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Domestic Fund Formation It is a simple process to enter the hedge fund industry; practically anyone with $15k to $20k can start a hedge fund and forming a hedge fund gets easier every year.
Offshore Fund Formation An offshore hedge fund is simply a structure used by hedge fund managers as a way to attract offshore investors (non-U.S. citizens) or U.S. tax-exempt investors such as pension and endowment funds.
Hedge Fund Strategies
The popular misconception is that all hedge funds are volatile — that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds. Most hedge funds use derivatives only for hedging or don’t use derivatives at all, and many use no leverage.

Convertible Arbitrage involves purchasing a portfolio of convertible securities, generally convertible bonds, and hedging a portion of the equity risk by selling short the underlying common stock. Certain managers may also seek to hedge interest rate exposure under some circumstances. Most managers employ some degree of leverage, ranging from zero to 6:1. The equity hedge ratio may range from 30 to 100 percent. The average grade of bond in a typical portfolio is BB-, with individual ratings ranging from AA to CCC. However, as the default risk of the company is hedged by shorting the underlying common stock, the risk is considerably better than the rating of the unhedged bond indicates.

Distressed Securities strategies invest in, and may sell short, the securities of companies where the security’s price has been, or is expected to be, affected by a distressed situation. This may involve reorganizations, bankruptcies, distressed sales and other corporate restructuring. Depending on the manager’s style, investments may be made in bank debt, corporate debt, trade claims, common stock, preferred stock and warrants. Strategies may be sub-categorized as “high-yield” or “orphan equities.” Leverage may be used by some managers. Fund managers may run a market hedge using S&P put options or put options spreads.

Emerging Markets funds invest in securities of companies or the sovereign debt of developing or “emerging” countries. Investments are primarily long. “Emerging Markets” include countries in Latin America, Eastern Europe, the former Soviet Union, Africa and parts of Asia. Emerging Markets – Global funds will shift their weightings among these regions according to market conditions and manager perspectives. In addition, some managers invest solely in individual regions. Emerging Markets – Asia involves investing in the emerging markets of Asia. Emerging Markets – Eastern Europe/CIS funds concentrate their investment activities in the nations of Eastern Europe and the CIS (the former Soviet Union). Emerging Markets – Latin America is a strategy that entails investing throughout Central and South America.

Equity Hedge investing consists of a core holding of long equities hedged at all times with short sales of stocks and/or stock index options. Some managers maintain a substantial portion of assets within a hedged structure and commonly employ leverage. Where short sales are used, hedged assets may be comprised of an equal dollar value of long and short stock positions. Other variations use short sales unrelated to long holdings and/or puts on the S&P 500 index and put spreads. Conservative funds mitigate market risk by maintaining market exposure from zero to 100 percent. Aggressive funds may magnify market risk by exceeding 100 percent exposure and, in some instances, maintain a short exposure. In addition to equities, some funds may have limited assets invested in other types of securities.

Equity Market Neutral investing seeks to profit by exploiting pricing inefficiencies between related equity securities, neutralizing exposure to market risk by combining long and short positions. One example of this strategy is to build portfolios made up of long positions in the strongest companies in several industries and taking corresponding short positions in those showing signs of weakness.

Equity Market Neutral: Statistical Arbitrage utilizes quantitative analysis of technical factors to exploit pricing inefficiencies between related equity securities, neutralizing exposure to market risk by combining long and short positions. The strategy is based on quantitative models for selecting specific stocks with equal dollar amounts comprising the long and short sides of the portfolio. Portfolios are typically structured to be market, industry, sector, and dollar neutral.

Equity Non-Hedge funds are predominately long equities although they have the ability to hedge with short sales of stocks and/or stock index options. These funds are commonly known as “stock-pickers.” Some funds employ leverage to enhance returns. When market conditions warrant, managers may implement a hedge in the portfolio. Funds may also opportunistically short individual stocks. The important distinction between equity non-hedge funds and equity hedge funds is equity non-hedge funds do not always have a hedge in place. In addition to equities, some funds may have limited assets invested in other types of securities.

Event-Driven is also known as “corporate life cycle” investing. This involves investing in opportunities created by significant transactional events, such as spin-offs, mergers and acquisitions, bankruptcy reorganizations, recapitalizations and share buybacks. The portfolio of some Event-Driven managers may shift in majority weighting between Risk Arbitrage and Distressed Securities, while others may take a broader scope. Instruments include long and short common and preferred stocks, as well as debt securities and options. Leverage may be used by some managers. Fund managers may hedge against market risk by purchasing S&P put options or put option spreads.

Fixed Income: Arbitrage 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. Fixed Income Arbitrage is a generic description of a variety of strategies involving investment in fixed income instruments, and weighted in an attempt to eliminate or reduce exposure to changes in the yield curve. 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.

Fixed Income: Convertible Bonds funds are primarily long only convertible bonds. Convertible bonds have both fixed income and equity characteristics. If the underlying common stock appreciates, the convertible bond’s value should rise to reflect this increased value. Downside protection is offered because if the underlying common stock declines, the convertible bond’s value can decline only to the point where it behaves like a straight bond.

Fixed Income: Diversified funds may invest in a variety of fixed income strategies. While many invest in multiple strategies, others may focus on a single strategy less followed by most fixed income hedge funds. Areas of focus include municipal bonds, corporate bonds, and global fixed income securities.

Fixed Income: High-Yield managers invest in non-investment grade debt. Objectives may range from high current income to acquisition of undervalued instruments. Emphasis is placed on assessing credit risk of the issuer. Some of the available high-yield instruments include extendible/reset securities, increasing-rate notes, pay-in-kind securities, step-up coupon securities, split-coupon securities and usable bonds.

Fixed Income: Mortgage-Backed funds invest in mortgage-backed securities. Many funds focus solely on AAA rated bonds. Instruments include: government agency, government-sponsored enterprise, private-label fixed- or adjustable-rate mortgage pass-through securities, fixed- or adjustable-rate collateralized mortgage obligations (CMOs), real estate mortgage investment conduits (REMICs) and stripped mortgage-backed securities (SMBSs). Funds may look to capitalize on security-specific mispricing. Hedging of prepayment risk and interest rate risk is common. Leverage may be used, as well as futures, short sales and options.

Foreign Exchange (FX) managers employ a proprietary, sometimes automated, trading system in order to benefit from arbitrage opportunities and price discrepancies between world currencies created by reasons varying from macro economic shocks to region-specific financial events. FX market is the world’s largest and most liquid market in the world therefore the trading volume is usually larger than equity and fixed income trading. Most managers rely heavily on technical analysis and attempt to predict future movements (both long and short term) in order to benefit from shifts in value.

Macro involves investing by making leveraged bets on anticipated price movements of stock markets, interest rates, foreign exchange and physical commodities. Macro managers employ a “top-down” global approach, and may invest in any markets using any instruments to participate in expected market movements. These movements may result from forecasted shifts in world economies, political fortunes or global supply and demand for resources, both physical and financial. Exchange-traded and over-the-counter derivatives are often used to magnify these price movements.

Managed Futures, otherwise known as “commodity trading advisors” (CTAs), manage client assets on a discretionary basis, using global futures markets (government securities, futures contracts and options on futures contracts) as an investment medium. CTAs generally manage their clients’ assets using a proprietary trading system or a discretionary method that may involve long/short investments in futures contracts. Typical areas of focus include metals (gold, silver), grains (soybeans, corn, wheat), equity indexes (S&P futures, Dow futures, NASDAQ 100 futures) and soft commodities (cotton, cocoa, coffee, sugar), as well as foreign currency and U.S government bond futures. As an asset class, managed futures are known to be inversely correlated with stocks and bonds.

Market Timing involves allocating assets among investments by switching into investments that appear to be beginning an uptrend, and switching out of investments that appear to be starting a downtrend. This primarily consists of switching between mutual funds and money markets. Typically, technical trend-following indicators are used to determine the direction of a fund and identify buy and sell signals. In an up move “buy signal,” money is transferred from a money market fund into a mutual fund in an attempt to capture a capital gain. In a down move “sell signal,” the assets in the mutual fund are sold and moved back into the money market for safe keeping until the next up move. The goal is to avoid being invested in mutual funds during a market decline.

Merger Arbitrage, sometimes called Risk Arbitrage, involves investment in event-driven situations such as leveraged buy-outs, mergers and hostile takeovers. Normally, the stock of an acquisition target appreciates while the acquiring company’s 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. Managers may employ the use of equity options as a low-risk alternative to the outright purchase or sale of common stock. Most Merger Arbitrage funds hedge against market risk by purchasing S&P put options or put option spreads.

Regulation D Managers invest in Regulation D securities, sometimes referred to as structured discount convertibles. The securities are privately offered to the investment manager by companies in need of timely financing and the terms are negotiated. The terms of any particular deal are reflective of the negotiating strength of the issuing company. Once a deal is closed, there is a waiting period for the private share offering to be registered with the SEC. The manager can only convert into private shares and cannot trade them publicly during this period; therefore their investment is illiquid until it becomes registered. Managers will hedge with common stock until the registration becomes effective and then liquidate the position gradually.

Relative Value Arbitrage attempts to take advantage of relative pricing discrepancies between instruments including equities, debt, options and futures. Managers may use mathematical, fundamental, or technical analysis to determine misvaluations. Securities may be mispriced relative to the underlying security, related securities, groups of securities, or the overall market. Many funds use leverage and seek opportunities globally. Arbitrage strategies include dividend arbitrage, pairs trading, options arbitrage and yield curve trading.

Sector: Energy is a strategy that focuses on investment within the energy sector. Investments can be long and short in various instruments with funds either diversified across the entire sector or specializing within a sub-sector, i.e., oil field service.

Sector: Financial is a strategy that invests in securities of bank holding companies, banks, thrifts, insurance companies, mortgage banks and various other financial services companies.

Sector: Healthcare/Biotechnology funds invest in companies involved in the healthcare, pharmaceutical, biotechnology, and medical device areas.

Sector: Miscellaneous funds invest in securities of companies primarily focused on miscellaneous sectors of investments, such as precious metals (gold, silver), beverage companies, retail stores, home improvement outlets, shipping industry, weather/climate opportunities, or the entertainment/sports industry.

Sector: Real Estate involves investing in securities of real estate investment trusts (REITs) and other real estate companies. Some funds may also invest directly in real estate property.

Sector: Technology funds emphasize investment in securities of the technology arena. Some of the sub-sectors include multimedia, networking, PC producers, retailers, semiconductors, software, and telecommunications.

Short Selling involves the sale of a security not owned by the seller; a technique used to take advantage of an anticipated price decline. To effect a short sale, the seller borrows securities from a third party in order to make delivery to the purchaser. The seller returns the borrowed securities to the lender by purchasing the securities in the open market. If the seller can buy that stock back at a lower price, a profit results. If the price rises, however, a loss results. A short seller must generally pledge other securities or cash with the lender in an amount equal to the market price of the borrowed securities. This deposit may be increased or decreased in response to changes in the market price of the borrowed securities.

Fund of Funds (FOF) invest with multiple managers through funds or managed accounts. The strategy designs a diversified portfolio of managers with the objective of significantly lowering the risk (volatility) of investing with an individual manager. The Fund of Funds manager has discretion in choosing which strategies to invest in for the portfolio. A manager may allocate funds to numerous managers within a single strategy, or with numerous managers in multiple strategies. The minimum investment in a Fund of Funds may be lower than an investment in an individual hedge fund or managed account. The investor has the advantage of diversification among managers and styles with significantly less capital than investing with separate managers.

FOF: Conservative: FOFs classified as “Conservative” exhibit one or more of the following characteristics: seeks consistent returns by primarily investing in funds that generally engage in more “conservative” strategies such as Equity Market Neutral, Fixed Income Arbitrage, and Convertible Arbitrage; exhibits a lower historical annual standard deviation than the HFRI Fund of Funds Composite Index. A fund in the HFRI FOF Conservative Index shows generally consistent performance regardless of market conditions.

FOF: Diversified: FOFs classified as “Diversified” exhibit one or more of the following characteristics: invests in a variety of strategies among multiple managers; historical annual return and/or a standard deviation generally similar to the HFRI Fund of Fund Composite index; demonstrates generally close performance and returns distribution correlation to the HFRI Fund of Fund Composite Index. A fund in the HFRI FOF Diversified Index tends to show minimal loss in down markets while achieving superior returns in up markets.

FOF: Market Defensive: FOFs classified as “Market Defensive” exhibit one or more of the following characteristics: invests in funds that generally engage in short-biased strategies such as short selling and managed futures; shows a negative correlation to the general market benchmarks (S&P). A fund in the FOF Market Defensive Index exhibits higher returns during down markets than during up markets.

FOF: Strategic: FOFs classified as “Strategic” exhibit one or more of the following characteristics: seeks superior returns by primarily investing in funds that generally engage in more opportunistic strategies such as Emerging Markets, Sector specific, and Equity Hedge; exhibits a greater dispersion of returns and higher volatility compared to the HFRI Fund of Funds Composite Index. A fund in the HFRI FOF Strategic Index tends to outperform the HFRI Fund of Fund Composite Index in up markets and underperform the index in down markets.