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Veritas Financial Group. Introduction to the Financial Universe Week 4– Hedge Funds. cash. Corporation. Investors. securities. reinvest. Secondary markets. dividends, etc. Cash flow. tax. Government. Review from last week /Today’s focus. Today’s discussion.
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Veritas Financial Group Introduction to the Financial Universe Week 4– Hedge Funds
cash Corporation Investors securities reinvest Secondary markets dividends, etc. Cash flow tax Government Review from last week /Today’s focus Today’s discussion
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?
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”
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
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
Hedge Fund vs. Mutual Fund • Investment vehicles that deploy capital using various strategies in the global public markets.
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
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?
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
“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
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.
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
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?
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’
Big names in Hedge Funds D.E. Shaw/ Citadel/ Fortress/ SAC Capital/ Greenlight Capital
