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DISCLAIMER
Material contained in this publication is a summary only, and is based on information believed to be reliable from sources within the market. The opinions contained in this publication are and must be construed solely as statements of opinion, and not statements of fact or recommendations to purchase, sell or hold any securities. It is not the intention of the Canadian Chapter of the Alternative Investment Management Association (AIMA Canada), that this publication be used as the primary source of readers information, but as an adjunct to their own resources and training. No representation is given, warranty made or responsibility taken as to the accuracy, timeliness or completeness of any information or recommendation contained in this publication. AIMA Canada will not be liable to the reader in contract or tort (including for negligence), or otherwise for any loss or damage arising as a result of the reader relying on any such information or recommendation (except in so far as any statutory liability cannot be excluded). This publication has been prepared for general information without regard to any particular persons investment objective, financial situation or needs. Accordingly, no recommendation (express or implied) or other information should be acted on without obtaining specific advice from an authorized representative. Any figures are purely estimates and may vary with changing circumstances. Also, past performance is not indicative of future performance. AIMA Canada gratefully acknowledges the work done by ASSIRT and AIMA Australia in producing their publication on hedge funds. A number of AIMA Canada members have extended considerable time and effort in preparing this document, and their valuable input is acknowledged at the end of this document.
| Preface |
Table of Contents
SECTION 1: THE HEDGE FUND INDUSTRY . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1. History of the Hedge Fund Industry 1.2. Size of the Hedge Fund Industry 1.3. Typical Hedge Fund Investors 1.4. Canadian Hedge Fund Landscape
SECTION 6: GLOSSARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 APPENDIX I: AIMA CANADA MEMBERS . . . . . . . . . . . . . . . . . . . . . . . . . . 43 APPENDIX II: ADDITIONAL READING AND WEBSITES . . . . . . . . . . . . . . . . 44
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| Preface |
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Number of Funds
Source: Hedge Fund Research, Inc. (Actual dollars under management and number of funds).
Figure 1.2 highlights that FOFs represented approximately 35% of the total assets invested in hedge funds at the end of 2003. While hedge fund assets in total had a compound annual growth rate (CAGR) of 20% over the three years to December 2003, FOFs assets had a CAGR of 40% for the period.
FIGURE 1.2: GROWTH IN HEDGE FUNDS AND FUND-OF-FUNDS (FOFS) (3 YEARS TO END 2003) US$ Billion 1,000 3-year CAGR was 20% for the industry
800
$775
600 $450 400 $370 200 $80 (FOFs) December 2000 December 2003 $280 (FOFs) $495 Hedge fund-of-funds (FOFs) now represent 35% of hedge fund investments, and have grown at 40% for the last 3 years
In their 2003 Hedge Fund Investor Survey, the Hennessee Group reported that the largest investors in hedge funds in the US were individuals and family offices, representing 47% of capital in the industry. The amount of total assets these investors were willing to allocate to hedge funds increased, reaching an average 28% at the time of the survey. Further, just over half of these investors planned to increase their hedge fund allocation, with 55% of respondents seeking to increase exposure in 2003.v In March 2004, Merrill Lynch and Cap Gemini Ernst & Young reported that as at December 2003, 73% of high-net-worth investors (HNWIs) in the US (i.e., those with investable assets in excess of US$1 million) held hedge fund investments. Moreover, the popularity of these funds is not expected to wane any time soon, given HNWIs desire to balance their portfolio returns over the long term. vi
Investor Economics conducted a study of the Canadian hedge fund landscape in 2003, which focused primarily on individual investors in Canada. While the number of hedge funds in Canada is small relative to the 6,000+ funds globally, Figure 1.4 highlights that there has been significant hedge fund growth in Canada from December 1999 to date, both in assets and in the number of domestic funds available to Canadian investors.viii
FIGURE 1.4: CANADIAN HEDGE FUND MARKET INDIVIDUAL INVESTORS (JUNE 2003) Growth in Hedge Fund Assets: CAGR Dec 1999-Jun 2003: 33.0% YTD Jun 2003: 21.8% $5.5 144 Funds $3.9 $3.0 $2.5 71 Funds 46 Funds 107 Funds $6.7 156 Funds
December 1999 December 2000 December 2001 December 2002 June 2003 Number of Funds Source: Investor Economics, Fall 2003 Assets in Billions of Dollars (US$)
Generally, Canadian individual investors have favoured guaranteed FOFs-linked notes backed by highly rated international banks. These note structures provide a principal-repayment feature and a low minimum investment. Institutional investors have also favoured FOFs as a first-time hedge fund investment. In fact, more than one third of the assets in the Canadian market are invested in FOFs. However, large institutional investors in Canada have also invested in single-strategy hedge funds. The number of Canadian hedge fund managers continues to grow, and as of March 2004, there were at least 14 Canadian single-strategy hedge fund managers with more than US$100 million in assets under management.ix Also, while many international FOFs are actively marketed in Canada, there are a number of high-quality Canadian-based FOFs, a few of which manage more than US$1 billion. Another interesting feature of the Canadian industry is the number of Canadian hedge fund managers that have a presence offshore. Despite their size, many Canadian managers already have offshore structures in the Bahamas, Ireland, and the Cayman Islands, among others. These managers recognize that an offshore structure is beneficial in attracting capital from internationallybased institutional investors outside of Canada. A growing number of Canadian managers have distribution and research activities outside of Canada, with offices located in countries such as the US, UK and Switzerland.
Hedge funds can be marketed in one or both of the following markets: _ The exempt market, which refers to high-net-worthx and institutional investors. _ The retail market, which refers to the general investing public. The retail market is subject to numerous regulations intended to provide investor protection, which restrict the type of products that can be offered. However, since the exempt market is not subject to the same type of regulation, numerous product structures can be used to service this market. Product Offerings for High-net-worth and Institutional Investors (Exempt Market): Hedge fund offerings restricted to the exempt market are often structured as managed accounts or pooled funds. A managed account allows a hedge fund manager to invest on behalf of investors according to the terms of an investment management agreement between the parties. One of the drawbacks of a managed account is that it requires a large investment (e.g., $50 million), in order to implement the particular trading strategies agreed upon by the parties. For example, a managed account may be used by a multi-strategy, multi-manager FOFs. An alternative is to invest with other investors on a pooled basis in a fund established by the hedge fund manager. Such pooled funds are usually structured as limited partnerships or trusts. Another alternative in the exempt market is to use derivatives to obtain exposure to an underlying hedge fund. Product Offerings for the General Investing Public (Retail Market): Regulatory restrictions apply to hedge funds offered to the retail market. These restrictions include the need for a prospectus, and prohibitions or restrictions on certain investment strategies. If a hedge fund permits redemption of its securities at the net asset value, it may be a mutual fund under securities law. Mutual funds sold to retail investors are subject to rules that prohibit the use of leverage or short selling by the fund manager. However, commodity pools are an exception, since they are considered a special type of mutual fund that can use leverage and engage in short selling using derivatives. Unlike conventional mutual funds, commodity pools must be sold pursuant to a long-form prospectus, and there are additional requirements for mutual fund salespersons that sell them. In order to avoid the mutual fund investment restrictions, a hedge fund may be structured as a closed-end fund (i.e., redemptions by the fund, if any, are not more frequent than once a year). Closed-end funds can be offered to retail investors by prospectus but are not subject to the investment restrictions applicable to mutual funds. In order to provide liquidity to investors, closed-end funds are often listed on the Toronto Stock Exchange (TSX). This listing also allows retail investors to gain access to the fund through the secondary market. Structured notes are also a popular structure that is not subject to the restrictions of securities law. These products provide investors with exposure to the returns of one or more hedge funds, and a return of principal on maturity that is guaranteed by a Schedule I or II bank in Canada. Retail investors can also gain exposure to hedge funds through segregated funds offered by insurance companies, since segregated funds are not subject to the mutual fund investment restrictions.
Disclosure: Hedge funds in Canada are sold primarily in the exempt market (i.e., without a prospectus). There are three commonly used prospectus exemptions: the minimum investment exemption, the accredited investor exemption and the offering memorandum exemption. 1. Minimum Investment Exemption: The minimum investment exemption allows hedge funds to sell their securities without a prospectus to investors who make a prescribed minimum investment. The prescribed minimum investment is not the same in all provinces and territories (ranges from $97,000 to $150,000), and there are also specific restrictions in each jurisdiction. 2. Accredited Investor Exemption: A prospectus exemption for accredited investors is available in a number of Canadian jurisdictions. An accredited investor is defined broadly to cover many different entities including pension funds, trust companies and corporations with net assets of at least $5 million. Individuals may be accredited investors if they own (alone or together with a spouse) financial assets exceeding $1,000,000, or if they have net income before taxes exceeding $200,000 (or $300,000 if combined with that of a spouse) in each of the two most recent years and have a reasonable expectation of exceeding the same net income level in the current year. Once again, the rules are not consistent in all jurisdictions. 3. Offering Memorandum Exemption: A number of jurisdictions provide an exemption from the prospectus requirement if the issuer delivers an offering memorandum to investors in the prescribed form and within the prescribed time. An offering memorandum may also be the primary disclosure document provided to investors in conjunction with either the minimum investment exemption or the accredited investor exemption. An offering memorandum provides investors with a right of action for rescission or damages against the issuer, if there is a misrepresentation in the offering memorandum. It is possible that securities regulators may deem any kind of offering materials provided to prospective investors as an offering memorandum. This could occur if the offering materials fall within the definition of an offering memorandum in the applicable securities legislation. Reporting: Once a hedge fund in Canada completes the sale of securities pursuant to a prospectus exemption, a report of trades must be completed and filed with the appropriate regulators. A report of trades sets out the name and address of the issuer (or seller), the name of the investor(s), a description of the securities, the date of the trade(s) and the particulars of the trade(s), such as the number of securities sold and the purchase price. The deadline for filing such reports varies across the country. In order to address this issue, it is possible to request exemption orders to co-ordinate the filing obligations. Most of the provinces and territories require a fee for filing a report of trades. Most fees are flat fees but some set maximum filing fees based on a percentage of the gross value of the securities distributed pursuant to the exemption. Financial Statements: Although hedge funds that are not sold pursuant to a prospectus are not reporting issuers under securities law, they may still have financial statement reporting obligations. Some jurisdictions require that funds established under local law must file interim and annual financial statements, even if they do not distribute securities pursuant to a prospectus. Statements must be filed in electronic format on the System for Electronic Document Analysis and Retrieval (SEDAR). Once filed on SEDAR, the financial statements are available to the public on the Internet. Regulators have granted exemptions from this filing requirement. The exemptions are subject to a number of conditions, which include retaining the financial statements indefinitely and providing them to regulators upon request. Privacy: Hedge funds are subject to applicable provincial or federal privacy legislation with respect to information about their investors. Privacy legislation addresses the collection, use, disclosure and disposal of personal information.
Money Laundering and Terrorist Financing: Hedge fund managers must comply with applicable reporting requirements of anti-money laundering and anti-terrorist financing legislation. Suspicious or large cash transactions must be reported to the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC). Registered advisers or dealers are also required to make monthly reports to securities regulators, stating whether they have had any dealings with persons on official lists of terrorists.
SERVICE PROVIDERS
Canada has a mature and established financial services industry. There are many domestic prime brokers offering custodial, brokerage, stock-lending and on-line portfolio services. Back-office fund administration, legal and accounting firms, including most of the large global franchises, are all active in the Canadian hedge fund industry. Many of these firms are members of AIMA Canada, and are listed in Appendix I. Many Canadian accounting and legal firms have representation internationally to support managers that have both domestic and offshore fund structures. This one-stop-shop approach works well for master-feeder structures used by many Canadian hedge fund managers. The centres for these support firms are mainly in Toronto, Montreal and Vancouver. Canada also has a number of well-established stock exchanges, with the TSX being the largest and most established. In addition, Canada has an active futures and derivatives exchange in the Montreal Exchange (ME). Many Canadian hedge fund managers actively trade on both the TSX and the ME, and are also active in the US markets. Since Canada is ranked as one of the worlds foremost adopters of technology per capita, a connection to most global markets is possible from nearly every major centre in the country. As discussed, hedge fund managers targeting retail investors (i.e., non-accredited investors) have offered hedge funds and FOFs through structured products and listed closed-end funds on the TSX. The majority of hedge fund products for individuals are sold though the major brokerage houses owned by the five major Canadian banks, along with several large insurance companies and nonbank-owned mutual fund dealers. A common electronic distribution platform (FundSERV) connects most Canadian fund distributors to Canadian hedge fund managers.
Characteristic
1. Return Objective 2. Benchmark 3. Investment Strategies
Traditional Investing
Relative returns Constrained by benchmark index Limited investment strategies Take long-only positions Do not use leverage High correlation to traditional asset classes Dependent on market direction Tied to assets under management, not to performance Manager may or may not co-invest alongside investors Good liquidity
7. Managers Investment
8. Liquidity
9. Investment Size
Usually large minimum investment size (e.g., $25,000 minimum; depends on prospectus exemption) Set up as a private investment, limited partnership or a trust Usually sold by offering memorandum Less regulated; no restrictions on strategies Less mandated disclosure, and limited or no position level and risk exposure transparency Marketing restrictions apply Prospectus exemption
10. Structure and Documentation Set up as a trust or investment company Often sold by prospectus 11. Regulation Highly regulated; restricted use of short selling and leverage High disclosure and transparency Can market fund publicly
For purposes of illustration, Figure 2.1 compares the quarterly returns of equity hedge funds (long/short managers), the average return of all Canadian equity funds (long-only managers), and the equity market return (S&P/TSX Index) for the 4 years to December 31, 2003. The chart shows that returns generated by equity hedge funds deviated substantially from the returns of the S&P/TSX and Canadian equity funds, which generally moved in the same direction during this period. (Note: The returns are in local currency: the HFRI Equity Hedge Index is in US$ and the S&P/TSX and Median Cdn. Equity Fund Indices are in C$.)
FIGURE 2.1: QUARTERLY RETURNS OVER 4 YEARS TO DECEMBER 31, 2003 EQUITY HEDGE FUNDS AND EQUITY MARKET RETURNS
15%
10%
5% R e tu r ns %
0%
-5%
-10%
-15% March June 2000 2000 Sept. 2000 Dec. 2000 March June 2001 2001 Sept. 2001 Dec. 2001 March June 2002 2002 Sept. 2002 Dec. 2002 March June 2003 2003 Sept. 2003 Dec. 2003
S&P/TSX
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Investor Fund Administrator Processes the subscriptions and redemptions. Calculates the value of investors holdings (NAV or partnership shares). Hedge Fund Custodian Holds the funds assets. Monitors and controls the capital flows to meet margin calls.
Hedge Fund Manager Sets and manages the funds investment strategy.
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Low Correlations with Traditional Asset Classes: A wide range of hedge fund strategies have low or even negative correlations with traditional asset classes, such as stocks and bonds. Many hedge fund strategies also have low correlations with each other. Therefore, hedge funds can provide valuable diversification benefits. Leverage: Varying amounts and types of leverage are used in most hedge fund strategies. Many relative value strategies (non-directional) tend to use higher leverage than directional strategies. Capacity Constraints: While hedge funds can stay open to new investment for many years, some hedge funds may close to new investors, because they wish to limit their size to preserve investment returns. FOFs managers will often reserve capacity with selected managers to allow their investors to continue participating in the underlying funds. Transparency: Many FOFs managers do not disclose the names and/or the positions of their underlying hedge funds to investors. Similarly, many single-strategy hedge fund managers do not disclose their holdings to fund investors. Position level transparency (i.e., disclosure of the funds underlying holdings) and/or risk transparency (i.e., disclosure of the funds overall risk parameters) is currently a key issue in the hedge fund industry. Investment Minimums: Since hedge funds are sold primarily in the exempt market (i.e., without a prospectus), there are high minimum investments, which are typically between $97,000 and $150,000, depending on the province or territory in which they are sold. Note that hedge fund companies can set their own minimum investment levels for accredited investors, which is typically $25,000. Income Distributions and Taxes: The income distributions from hedge funds differ depending on the hedge fund structure (i.e., whether it is a limited partnership or a trust). Investors should understand the tax implications of any distributions, and consult a tax professional prior to investing in hedge funds.
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Low Non-directional
Market Exposure
High Directional
1. Relative Value
2. Event Driven
3. Opportunistic
Convertible Arbitrage
Merger (Risk)Arbitrage
Fixed-income Arbitrage
Global Macro
Equity Market-neutral
Managed Futures
Emerging Markets
Note on Strategy Explantions and Examples: The explanations and examples of the different hedge fund strategies in the document have been simplified in order to convey the key concepts to the reader. For a more detailed, technical explanation of the different hedge fund strategies, refer to the bibliography in Appendix II at the end of the document.
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Assume a fund manager believes a convertible bond is undervalued relative to its component parts. Managers Actions and Profit Opportunity: The manager buys the convertible bond (goes long the bond) and shorts the stock of the same issuer to eliminate the stock-price risk embedded in the convertible bond. The manager typically expects to generate a profit on the trade based on the stock prices volatility.
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A basis trade is an example of a fixed-income arbitrage strategy. This trade involves the purchase or sale of an interest-rate futures contract and a concurrent offsetting sale or purchase of a fixedincome security that is deliverable under the futures contract. Managers Actions and Profit Opportunity: Assume a hedge fund manager simultaneously buys a government bond and sells a bond futures contract on this bond. The manager may profit from the: 1. Uncertainty regarding the bond to be delivered under the bond futures contract. 2. Shifts in the supply and demand for the underlying bonds.
An example of a typical equity market-neutral trade is a pairs trade in two listed companies of similar size and geography in the same industry. This strategy involves buying one companys stock and selling short the stock of another company in the same sector. Managers Actions and Profit Opportunity: The manager: Buys $100,000 of shares in Company A in sector X. Sells short $100,000 of shares in Company B in sector X. The manager expects Company As stock to rise in price relative to Company Bs stock. The manager does not take market or sector risk, but instead tries to profit from differences in company-specific performance.
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In mergers where the target companys shareholders are offered stock in the acquiring company, the spread is the difference between the current values of the target companys stock and the acquiring companys stock. The spread is captured where the arbitrageur buys the stock of the target company (Company B) and sells the stock of the acquiring company (Company A). Managers Actions and Profit Opportunity: Table 3.1 provides an overview of the hedge fund managers actions and the profit opportunity (Actions 1-6). A key risk of this strategy is deal risk, since the merger may not be completed as planned.
Action
Company A (Acquirer)
Company B (Target)
Company B is the target The offer is at a 20% premium of Company Bs current market price Company Bs stock price appreciates by 10% Company Bs stock price will rise Manager buys Company Bs stock
1. Takeover Announcement: Company A is the acquirer 2. Offer: Company A makes an offer to acquire Company B
3. Markets Reaction:
4. Managers Expectation: Company As stock price will decline or remain flat 5. Managers Response: 6. Position Will Profit If: Manager sells short Company As stock
Takeover completed successfully and stock prices converge, so that Company As stock price declines and/or Company Bs stock price rises. OR Another suitor, Company E (the new acquirer) makes a bid for Company B (the target) for a higher price than offered by Company A. The manager then switches the short position from Company A to Company E.
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The following is an example of a typical distressed securities scenario (cross reference the numbered steps below to Figure 3.2): 1. A financial institution (Finance Co.) makes a loan of $10 million to a borrower (Tel Co.). Tel Co. uses the funds to restructure the company and/or to repay some of its debt. 2. Tel Co. then finds itself in financial difficulty, resulting in bankruptcy or near-bankruptcy. 3. Tel Co. defaults on its debt, resulting in a decrease in the loans value. Managers Actions and Profit Opportunity: 4. A hedge fund manager specializing in distressed securities analyzes the situation for possible investment, either in the companys debt or equity. 5. The hedge fund considers the following types of questions: _ Does the business have long-term value? _ Is the company having problems, such as over-leveraging, which can be rectified? _ Are the companys operating metrics declining? _ What class of debt will have the highest priority in the restructuring? If the cost-benefit analysis of the distressed company appears favourable, the hedge fund then makes either a passive or an active investment. The managers goal is to buy the distressed securities at a deep discount and sell them at a significantly higher price, which is usually after an extended period of restructuring. A key risk of this strategy is that the company goes bankrupt and does not recover after a restructuring.
FIGURE 3.2: DISTRESSED SECURITIES EXAMPLE
Loan of $10 million issued. Tel Co. uses financing to repay debt and to restructure. Tel Co. (Borrower) Tel. Co defaults on loan repayments to Finance Co. Tel Co. then has financial difficulty and files for bankruptcy. Hedge Fund Manager Finance Co. (Lender)
& Hedge fund manager buys core position of debt or equity in Tel Co. Passive Investment Buy debt or equity at a discount and wait for appreciation. Active Investment Buy debt or equity at a discount and become actively involved in restructuring/refinancing to influence process to funds advantage.
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Managers with a long bias take both long and short equity positions, depending on their market outlook. Portfolios may shift between small-, medium- and large-capitalization stocks, and across sectors within a particular market. Managers Actions and Profit Opportunity: Table 3.2 provides an example of a managers typical positions in a long-bias equity hedge fund portfolio that trades within and across sectors. The portfolio has a long exposure of 60%, with 42% held in short positions, which results in a gross exposure of 102% (60% long + 42% short = 102%), and a net long exposure of 18% (60% long - 42% short = 18% net long). Ideally, the manager expects to profit from both the long and short positions in the portfolio. However, this strategy is exposed to equity market risk as the portfolio has a net long exposure. Further, the strategy has stock selection risk.
Industry Sector
Banking
Position
Long Short Long Long Short Long Short
Stock
Bank 1 Bank 2 Bank 3 Tech. Co. 1 Tech. Co. 2 Department Store 1 Department Store 2
Technology
Up Down
Consumer Discretionary
Up Down
Total Long Positions in Portfolio Total Short Positions in Portfolio Net Portfolio Exposure
(1) Note: The percentages used are for illustrative purposes only, where 100% of the portfolio is invested in stocks. In reality, a long-bias equity hedge fund portfolio is more diversified, and is not concentrated with such large weightings in each stock.
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A manager will attempt to exploit global trends and market movements by entering into leveraged directional positions. Assume a global macro manager expects interest-rate spreads between Canada and the US to widen due to interest rate increases in Canada. Managers Actions and Profit Opportunity: The fund manager takes a position to buy the Canadian dollar (and sell the US dollar) with the expectation that the Canadian dollar will rise against the US dollar following an increase in Canadian interest rates. The risk of this strategy is that the Canadian dollar may depreciate against the US dollar.
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FIGURE 3.3: BREAKDOWN OF GLOBAL HEDGE FUND ASSETS BY STRATEGY AS AT DECEMBER 1990
Relative Value Arbitrage 10.1% Equity Hedge 5.3% Event-driven 3.8% Fixed Income (Total) 3.2% Distressed Securities 2.4% Equity Market-neutral 1.7% Other 1.0% Source: Hedge Fund Research, Inc.
Figure 3.4 shows the strategies that currently dominate the hedge fund industry (as at December 2003). Global macro funds had a significant decline in market share from 71.0% in 1990 to 18.7% by the end of 2003. This decline reflects outflows from global macro funds following the strategys poor performance (particularly in 1994 and 1998), and the closure of a small number of dominant global macro managers in the industry. Equity hedge strategies increased in market share from 5.3% in 1990 to 25.1% by the end of 2003. Also, event-driven strategies increased from 3.8% to 11.9%, while equity market-neutral funds increased from 1.7% to 2.5% for the period. Other significant changes for the period include an increase in convertible arbitrage strategies from 0.5% to 5.9%, an increase of relative value strategies from 10.1% to 14.7%, and an increase in the total fixed income strategies from 3.2% to 7.6%.
FIGURE 3.4: BREAKDOWN OF GLOBAL HEDGE FUND ASSETS BY STRATEGY AS AT DECEMBER 2003
Event-driven 11.9% Fixed Income (Total) 7.6% Other 6.9% Global Macro 18.7% Relative Value Arbitrage 14.7% Convertible Arbitrage 5.9% Distressed Securities 3.5% Equity Market-neutral 2.5% Merger Arbitrage 1.7% Emerging Markets 1.6% Equity Hedge 25.1% Source: Hedge Fund Research, Inc
FIGURE 3.5: BREAKDOWN OF CANADIAN SINGLE-STRATEGY HEDGE FUND ASSETS (JUNE 2003)
Convertible Arbitrage 9.2% Event-driven 10.3% Managed Futures 17.3% Equity Hedge 41.0% Equity Market-neutral 8% Opportunistic 5.8% Other Relative Value 5.6% Other 2.9%
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| Section 3
Hedge fund investors must consider a funds degree of exposure to broad market movements, and its effect on the funds risk and return. Hedge funds are generally constructed with specific targets and strategies, where investors expect a certain risk/return profile.
Equity Hedge Event Driven Con. Arb Global Macro S&P 500 S&P/TSX
MSCI EAFE
Short Selling 20
25
Note: All figures in US$, except S&P/TSX Composite and SC Universe Indices, which are in Cdn $. Source: Hedge Fund Research, Inc., CSFB/Tremont, and TD Securities Inc.
Figure 4.1 highlights that the risk/return characteristics of hedge fund strategies differ substantially from each other, and from traditional bond and equity markets. For example, the S&P 500 Index earned the highest return with a similar risk level to the other equity market indices (i.e., close to 15% volatility). A number of hedge fund strategies earned returns in line with North American equity markets, but achieved them with lower risk. These include event-driven, convertible arbitrage and equity market-neutral strategies. Short selling earned the lowest return at the highest risk level of the hedge fund strategies analyzed. (Note: It is difficult to consistently outperform trading a strategy that relies on falling stock prices, as markets have generally risen over time.) Note that a large number of hedge fund strategies earned higher returns than Canadian bonds (Scotia Capital Universe Index [SCU]). The trade-off for these higher returns was often higher volatility, albeit with lower volatility than equities.
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The HFR Fund of Funds Composite Index (FOFs in Figure 4.1) is in the middle of the risk/return range for hedge fund strategies and broader market indices. The FOFs risk/return profile highlights the diversification benefits that can be achieved using a range of hedge fund strategies. Note that the HFR Index includes a number of FOFs, each with unique risk, return, correlation, and strategy characteristics.
-5
R e t u r n (% )
-10
-15
-20
-25
Convertible Arbitrage Aug 98 Short Selling Feb 00 Emerging Markets Aug 98 Equity Marketneutral Aug 98 Eventdriven Aug 98 Fixedincome Arbitrage Sept 98 Global Macro Feb 94 Equity Hedge Aug 98 Managed Futures Sept 95 S&P 500 Aug 98 MSCI World Aug 98 S&P/TSX Aug 98
Note: All figures in US$, except S&P/TSX Composite Index, which is in Cdn $. Source: Hedge Fund Research, Inc., CSFB/Tremont, TD Securities Inc.
As Figure 4.2 highlights, all hedge fund strategies and equity market returns have had at least one negative monthly return during the period January 1994 to December 2003. However, most hedge fund strategies have had substantially smaller negative returns than the traditional equity markets. The incidence of positive returns is generally expected to be higher with absolute return strategies. However, short-term volatility can result in negative monthly returns for hedge fund strategies.
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Counterparty Risk
Issue r Risk
Trading Risk
Gap Risk
Commodity Risk
Liquidity Risk
Systems Risk
Clearance Risk Source: Estenne (2000); in Absolute Returns: The Risks and Opportunities of Hedge Fund Investing, by A. M. Ineichen, Pages 36-37. Human Factor Risk Regulatory Risk
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2. Event Driven
1. Merger Arbitrage: Deal risk/corporate event risk, equity volatility risk. 2. Distressed/High-yield Securities: Corporate event risk, credit risk, equity volatility risk, interest rate risk, liquidity risk.
3. Opportunistic
1. Equity Hedge: Equity market risk, equity volatility risk. 2. Global Macro: Equity market risk, interest rate risk, currency risk, credit risk. 3. Managed Futures: Commodity market risk, interest rate risk, currency risk, model risk. 4. Emerging Markets: Equity market risk, interest rate risk, political risk, credit risk, currency risk, liquidity risk.
In addition, it is important to consider the operational risks of hedge funds. Some of the risks of investing in hedge funds are non-quantifiable risks, such as transparency issues, key person risk, and fraud. These risks are more pronounced in hedge funds since the majority of hedge fund firms are entrepreneurial boutique finance companies.
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Relative Value Strategies 35-55% Convertible Arbitrage Fixed-income Arbitrage Equity Market-neutral
Opportunistic Strategies 20-40% Equity Hedge Global Macro Managed Futures Emerging Markets
Numerous managers are selected for different strategy allocations in the FOFs
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S&P 500
1.00 0.85 0.30 0.13 0.66 -0.13 0.38 -0.68 0.68 -0.22
MSCI World
0.85 1.00 0.27 0.13 0.67 -0.04 0.39 -0.70 0.71 -0.17
Over the past decade, the lowest correlations with equity markets occur with short selling and managed futures strategies. Equity-based strategies demonstrate the highest correlations with equity markets, notably an equity hedge strategy (long/short equity) (0.68 correlation with the S&P 500) and an event-driven strategy (0.66 correlation with the S&P 500). However, the correlations of these equity-based strategies with the US market (S&P 500) and the global market (MSCI World US$), are significantly lower than the correlation between these markets (0.85). Correlations change over time and may rise or fall in different market conditions. (Note: Many hedge fund managers often have low correlations with their respective hedge fund strategy indices.) A key question is whether hedge funds should be treated as a separate asset class, like equities or bonds. To be considered a separate asset class, the securities within an asset class should be highly correlated with each other, and these securities should exhibit the same distinct risk/return characteristics. However, this is not the case for hedge funds. Hedge funds are not a homogeneous asset class, since there is a diverse range of hedge fund strategies, and these strategies tend to have low correlations with each other. Note that one could consider a multi-strategy, multi-manager hedge FOFs as a separate asset class, like equities or bonds. We demonstrate this in the efficient frontier example in Section 5.3 below.
In order to determine the potential impact of adding hedge funds to a portfolio, a useful starting point is to assess how a portfolio would have performed historically with or without a hedge fund allocation. Figure 5.2 shows two efficient frontiers that were constructed using historical data from
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1990-2003. An efficient frontier is a two-dimensional risk-return chart showing all optimal combinations of a portfolios return and risk, given a specified set of asset classes/investment strategies. The risk is measured by the standard deviation of a particular portfolio. Efficient Frontier Curve I Traditional US Portfolio of Cash, Bonds and Stocks (Total of 100%) (EF Curve I): The EF Curve I represents an efficient frontier for the three asset classes of cash, bonds and stocks. The data is from January 1990 to December 2003 using the following indices (all data is in US$): _ Cash: Merrill Lynch 3-month T-Bill Index _ Bonds: Lehman Aggregate Bond Index _ Stocks: S&P 500 Total Return Index The optimal portfolios on EF Curve I range from 100% cash to 100% stocks. Efficient Frontier Curve II (with 20% in FOFs) Traditional US Portfolio of Cash, Bonds, Stocks (Total of 80%) and Hedge Fund-of-Funds (Total of 20% in FOFs) (EF Curve II): The EF Curve II represents an efficient frontier for the three asset classes of cash, bonds and stocks and a set 20% allocation to a hedge FOFs. (Note: The 20% allocation to hedge funds is only for illustration purposes. As stated in Section 3, we have simplified the examples in order to convey the key concepts.) _ Hedge Funds: The hedge fund data is based on the HFRI Fund of Funds Composite Index, which is from 1990-2003 (in US$). The optimal portfolios on EF Curve II range from 80% cash/20% in hedge FOFs to 80% stocks/20% hedge FOFs.
FIGURE 5.2: EXAMPLES OF EFFICIENT PORTFOLIOS: TRADITIONAL PORTFOLIO VS. FUND-OF-FUNDS (HISTORICAL DATA FROM 1990-2003) 11.5% A n n u al i z e d H i s t o r i c al R e t u r n ( % ) ( 1 9 9 0 - 2 0 0 3 ) 11.0% 10.5% 10.0% 9.5% 9.0% 8.5% 8.0% 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 0% 100% Cash 2% 4% 6% 8% 10% 12% 14% 16% 80% Cash 20% FOFs EF Curve II EF Curve I 80% Stocks 20% FOFs 100% Stocks
Historical Volatility (%) (1990-2003) Traditional Portfolio with 20% Hedge FOFs Traditional Portfolio of Cash, Bonds and Stocks
When determining a portfolios optimal asset allocation, the goal is to maximize return for a given level of portfolio risk. Portfolio optimization software can be used to determine the optimal asset allocation for a set of portfolios that provide the highest potential returns for a given level of risk. These portfolios are said to be efficient or optimized and the optimized range of portfolios is referred to as the efficient frontier. Non-optimized portfolios are inefficient since they lie below the efficient frontier (i.e., they have same risk as efficient portfolios, but with lower potential returns). As Figure 5.2 highlights, based on the historical US data from 1990-2003, the traditional portfolios along EF Curve I, which included only cash, bonds and stocks, were somewhat inefficient, since they had unnecessary risk that could have been eliminated by diversifying a portion of the portfolio into hedge funds using FOFs (EF Curve II). The goal of every investor is to construct a portfolio with the least risk and the best potential return. In other words, investors could have enhanced the efficiency of their portfolios during the period 1990-2003, had they selected a portfolio with an allocation to hedge funds along EF Curve II. Note on Efficient Frontiers and Historical Data: AIMA Canada does not recommend using historical data for either traditional asset classes or hedge funds to forecast future returns. We use the period 1990-2003 for the examples in Figure 5.2, since it is the only period for which we have available hedge fund data. Recognize that these figures represent historical data, and past performance is not indicative of future performance. Any forecasts of expected returns, risks and correlations of both traditional asset classes and hedge fund strategies, should use conservative estimates, based on a consistent, risk-anchored approach.
FIGURE 5.3: RISK/RETURN OF EQUITY-BASED STRATEGIES AND EQUITY MARKETS FOR THE 10 YEARS TO DECEMBER 31, 2003
18 16 A n n u al i z e d R e t u r n ( % ) 14 12 10 8 6 4 2 0 2 4 6 8 10 12 14 16 18 S&P 500
Equity Hedge
S&P/TSX
MSCI EAFE
Annualized Volatility (%) Note: S&P/TSX returns are in $Cdn. Source: Hedge Fund Research, Inc., TD Securities Inc.
AIMA CANADA HEDGE FUND PRIMER
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When using portfolio optimization software to make asset allocation decisions, it is best to use conservative expected risk, return and correlation forecasts for all asset classes/investment strategies. While historical data can be used as a starting point for analysis, it is essential to be conservative in any forecast. In general, it is not appropriate to use hedge fund indices (such as CSFB/Tremont or HFR) as proxies for the risk/return profiles of the various hedge fund strategies. These hedge fund indices provide an indication of the average manager skill available, rather than passive (i.e., market-based) risks and returns available from this form of investing. In effect, there is no data available to forecast hedge fund risks and returns given that there is no passive benchmark. Consequently, investors must recognize the limitations of hedge funds in portfolio modeling. Any form of analysis should be used only as an initial tool, not as the sole criterion for the decision. One way to address the hedge fund allocation in an investors portfolio is to diversify the portfolio based on market specialization. Market specialization categories include active versus passive, value versus growth, large capitalization versus small capitalization, and now market-based strategies versus skill-based strategies (i.e., hedge funds). Therefore, investing in skill-based strategies can be considered as part of the active versus passive portfolio management decision, rather than part of the strategic asset allocation decision.
E XAMPLE 1: H EDGE F UND - OF -F UNDS (FOF S )
We provide a basic example of allocating hedge funds within a Canadian investors portfolio. Consider an investors portfolio with 50% allocated to bonds (Scotia Capital Universe Index) and 50% to equities (30% S&P/TSX Index, 20% MSCI World Index). Table 5.2 details the 5- and 10-year historical risks and returns of the portfolio to December 2003. The analysis is in Canadian dollars.
TABLE 5.2: RISK/RETURN TO DECEMBER 2003 FOR A PORTFOLIO OF 50% BONDS/50% EQUITIES (1)
Time Period
5 Years 10 Years
Returns (2)
4.69% 9.28%
(1): Equities allocated 30% S&P/TSX, 20% MSCI World (2): Return in $ Cdn. (3): 5-year risk-free rate was 3.7%; 10-year risk-free rate was 5.6%.
If the investor allocated 10% of the portfolio to a FOFs, the risk and return for the period differs, depending on which asset classes the 10% allocation is sourced from. An allocation of 10% from equities to a FOFs would have increased portfolio returns with a reduction in risk. (Refer to Table 5.3 and to Figures 5.4(A) and (B)). (Note: The analysis is in Canadian dollars.) As Table 5.3 highlights, replacing equities has a greater effect on risk reduction than enhancing the portfolios returns. This effect is greater because the volatility of a diversified FOFs portfolio is lower than the equity volatility. Replacing bonds increases risk with similar or higher returns. However, the change is not as large for bonds as for equities, due to the returns and low volatility of the Scotia Capital Universe Index over the respective periods.
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Returns
Sharpe Ratio
Returns
Sharpe Ratio
Notes: The analysis used the CSFB/Tremont Hedge Fund Index. Different results would be obtained using the actual manager returns for stocks, bonds, and FOFs for the respective periods. The analysis is in Canadian dollars.
FIGURE 5.4(A): RISK/RETURN OF 10% ALLOCATION TO FUND-OF-FUNDS (FOFS) (5 YEARS TO DECEMBER 2003)
6.0 5.8 5-year Return (%) in $Cdn 5.6 5.4 5.2 5.0 4.8 4.6 4.4 4.2 4.0 6.0 6.2 6.4 6.6 6.8 7.0 7.2 7.4 7.6 7.8 8.0 Original Portfolio
Volatility (Standard Deviation) (%) Replace Equities Replace Bonds Traditional Asset Classes
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FIGURE 5.4(B): RISK/RETURN OF 10% ALLOCATION TO FUND-OF-FUNDS (FOFS) (10 YEARS TO DECEMBER 2003)
9.9 10-year Return (%) in $Cdn 9.7 9.5 9.3 9.1 8.9 8.7 8.5 6.8 7.0 7.2 7.4 7.6 7.8 8.0 8.2 Original Portfolio
Volatility (Standard Deviation) (%) Replace Equities Replace Bonds Traditional Asset Classes
Source: CSFB/Tremont Hedge Fund Index, TD Securities Inc. E XAMPLE 2: E QUITY H EDGE F UND (L ONG /S HORT E QUITY )
If the investor allocated 10% of the portfolio to an equity hedge fund (long/short equity), the risk and return for the period differs, depending on which asset classes the 10% allocation is sourced from. An investor allocating a total of 10% equally from Canadian equities (5%) and international equities (5%) to an equity hedge fund would have increased portfolio returns with a reduction in risk. (Refer to Table 5.4 and to Figures 5.5(A) and (B)). (Note: The analysis is in Canadian dollars.) As Table 5.4 highlights, replacing equities has a small effect on risk reduction, but significantly improves portfolio returns. Replacing all asset classes increases returns but at a similar risk. In both cases, the Sharpe Ratio improved, especially for the 10-year period.
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TABLE 5.4: RISK/RETURN OUTCOMES OF INVESTORS PORTFOLIO INCLUDING EQUITY HEDGE FUND
Returns
Sharpe Ratio
Returns
Sharpe Ratio
FIGURE 5.5(A): RISK/RETURN OF 10% ALLOCATION TO EQUITY HEDGE FUND (5 YEARS TO DECEMBER 2003)
6.0 5.8 5-year Return (%) in $Cdn 5.6 5.4 5.2 5.0 4.8 4.6 4.4 4.2 4.0 6.7 6.8 6.9 7.0 7.1 7.2 7.3 7.4 7.5 7.6 7.7 Original Portfolio
Volatility (Standard Deviation) (%) Replace Equities Replace All Asset Classes Traditional Asset Classes
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FIGURE 5.5(B): RISK/RETURN OF 10% ALLOCATION TO EQUITY HEDGE FUND (10 YEARS TO DECEMBER 2003)
10.4 1 0 - y e ar R e t u r n ( % ) i n $ C d n 10.2 10.0 9.8 9.6 9.4 9.2 9.0 7.0 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 Original Portfolio 7.9 8.0
Volatility (Standard Deviation) (%) Replace Equities Replace All Asset Classes Traditional Asset Classes
Note that each hedge fund and FOFs will have different risk, return and correlation characteristics over time, depending on the strategies and managers used. Investors should ensure that they fully understand the sources of returns and all of the risk exposures of the different hedge fund strategies before investing. When investing in a single-strategy hedge fund, it is appropriate to allocate funds from the asset class that exhibits similar risk/return characteristics to that fund. In Example 2 above, if the equity hedge fund had a large equity market exposure (long bias), the allocation could then be sourced from the portfolios equity allocation, not across all asset classes.
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Conclusion
Quo vadis hedge funds? Hedge funds are quickly becoming mainstream investments for high-networth investors (HNWIs). As Merrill Lynch and Cap Gemini Ernst & Young state in their March 2004 report: HNWIs are looking to protect themselves from losses by increasing the ratio of noncorrelated instruments such as derivatives in their portfolios, with hedge funds increasingly viewed as the strategy of choice.xiv Further, institutional investors are also beginning to recognize the benefits of adding hedge funds to a diversified portfolio, since these strategies provide an opportunity to achieve absolute returns and to protect their portfolios against downside risk. As James P. Owen states in The Prudent Investors Guide to Hedge Funds: Drawn by the chance to invest with top money managers who find opportunity outside the market mainstream, individual and institutional investors alike are increasingly using hedge funds to boost portfolio returns while managing risk.XV
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Section 6: Glossary
Note on Key Terms: The glossary below provides a general description of the key terms used in the document. Accredited Investor Refers to institutional investors or individuals with high net worth or high net income, as specified by securities regulators, and therefore not requiring the protection of a prospectus and registration requirements under securities law. Refers to the variation between a funds returns and a benchmarks returns. A large tracking error indicates a large variation from the benchmark, and implies a high level of manager risk. A numerical value indicating a funds risk-adjusted excess return relative to a benchmark. It also measures a fund managers value-added in selecting individual securities. To take advantage of disparate pricing between two similar instruments in the same or different markets. An interest rate or cross currency swap used to convert the cash flows from an underlying security (a bond or floating-rate note), from a fixed coupon to a floating coupon, a floating coupon to a fixed coupon, or from one currency to another. An interest rate swap can be used to change the cash flow characteristics of an institutions assets to provide a better match with its liabilities. A reference security or index against which an investment portfolios performance can be evaluated and compared. Measures the sensitivity of a security/funds returns relative to the markets returns. Beta represents the extent to which the funds returns have varied relative to movements in the benchmarks returns. The market has a beta of 1.0. A fund with a beta greater than 1.0 is more volatile than the market, while a fund with a beta less than 1.0 is less volatile than the market. Note on Beta and Alpha: In colloquial terms, beta refers to the marketbased returns of the asset class (i.e., returns generated from a benchmark index), while alpha refers to skill-based returns generated by hedge fund managers (i.e., returns generated from security selection and exploiting market inefficiencies). Beta Neutral CTA Closed-end Fund Describes a fund with no sensitivity to broad market movements. Therefore, the funds beta is close to zero. Commodity Trading Advisor (CTA). CTAs generally trade commodity futures, options and foreign exchange, and many are leveraged. An investment fund whose securities do not provide a right of redemption on demand based on a net asset value. The funds securities may be listed on an exchange and, as a result, may trade at a discount (or premium) to the funds net asset value. Canadian securities regulators treat funds that redeem at net asset value no more frequently than once a year as closed-end funds. A measure of how investments/asset classes tend to move in relation to one another. Investments/asset classes that rise or fall in the same direction are positively correlated, and those that move in opposite directions are negatively correlated. Correlations range from -1 to +1.
Benchmark Beta
Correlation
| Section 6 | Glossary |
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Credit Risk
The financial risk that debt will not be repaid, resulting in a loss. For example, debt holders face the risk of not receiving interest and/or principal from the issuer when payments are due. Usually, the higher the issuers credit rating, the lower the default risk, and vice-versa. Credit risk is closely linked with the financial condition of the company or government issuing the security. Companies with strong sales and profits have a lower credit risk. The federal government has almost no default risk, due to its powers of taxation, while provincial governments have lower default risk than corporations. The spread between government securities and non-government securities, which are similar in all respects except for their credit rating. An example of a credit spread is the difference between yields on government bonds and those on single A-rated corporate bonds with the same term to maturity. Financial instruments whose value is derived from the value of an underlying security, asset or variable. Examples include options, warrants, futures, forwards and swaps. Minimizing portfolio risk by investing capital in several securities and investment strategies with low correlation to each other. A measure of how interest rate changes affect a bonds price. Duration also measures how long, on a present value basis, the bondholder has to wait to receive coupon payments and the final repayment. It is the bonds weighted-average term to maturity. A two-dimensional risk-return chart showing all optimal combinations of a portfolios expected return and expected risk, given a specified set of asset classes/investment strategies. The risk is measured by the standard deviation of a particular portfolio. An agreement between two parties to buy or sell an underlying asset at a specified future date for a specified price. The contract is not traded on an exchange, but between specific parties. A fund that invests in a series of other underlying hedge funds. A fundof-fund portfolio typically diversifies across a variety of hedge fund strategies and hedge fund managers. A standardized, exchange-traded contract for the future delivery or receipt of a specified amount of an asset at a specified price. Transactions entered into that protect against adverse price movements, and limit exposure to a specific risk. These are usually opposite transactions within the same asset class or market. The assurance that a hedge fund only earns fees on profits once past losses are recovered. If an investment is made and subsequently falls in value, the fund will only earn performance fees if the investment grows above its initial value. The minimum investment return a fund must exceed before a performance fee is earned. The practice of borrowing money to add to an investment position when one believes that the return from the position will exceed the cost of borrowed funds. Hedge fund managers use leverage in order to increase returns. Leverage can have the effect of magnifying returns as well as losses. Holding (buying) a positive amount of an asset.
Credit Spread
Derivatives
Diversification Duration
Efficient Frontier
Forward Contract
Fund-of-Funds (FOFs)
High-water Mark
Long Position
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| Section 6 | Glossary |
Market Risk
Refers to risk factors that affect financial market returns as a whole. This risk is present in all financial markets, including the money, bond, stock, and currency markets. Market risk is common to all portfolios with securities from these particular markets. For example, market risk is present in nearly all equities in the stock market, since the prices of equities generally move together. Market risk is due to macroeconomic factors, such as major changes in interest rates. (Note: Market risk is often referred to as beta.) A trading account held with a broker and owned directly by the investor (e.g., an individual investor or a FOFs). Hedge fund managers complete their transactions on behalf of the investor by executing trades in the investors managed account.
Managed Account
Master-feeder Structure In this structure, one or more investment vehicles (the feeder funds) with identical investment objectives, pool their assets in a common portfolio held by a separate investment vehicle (the master fund). This structure allows both domestic and offshore investors to invest in the same offshore corporation, limited liability company, or partnership (the master fund). Domestic investors generally invest directly in a limited partnership (the domestic feeder), which invests its assets in the master fund. Offshore investors generally invest in an offshore corporation (the offshore feeder), which also invests in the master fund. Market-neutral Strategy Taking long and short positions in related assets (such as spread trades) in order to offset directional market risk. Offering Memorandum A document provided to a potential hedge fund investor that describes the hedge funds business and operations. This document is usually developed for potential purchasers of hedge funds offered under a prospectus exemption. The offering memorandum should disclose all of the funds material facts and help the potential investor assess whether to purchase the hedge fund offered. A financial instrument that gives the holder the right, but not the obligation to buy (call option) or sell (put option) the underlying asset up to and including (American option), or on (European option) a defined expiration date for a specified price. Over-the-counter (OTC) trading. Trading of financial instruments between two parties outside of exchanges. Non-directional, relative-value investment strategy that seeks to identify two companies with similar characteristics whose shares are currently trading at a price relationship outside of their historical trading range. This strategy involves buying the undervalued stock and selling the overvalued stock, usually in the same sector. Refers to a broker offering professional services specifically aimed at hedge funds and other large institutional clients. The prime broker clears the trades, custodies the securities, provides margin financing, lends stock to cover short sales, and provides cash and position reports. When a hedge fund designates a prime broker, it instructs all executing brokers to settle its trades for cash with a single firm. After the fund executes a trade, it reports the details to its prime broker. A remedy that cancels an existing contract and restores the parties to their situation prior to entering into the contract. If money has been paid by one party to another, that money is returned as part of the rescission process.
Option
Prime Broker
Rescission
| Section 6 | Glossary |
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Refers to the potential loss of invested capital at some point in the future. Demonstrates the reward to risk generated by an asset. It is the difference between the portfolios return and the risk-free rate, divided by the portfolios standard deviation. Holding a negative amount of an asset, whereby assets are sold without owning them (i.e., selling short an asset). A statistical measure of the variability of investment returns. It is the most commonly used measure of the volatility of returns or investment risk. An agreement between two parties to exchange cash flows over time according to a pre-determined formula. The potential loss of invested capital. The goal of absolute return managers is to manage total risk, which is to avoid absolute financial losses, preserve principal and to actively manage volatility. The degree of price fluctuation for a given asset, rate, or index. The variability of investment returns is one form of investment risk and is measured by the standard deviation of the returns. An option in the form of a security. Banks or companies issue warrants that are either traded on exchanges or OTC.
Volatility
Warrant
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| Section 6 | Glossary |
Deloitte & Touche Canada Ernst & Young LLP PricewaterhouseCoopers LLP
C ONSULTANTS
Aird & Berlis LLP Blake, Cassels & Graydon LLP Gowling Lafleur Henderson LLP McMillan Binch LLP Torys LLP
P RIME B ROKERS
Ontario Municipal Employees Retirement System (OMERS) Ontario Teachers Pension Plan (OTPP)
| Appendix I |
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Hedge Funds for Canadians: New Investment Strategies for Winning in any Market, by Peter Beck and Miklos Nagy. (Canadian Book) A Practical Guide to Hedge Funds, by Renata Neufeld. (Canadian Book) All About Hedge Funds: The Easy Way to Get Started, by Robert A. Jaeger. Hedge Fund of Funds Investing: An Investors Guide, by Joseph G. Nicholas. The Prudent Investors Guide to Hedge Funds: Profiting from Uncertainty and Volatility, by James P. Owen.
A DVANCED B OOKS
Absolute Returns: The Risks and Opportunities of Hedge Fund Investing, by Alexander M. Ineichen. Managing Risk in Alternative Investment Strategies: Successful Investing in Hedge Funds and Managed Futures, by Lars Jaeger. Hedge Funds: Myths and Limits, by Francois-Serge Lhabitant. Hedge Fund Risk Transparency: Unravelling the Complex and Controversial Debate, by Leslie Rahl.
WEBSITES
N EWS S ERVICES
Canadian Hedge Watch: http://www.canadianhedgewatch.com/ HedgeWorld: http://www.hedgeworld.com/ Hedge Fund Research, Inc.: http://www.hedgefundresearch.com/ InvestHedge: http://www.hedgefundintelligence.com/ih/index.htm Albourne Village: http://village.albourne.com/ Van Hedge Fund Advisors: http://www.hedgefund.com/
Acknowledgements
We would like to extend a special thanks to the team who helped to develop this publication: Arrow Hedge Partners Inc. Bernice Miedzinski Gowling Lafleur Henderson LLP J.C. Clark Ltd. Norshield Asset Management (Canada) Ltd. York Hedge Fund Strategies Inc.
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| Appendix II |
E N D N OT E S
i
The Case for Hedge Funds, Tremont Advisors Inc. & Tass Research, Third Edition, February 2003, Page 7. Source: Dealing with Myths of Hedge Fund Investment, Thomas Schneeweis, The Journal of Alternative Investments, Winter 1998. The Case for Hedge Funds, Tremont Advisors Inc. & Tass Research, Third Edition, February 2003, Page 7. Source: HFR Q4 2003 Industry Report, from Hedge Fund Research, Inc. Source: Seventh Annual Hennessee Hedge Fund Investor Survey, published in Spring 2004 by the Hennessee Group LLC. Source: Executive Briefing: World Wealth Report, March 2004, published by Merrill Lynch and Cap Gemini Ernst & Young, Page 3. Source: Estimates made by AIMA Canada based on industry sources. Source: Hedge Funds Report, (Fall 2003) published by Investor Economics (A Canadian investment research and reporting firm). Source: Absolute Returns, Volume 2, Issue 2, May 2004, published by HedgeFund Intelligence Ltd. High-net-worth investors are defined as those who have at least $1 million in investable assets. Source: Absolute Returns: The Risks and Opportunities of Hedge Fund Investing, by Alexander M. Ineichen, published by John Wiley & Sons, 2002, Page 34. Source: Adapted from Managing Risk in Alternative Investment Strategies: Successful Investing in Hedge Funds and Managed Futures, by Lars Jaeger, published by Prentice Hall/Financial Times, 2002, Pages 145-150. Source: Why Hedge Funds Make Sense, Morgan Stanley Dean Witter, November, 2000. Source: Executive Briefing: World Wealth Report, March 2004, published by Merrill Lynch and Cap Gemini Ernst & Young, Page 3. The Prudent Investors Guide to Hedge Funds: Profiting from Uncertainty and Volatility, by James P. Owen (Jacket cover), published by John Wiley & Sons, 2000.
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AIMA Canada P.O. Box 786, Station A Toronto, Ontario M5W 1G3 Tel: 416.453.0111 Fax: 416.322.9074 www.aima-canada.org www.aima.org
June 2004