, Acquisitions Director, Consumer Dummies Kristin A. Cocks, Product Development Director, Consumer Dummies Michael Spring, Vice President and Publisher, Travel Kelly Regan, Editorial Director, Travel Publishing for Technology Dummies Andy Cummings, Vice President and Publisher, Dummies Technology/General User Composition Services Gerry Fahey, Vice President of Production Services Debbie Stailey, Director of Composition Services

7 Contents at a Glance Introduction...1 Part I: What Is a Hedge Fund, Anyway?...7 Chapter 1: What People Talk About When They Talk About Hedge Funds...9 Chapter 2: Examining How Hedge Funds Are Structured...27 Chapter 3: Not Just a Sleeping Aid: Analyzing SEC Registration...47 Chapter 4: How to Buy into a Hedge Fund...59 Part II: Determining Whether Hedge Funds Are Right for You...71 Chapter 5: Hedging through Research and Asset Selection...73 Chapter 6: Calculating Investment Risk and Return...95 Chapter 7: You Want Your Money When? Balancing Time and Liquidity Chapter 8: Taxes, Responsibilities, Transparency, and Other Investment Considerations Chapter 9: Fitting Hedge Funds into a Portfolio Part III: Setting Up Your Hedge Fund Investment Strategy Chapter 10: Buying Low, Selling High: Using Arbitrage in Hedge Funds Chapter 11: Short-Selling, Leveraging, and Other Equity Strategies Chapter 12: Observing How Hedge Funds Profit from the Corporate Life Cycle Chapter 13: Macro Funds: Looking for Global Trends Chapter 14: But Will You Make Money? Evaluating Hedge-Fund Performance Part IV: Special Considerations Regarding Hedge Funds Chapter 15: Hooking Onto Other Types of Hedge Funds Chapter 16: Using Hedge-Fund Strategies without Hedge Funds Chapter 17: Hiring a Consultant to Help You with Hedge Funds Chapter 18: Doing Due Diligence on a Hedge Fund...303

8 Part V: The Part of Tens Chapter 19: Ten (Plus One) Big Myths about Hedge Funds Chapter 20: Ten Good Reasons to Invest in a Hedge Fund Index...333

9 Table of Contents Introduction...1 Part I: What Is a Hedge Fund, Anyway?...7 Chapter 1: What People Talk About When They Talk About Hedge Funds Defining Hedge Funds (Or Should I Say Explaining Hedge Funds?)...10 Hedging: The heart of the hedge-fund matter...10 Identifying hedge funds: The long explanation...11 Pledging the secret society: Getting hedge fund information...14 Surveying the History of Hedge Funds...15 Alfred Winslow Jones and the first hedge fund to 1972: Moving from hedging to speculating...16 George Soros, Julian Robertson, and hedge-fund infamy...17 The rise and fall of Long-Term Capital Management...17 The Yale Endowment: Paying institutional attention to hedge funds...18 Generating Alpha...19 Introducing Basic Types of Hedge Funds...20 Absolute-return funds...20 Directional funds...21 Meeting the People in Your Hedge Fund Neighborhood...21 Managers: Hedging for you...21 Lawyers: Following the rules...22 Consultants: Studying funds and advising investors...22 Paying Fees in a Hedge Fund...23 Managing management fees...24 Shelling out your percentage of performance fees...24 Chapter 2: Examining How Hedge Funds Are Structured Exploring the Uneven Relationships between Fund Partners...28 General partners: Controlling the fund...28 Limited partners: Investing in the fund...29 Only Accredited or Qualified Investors Need Apply...30 Which kind of investor are you?...30 Why do hedge fund investors need to be qualified or accredited?...32

10 viii Hedge Funds For Dummies Do funds really check up on you?...33 Do I have alternatives if I don t qualify?...33 Following the Cash Flow within a Hedge Fund...34 Substituting commitments for cash...34 Waiting for withdrawals and distributions...35 Fee, Fi, Fo, Cha Ching! Paying the Fees Associated with Hedge Funds...37 Management fees...38 Sales charges...39 Performance fees...39 Redemption fees...41 Commissions...41 Dealing with the Hedge Fund Manager...42 Making time for meetings...42 Communicating with the written word...42 Seeking Alternatives to Hedge Funds...43 Making mutual funds work for you...45 Profiting from pooled accounts...45 Entering individually managed accounts...45 Chapter 3: Not Just a Sleeping Aid: Analyzing SEC Registration Getting to Know the SEC s Stance on Registration and Regulation...48 Examining the SEC s past and current policies on registration...49 Meeting investor needs with regulation...53 Realizing that registered doesn t mean approved...53 Addressing registration at the state level...54 Going Costal: Avoiding the Registration Debate through Offshore Funds...55 Investing in a Fund without Registration...56 Contracting the manager s terms...56 Covering yourself with due diligence...57 Chapter 4: How to Buy into a Hedge Fund Using Consultants and Brokers...60 Marketing to and for Hedge Fund Managers...61 Investor, Come on Down: Pricing Funds...62 Calculating net asset value...63 Valuing illiquid securities...66 Managing side pockets...67 Purchasing Your Stake in the Fund...67 Fulfilling paperwork requirements...68 Working with brokers...68 Reporting to the taxman...69 Signing Your Name on the Bottom Line...69 Drawing up the contract...69 Addressing typical contract provisions...70 Finding room for negotiation...70

11 Table of Contents ix Part II: Determining Whether Hedge Funds Are Right for You...71 Chapter 5: Hedging through Research and Asset Selection First Things First: Examining Your Asset Options...74 Sticking to basics: Traditional asset classes...75 Going for some flavor: Alternative assets...78 Custom products and private deals...83 Kicking the Tires: Fundamental Research...85 Top-down analysis...86 Bottom-up analysis...88 Focusing on finances: Accounting research...89 Gnawing on the numbers: Quantitative research...89 Reading the charts: Technical analysis...90 How a Hedge Fund Puts Research Findings to Work...91 The long story: Buying appreciating assets...92 The short story: Selling depreciating assets...93 Chapter 6: Calculating Investment Risk and Return Market Efficiency and You, the Hedge Fund Investor...96 Why efficiency matters...96 Perusing profitable inefficiencies...97 Efficiency and the random walk...97 Using the Modern (Markowitz) Portfolio Theory (MPT)...98 So what s risky?...99 Reviewing risk types in the MPT Distributing risk Determining the market rate of return Beta: Ranking market return Alpha: Return beyond standard deviation The Arbitrage Pricing Theory (APT): Expanding the MPT Discovering How Interest Rates Affect the Investment Climate Seeing what goes into an interest rate Relating interest rates and hedge funds Witnessing the power of compound interest Investing on the Cutting Edge: Behavioral Finance Examining the principles of behavioral finance Applying behavioral finance to hedge funds Chapter 7: You Want Your Money When? Balancing Time and Liquidity Considering Your Cash Needs Like Dollars through the Hourglass: Determining Your Time Horizon Taking stock of temporary funds Fathoming matched assets and liability Peeking into permanent funds...127

12 x Hedge Funds For Dummies Poring Over Your Principal Needs Handling Liquidity After You Make Your Initial Investment Taking advantage of additional investments Knowing when (and how) you can withdraw funds Receiving distributions Moving on after disbandment Chapter 8: Taxes, Responsibilities, Transparency, and Other Investment Considerations Taxing You, the Hedge Fund Investor (Hey, It s Better than Death!) Making sense of capital-gains taxes Taxing ordinary income Exercising your right to be exempt Figuring Out Your Fiduciary Responsibility Coming to terms with common law Tackling trust law Uniform Management of Institutional Funds Act (UMIFA) Employee Retirement Income Security Act (ERISA) of Transparency in Hedge Funds: Rare but There Appraising positions Interpreting risk Avoiding window dressing Activists and opponents in the hedge fund world Practicing Socially Responsible Investing Chapter 9: Fitting Hedge Funds into a Portfolio Assaying Asset Allocations Matching goals to money Chasing return versus allocating assets Using Hedge Funds as an Asset Class How hedge funds are assets Diversification, risk, and return: How the asset pros and cons play out Viewing a Hedge Fund as an Overlay Considering the overlay pros and cons Investment reporting: An overlay example Mixing and Matching Your Funds Looking for excess capital under the couch cushions Taking different funds to the dressing room Working without transparency...163

13 Table of Contents xi Part III: Setting Up Your Hedge Fund Investment Strategy Chapter 10: Buying Low, Selling High: Using Arbitrage in Hedge Funds Putting Arbitrage to Good Use Understanding arbitrage and market efficiency Factoring transaction costs into arbitrage Pitting true arbitrage versus risk arbitrage Cracking Open the Arbitrageur s Toolbox Drawing upon derivatives Using leverage Short-selling Synthetic securities Flipping through the Rolodex of Arbitrage Types Capital-structure arbitrage Convertible arbitrage Fixed-income arbitrage Index arbitrage Liquidation arbitrage Merger arbitrage Option arbitrage Pairs trading Scalping Statistical arbitrage Warrant arbitrage Chapter 11: Short-Selling, Leveraging, and Other Equity Strategies Short-Selling versus Leveraging: A Brief Overview Strutting in the Equity Style Show Trying on a large cap Fitting for a small cap Investing according to growth and GARP Swooping in on lowly equities with value investing Keeping options open for special style situations Market Neutrality: Taking the Market out of Hedge-Fund Performance Being beta neutral Establishing dollar neutrality Staying sector neutral Rebalancing a Portfolio Long-Short Funds...195

14 xii Hedge Funds For Dummies Making Market Calls Investing with event-driven calls Taking advantage of market timing Putting the Power of Leverage to Use Buying on margin Gaining return with other forms of borrowing Chapter 12: Observing How Hedge Funds Profit from the Corporate Life Cycle Examining the Corporate Structure (And How Hedge Funds Enter the Picture) Observing the relationship between owners and managers Pitting business skills versus investment skills From Ventures to Vultures: Participating in Corporate Life Cycles Identifying venture capital and private equity as hedge-fund investments Project finance: Are hedge funds replacing banks? Gaining return from company mergers and acquisitions Investing in troubled and dying companies with vulture funds Chapter 13: Macro Funds: Looking for Global Trends Fathoming Macroeconomics Focusing on fiscal policy Making moves with monetary policy Taking Special Issues for Macro Funds into Consideration Diversified, yes. Riskless, no Global financial expertise Subadvisers The multinational conundrum Widening or Narrowing Your Macro Scope Coming to terms with currencies Contemplating commodities Chapter 14: But Will You Make Money? Evaluating Hedge-Fund Performance Measuring a Hedge Fund s Risk and Return Reviewing the return Sizing up the risk Benchmarks for Evaluating a Fund s Risk and Return Looking into indexes Picking over peer rankings Standardizing performance calculation: Global Investment Performance Standards...246

15 Table of Contents xiii Putting Risk and Return into Context with Academic Measures Sharpe measure Treynor measure Jensen s alpha The appraisal ratio Serving Yourself with a Reality Check on Hedge-Fund Returns Risk and return tradeoff Survivor bias Performance persistence Style persistence Hiring a Reporting Service to Track Hedge-Fund Performance Greenwich-Van HedgeFund.net Hedge Fund Research Lipper Hedge World Managed Account Report Morningstar Part IV: Special Considerations Regarding Hedge Funds Chapter 15: Hooking Onto Other Types of Hedge Funds Multi-Strategy Funds: Pursuing a Range of Investment Strategies Determining the strategies Dividing in-house responsibilities Scoping the pitfalls of working with a broad portfolio Funds of Funds: Investing in a Variety of Hedge Funds Surveying fund of funds types Highlighting the advantages of funds of funds Acknowledging the problems with funds of funds Multiple funds, multiple fees Advancing to funds of funds of funds (I m not making this up!) Hedge Funds by Any Other Name Entering Mutual Funds That Hedge Chapter 16: Using Hedge-Fund Strategies without Hedge Funds A Diversified Portfolio Is a Hedged Portfolio A slow-and-steady strategy works over the long run But some investors want to hit a home run NOW Exploring Your Expanding Asset Universe Rounding up the usual asset alternatives Other assets you may not have considered...278

Hedge Funds. DUMmIES. by Ann C. Logue FOR

Hedge Funds. DUMmIES. by Ann C. Logue FOR Hedge Funds FOR DUMmIES by Ann C. Logue Hedge Funds FOR DUMmIES by Ann C. Logue Hedge Funds For Dummies Published by Wiley Publishing, Inc. 111 River St. Hoboken, NJ 07030-5774 www.wiley.com Copyright