The Hindu Business Line : To know a hedge fund when you see it

"Vikram Pandit and John Havens, former top executives at Morgan Stanley, have raised at least $2 billion for a new hedge fund that probably will begin operations next month," says www.bloomberg.com in a story dated March 16.

"Hedge funds, which cater to wealthy investors and institutions, returned 9.3 per cent in 2005, down from an average of 16 per cent a year in the 1990s, according to Chicago-based Hedge Fund Research Inc," notes the report.

"There were 2,073 funds started last year, up 44 per cent from 2004. Hedge-fund assets have more than doubled since 2000 to $1.1 trillion. There were 8,661 funds worldwide at the end of last year," are more statistics from Bloomberg.

"The first known hedge fund was created by Alfred Winslow Jones in 1949," informs Stuart A. McCrary in Hedge Fund Course, from Wiley (www.wiley.com). The book presents "all the technical and quantitative knowledge necessary to understand hedge funds," apart from providing "an extensive survey of the hedge fund management business."

A `typical definition' of hedge fund is: "A loosely regulated investment company that charges incentive fees and usually seeks to generate returns that are not highly correlated to returns on stocks and bonds." It is not as if you know a hedge fund when you see it, because there are no firm lines separating hedge funds from other investments such as `private equity partnerships, venture capital funds and real estate partnerships'.

In a recent interview (Business Line, March 12), Aswath Damodaran had opined that `disguised hedge funds' must already be operating in India. "No fund will call itself a hedge fund, but there will be 15 acronyms for hedge funds and they will all be in the market anyway," he'd said.

Though hedge funds defy neat categorisation, McCrary groups them into equity, fixed income and other. In the `other' are global macro hedge funds (which have `some of the highest returns of all hedge fund strategies'); currency hedge funds that `take strategic positions in a variety of currencies'; and funds of funds that invest in other hedge funds.

The author classifies hedge fund investors into individuals, endowments, pensions, family offices, trusts, foundations, banks and insurance companies. Individuals are "an important group to understand for marketing, investment policy, tax reporting, and public policy." Among these are the high-net-worth ones, with income of at least $200,000 or assets of $1 million. The semi-affluent (with net worth between $500,000 and $1 million) control `between $6 trillion and $8 trillion in assets'! What are the different hedge fund investment techniques? One is `long/short equity', in which the hedge fund picks up sectors and stocks `based on either fundamental or technical valuation'. Another is `event driven — merger arbitrage'; this anticipates a takeover attempt, buys `the target of a rumoured or announced merger' and sells short the acquirer company shares.

"When a hedge fund has investors from many different countries, it is usually efficient to organise the fund in a low-tax or no-tax domicile. This is a tax avoidance strategy but it is not a tax evasion strategy," explains McCrary, in a chapter on `hedge fund business models'. With the help of diagrams, he explains the distribution between assets, liabilities and equity in the fund balance-sheet, before and after loss.

Read about SPAN (standardised portfolio analysis of risk) in the `leverage' topic. "SPAN margin equals the largest likely loss on the entire position for a one-day horizon." The chapter on `performance measurement' helps with calculating and averaging returns, and measure investment risk.

`The most common measure of portfolio risk' is standard deviation. `Downside deviation' omits `favourable deviations', because "most investors worry less about very good performance than very bad performance". Drawdown is a measure of `cumulative loss from the previous high-water mark'.

Investors may like to know answers to questions such as: `How long did it take to recover the largest monthly loss?' And `What is the longest period of time that a drawdown persisted?' Sharpe, Sortino and Treynor ratios, and Jensen's Alpha are other performance measures. There are chapters on accounting, legislation, taxation, risk management, marketing, and derivatives, all in the context of hedge funds. The `brave new hedge fund world' that McCrary foresees "may make no distinction between the traditional money management business and the hedge fund industry". Such a `merger to the mainstream' may augur well for `stronger financial markets and better-managed portfolios', provided there is `constructive oversight from government regulators'. Bankable read.

BookValue@TheHindu.co.in