Understanding Hedge Funds: Strategies, Risks, and Regulation

1. Veritas Financial Group Introduction to the Financial Universe Week 4– Hedge Funds

2. cash Corporation Investors securities reinvest Secondary markets dividends, etc. Cash flow tax Government Review from last week /Today’s focus Today’s discussion

3. Today’s Agenda – Hedge Funds • What is shorting? What is going long? • What is a Hedge Fund? • What types of Hedge Funds are there? • What role does leverage play? • What causes Hedge Fund blow-ups? • Does the government regulate HFs? • What is it like to work for an HF?

4. Going Long • Buy a stock/bond • Profit when you buy at $5 and sell at $10 • Implies that you have a positive outlook • Also referred to as being ‘bullish’ on a stock • I.e. “I’m really bullish on Wal-Mart”

5. Shorting Stock • Sell a stock/bond • Profit when you enter the position at $10 and exit at $5 • To short stock, borrow shares from a broker, sell them into the market • To exit, you buy them back at a (hopefully) lower price, return them to the broker and keep the profit

6. Why might you short a stock? • Express a negative outlook • Think that the stock will go down • Referred to as being ‘bearish’ on a stock • i.e. “I’m super beared up on Wal-Mart” • Hedging • Own $100 of Wal-Mart • Short $20 of Wal-Mart • Have “Net Exposure” of $80

7. Hedge Fund vs. Mutual Fund • Investment vehicles that deploy capital using various strategies in the global public markets.

8. What types of HFs are there?

9. Equity Long-Short Hedge Funds • Conduct “fundamental” analysis on companies • Evaluate business fundamentals • Revenues, earnings, free cash flow • Make projections into the future • Results in a ‘fair market value’ • Buy the companies thought to be undervalued • Short the companies thought to be overvalued

10. Event Driven/Arbitrage Funds • Strategies take advantage of inefficiencies in pricing • Example: One company trades on two different exchanges. The prices are not equal. Short the higher-priced security and buy the lower-priced security. Close the trade when prices converge. • Example: Target is currently trading at $30. Buyer issues a tender offer for Target at $40 per share. Target jumps to $35. Merger Arbitrage Hedge Fund buys lots of shares at $35, anticipating the shares will go up to $40. • Challenge: What does the market think the odds are that the deal will close?

11. Macro Funds • Strategies that seek to identify and profit from global trends • Macro funds don’t look at the ‘fair value’ of a single stock, but rather take positions in global currencies, fixed income, commodities, equity indices • Involves analysis of government data (GDP growth, unemployment trends, productivity numbers, monetary policy, political changes, etc.) • Example: The Federal Reserve meeting is next week and unemployment numbers have been disappointing. Will the Fed lower interest rates more than the market thinks? • Yes: Buy the S&P • No: Buy the USD

12. “Quant” Funds • Discretionary Hedge Fund • Individual analysts conduct research • Buy/sell decisions are made by an individual (a Portfolio Manager) • Discretionary funds tend to be more concentrated and can have longer holding periods • Systematic Hedge Fund (“Quant”) • Rather than have analysts conduct research, these hedge funds identify trends in the market • Buy/sell decisions are made by an algorithm • Quant funds tend to hold a lot of positions and can trade more frequently

13. What role does leverage play? • Leverage puts you in the “tails” • You have $10. You borrow $10 and buy $20 worth of stock. Stock goes up 50% and is worth $30. You sell, pay the debt, and now have $20. • 2x levered. 50% return on stock = 100% return. • Same example, but stock goes down 50% and is worth $10. You sell, pay the debt, and have $0. • 2x levered. -50% return on stock = -100% return.

14. Some famous HF blow-ups • Bernie Madoff – Not really a hedge fund • Ponzi Scheme – Using new investors’ money to pay out withdrawals from current investors. • Basically, he said he was just smart, and everyone believed him. • Long-Term Capital Management • Extreme leverage + Russian debt default + Asian currency devaluation = spectacular failure • Bear Stearns Structured Credit • Extreme leverage + Freefall in housing prices = spectacular failure

15. Government regulation of HFs • Hedge Funds can be very secretive • Why? Their trading and investment strategies are proprietary. • HFs do not have to disclose their current positions or trades on a regular basis. • Have to disclose holdings in stocks at the end of every quarter in a “13F” filing • How should they be regulated?

16. Working for a Hedge Fund • There are only two ways to gain an edge in investment management: • Have better information than the competition • Interpret information better than competition • Fundamental analysis requires a solid understanding of how companies work • Investment Banking experience is often a path into a hedge fund • Portfolio management and more active strategies require an ability to trade markets • Working on a prop desk, or equity capital markets and debt capital markets can help develop ‘market sense’

17. Big names in Hedge Funds D.E. Shaw/ Citadel/ Fortress/ SAC Capital/ Greenlight Capital

18. Hedge Fund Universe