The name hedge funds can be confusing because it is not the case that these funds hedge with its strategies only against losses. Moreover they absorb risks and focus on misvalues of shares or markets they have identified. In this way hedge funds try to achieve high yields by using appropriate strategies in the right time. Therefore hedging can only be a part of the strategy as it secures the portfolio against risks which the hedge fund has not included. The final success of the investment of hedge funds ultimately depends on the correction of assumed misvalues. Alfred Winslow Jones was the founder of the first hedge fund in 1949 and obtained the idea to eliminate the unpredictable market trend.
Therefore he launched an investment company named “Jones Hedge Fund” which was the first hedge fund worldwide. But his invention was not in demand until 1962 when the stock market collapsed. While all shares and funds lost their value, the “Jones Hedge Fund” reached an absolute return due to the falling prices of shares. The reason for this phenomenon will be explained in the fourth chapter. Since then hedge funds became
quite popular even though the real break trough started during the
technolgy boom in the 1980’s. The total capital asset under management of hedge funds was in the beginning less than 200 million US Dollar which has been extensively growing up to 25% in average in the last 16 years. Although they have been growing a little weaker with approximately 19 % for the last six years, their asset under management is risen of approximately 1.5 billion US Dollar. So far there is no predicted end in sight. But surprisingly they represent a relative small size compared to the asset management industry. Furthermore due to the remarkable growth of hedge funds, the significance on the financial market is increasing and ensures a continued attention of public authorities and the financial community. The following chapters will show the position of hedge funds in the present time and discuss the role of hedge funds on the financial market as well as possible chances and risks.
INDEX
1. THE BEGINNING OF HEDGE FUNDS
2. WHAT ARE HEDGE FUNDS?
3. HOW D O HEDGE FUNDS WORK?
4. THE FIRST HEDGE FUND
5. CLASSIFICATION OF HEDGE FUNDS
5.1. Relative Value (Arbitrage Strategy)
5.2. Event Driven
5.3. Directional Strategy
5.3.1. Quantum Fund
5.3.2 Long Term Capital Management (LTCM)
6. HEDGE FUNDS IN GERMANY
7. POSSIBLE DANGERS FOR FINANCIAL MARKETS THROUGH HEDGE FUNDS
7.1. The Risk through Leverage
7.2. Risk for the banking section
8. POSITIVE EFFECT OF HEDGE FUNDS
9. CONCLUSIVE STATEMENT TO HEDGE FUNDS
BIBLIOGRAPHY
1. The Beginning of Hedge Funds
The name hedge funds can be confusing because it is not the case that these funds hedge with its strategies only against losses. Moreover they absorb risks and focus on misvalues of shares or markets they have identified. In this way hedge funds try to achieve high yields by using appropriate strategies in the right time. Therefore hedging can only be a part of the strategy as it secures the portfolio against risks which the hedge fund has not included. The final success of the investment of hedge funds ultimately depends on the correction of assumed misvalues.1 Alfred Winslow Jones was the founder of the first hedge fund in 1949 and obtained the idea to eliminate the unpredictable market trend. Therefore he launched an investment company named "Jones Hedge Fund" which was the first hedge fund worldwide.2 But his invention was not in demand until 1962 when the stock market collapsed. While all shares and funds lost their value, the "Jones Hedge Fund" reached an absolute return due to the falling prices of shares. The reason for this phenomenon will be explained in the fourth chapter. Since then hedge funds became quite popular even though the real break trough started during the technolgy boom in the 1980's.3 The total capital asset under management of hedge funds was in the beginning less than 200 million US Dollar which has been extensively growing up to 25% in average in the last 16 years. Although they have been growing a little weaker with approximately 19 % for the last six years, their asset under management is risen of approximately 1.5 billion US Dollar.4 S o far there is no predicted end in sight. But surprisingly they represent a relative small size compared to the asset management industry. Furthermore due to the remarkable growth of hedge funds, the significance on the financial market is increasing and ensures a continued attention of public authorities and the financial c ommunity.5 The following chapters will show the position of hedge funds in the present time and discuss the role of hedge funds on the financial market as well as possible chances and risks.
2. What are Hedge Funds?
It is difficult to clarify a definition for Hedge Funds. Nevertheless they can be described as loosely unregulated funds which are neither restricted by the federal financial supervisory agency world- wide nor controlled and supervised by anyone. Absolutely independent from the market exposure, hedge funds try to achieve a higher performance as other investment funds. The ability of hedge fund managers to find constantly new under- or overvalued assets is from essential importance. Therefore they use these market imperfections to make profit which provides a certain freedom of action and financial incentives for them. Out of this reason, hedge funds choose their surrounding conditions concerning the form of organization, location and investors to be not controlled by public authorizati on.6 In most cases they are typically organized as corporations or limited partnerships and work in certain ways similar to their institutional investors as banks or insurances. But hedge funds have free choice of investment markets, several instruments and strategies which could be eventually restricted by the memorandum of association. The location is mostly in offshore jurisdictions e.g. on the Bahamas, Caymand Islands or in EU-States like Luxembourg or Monaco because those states claim lower taxes and less restrictions. As to that they are managed from international financial centers as the worlds leading location New York and the second largest global center London, in particular. This sort of procedure saves costs due to cheaper taxes but blurres the transparency of them even more. In addition, the relationship between investors and the hedge fund management companies, that administrate hedge funds, is basically based on trust.
It is currently estimated that the number of existing hedge funds is approximately 10.000. But the fact of unrestricted principles for hedge funds let vaguely assume that the total number of existing funds might be even a lot higher then predicted.7
3. How do Hedge Funds work?
Truly independent from the risk hedge funds absorb, they all attempt the goal to achieve an absolute positive return under all market conditions. This means other than traditional investment funds like mutual stock- and real estate funds, hedge funds, as a species of alternative funds, do not depend on a rising market performance to obtain a good rate of return. Furthermore they expect exclusively absolute positive returns on a quite volatile market.8 The conditions are positively ruled for the hedge fund managers, to provide a quick reaction to any possible chances that arise on the market. Mostly they trade extensively with derivatives and short-sellings, which happens with little amounts of equity and a multifold of borrowed money to achieve a good leverage. The aim is a notable return on investment and a maximum gain on profit. However the combination of short- selling and leverage increases the risk of high eventually even total losses because of unexpected negative market events. Therefore the salary for hedge fund managers depends on their success because they usually get 15 to 25% of the profit they make and another 1- 2% of management fee.9 The moral hazard shall lower the risk when hedge fund managers trade with large amounts of money which their investors have put in. For this reason they also need to invest a very high contribution of their own assett in this investment to prevent immoderate high risks. Otherwise if this fails, hedge fund managers will lose automatically their invested capital as well. In addition, the invested capital from their customers, which are institutional or rich private investors, give hedge funds the opportunity to distribute the money for a quite long period of time. S o investors must agree that the managers can direct the money, depending on the contract, from thirty days to three years.10
4. The 9rst Hedge Fund
As the first investment strategy, Alfred Winslow Jones' hedge fund contained two investment tools — short/ long positions and leverage— . As to that, he bought undervalued shares with half of the capital in expectation to sell them for a higher price (long position). In return to that he borrowed overvalued shares with the other half of capital from a prime broker for a certain fee. In consideration of a speculative hope or knowledge these shares lose their value, he sold them on the market to repurchase them for a lower price (short position). This all must happened before the shares had to be given back to the stockbroker. In case of success, the price of sale minus the repurching price of short positions and the paid fee shows the profit of this arbitrage. It points out that the long position was hedged by the short position as well as the other way around if the market would have gone up with long position. The profit in a market neutral strategy could only be made by absorbed conscious risks through single shares s o that long positions were usually not covered over the same value as short positions. Thus there was a certain market exposure left over. T o maximize the return for each unit of capital, he also took borrowed money to use the leverage which provides that the return of each unit of borrowed money is higher than the interest rate. Therefore the leverage-effect can rise the expected profit but also the profit- exposure. This underlines that the development of hedge funds absolutely depend on the performance of the capital market but not on a certain benchmark in particular.11
5. Classification of Hedge Funds
Since the beginning of hedge funds, they have formed to specific mediums of investments over the years. At present hedge funds have a wide spread in their investment strategies with the same primarly objective to generate high yields. Hedge fund managers can use different types of investments which reach from less risky arbitrage trading techniques over short selling of stocks to highly speculative derivatives that do not necessarily involve hedging. However all of them can be devided into three main strategies:
- Relative Value Strategy
- Event Driven Strategy
- Directional Strategy
[...]
1 vgl. http://217.110.182.54/downl oad/volkswirtschaft/mba/1999/ 199903mba_hedgefonds.pdf , March 1999, p.32
2 vgl. http://www.uhlenbruch.c om/fileadmin/downloads/Auszug_Rating Aktuelß4_05.pdf, August 2005, p.2
3 vgl. http://www.ursbirchler.ch/fi2002/arbeiten/hedgefundsfinal.doc, 06.06.2000, p.1
4 vgl. http://www.banque-france.fr/gb/publicati ons/telnomot/rsf/2007/rsf_ 0407.pdf, April 2007, p.27
5 vgl. http://www.ecb.int/pub/pdf/scp ops/ecbocp34.pdf, August 2005, p.6
6 vgl. http://www.ecb.int/pub/pdf/scp ops/ecb ocp34.pdf, August 2005, p.33
7 vgl. http://www.be24.at/bl og/entry/2030/hedge-fonds-um-ein-paar-dollar-mitinvestieren.html, 11.26.2006
8 vgl. http://www.ecb.int/pub/pdf/scp ops/ecbocp34.pdf, August 2005, p.6
9 vgl. http://www.ecb.int/pub/pdf/scp ops/ecb ocp34.pdf, August 2005, p.8
10 vgl. http://217.110.182.54/download/volkswirtschaft/mba/1999/ 199903mba_hedgefonds.pdf , March 1999, p.33
11 vgl. http://217.110.182.54/download/volkswirtschaft/mba/1999/ 199903mba_hedgefonds.pdf , March 1999, p.32
- Quote paper
- Dennis Sauert (Author), 2007, Hedge Funds. Principles, Chances and Risks, Munich, GRIN Verlag, https://www.grin.com/document/138912
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