Hedge Fund.
What is a 'Hedge Fund'
Hedge funds are alternative investments using pooled funds that employ numerous different strategies to earn active return, or alpha, for their investors. Hedge funds may be aggressively managed or make use of derivatives and leverage in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). It is important to note that hedge funds are generally only accessible to accredited investors as they require less SEC regulations than other funds. One aspect that has set the hedge fund industry apart is the fact that hedge funds face less regulation than mutual funds and other investment vehicles.
BREAKING DOWN 'Hedge Fund'
Each hedge fund is constructed to take advantage of certain identifiable market opportunities. Hedge funds use different investment strategies and thus are often classified according to investment style. There is substantial diversity in risk attributes and investments among styles.
Legally, hedge funds are most often set up as private investment limited partnerships that are open to a limited number of accredited investors and require a large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year, a time known as the lock-up period. Withdrawals may also only happen at certain intervals such as quarterly or bi-annually.
The History of the Hedge Fund.
Former writer and sociologist Alfred Winslow Jones’s company, A. W. Jones & Co. launched the first hedge fund in 1949. It was while writing an article about current investment trends for Fortune in 1948 that Jones was inspired to try his hand at managing money. He raised $100,000 (including $40,000 out of his own pocket) and set forth to try to minimize the risk in holding long-term stock positions by short selling other stocks. This investing innovation is now referred to as the classic long/short equities model. Jones also employed leverage to enhance returns.
In 1952, Jones altered the structure of his investment vehicle, converting it from a general partnership to a limited partnership and adding a 20% incentive fee as compensation for the managing partner. As the first money manager to combine short selling, the use of leverage, shared risk through a partnership with other investors and a compensation system based on investment performance, Jones earned his place in investing history as the father of the hedge fund.
Hedge funds went on to dramatically outperform most mutual funds in the 1960s and gained further popularity when a 1966 article in Fortune highlighted an obscure investment that outperformed every mutual fund on the market by double-digit figures over the past year and by high double-digits over the last five years.
However, as hedge fund trends evolved, in an effort to maximize returns, many funds turned away from Jones' strategy, which focused on stock picking coupled with hedging and chose instead to engage in riskier strategies based on long-term leverage. These tactics led to heavy losses in 1969-70, followed by a number of hedge fund closures during the bear market of 1973-74.
The industry was relatively quiet for more than two decades until a 1986 article in Institutional Investor touted the double-digit performance of Julian Robertson's Tiger Fund. With a high-flying hedge fund once again capturing the public's attention with its stellar performance, investors flocked to an industry that now offered thousands of funds and an ever-increasing array of exotic strategies, including currency trading and derivatives such as futures and options.
High-profile money managers deserted the traditional mutual fund industry in droves in the early 1990s, seeking fame and fortune as hedge fund managers. Unfortunately, history repeated itself in the late 1990s and into the early 2000s as a number of high-profile hedge funds, including Robertson's, failed in spectacular fashion. Since that era, the hedge fund industry has grown substantially. Today the hedge fund industry is massive—total assets under management in the industry is valued at more than $3.2 trillion according to the 2016 Preqin Global Hedge Fund Report.
The number of operating hedge funds has grown as well. There were around 2,000 hedge funds in 2002. That number increased to over 10,000 by 2015. However, in 2016, the number of hedge funds is currently on a decline again according to data from Hedge Fund Research. Below is a description of the characteristics common to most contemporary hedge funds.
Key Characteristics of Hedge Funds.
1. They're only open to "accredited" or qualified investors: Hedge funds are only allowed to take money from "qualified" investors—individuals with an annual income that exceeds $200,000 for the past two years or a net worth exceeding $1 million, excluding their primary residence. As such, the Securities and Exchange Commission deems qualified investors suitable enough to handle the potential risks that come from a wider investment mandate.
2. They offer wider investment latitude than other funds: A hedge fund's investment universe is only limited by its mandate. A hedge fund can basically invest in anything—land, real estate, stocks, derivatives, and currencies. Mutual funds, by contrast, have to basically stick to stocks or bonds, and are usually long-only.
3. They often employ leverage: Hedge funds will often use borrowed money to amplify their returns. As we saw during the financial crisis of 2008, leverage can also wipe out hedge funds.
4. Fee structure: Instead of charging an expense ratio only, hedge funds charge both an expense ratio and a performance fee. This fee structure is known as "Two and Twenty"—a 2% asset management fee and then a 20% cut of any gains generated.
There are more specific characteristics that define a hedge fund, but basically, because they are private investment vehicles that only allow wealthy individuals to invest, hedge funds can pretty much do what they want as long as they disclose the strategy upfront to investors. This wide latitude may sound very risky, and at times it can be. Some of the most spectacular financial blow-ups have involved hedge funds. That said, this flexibility afforded to hedge funds has led to some of the most talented money managers producing some amazing long-term returns.
The first hedge fund was established in the late 1940s as a long/short hedged equity vehicle. More recently, institutional investors – corporate and public pension funds, endowments and trusts, and bank trust departments—have included hedge funds as one segment of a well-diversified portfolio.
It is important to note that "hedging" is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market. (Mutual funds generally don't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk." In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.
Below are some of the risks of hedge funds:
1. Concentrated investment strategy exposes hedge funds to potentially huge losses.
2. Hedge funds typically require investors to lock up money for a period of years.
3. Use of leverage, or borrowed money, can turn what would have been a minor loss into a significant loss.
Hedge Fund Strategies.
There are numerous strategies that managers employ but below is a general overview of common strategies.
Equity market neutral: These funds attempt to identify overvalued and undervalued equity securities while neutralizing the portfolio’s exposure to market risk by combining long and short positions. Portfolios are typically structured to be market, industry, sector, and dollar neutral, with a portfolio beta around zero. This is accomplished by holding long and short equity positions with roughly equal exposure to the related market or sector factors. Because this style seeks an absolute return, the benchmark is typically the risk-free rate. Convertible arbitrage: These strategies attempt to exploit mis-pricings in corporate convertible securities, such as convertible bonds, warrants, and convertible preferred stock. Managers in this category buy or sell these securities and then hedge part or all of the associated risks. The simplest example is buying convertible bonds and hedging the equity component of the bonds’ risk by shorting the associated stock. In addition to collecting the coupon on the underlying convertible bond, convertible arbitrage strategies can make money if the expected volatility of the underlying asset increases due to the embedded option, or if the price of the underlying asset increases rapidly. Depending on the hedge strategy, the strategy will also make money if the credit quality of the issuer improves. Fixed-income arbitrage: These funds attempt to identify overvalued and undervalued fixed-income securities (bonds) primarily on the basis of expectations of changes in the term structure or the credit quality of various related issues or market sectors. Fixed-income portfolios are generally neutralized against directional market movements because the portfolios combine long and short positions, therefore the portfolio duration is close to zero. Distressed securities: Portfolios of distressed securities are invested in both the debt and equity of companies that are in or near bankruptcy. Most investors are not prepared for the legal difficulties and negotiations with creditors and other claimants that are common with distressed companies. Traditional investors prefer to transfer those risks to others when a company is in danger of default. Furthermore, many investors are prevented from holding securities that are in default or at risk of default. Because of the relative illiquidity of distressed debt and equity, short sales are difficult, so most funds are long. Merger arbitrage: Merger arbitrage, also called “deal arbitrage,” seeks to capture the price spread between current market prices of corporate securities and their value upon successful completion of a takeover, merger, spin-off, or similar transaction involving more than one company. In merger arbitrage, the opportunity typically involves buying the stock of a target company after a merger announcement and shorting an appropriate amount of the acquiring company’s stock. Hedged equity: Hedged equity strategies attempt to identify overvalued and undervalued equity securities. Portfolios are typically not structured to be market, industry, sector, and dollar neutral, and they may be highly concentrated. For example, the value of short positions may be only a fraction of the value of long positions and the portfolio may have a net long exposure to the equity market. Hedged equity is the largest of the various hedge fund strategies in terms of assets under management. It is also known as the long/short equity strategy. Global macro: Global macro strategies primarily attempt to take advantage of systematic moves in major financial and non-financial markets through trading in currencies, futures, and option contracts, although they may also take major positions in traditional equity and bond markets. For the most part, they differ from traditional hedge fund strategies in that they concentrate on major market trends rather than on individual security opportunities. Many global macro managers use derivatives, such as futures and options, in their strategies. Managed futures are sometimes classified under global macro as a result. Emerging markets: These funds focus on the emerging and less mature markets. Because short selling is not permitted in most emerging markets and because futures and options may not available, these funds tend to be long. Fund of funds: A fund of funds (FOF) is a fund that invests in a number of underlying hedge funds. A typical FOF invests in 10-30 hedge funds and some FOFs are even more diversified. Although FOF investors can achieve diversification among hedge fund managers and strategies, they have to pay two layers of fees: one to the hedge fund manager, and the other to the manager of the FOF. FOF are typically more accessible to individual investors and are more liquid.
Hedge Fund Manager Pay Structure.
Hedge fund managers are notorious for their typical 2 and 20 pay structure whereby the fund manager to receive 2% of assets and 20% of profits each year. It's the 2% that gets the criticism, and it's not difficult to see why. Even if the hedge fund manager loses money, he still gets 2% of assets. For example, a manager overseeing a $1 billion fund could pocket $20 million a year in compensation without lifting a finger.
That said, there are mechanisms put in place to help protect those who invest in hedge funds. Often times, fee limitations such as high-water marks are employed to prevent portfolio managers from getting paid on the same returns twice. Fee caps may also be in place to prevent managers from taking on excess risk.
How to Pick a Hedge Fund.
With so many hedge funds in the investment universe, it is important that investors know what they are looking for in order to streamline the due diligence process and make timely and appropriate decisions.
When looking for a high-quality hedge fund, it is important for an investor to identify the metrics that are important to them and the results required for each. These guidelines can be based on absolute values, such as returns that exceed 20% per year over the previous five years, or they can be relative, such as the top five highest-performing funds in a particular category.
Absolute Performance Guidelines.
The first guideline an investor should set when selecting a fund is the annualized rate of return. Let's say that we want to find funds with a five-year annualized return that exceeds the return on the Citigroup World Government Bond Index (WGBI) by 1%. This filter would eliminate all funds that underperform the index over long time periods, and it could be adjusted based on the performance of the index over time.
This guideline will also reveal funds with much higher expected returns, such as global macro funds, long-biased long/short funds, and several others. But if these aren't the types of funds the investor is looking for, then they must also establish a guideline for standard deviation. Once again, we will use the WGBI to calculate the standard deviation for the index over the previous five years. Let's assume we add 1% to this result, and establish that value as the guideline for standard deviation. Funds with a standard deviation greater than the guideline can also be eliminated from further consideration.
Unfortunately, high returns do not necessarily help to identify an attractive fund. In some cases, a hedge fund may have employed a strategy that was in favor, which drove performance to be higher than normal for its category. Therefore, once certain funds have been identified as high-return performers, it is important to identify the fund's strategy and compare its returns to other funds in the same category. To do this, an investor can establish guidelines by first generating a peer analysis of similar funds. For example, one might establish the 50th percentile as the guideline for filtering funds.
Now an investor has two guidelines that all funds need to meet for further consideration. However, applying these two guidelines still leaves too many funds to evaluate in a reasonable amount of time. Additional guidelines need to be established, but the additional guidelines will not necessarily apply across the remaining universe of funds. For example, the guidelines for a merger arbitrage fund will differ from those for a long-short market-neutral fund.
Relative Performance Guidelines.
To facilitate the investor's search for high-quality funds that not only meet the initial return and risk guidelines but also meet strategy-specific guidelines, the next step is to establish a set of relative guidelines. Relative performance metrics should always be based on specific categories or strategies. For example, it would not be fair to compare a leveraged global macro fund with a market-neutral, long/short equity fund.
To establish guidelines for a specific strategy, an investor can use an analytical software package (such as Morningstar) to first identify a universe of funds using similar strategies. Then, a peer analysis will reveal many statistics, broken down into quartiles or deciles, for that universe.
The threshold for each guideline may be the result for each metric that meets or exceeds the 50th percentile. An investor can loosen the guidelines by using the 60th percentile or tighten the guideline by using the 40th percentile. Using the 50th percentile across all the metrics usually filters out all but a few hedge funds for additional consideration. In addition, establishing the guidelines this way allows for flexibility to adjust the guidelines as the economic environment may impact the absolute returns for some strategies.
Here is a sound list of primary metrics to use for setting guidelines:
Five-year annualized returns Standard deviation Rolling standard deviation Months to recovery/maximum drawdown Downside deviation.
These guidelines will help eliminate many of the funds in the universe and identify a workable number of funds for further analysis. An investor may also want to consider other guidelines that can either further reduce the number of funds to analyze or to identify funds that meet additional criteria that may be relevant to the investor. Some examples of other guidelines include:
Fund Size/Firm Size: The guideline for size may be a minimum or maximum depending on the investor's preference. For example, institutional investors often invest such large amounts that a fund or firm must have a minimum size to accommodate a large investment. For other investors, a fund that is too big may face future challenges using the same strategy to match past successes. Such might be the case for hedge funds that invest in the small-cap equity space. Track Record: If an investor wants a fund to have a minimum track record of 24 or 36 months, this guideline will eliminate any new funds. However, sometimes a fund manager will leave to start their own fund and although the fund is new, the manager's performance can be tracked for a much longer time period. Minimum Investment: This criterion is very important for smaller investors as many funds have minimums that can make it difficult to diversify properly. The fund's minimum investment can also give an indication of the types of investors in the fund. Larger minimums may indicate a higher proportion of institutional investors, while low minimums may indicate of a larger number of individual investors. Redemption Terms: These terms have implications for liquidity and become very important when an overall portfolio is highly illiquid. Longer lock-up periods are more difficult to incorporate into a portfolio, and redemption periods longer than a month can present some challenges during the portfolio-management process. A guideline may be implemented to eliminate funds that have lockups when a portfolio is already illiquid, while this guideline may be relaxed when a portfolio has adequate liquidity.
How Are Hedge Fund Profits Taxed?
When a domestic U. S. hedge fund returns profits to its investors, the money is subject to capital gains tax. The short-term capital gains rate applies to profits on investments held for less than one year, and it is the same as the investor's tax rate on ordinary income. For investments held for more than one year, the rate is not more than 15% for most taxpayers, but it can go as high as 20% in high tax brackets. This tax applies to both U. S. and foreign investors.
An offshore hedge fund is established outside of the United States, usually in a low-tax or tax-free country. It accepts investments from foreign investors and tax-exempt U. S. entities. These investors do not incur any U. S. tax liability on the distributed profits.
Ways Hedge Funds Avoid Paying Taxes.
Many hedge funds are structured to take advantage of carried interest. Under this structure, a fund is treated as a partnership. The founders and fund managers are the general partners, while the investors are the limited partners. The founders also own the management company that runs the hedge fund. The managers earn the 20% performance fee of the carried interest as the general partner of the fund.
Hedge fund managers are compensated with this carried interest; their income from the fund is taxed as a return on investments as opposed to a salary or compensation for services rendered. The incentive fee is taxed at the long-term capital gains rate of 20% as opposed to ordinary income tax rates, where the top rate is 39.6%. This represents significant tax savings for hedge fund managers.
This business arrangement has its critics, who say that the structure is a loophole that allows hedge funds to avoid paying taxes. The carried interest rule has not yet been overturned despite multiple attempts in Congress. It became a topical issue during the 2016 primary election.
Many prominent hedge funds use reinsurance businesses in Bermuda as another way to reduce their tax liabilities. Bermuda does not charge a corporate income tax, so hedge funds set up their own reinsurance companies in Bermuda. The hedge funds then send money to the reinsurance companies in Bermuda. These reinsurers, in turn, invest those funds back into the hedge funds. Any profits from the hedge funds go to the reinsurers in Bermuda, where they owe no corporate income tax. The profits from the hedge fund investments grow without any tax liability. Taxes are only owed once the investors sell their stakes in the reinsurers.
The business in Bermuda must be an insurance business. Any other type of business would likely incur penalties from the U. S. Internal Revenue Service (IRS) for passive foreign investment companies. The IRS defines insurance as an active business. To qualify as an active business, the reinsurance company cannot have a pool of capital that is much larger than what it needs to back the insurance that it sells. It is unclear what this standard is, as it has not yet been defined by the IRS.
Hedge Fund Controversies.
A number of hedge funds have been implicated in insider trading scandals since 2008. The two most high-profile insider trading cases involve the Galleon Group managed by Raj Rajaratnam and SAC Capital managed by Steven Cohen.
The Galleon Group managed over $7 billion at its peak before being forced to close in 2009. The firm was founded in 1997 by Raj Rajaratnam. In 2009, federal prosecutors charged Rajaratnam with multiple counts of fraud and insider trading. He was convicted on 14 charges in 2011 and began serving an 11-year sentence. Many Galleon Group employees were also convicted in the scandal.
Rajaratnam was caught obtaining insider information from Rajat Gupta, a board member of Goldman Sachs. Before the news was made public, Gupta allegedly passed on information that Warren Buffett was making an investment in Goldman Sachs in September 2008 at the height of the financial crisis. Rajaratnam was able to buy substantial amounts of Goldman Sachs stock and make a hefty profit on those shares in one day.
Rajaratnam was also convicted on other insider trading charges. Throughout his tenure as a fund manager, he cultivated a group of industry insiders to gain access to material information.
Steven Cohen and his hedge fund, SAC Capital, were also implicated in a messy insider trading scandal. SAC Capital managed around $50 billion at its peak. The SEC raided offices of four investment companies run by former SAC Capital traders in 2010. Over the next few years, the SEC filed a number of criminal charges against former SAC Capital traders.
Mathew Martoma, a former SAC Capital portfolio manager, was convicted on insider trading charges that allegedly led to over $276 million in profits for SAC. He obtained insider information on FDA clinical drug trials on an Alzheimer’s drug that SAC Capital then traded.
Steven Cohen individually never faced criminal charges. Rather, the SEC filed a civil suit against SAC Capital for failing to properly supervise its traders. The Department of Justice filed a criminal indictment against the hedge fund for securities fraud and wire fraud. SAC Capital agreed to settle all claims against it by pleading guilty and paying a $1.2 billion fine. The hedge fund further agreed to stop managing outside money. However, a settlement in January 2016 overturned Cohen’s lifetime ban from managing money and will let him manage money in two years, subject to review by an independent consultant and SEC exams.
New Regulations for Hedge Funds.
Hedge funds are so big and powerful that the SEC is starting to pay closer attention, particularly because breaches such as insider trading and fraud seem to be occurring much more frequently. However, a recent act has actually loosened the way that hedge funds can market their vehicles to investors.
In March 2012, the Jumpstart Our Business Startups Act (JOBS Act) was signed into law. The basic premise of the JOBS Act was to encourage funding of small businesses in the U. S. by easing securities regulation. The JOBS Act also had a major impact on hedge funds: In September 2013, the ban on hedge fund advertising was lifted. In a 4-to-1 vote, the SEC approved a motion to allow hedge funds and other firms that create private offerings to advertise to whomever they want, but they still can only accept investments from accredited investors. Hedge funds are often key suppliers of capital to startups and small businesses because of their wide investment latitude. Giving hedge funds the opportunity to solicit capital would in effect help the growth of small businesses by increasing the pool of available investment capital.
Hedge fund advertising entails offering the fund's investment products to accredited investors or financial intermediaries through print, television and the internet. A hedge fund that wants to solicit (advertise to) investors must file a “Form D” with the SEC at least 15 days before it starts advertising. Because hedge fund advertising was strictly prohibited prior to lifting this ban, the SEC is very interested in how advertising is being used by private issuers, so it has made changes to Form D filings. Funds that make public solicitations will also need to file an amended Form D within 30 days of the offering’s termination. Failure to follow these rules will likely result in a ban from creating additional securities for a year or more.

Spencer Patton Building Hedge Fund Using Far-Out-Of-Money Options Strategy.
(Kitco News) - Talk about an early start.
Spencer Patton has been actively involved with financial markets since grade school. Now, only a few years removed from college, he has founded a hedge fund, using a strategy of selling options far out of the money with strike prices that he figures are unlikely to be hit by expiration.
Patton began investing as a 7-year-old when his father Jim, a private-equity investor who bought failing companies and sold them as they became profitable, offered to match any money the lad put into the stock market. So young Spencer took allowance and gift money and began researching companies.
"I had about as much money as you have as a 7-year-old-like $20," he recalled. "But it allowed me to start thinking about different companies."
A family friend who was a stock broker handled trades at a commission of one penny until Patton was an adult. "My passion for it just grew," Patton said.
In college, he often used a laptop computer to put on positions while in classes at Vanderbilt University, where he earned degrees in psychology and economics. He continually refined his strategies.
After graduation, he went to work for KPAC Solutions, a private-investment company focused on acquiring and turning around distressed manufacturers. This enabled Patton to learn about commodities, since many of these companies were involved with commodities in some way.
Patton, now 25, has since founded Steel Vine Investments.
Fund Manager Looks To Pocket Premiums From Options Positions.
Patton aims to sell options far enough out of the money that strike prices are never triggered, allowing him to keep premiums collected for selling the option. This puts a ceiling on the profit from any one position, yet also takes away the pressure of having to correctly predict whether a market's next move will be up or down.
An option is a contract giving the buyer the right, but not the obligation, to buy or sell a commodity or stock at a fixed price, on or before a certain future date, from the seller.
He generally sells options on stocks and commodities that are 30% to 100% out of the money, with expiration anywhere from three months to a year away. He looks for strike prices that he views as "historically or statistically unlikely" within the options' time frame, in many cases selling options at strikes for which prices have never achieved.
"You're looking to capture the premium of selling those options," he said. "The historical issue with selling options is that there is a limited profit potential. The most you can make is make is the premium you are paid to sell that option. You can't make a single dollar more on that position, whereas your loss is theoretically unlimited. Silver could go to infinity, and you would have unlimited losses.
"But, the trade-off is that the likelihood you are going to keep that premium is very high…There are a lot of great statistics out there saying that roughly 80% to 85% of all options expire worthless."
As of this interview, silver was just under $50 an ounce. A trader selling a $75 silver option expiring on Nov. 22 would receive a premium of $4,100, which he would keep as long as any rally stops shy of $75, Patton said in listing a hypothetical trade. The risk would be that silver does in fact hit that price.
If silver keeps rocketing higher and threatens this price, Patton would favor simply closing out a position. By July, that option might be worth say $7,000, he said. A trader would have to pay this to close out, leaving a loss of $2,900, which would be less than if the options were actually triggered.
A "more aggressive" way to manage risk, which Patton said he tends to avoid, would be to hedge with a position in the futures market. For instance, if a trader sold a silver call at $75, he might buy a silver futures contract. Then if the option call ends up a loser, this would be offset by a gain in the silver futures contract. A double benefit would be if silver rises but stops shy of $75 by expiration. Then a trader would both keep the premium for selling the option and also gain on the rise in the futures contract, Patton said. However, should the futures contract instead decline, the futures loss might end up offsetting the premium from the option.
"You are paid a certain premium, and if you lose all of that money trading silver (futures) trying to hedge yourself, then you've done yourself no good," he said. "I just think the smarter way to go (to manage risk) is to just close out the position. Have a set, defined stop loss. Say 'if it reaches this point, I'm going to have the discipline to close the position.'"
With Patton's trading system, he simply has to decide "where commodities will not go" rather than "where commodities will go."
By contrast, a traditional futures trader has to decide whether the market will rise or fall from the current price. "If you say it's headed higher and it goes lower by one penny, you've lost money," Patton said.
He generally trades only equities or commodities with strong volume. He sticks to stocks in the Dow Jones Industrial Average or S&P 500, which seldom lose more than a percentage point or two a day. He avoids small, developing companies, such as a small biotech firm that could be vulnerable to 20% moves in a single day if major news breaks.
Assets under management in his fund are just under $5 million, which Patton concedes are "small potatoes" in the world of hedge funds. However, he has not been actively seeking capital as he developed his strategies. Starting May 1, however, the fund will be opened up to institutional investors. Steel Vine posted returns of 27% in 2009 and 26% for 2010, he reported.
Patton avoids putting more than 10% of a portfolio in any single position. He favors diversification, yet said "don't diversify just for the sake of diversifying," instead only putting on positions when confident in them.
His main advice for novices is to work with a mentor, such as a broker or another trader who can help walk them through potential pitfalls.
"There's a lot to be said for personal experience, and paper trading will not do it for you," he said. "Paper trading is so different…because you don't have the gain or loss of capital and swings of emotion that come with that. I'm not nearly a big of a believer in paper trading as most."
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of NASDAQ, Inc.

Hedge Funds: Strategies.
Hedge funds use a variety of different strategies, and each fund manager will argue that he or she is unique and should not be compared to other managers. However, we can group many of these strategies into certain categories that assist an analyst/investor in determining a manager's skill and evaluating how a particular strategy might perform under certain macroeconomic conditions. The following is loosely defined and does not encompass all hedge fund strategies, but it should give the reader an idea of the breadth and complexity of current strategies. (Learn more in Taking A Look Behind Hedge Funds .)
The equity hedge strategy is commonly referred to as long/short equity and although it is perhaps one of the simplest strategies to understand, there are a variety of sub-strategies within the category.
Long/Short – In this strategy, hedge fund managers can either purchase stocks that they feel are undervalued or sell short stocks they deem to be overvalued. In most cases, the fund will have positive exposure to the equity markets – for example, having 70% of the funds invested long in stocks and 30% invested in the shorting of stocks. In this example, the net exposure to the equity markets is 40% (70%-30%) and the fund would not be using any leverage (Their gross exposure would be 100%). If the manager, however, increases the long positions in the fund to, say, 80% while still maintaining a 30% short position, the fund would have gross exposure of 110% (80%+30% = 110%), which indicates leverage of 10%.
There is a second way to achieve market neutrality, and that is to have zero beta exposure. In this case, the fund manager would seek to make investments in both long and short positions so that the beta measure of the overall fund is as low as possible. In either of the market-neutral strategies, the fund manager's intention is to remove any impact of market movements and rely solely on his or her ability to pick stocks.
Either of these long/short strategies can be used within a region, sector or industry, or can be applied to market-cap-specific stocks, etc. In the world of hedge funds, where everyone is trying to differentiate themselves, you will find that individual strategies have their unique nuances, but all of them use the same basic principles described here.
Generally speaking, these are the strategies that have the highest risk/return profiles of any hedge fund strategy. Global macro funds invest in stocks, bonds, currencies, commodities, options, futures, forwards and other forms of derivative securities. They tend to place directional bets on the prices of underlying assets and they are usually highly leveraged. Most of these funds have a global perspective and, because of the diversity of investments and the size of the markets in which they invest, they can grow to be quite large before being challenged by capacity issues. Many of the largest hedge fund "blow-ups" were global macros, including Long-Term Capital Management and Amaranth Advisors. Both were fairly large funds and both were highly leveraged. (For more, read Massive Hedge Fund Failures and Losing The Amaranth Gamble .)
Relative Value Arbitrage.
This strategy is a catchall for a variety of different strategies used with a broad array of securities. The underlying concept is that a hedge fund manager is purchasing a security that is expected to appreciate, while simultaneously selling short a related security that is expected to depreciate. Related securities can be the stock and bond of a specific company; the stocks of two different companies in the same sector; or two bonds issued by the same company with different maturity dates and/or coupons. In each case, there is an equilibrium value that is easy to calculate since the securities are related but differ in some of their components.
Let's look at a simple example:
Assume that a company has two outstanding bonds: one pays 8% and the other pays 6%. They are both first-lien claims on the company's assets and they both expire on the same day. Since the 8% bond pays a higher coupon, it should sell at a premium to the 6% bond. When the 6% bond is trading at par ($1,000), the 8% bond should be trading at $1,276.76, all else being equal. However, the amount of this premium is often out of equilibrium, creating an opportunity for a hedge fund to enter into a transaction to take advantage of the temporary price differences. Assume that the 8% bond is trading at $1,100 while the 6% bond is trading at $1,000. To take advantage of this price discrepancy, a hedge fund manager would buy the 8% bond and short sell the 6% bond in order to take advantage of the temporary price differences. I have used a fairly large spread in the premium to reflect a point. In reality, the spread from equilibrium is much narrower, driving the hedge fund to apply leverage to generate a meaningful levels of returns.
This is one form of relative value arbitrage. While some hedge funds simply invest in convertible bonds, a hedge fund using convertible arbitrage is actually taking positions in both the convertible bonds and the stocks of a particular company. A convertible bond can be converted into a certain number of shares. Assume a convertible bond is selling for $1,000 and is convertible into 20 shares of company stock. This would imply a market price for the stock of $50. In a convertible arbitrage transaction, however, a hedge fund manager will purchase the convertible bond and sell the stock short in anticipation of either the bond's price increasing, the stock price decreasing, or both.
Keep in mind that there are two additional variables that contribute to the price of a convertible bond other than the price of the underlying stock. For one, the convertible bond will be impacted by movements in interest rates, just like any other bond. Secondly, its price will also be impacted by the embedded option to convert the bond to stock, and the embedded option is influenced by volatility. So, even if the bond was selling for $1,000 and the stock was selling for $50 – which in this case is equilibrium – the hedge fund manager will enter into a convertible arbitrage transaction if he or she feels that 1) the implied volatility in the option portion of the bond is too low, or 2) that a reduction in interest rates will increase the price of the bond more than it will increase the price of the stock.
Even if they are incorrect and the relative prices move in the opposite direction because the position is immune from any company-specific news, the impact of the movements will be small. A convertible arbitrage manager, then, has to enter into a large number of positions in order to squeeze out many small returns that add up to an attractive risk-adjusted return for an investor. Once again, as in other strategies, this drives the manager to use some form of leverage to magnify returns. (Learn the basics of convertibles in Convertible Bonds: An Introduction . Read about hedging details at Leverage Your Returns With A Convertible Hedge .)
Hedge funds that invest in distressed securities are truly unique. In many cases, these hedge funds can be heavily involved in loan workouts or restructurings, and may even take positions on the board of directors of companies in order to help turn them around. (You can see a little more about these activities at Activist Hedge Funds .)
That's not to say that all hedge funds do this. Many of them purchase the securities in the expectation that the security will increase in value based on fundamentals or current management's strategic plans.
In either case, this strategy involves purchasing bonds that have lost a considerable amount of their value because of the company's financial instability or investor expectations that the company is in dire straits. In other cases, a company may be coming out of bankruptcy and a hedge fund would be buying the low-priced bonds if their evaluation deems that the company's situation will improve enough to make their bonds more valuable. The strategy can be very risky as many companies do not improve their situation, but at the same time, the securities are trading at such discounted values that the risk-adjusted returns can be very attractive. (Learn more about why funds take on these risks at Why Hedge Funds Love Distressed Debt .)
There are a variety of hedge fund strategies, many of which are not covered here. Even those strategies that were described above are described in very simplistic terms and can be much more complicated than they seem. There are also many hedge funds that use more than one strategy, shifting assets based on their assessment of the opportunities available in the market at any given moment. Each of the above strategies can be evaluated based on their potential for absolute returns and can also be evaluated based on macro - and microeconomic factors, sector-specific issues, and even governmental and regulatory impacts. It is within this assessment that the allocation decision becomes crucial in order to determine the timing of an investment and the expected risk/return objective of each strategy.

Hedge fund strategies with options

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Option Strategies.
Hedge fund strategies are the backbone of return generation for the hedge fund community. One of the most profitable are options strategies which can generate healthy and stable returns. Options strategies range from complex volatility strategies to a simple covered call approach.
Options are the right, but not the obligation to purchase an asset at a specific price on a specific date and time. Options exist in both the regulated exchange environment as well as in the over-the-counter market. Simple vanilla options are calls, which give an investor the right to purchase an asset, and puts, which give an investor the right to sell an asset.
Options are priced using a formula, the most famous being the Black Scholes model. The major components to the model are the current price of the asset, the strike price, interest rates, the time to expiration and implied volatility.
Implied volatility is considered the most important component of options valuation. This variable is created by the marketplace. It can be defined as the perceived fluctuation in prices of an asset over the course of a specific period from the current price on an annualized basis. Implied volatility is different from historical volatility in that implied volatility is not the actual movements, but instead the estimated future movement of an asset price.
Many options strategies are geared toward speculating on the direction of implied volatility (IV) which is a mean reverting process. One of the easiest ways to speculate on implied volatility is to trade futures or ETF's that follow the direction of implied volatility. For example, one of the most prolific products is the VIX volatility index which measures the level of at-the-money implied volatility of the S&P 500 index.
Generally, implied volatility moves around in a well defined range which allows strategies to create an approach in which IV is purchased at the bottom end of a defined range, and sold at the upper end of a defined range as shown in the graph below which uses Bollinger bands. This study uses a 2-standard deviation around a 20-day moving average as its range levels.
Other types of volatility strategies include purchasing and selling Straddles, Strangles and Iron Condors. These types of strategies attempt to take advantage of not only implied volatility, but additionally the shape of the volatility strike map curve. The skew, which is defined by the shape of the volatility curve, changes as supply and demand for out of the money options change. The skew fluctuates independently and does not follow at-the-money implied volatility which is the benchmark for volatility trading.
A Straddle is a strategy where the portfolio manager purchases or sells at-the-money calls and puts at the same strike, which is also the most liquid of the current available options. To buy or sell out of the money options simultaneously, an investor would transact a Strangle. An Iron Condor is the simultaneous purchase and sale of a call spread and a put spread.
Other strategies include covered call selling, which is an income producing trading strategy, along with outright naked long and short sales of options. Covered calls allow a portfolio manager to hedge their downside exposure and receive a guaranteed income in return for capping the upside. Naked calls and puts simultaneously speculate on the direction of the underlying market along with the direction of implied volatility.
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