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UNDERSTANDING HEDGE FUNDS (A Brief Overview) - YouTube
Channel: The Duomo Initiative
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in the world of Finance there are
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certain terms that get thrown around
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frequently and often people within the
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industry just assume that everyone knows
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what they mean in fact sometimes people
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even assume that they themselves
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understand what it means but when they
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actually stop and think about it they
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really don't know at all
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one of these terms is the infamous hedge
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fund these types of companies gained a
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bit of notoriety thanks to their
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perceived involvement in some of the
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darkest days in the financial markets
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and with specific assets although we're
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all familiar with the term hedge fund it
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seems not everyone is familiar with what
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it actually means so in this video I'm
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going to be giving you a basic overview
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of hedge funds including their history
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how they've involved some of the key
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attributes of them their strategies and
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their role in the financial markets this
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will allow you to make more sense of
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when this term is used in the financial
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media and hopefully allows you to
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differentiate between other types of
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investment firm the birth of the hedge
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funds can be attributed to Alfred
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Winslow Jones who in 1949 took long
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positions of undervalued securities and
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short positions of overvalued securities
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as an insurance against the downturn in
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the market thus creating a hedge fund as
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he was hedging at the position however
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according to Warren Buffett the roots of
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the concept dates back to the mid 1920s
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Benjamin Graham who is widely known as
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the father of value investing used the
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same strategy to hedge his investments
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and also to charge an incentive fee to
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investors the strategy was to generate
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returns irrespective of the markets
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direction hence the name of the funds
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comes from the strategy itself the
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authorities have yet to assign the hedge
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fund a legal definition essentially many
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regard hedge funds as an alternative
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investment vehicle a pool of private
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funds managed by a sophisticated manager
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for a sophisticated and wealthy
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investors due to their requirements and
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the structure hedge funds unlike other
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funds such as mutual funds or ETFs are
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partially not regulated in addition to
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that hedge funds cannot seek funds from
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the general public they operate on a
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private
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investment partnership therefore they
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have more operational freedom and can
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aim to generate returns in any kind of
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market regardless of the market
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condition in general hedge funds and
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mutual funds fall under the same
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category of pooled investments however
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they're differentiated by the
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distinguishing attributes of the
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investor's requirements according to the
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SEC an investor is considered accredited
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when they have earned an income of
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$200,000 in the last two years and
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expects the same in the current and the
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future year or hold a net worth of more
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than a million dollars this is required
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to ensure that the investor is able to
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take on the risk of investing in these
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unregulated securities therefore the
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investor needs to be conscious of the
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uncertainties of taking such risk which
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in case of unexpected events could
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destroy their entire investment unlike
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the traditional mutual fund managers the
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managers of hedge funds are more diverse
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in nature and have the technical
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know-how to use exotic or complex
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instruments like derivatives to generate
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returns the ability to go long or short
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in an asset means they can make use of
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more complex strategies such as equity
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hedging tactical trading and arbitrage
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where they take advantage of pricing and
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efficiencies in an asset although this
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is not so common anymore with there
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being fewer opportunities due to the
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rise of high-frequency trading and the
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overall competitiveness of the market so
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basically the managers have the skill to
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formulate their own trading strategies
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depending on the market conditions
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therefore they can charge an extra
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incentive fee on top of the management
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fee for their performance the annual
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management fee ranges from 1 to 2
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percent independent of the performance
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of the fund
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additionally the incentive fees
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typically range from 20 percent to a
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whopping 50 percent this fee acts as an
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incentive for the manager to outperform
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and generate better returns in the
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market there's been a lot of pressure on
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hedge fund managers to reduce their fees
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and in fact this year we have seen a low
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of capital being withdrawn from hedge
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funds particularly in Asia due to the
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excessive fees that they're charging and
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the availability of alternatives
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this also partly due to the relative
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underperformance of macro related funds
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this has led to a lot of money moving to
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private equity and real estate instead
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overall there's been a big rise in the
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number of hedge funds from a mere six
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hundred and ten in 1992 a phenomenal
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amount of 15,000 in 2017 the funds that
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practice automation in their investment
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procedure have seen enormous growth in
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the hedge fund segment Barclays claims
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that quants are now responsible for
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around 17% of the total hedge fund
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assets this past decade has seen a sharp
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rise in a technological fields such as
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machine learning and artificial
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intelligence in fact a new kind of hedge
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fund is now combining machine
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intelligence to manage the investment of
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an American hedge fund is believed by
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some that the high usage of technology
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might prove to be helpful in preventing
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the market from large shocks in the
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future as with time AI artificial
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intelligence will eventually exceed
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human abilities and perhaps get closer
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to solving the stability puzzle by
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Nature hedge fund managers tend to be
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secretive therefore transparency remains
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a big issue when considering investing
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in hedge funds the managers tend to be
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secret in their ways and the use of
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their strategies and may even keep the
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funds under a lock-up periods whereby
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investors can only take out their funds
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during specific intervals that are set
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by the manager this overall issue was
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heightened by the infamous Ponzi scheme
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run by Bernie Madoff Madoff took the
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money from investors and portrayed false
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returns to get away with it this
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multi-billion dollar scam affected many
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many investors and charities and Madoff
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was later sentenced to a hundred and
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fifty years in prison for various
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charges these events suggest that this
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level of secrecy might be wrong and
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pressure from institutional investors
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has compelled some of the hedge fund
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managers to present their financial
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reports on a regular basis hedge fund
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managers often use leverage to boost
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their returns and to make the fund more
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attractive while leverage has of course
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caused benefits it also has its
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downsides as it increases the volatile
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of the fund thereby making it much more
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vulnerable to downside risks this is
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illustrated in the case of long-term
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capital management LTCM LTCM was formed
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in 1994 and was highly publicized around
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the world due to the reputation of the
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founder and the board members John
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Merriweather the former vice chairman of
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bond trading at Salomon Brothers and
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Myron sculls and Robert Merton who both
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want a Nobel Prize for their work on a
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valuation of derivatives including their
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famous black scores options pricing
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model LTCM generates an average annual
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return of 30% after fees up until 1997
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due to their reputation and popularity
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LTCM was able to obtain extremely high
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leverage from large banks and was in a
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position to enter large swaps contracts
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but soon disaster struck after the
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Russian crisis LTCM was hit by a loss of
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more than four billion dollars his loan
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to value had reached 250 to 1 as peak
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leveraged and ultimately the US Federal
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Reserve had to come in and bailout LTCM
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as this kind of event could have
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resulted in a complete financial
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meltdown however the blame for this does
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not solely fall with LTCM is also the
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fault of the banks that provided such
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ridiculous levels of leverage without
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fully assessing the risk in LTCM
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strategy nevertheless operating with
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such high levels of leverage is an
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invitation to a lot of trouble perhaps
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the most documented role of hedge funds
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was their involvement in the financial
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crisis now although this is something
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that does warrant a whole series of
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videos of its own let's just go over a
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very quick and brief overview so in
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response to the recession of 2001 the US
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Federal Reserve lowered its race down to
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1.5%
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which also meant there were low returns
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on bonds hence the pension funds move
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their investments into hedge funds to
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earn greater returns this results dim
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manages generating riskier investments
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such as the mortgage-backed securities
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these were a pool of mortgages which at
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the time were really profitable
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due to the huge demand for
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mortgage-backed securities some of the
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larger institutions also starts to form
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their own hedge funds it was also at
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this time that the lowered interest
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rates resolved in large amounts of
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people opting for interest only
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mortgages homeowners would take a home
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loan from the lender who would then sell
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them on for a commission to investment
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banks the investment banks bundled these
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mortgages along with other debt such as
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student loans car loans and so on and
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created something called a
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collateralized debt obligation a CDO and
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then passed it on to the investors as it
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gave the investor a wide variety of
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choice in terms of risk however in order
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to tackle inflation the US Federal
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Reserve increased their interest rates
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as you can imagine this results in more
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defaults by homeowners and especially
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the subprime segments the wake of 2007
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saw many of the eminent hedge funds
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collapsing due to their higher risk
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levels and finally when the housing
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bubble burst this whole chain was jolted
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and the markets collapsed hedge funds
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managed to avoid a low of the
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responsibility since these risky
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investments were also being used by
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banks insurance companies and other
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funds and the hedge funds were not
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directly responsible for the formation
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of these destructive securities however
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they did actually hold the largest
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amount of CEOs at the start of the
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crisis 47 percent and it can be argued
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that the hedge funds gave the CEOs the
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impetus which ultimately led to part of
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the crisis this suggests a strict
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regulation of hedge funds should be put
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in place to avoid these kinds of events
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happening in future although there has
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been a lot of skepticism about investing
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in hedge funds most of the criticism
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actually lies with their high fees and
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lack of transparency however there has
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been a gradual shift over time towards
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more transparency better regulation and
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lower fees and these issues are also
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expected to further improve in the
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future hedge funds are accessible to
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retail investors via funds of hedge
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funds and statistically speaking hedge
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funds have in general outperformed other
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asset
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while remaining relatively stable amidst
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various crises the structure of hedge
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funds gives the hedge fund manager the
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freedom to invest in any market using
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any kind of investment naturally giving
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them a wide variety of choices
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historically hedge funds have proved to
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reduce volatility and provide diversity
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in an investor's overall portfolio and
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with the advent of machine learning and
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AI we may even see better stability in
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the future in one of the most complex
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systems in the world the capital markets
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if you liked this video please hit the
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subscribe for more financial education
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