an introduction to hedge funds - cfa institute - the role... · fund of hedge funds, single manager...

1

An introduction to Hedge Funds

Andrew Whelan – Executive Director

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Ermitage profile

� Founded 1975 – 1st hedge fund investment 1984

� Owned by Management and Caledonia Investments

� $1.8bn assets under management

� 46 employees, offices in Jersey, London, New York

� Fund of hedge funds, single manager hedge funds &

wealth management absolute return portfolio

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Hedge Fund strategy classification

Long Short Equity

� Traditional

� Market Neutral

� Systematic

� Quantitative

Relative Value

� Volatility Strategies

(Convertible Arbitrage &

Volatility Arbitrage

� Event Driven (e.g. Merger

Arbitrage)

� Distressed Debt

� Fixed Income & Credit

Arbitrage

� Multi-Strategy Arbitrage

Directional

� Macro & CTA:

- Discretionary

- Systematic Trend Following

- Systematic Non-Tend Following

� Commodities & Resources

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What is Long Short Equity?

� A smart way to manage equity exposure, not a separate asset class

� Managers can buy shares – and sell shares short

� Profit from falling markets & relative value between shares

� Generate profit, irrespective of market direction (i.e. alpha)

� Flex market exposure (gross/net)

…adaptability to market opportunity and risks

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Trade example 1 – index hedge

Long only (Traditional):

Buy 1 share Unilever

Rationale:

� Defensive/ undervalued,

should hold up in recession

Long Short (Hedged):


Short FTSE Futures

Rationale:

� High probability Unilever will

outperform FTSE index

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Trade example 2 – relative hedge

Long only (Traditional):


Rationale:

� Defensive/ undervalued,

should hold up in recession

Long Short (Hedged):


Short Premier Foods

(debt-ridden rival)

Rationale:

� Unilever should outperform rival

� ‘Same sector’ hedge

� Potential ‘double alpha’ trade

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Short trades

Short (Hedged):

Short Premier Foods

Buy FTSE

Rationale:

� Strong negative view on

Premier Foods vs. the market

Short (Hedged):

Short Premier Foods

Buy Unilever

Rationale:

� Strong negative view on Premier

Foods, hedged with Unilever

� Direction of market not important to make money

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Gross and net exposure

Gross exposure:

� Sum of ‘longs’ and ‘shorts’…

+75% combined long positions

+50% combined short positions

+125% gross exposure

� Management of gross and net exposure key to effective risk management

� Net and gross levels reflect manager’s view on market

Net exposure:

� ‘Longs’ minus ‘shorts’…

+75% combined long positions

-50% combined short positions

+25% net exposure

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Gross exposure

The sum of longs and shorts e.g....

+75% aggregated long positions

+50% aggregated short positions

+125% gross exposure

= Total market exposure if relative value trades

reverse (e.g. ‘08 deleveraging)

= Level of active trades (& confidence level)

� Manager benefits from leveraging idiosyncratic stock picking skill (i.e. active risk)

Gross exposure

� Manager has 25% leverage; if longs � and shorts �, he can lose at 1.25X the rate of a

long-only investor (with same longs)

… i.e. his hedges have also now become loss-making, adding to rate of loss

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Net exposure

The sum of longs minus shorts e.g.

+75% aggregated long positions

-50% aggregated short positions

+25% net exposure

= Net adjusted exposure to market

= Overall trade direction (if correlation / relative

trade assumptions prove correct)

� Manager only has 25% net exposure – could be highly defensive in falling market

– i.e. short positions act as hedge to market beta in sell-off

Net exposure

� Low net managers provide lower volatility returns, over time

� In strong bull market, lower net exposure can mean lower performance vs. index

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Long Short Equity

Manager Style

Traditional

(fundamental

stock-pickers)

Market Neutral /

Contrarian Top Down

DynamicNiche

Portfolio diversification – sub strategies

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Gross Expsoures

0

25

50

75

100

125

150

175

200

225

250

Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09

Gro

ss %

Gross L/S Traditional

Gross L/S Contrarian & MN

S&P NAV

Source: Ermitage Group and Bloomberg

Gross exposure management

- 1400

- 1300

- 1200

- 1100

- 1000

- 900

- 800

- 700

- 600

S&

P 5

00

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Gross exposure management

Gross Expsoures

0

25

50

75

100

125

150

175

200

225

250


Gro

ss %

Gross L/S Traditional

Gross L/S Contrarian & MN

Gross L/S Top-Down Dynamic

S&P NAV- 1400

- 1300

- 1200

- 1100

- 1000

- 900

- 800

- 700

- 600

S&

P 5

00

14


Net exposure management

-25

0

25

50

75

100

125

150

175

200

225

250


Net

%

Net L/S Traditional

Net L/S Contrarian & MN

Net L/S Top-Down Dynamic

S&P NAV

S&

P 5

00

- 1400

- 1300

- 1200

- 1100

- 1000

- 900

- 800

- 700

- 600

15


Net exposure management

-25

0

25

50

75

100

125

150

175

200

225

250


Net

%

Net L/S Traditional

Net L/S Contrarian & MN

Net L/S Top-Down Dynamic

S&P NAV

- 1400

- 1300

- 1200

- 1100

- 1000

- 900

- 800

- 700

- 600

S&

P 5

00

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� Managers adjust net & gross through market cycle – adds value vs. long-only

� Most L/S managers are ‘traditional’ – and highly correlated

� Therefore, vital to blend mix of styles within portfolio

� Aim: create ‘all weather’ portfolio with significant downside protection

Long / Short Funds – Portfolio construction

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Myth # 1: “I can time equity markets”

S&P 500 since 1994 – Capturing or missing 5 best equity months


0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

Jan-

94

Oct

-94

Jul-9

5

Apr

-96

Jan-

97

Oct

-97

Jul-9

8

Apr

-99

Jan-

00

Oct

-00

Jul-0

1

Apr

-02

Jan-

03

Oct

-03

Jul-0

4

Apr

-05

Jan-

06

Oct

-06

Jul-0

7

Apr

-08

Jan-

09

S&P 500

(fully invested)

S&P 500

(missing 5 best months)

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Myth # 1: “I can time equity markets”

S&P 500 since 1994 – Capturing / missing 5 best or 5 worst equity months


0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

Jan-

94

Oct

-94

Jul-9

5

Apr

-96

Jan-

97

Oct

-97

Jul-9

8

Apr

-99

Jan-

00

Oct

-00

Jul-0

1

Apr

-02

Jan-

03

Oct

-03

Jul-0

4

Apr

-05

Jan-

06

Oct

-06

Jul-0

7

Apr

-08

Jan-

09

S&P 500

(fully invested)

S&P 500

(missing 5 best months)

S&P 500

(missing 5 worst months)

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Myth # 2: Equities rise over time, so why hedge?

�� Nikkei same level as mid 1980’s

�� Same with S&P 500…a zero sum

game if invested since 1996

Nikkei performance since late 1970’s

S&P 500 performance since late 1995

Source: Bloomberg

Last 10265.98High on 12/29/89 38957.44Average 15989.90Low on 10/26/79 6207.89

Last 1044.38High on 10/12/07 1576.09Average 1118.35Low on 09/01/95 555.71

�� Long short is about accessing

absolute returns, not assuming

markets trend up!

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Capital preservation in stressed equity markets

European Absolute Fund vs. MSCI Europe in 15 worst equity months: Dec 1999 – Aug 2009*

� Capital preservation in stressed equity markets is key

-20%

-15%

-10%

-5%

0%

5%

10%

Sep

-02

Oct

-08

Sep

-08

Jul-0

2

Jan-

08

Sep

-01

Jun-

08

Feb

-09

Jun-

02

Dec

-02

Feb

-01

Jan-

03

Jan-

09

Jan-

00

Aug

-01

Ermitage European Absolute Class B EUR MSCI Europe

(Av. return 0.33%) (Av return: -9.32%)

Source: Ermitage Group and Bloomberg. *August 2009 estimate – Ermitage European Absolute Fund Class B EUR

Performance figures for Class B EUR reflect the performance of the Class EUR shares adjusted for the effect of a performance fee and a different administration fee.

21Myth # 3: “Capital preservation isn’t essential…I can recapture my loss”

� Here’s how the maths works…

� Downside protection key to consistent long term capital appreciation

Client A – in Ermitage European

Absolute Fund Class EUR

Down 1.89% in 2008

Needs 1.93% to get back to flat

Client B – in MSCI Europe Total

Return Index EUR

Down 38.9% in 2008

Needs X%? to get back to flat

Answer: 63.7%

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Myth: “FoHF’s charge high fees and are high risk”

400

600

800

1000

1200

1400

1600

1800

2000

2200

Nov

-99

Aug

-00

May

-01

Feb

-02

Nov

-02

Aug

-03

May

-04

Feb

-05

Nov

-05

Aug

-06

May

-07

Feb

-08

Nov

-08

Aug

-09

Ermitage European Absolute Fund Class B EUR

MSCI Europe Total Return Index

Euro Cash

Source: Ermitage Group and Bloomberg *Sept 2009 estimate – Ermitage European Absolute Fund Class B EUR

Performance figures for Class B EUR reflect Class EUR shares adjusted for the effect of a performance fee and a different administration fee.

Ermitage European Absolute Fund vs. MSCI Europe cumulative performance: Dec 99 - Sept 09*

European Absolute Fund B EUR: Av. return: 7.51% paStd. Dev: 4.83%

MSCI Europe TR Index EUR:Av. return: -0.13% paStd. Dev: 17.37%

Euro Cash

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1. “Haven't hedge fund managers crowded themselves out of trades?”

2. “With liquidity falling, volatility rising and markets moving down, why should I

invest in equity long short?”

3. “Have the changes to legislation had a negative impact on equity long short funds

– and their ability to execute their strategy?”

4. “What about the risk of fraud – Madoff?”

Current questions

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� Equity long short funds are not a separate asset class

� They are an essential tool for portfolio management

� Ability to adapt is key to success

� Capital preservation & power of compounding not to be underestimated

� Key to performance – portfolio construction / robust risk management

� Hedge fund industry suffered in 2008, but we believe many strategies will offer

outsized returns going forward

Summary – Equity Long Short

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Company overview │ Investment approach │ Risk management & ODD │ Client solutions │ Summary

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DISCLAIMER Ermitage Global Wealth Management Jersey Limited is registered with the Jersey Financial Services Commission under the Financial Services (Jersey) Law 1998 for the conduct of investment business and

fund services business and has issued this publication which is for private circulation only, is published solely for information purposes and does not constitute an offer to sell or an invitation to buy any of the securities or

funds mentioned herein or any other financial instruments. Subscriptions will only be received and units or shares issued on the basis of the current offering documents) for the fund and prospective investors should

carefully consider the risk warnings and disclosures for the fund set out therein. Investors should also consider any other factors that may be relevant to their circumstances. The investor must make an independent

assessment of any legal, credit, tax, regulatory and accounting issues and determine with his or her professional advisors any suitability or appropriateness implications of any transaction contemplated or referred to herein.

Units or shares in the fund are not for sale in any jurisdiction in which such sale would be prohibited. Whilst reasonable efforts have been made to ensure the accuracy of the information herein, which is based on proforma,

estimated or unaudited figures, the Ermitage Group accepts no responsibility for its accuracy, nor the reasonableness of the conclusions based upon such information. The contents of this document are believed to be

accurate at the date hereof but are subject to change without prior notification. Past performance is not a guarantee of future performance. The price of units or shares can go down as well as up and may be affected by

changes in rates of exchange. An investor may not receive back the amount invested. Important information for South African (SA) Residents: When issued in SA, issued by Ermitage Global Wealth Management Jersey

Limited, a representative of STANLIB Wealth Management Limited ("STANLIB"), an authorised Financial Services Provider in terms of the Financial Advisory and Intermediary Services Act, 2002, with FSP No 26/10/590.

STANLIB's contact details are as follows: 17 Melrose Boulevard, Melrose Arch, 2169, P O Box 202, Melrose Arch, 2076, Tel +27 (0) 11 - 448 6000, Fax 0867 277 505, contact centre 0860 123 003, www.stanlib.com.

Ermitage Asset Management Jersey Ltd Ermitage

Global Wealth Management Jersey Ltd

47 The Esplanade, St Helier, Jersey

Channel Islands JE1 9LB

Tel: +44 (0) 1534 615500

Fax: +44 (0) 1534 615520

Ermitage UK Ltd

25 Savile Row, London, W1S 2ES

Tel: +44 (0) 207 333 0900

Fax: +44 (0) 207 333 0443

Ermitage Americas Inc

Suite 917, 9th Floor, 330 Madison Avenue

New York, NY 10017

Tel: +1 646 495 5665

[email protected]

www. ermitagegroup.com

an introduction to hedge funds - cfa institute - the role... · fund of hedge funds, single manager...

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