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[I482]Invest In Hedge Fund

by Pat Regan, Pat

Now some mutual funds use these strategies, too.

How Hedge Funds Differ from Mutual Funds

Aside from minimal regulation and the high minimum investment, hedge funds are similar to mutual funds. It is the strategies they employ that are the main difference.

Hedge fund managers have greater flexibility over their funds' investments. A typical mutual fund manager will be limited by set asset allocations (say, 70% stocks and 30% bonds). A hedge fund's investments, on the other hand, are up to the sole discretion of the manager.

So, let's have a look at the strategies that hedge funds – and now some mutual funds -- use.

Hard Assets

Hedge fund managers may sell most of the fund's securities and hold cash (US dollars or Euros, usually) or other assets (commodities). Hard assets shield investors from overexposure to the equity markets.

Short Selling (Shorting)

Shorting is selling stocks that you do not own so that you can buy them back at a discount later. Any investor with a margin account can do this, but few mutual fund managers are entrusted with this high-risk strategy.

If an investor decides that a stock is overvalued -- Let's say XYZ is trading at $7.50 -- the investor shorts 1,000 shares of XYZ at a profit of $7,500 ($7.50 per share X 1,000 shares). She now has an extra $7,500, but must buy back those 1,000 shares of XYZ in the future.

Luckily, a week passes and XYZ releases a negative outlook press release and the stock price drops to $6.50. Our investor calls her broker and "covers" (purchases) 1,000 shares for $6,500, keeping the remaining $1,000 for herself. This is a risky strategy which loses money when the stock rises in value.

Long-Short

Hedge funds typically blend short selling with "long" positions, hence the name long-short. Long-short funds purchase securities that they think will increase in value while shorting securities they think will fall. This hedges

Equity Market Neutral

Equity market neutral is stock-picking within an asset class that hedges against risk using a long-short method within that asset class. A manager may believe that ABC stock is a better health insurance stock than ZZZ. The manager will then buy, or "long," ABC while simultaneously shorting ZZZ.

With this strategy all that matters is the relative performance of these two stocks, regardless of the larger market's performance. If ABC stock rises more than ZZZ (or falls), the investment makes money.

Market Neutral Arbitrage

Arbitrage investing exploits imbalances in pricing between securities.

Market neutral arbitrage seeks out imbalances in securities from the same issuer. This strategy hedges against market risk by investing in opposing positions (long and short) in different asset classes of the same issuer. A manager, then, may short sell a company's stock while simultaneously purchasing the same company's bonds.

Merger Arbitrage

Merger arbitrage focuses on companies involved in a takeover or merger. When Company A announces that it is going to buy Company B for a set price (let's say, $50 per share), Company B's stock will rise to a point just below that of Company A's purchasing price (let's say $48 per share). The difference between the acquiring price ($50) and the stock price of Company B ($48) is called the spread ($2 in our example). The point of merger arbitrage is to turn that spread into short-term profit.

If two companies are merging, the manager purchases shares of the smaller company while shorting the larger until the merger.

The only risk in merger arbitrage is deal risk - the possibility that the merger or acquisition will fall through.

Convertible Arbitrage

A convertible bond is a corporate bond that can be redeemed for company stock at some future point. Like any bond, its price falls if a company's credit rating falls or if interest rates rise. Convertible arbitrage profits from the difference between the price of the bond and the value of the stocks it can be redeemed for.

Fund of Funds

As its name implies, a fund of fund invests in multiple mutual funds or hedge funds. Multiple funds may diversify a single strategy over different asset classes, or they may employ various strategies. Such a fund spreads the investment over multiple hedging strategists.

Use These Strategies Sparingly

In recent years many mutual funds have emerged that use these strategies. Look out for them and invest cautiously. No more than 10% of your portfolio should invest in any of these off-market strategies, but they will provide stable returns even in a down market.

But first ? A METAPHOR

What would happen if you had a pain in your chest, and you had tests taken at your doctor on a Monday who you have known and trusted for 30 years? He tells you that the results will tell you if you are going to live or die, no in between. You now visit the doctor on a Friday to discuss the results. The doctor says to you how would you like to bet on the results.

You offer to bet $1 million that you are going to live. The doctor says, "I will take your bet myself." Would you still make the bet? The answer is no, of course you wouldn't because the doctor already knows the result. and you don't. It's like betting against the house in Las Vegas when the house already KNOWS how the results will turn out.

This is the same situation in our opinion that Amaranth the hedge fund faced during its trading crisis. Hedge funds have to book their trades through a clearing firm, no different than many major brokerage firms clearing trades for smaller brokerage firms. The smaller firm pays a fee to the bigger firm that clears the trades for them.

In the case of Amaranth the hedge fund, JP Morgan was the clearing broker, known as a Prime Broker. In essence Amaranth made bets on the energy futures markets, and these bets went the wrong way. As a hedge fund, Amaranth uses leverage when it trades against its equity, usually borrowing about 6 to 1, and sometimes as high as 8 to 1. JP Morgan as the clearing broker was the lender of the additional margin.

Now when a trade goes against a hedge fund, the fund may be called upon by the clearing firm to put up more margin, meaning cash, or securities to protect the clearing firm. In this case the problem happened on a Friday. Amaranth wanted to get rid of billions of dollars of toxic bad trades by giving them to Goldman Sachs, who agreed to take them if Amaranth would give Goldman $2 billion in cash along with the trades. Goldman would then assume the risk of what happens to those trades. Amaranth wanted its clearing firm, JP Morgan to give Goldman the $2 billion from its capital account simultaneous with the movement of the trades.

JP Morgan would not release the funds. They barked, stating that they felt they would still be at risk if this were to happen. A clearing firm hates risk, and never wants to take risk. Amaranth very quickly had to operate in the most treacherous waters imaginable. They had to begin talking to outsiders in a desperate attempt to structure a transaction with anyone capable of taking these trades or injecting new additional capital. Remember, this is Wall Street, the sharks were circling.

Anyone who had knowledge of Amaranth's trades knew immediately how precarious the oil markets that Amaranth was involved in. They also knew how to play the market to its own advantage using Amaranth's weaknesses. The SHARKS came in and did trades that would work to their advantage. Within a matter of trading hours, this giant hedge fund was losing hundreds of millions of additional dollars. Merrill Lynch decided to take a piece of the funding deal, and this drove Goldman Sachs up a wall. Goldman upped the ante, and decided to charge Amaranth hundreds of millions more to do the deal which would partially save Amaranth.

Now here's where our story of the doctor with the patients information and the patient's bet come in handy. JP Morgan as the clearing broker was in a position to know more about the condition of Amaranth's books, and their trading positions than anyone else in the industry. Since JP Morgan also trades in the same market as Amaranth, the bank knew the market's condition better than anyone else also.

When the Morgan bank was informed that a deal was imminent between Goldman and Amaranth, the Chairman of Morgan got involved himself and called in his top energy trader over the weekend. Morgan was thinking of making their own deal for Amaranth's positions, the very positions that they cleared for Amaranth over the preceding months.

The Morgan bank was sitting in the catbird seat. They knew everything; they saw everything, no different than a black jack dealer in Las Vegas being able to tell everyone's cards. As a person who has been in this field for 30 years, and watched a few firms go down the tubes in a deal like this, I tell you, it doesn't SMELL RIGHT.

JP Morgan knew that Amaranth couldn't make a deal with anyone as long as the Morgan bank held the collateral. No deal could be structured if Morgan wouldn't release at least part of the money in the Amaranth account at Morgan. The Morgan bank was in complete control of Amaranth's destiny. What would the bank do?

JP Morgan also acts as a giant hedge fund trader for its own account in the energy markets, and in other markets. In a sense it competes against its clients if it chooses to, in these markets. The difference is when you are a major clearing firm as well as trading yourself, which is what Morgan does, you have the advantage. You have an understanding of the market place that nobody else can even dream about having. It is the trader's ultimate dream. There are times when the clearing firm can dictate the market.

The FINAL DEAL

Discussions ensued through the weekend, into Monday, and Tuesday. Amaranths finally capitulated at 5:30AM on Wednesday morning, and guess who signed the deal. J.P. Morgan in conjunction with the Citadel Investment Group, another hedge fund inked the deal. Amaranth's $800 million in portfolio losses from the weekend would be eaten by Amaranth themselves. Morgan and Citadel got $1.6 billion in cash to take the trading positions in the portfolio off Amaranth's books. They got another $300 million to assume options positions, plus a $250 million kicker for commodity investments.

What's the bottom line here? It just became public information that J.P. Morgan made $725 million for its bottom line on the deal. Congratulations to a nice conservative bank, that always catered to conservatively managing the trust funds of its wealthy clientele. Do you think that GREED had anything to do with the bank's decision to cut the deal with Amaranth, as opposed to arranging a bailout? Gee, a bank wouldn't function like that, would it?

Article Source : Hedge Funds of Funds

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Both Pat Regan & Richard Stoyeck are contributors for EditorialToday. The above articles have been edited for relevancy and timeliness. All write-ups, reviews, tips and guides published by EditorialToday.com and its partners or affiliates are for informational purposes only. They should not be used for any legal or any other type of advice. We do not endorse any author, contributor, writer or article posted by our team.

Pat Regan has sinced written about articles on various topics from Finances, Hedge Funds of Funds and Finances. . Pat Regan's top article generates over 1000 views. to your Favourites.

Richard Stoyeck has sinced written about articles on various topics from Politics, Finances and Foreclosure Help. Richard Stoyeck’s background includes being a limited partner at , Senior VP at Lehman Brothers, Kuhn Loeb, Arthur Andersen, and KPMG. Educated at Pa. Richard Stoyeck's top article generates over 22200 views. to your Favourites.