1.  Hedge Funds

2. The Name  Act as hedging mechanism  Investing can hedge against something else  Typically do well in bull or bear market

3. Mutual Fund  Group of investment vehicles  Professionally managed  Each shareholder gains or loses proportionally

4. Sector Allocation

5. Holdings

6. Fees and Expenses

7. Depletion of Returns

8. Similarities and Differences

9. Sources of Hedging  Direct Hedge  Cross Hedge  Dynamic Hedge  Static Hedge

10. Direct Hedge  Hedge one asset  Use another asset that trades in a similar fashion  Example: Call option hedge for equity position

11. Optimal Hedge Ratio  What you need:  Portfolio Volatility  Futures Volatility  Correlation Coefficient  Portfolio Value  Contract Size  Price

12. Volatility and Correlation  Portfolio and Futures Volatility  Simply a measure of returns variance  Correlation measures strength of relationship between returns of futures and equities

13. Contract Size and Price  Contract size simply number of shares futures contract represents  Standard is 100 shares per futures contract  Price is simply the cost per futures contract

14. Optimal Ratio and Hedge  The optimal ratio is simply the combination that minimizes volatility  Found using the cross volatility and correlation (Denoted h*)  The number of futures for optimal hedge is found using h* and the respective values of the contracts and the portfolio

15. Optimal Hedge Ratio

16. Cross Hedge  Hedging instrument with unlike instrument  Long preferred stocks  Treasury futures as hedge (Tend to follow each other)  Trace happens approximately 85% of the time

17. Dynamic Hedge  Similar to aforementioned hedges  Constantly adjusted  Can think of this as ongoing insurance for portfolio  Regularly employed by hedge funds  Adding or subtracting from existing hedge depending on market environment

18. Static Hedge  Simply call or put options  Keep until maturity  No future adjustment needed  i.e. Hedging for the period until maturity

19. Fund Strategies  Market Neutral  Convertible Arbitrage  Fixed Income Arbitrage  Distressed Securities  Merger Arbitrage  Hedged Equities  Global Macro  Emerging Markets  Fund of Funds

20. Market Neutral  Attempt to identify over and undervalued securities  Benchmark typically risk-free rate  Neutralizes the portfolio’s exposure to market risk  Combination of long and short position  Usually have beta of zero  Benchmark typically risk-free rate, due to beta

21. Convertible Arbitrage  Attempt to exploit mispricing in convertible securities  Convertible bonds, convertible preferred stock, etc.  Buy or sell these securities and then fully or partially hedge risk  Make money  Coupon on convertible bond  Expected volatility of underlying asset increases  Price of underlying asset increases

22. Fixed Income Arbitrage  Identify overvalued and undervalued fixed income  In anticipation of changes in term structure of credit quality  Generally neutralized against market risk due to long and short positions  Duration is equal to zero

23. Duration  How long it takes, in years, for the price of a bond to be repaid by its internal cash flows  Represents price sensitivity to IR changes  Zero Coupon Bond – Duration equal to TTM  Vanilla Bond – Duration < TTM

24. Duration of Zero Coupon  Bought at discount, full price paid out at end, no coupons  Fulcrum represents where the price paid for the bond and the cash flows are equal

25. Duration of Vanilla Bond  Annual coupons, say 5 year maturity  Last payment includes face value of bond

26. Duration Formula

27. Continuously Compounded

28. Let’s Try an Example

29. Bond Prices  New bond prices can be easily assessed with duration  Using the change in interest rate, duration, and present value

30. Why is this important?  Hedge funds constantly asses risk in fixed income arbitrage  Duration risk is an important factor  Higher duration means more duration risk  Zero coupons have highest duration risk

31. Distressed Securities  Debt and Equity of companies near bankruptcy  Legal risk is transferred from HNWI to hedge fund  Many HNWI are prevented from investing in these types of companies  Most funds long due to lack of liquidity

32. Merger Arbitrage  Captures price spread before and after transaction  Acquisition, Merger, JV, Spin-Off  Usual strategy  Buying stock of target company  Shorting stock of acquiring company

33. Hedged Equity  Attempt to identify overvalued and undervalued equity securities  Not market neutral, many times very concentrated  Usually have net long exposure to equity markets

34. Global Macro  Take advantage of systematic moves in global markets  Concentrate on major market trends  Managers many times use derivatives, options and futures

35. Emerging Markets  Focus on emerging and less mature markets  Short selling is not permitted  Most funds are long

36. Fund of Funds  Invests in a number of underlying hedge funds  Typically more accessible to individual investors  Greater liquidity  Two layers of fees for investors  Typically invest in 10-30 hedge funds  Some are even more diversified

38. AUM Growth

39. Industry Trends 14-15

40. Industry Breakdown

42. Performance by Fund Type

43. Leverage Ratios by Fund Type