Question

4. A friend has suggested that you should consider investing in an equity hedge fund because the fund may achieve returns higher than the share market. (LO 3.6) (a) Describe how a hedge fund is structured, including the manager, investors and types of investment (b) Explain how a hedge fund may use leverage strategies to achieve higher returns. Give an example.

Answer 1

a)

i) Hedge funds may be offered and managed by individual managers or financial institutions, particularly investment banks. Individual managers usually have a very high profile and an established reputation in the financial markets. Similarly, investment banks employ individuals with specialist skills.

ii) The hedge fund sector is generally divided into single-manager hedge funds, and fund of funds. Fund of funds diversify their investments across a number of single-manager funds.

iii)Hedge funds will tend to specialize in equity, foreign exchange, bonds, commodities and derivatives. Hedge funds obtain their funds from institutional investors, high net-worth individuals and retail investors. In particular, superannuation funds and life offices are a major source of institutional funds

iv)A hedge fund typically uses so-called sophisticated investment strategies and exotic investment products to try and achieve higher returns on investments and is therefore generally regarded as a higher risk investment

v)A hedge fund may choose to list on a stock exchange, thus providing a secondary market that will allow investors to buy and sell units in the fund.

vi) An expectation of investors is that hedge funds will achieve positive returns in both an upward and a downward moving market.

b)

i) Hedge funds leverage investment opportunities by borrowing large amounts of debt.

ii) Further, a hedge fund may leverage a position by using derivative products such as options, forwards and futures contracts.

iii)Derivatives may be bought or sold to take either a short or a long position in the equity market or the foreign exchange market.

iv) For example, a hedge fund may buy shares they forecast will rise in price by either using borrowed funds or derivative products.

v)The profit potential to the hedge fund is multiplied by the high level of leverage taken, but the level of risk is also much higher