Question

Explain differences between hedge funds and absolute return fund

Answer 1

Explain differences between hedge funds and absolute return fund

1.What Is Hedge Fund?

A) Meaning Of Hedge:

The word "hedge", meaning a line of bushes around the perimeter of a field, has long been used as a metaphor for placing limits on risk. Early hedge funds sought to hedge specific investments against general market fluctuations by shorting the market, hence the name.Nowadays, however, many different investment strategies are used, many of which do not "hedge risk".

B) Hedge Fund:

A hedge fund is an investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading, portfolio-construction and risk management techniques to improve performance, such as short selling, leverage, and derivatives.Because of its use of complex techniques, financial regulators typically do not allow hedge funds to be marketed or made available to anyone except institutional investors, high net worth individuals and other investors who are considered sufficiently sophisticated, such as being an accredited investor.

Hedge funds are regarded as alternative investments. Their ability to make more extensive use of leverage and more complex investment techniques distinguishes them from regulated investment funds available to the retail market, such as US mutual funds and UCITS. They are also considered distinct from private equity funds and other similar closed-end funds, as hedge funds generally invest in relatively liquid assets and are generally open-ended, meaning that they allow investors to invest and withdraw capital periodically based on the fund's net asset value, whereas private equity funds generally invest in illiquid assets and only return capital after a number of years. However, other than a fund's regulatory status there are no formal or fixed definitions of fund types, and so there are different views of what can constitute a "hedge fund".

Although hedge funds are not subject to many restrictions that apply to regulated funds, regulations were passed in the United States and Europe following the financial crisis of 2007–2008 with the intention of increasing government oversight of hedge funds and eliminating certain regulatory gaps.

C) Strategies of Hedge Fund:

Hedge fund strategies are generally classified among four major categories: global macro, directional, event-driven, and relative value (arbitrage).Strategies within these categories each entail characteristic risk and return profiles. A fund may employ a single strategy or multiple strategies for flexibility, risk management, or diversification. The hedge fund's prospectus, also known as an offering memorandum, offers potential investors information about key aspects of the fund, including the fund's investment strategy, investment type, and leverage limit.

The elements contributing to a hedge fund strategy include: the hedge fund's approach to the market; the particular instrument used; the market sector the fund specializes in (e.g., healthcare); the method used to select investments; and the amount of diversification within the fund. There are a variety of market approaches to different asset classes, including equity, fixed income, commodity, and currency. Instruments used include: equities, fixed income, futures, options, and swaps.

D) Relative value:

Relative value arbitrage strategies take advantage of relative discrepancies in price between securities. The price discrepancy can occur due to mispricing of securities compared to related securities, the underlying security or the market overall. Hedge fund managers can use various types of analysis to identify price discrepancies in securities, including mathematical, technical, or fundamental techniques. Relative value is often used as a synonym for market neutral, as strategies in this category typically have very little or no directional market exposure to the market as a whole.

Other relative value sub-strategies include:

• Fixed income arbitrage: exploit pricing inefficiencies between related fixed income securities.
• Equity market neutral: exploit differences in stock prices by being long and short in stocks within the same sector, industry, market capitalization, country, which also creates a hedge against broader market factors.
• Convertible arbitrage: exploit pricing inefficiencies between convertible securities and the corresponding stocks.
• Asset-backed securities (fixed-income asset-backed): fixed income arbitrage strategy using asset-backed securities.
• Credit long / short: the same as long / short equity, but in credit markets instead of equity markets.
• Statistical arbitrage: identifying pricing inefficiencies between securities through mathematical modeling techniques
• Volatility arbitrage: exploit the change in volatility, instead of the change in price.
• Yield alternatives: non-fixed income arbitrage strategies based on the yield, instead of the price.
• Regulatory arbitrage: exploit regulatory differences between two or more markets.
• Risk arbitrage: exploit market discrepancies between acquisition price and stock price.

E) Risk:

For an investor who already holds large quantities of equities and bonds, investment in hedge funds may provide diversification and reduce the overall portfolio risk.Managers of hedge funds use particular trading strategies and instruments with the specific aim of reducing market risks to produce risk-adjusted returns that are consistent with investors' desired level of risk. Hedge funds ideally produce returns relatively uncorrelated with market indices.While "hedging" can be a way of reducing the risk of an investment, hedge funds, like all other investment types, are not immune to risk. According to a report by the Hennessee Group, hedge funds were approximately one-third less volatile than the S&P 500 between 1993 and 2010.

F) Risk management:

Investors in hedge funds are, in most countries, required to be qualified investors who are assumed to be aware of the investment risks, and accept these risks because of the potential returns relative to those risks. Fund managers may employ extensive risk management strategies in order to protect the fund and investors. According to the Financial Times, "big hedge funds have some of the most sophisticated and exacting risk management practices anywhere in asset management."^[82] Hedge fund managers that hold a large number of investment positions for short durations are likely to have a particularly comprehensive risk management system in place, and it has become usual for funds to have independent risk officers who assess and manage risks but are not otherwise involved in trading.

2. What is Absolute return?

A) Meaning:

The absolute return or simply return is a measure of the gain or loss on an investment portfolio expressed as a percentage of invested capital. The adjective "absolute" is used to stress the distinction with the relative return measures often used by long-only stock fundsthat are not allowed to take part in short selling.

The hedge fund business is defined by absolute returns. Unlike traditional asset managers, who try to track and outperform a benchmark (a reference index such as the Dow Jones and S&P 500), hedge fund managers employ different strategies in order to produce a positive return regardless of the direction and the fluctuations of capital markets. This is one reason why hedge funds are referred to as alternative investment vehicles (see hedge funds for more details).

Absolute return managers tend to be characterised by their use of short selling, leverage and high turnover in their portfolios.

Absolute return is the return that an asset achieves over a specified period. This measure looks at the appreciation or depreciation, expressed as a percentage, that an asset, such as a stock or a mutual fund, achieves over a given period. Absolute return differs from relative return because it is concerned with the return of a particular asset and does not compare it to any other measure or benchmark.

B) Relative:

In general, a mutual fund seeks to produce returns that are better than its peers, its fund category, and the market as a whole. This type of fund management is referred to as a relative return approach to fund investing. The success of the asset is often based on a comparison to a chosen benchmark, industry standard, or overall market performance.

As an investment vehicle, an absolute return fund seeks to make positive returns by employing investment management techniques that differ from traditional mutual funds. Absolute return investment strategies include using short selling, futures, options, derivatives, arbitrage, leverage, and unconventional assets. Absolute returns are examined separately from any other performance measure, so only gains or losses on the investment are considered.

C) WHAT ARE SOME EXAMPLES OF ABSOLUTE RETURN STRATEGIES?

Absolute Return Strategies vary widely. However, some common examples are as follows:

• Long-short equity strategies: These are strategies that involve a combination of ‘long’ and ‘short’ positions and are generally highly liquid. Examples include long-bias equity, portfolios of paired trades, market neutral equity and short-bias equity.

• Relative value strategies : These are strategies that seek to exploit apparent pricing/ valuation anomalies between particular securities. Typically, the manager will take a ‘long’ position in the security, which appears to be undervalued and a ‘short’ position in the security, which appears to be overvalued. Examples include equity market neutral and fixed interest relative value strategies.

• Event-driven strategies : These strategies involve an assessment by the manager of how company specific events, such as mergers, bankruptcies and restructurings, are likely to evolve. Depending on the exact circumstances, the manager often takes a ‘long’ position in the securities of one of the companies involved, and a ‘short’ position in another. Examples include merger arbitrage and distressed debt.

• Global macro strategies : These strategies involve an assessment by the manager of developments in global economies and financial markets. Sometimes they are driven by the qualitative judgments of the manager. In other cases, the strategies are driven mainly by the use of quantitative models.
• Managed futures funds : These strategies typically use algorithmic3 and technical models that focus on the trends exhibited by futures and other very liquid securities. These include most commodities funds.

• Multi-strategy funds : These strategies use a number of the strategies noted above. As they are diversified across a wide range of different absolute return strategies and asset classes, they aim to deliver consistent returns with low levels of volatility. They are generally managed by one manager, providing a single, cost-effective access point to absolute return strategies.

• Funds of hedge funds (FOHF) : These strategies often invest in 30 to 70 different underlying alternative strategies. What sets them apart from multistrategy funds is that each of the underlying alternative strategies is typically handled by a different manager.

3.Differences between hedge funds and absolute return fund

The major difference between the two is the definition of their return objective: Hedge funds aim for absolute returns by balancing investment opportunities and risk of financial loss. Long-only managers, by contrast, define their return objective in relative terms.

Sometimes called a “non-directional fund,” an absolute-return fund is designed to generate a steady return no matter what the market is doing. Hedge fund managers can use many different investment tools within an absolute-return strategy.

Although absolute-return funds are close to the true spirit of the original hedge fund, some consultants and fund managers prefer to stick with the label absolute-return fund rather than “hedge fund.” The thought is that hedge funds are too wild and aggressive, and absolute-return funds are designed to be slow and steady. In truth, the label is just a matter of personal preference.

There are strategies in Absolute-Return Fund that seek to exploit apparent pricing/ valuation anomalies between particular securities.And in Hedge fund arbitrage strategies take advantage of relative discrepancies in price between securities.

Hedge funds are able to employ a wide variety of financial instruments and risk management technique,they can be very different from each other in respect of their strategies, risks, volatility and expected return profile. It is common for hedge fund investment strategies to aim to achieve a positive return on investment regardless of whether markets are rising or falling ("absolute return"). Although hedge funds can be considered risky investments, the expected returns of some hedge fund strategies are less volatile than those of retail funds with high exposure to stock markets, because of the use of hedging techniques.