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expansion of european

Although hedge funds are not yet sold at the corner bank branch or ATM, that is not beyond the realm of possibility. The industry continues to experience exponential growth with studies predicting $4 trillion in hedge fund assets by 2010-up from close to $800 billion in 2004. (See Figure P.1.) Because hedge fund investing is based on a dynamic approach that is uncorrelated to general market conditions, its appeal continues to expand and more investors than ever seek ways to capitalize on the hedge fund opportunity. As a result, there are more hedge funds around than ever, a number of new products, and increasing confusion.

Indeed, hedge fund investing is a complicated task even for those with substantial resources or investment experience. The hedge fund industry is rife with both deliberate mystification and legitimate complexity. This book demystifies hedge funds and clarifies the built-in complexities to enable more investors to introduce, in a prudent manner, absolute return-oriented investment strategies and vehicles into their overall investment program.

Misconceptions regarding hedge fund investing stem largely from high-profile stories about large, highly secretive and speculative hedge



A. Number of Hedge Funds (Growth from 1991-2003)

7,000 6,000 5,000 4,000 3,000 2,000 1,000 0


91 92 93 94 95 96 97 98 99 00 01 02 03


90 91 92 93 94 95 96 97 98 99 00 01 02 03

FIGURE P.1 The historical growth of hedge funds. Source: Hedge Fund Research, Inc. Approximate industry estimations

funds that either blew up or made a bundle on a multibillion-dollar gamble, in either instance taking down a national economy or two as a result. But as the hedge fund industry has grown and evolved, the headlines and the stories that followed have taken on a lot more of the substance and nuance required to do justice to the complexities of hedge funds and the hedge fund industry. Figure P.2 presents a history of the hedge fund market.

Although scandalous headlines still show up with disturbing regularity, it is increasingly common to see stories that report on the real



substance behind the dramatic growth of hedge funds: the growing demand for opportunities to pursue absolute as opposed to relative investment returns.

This book summarizes what hedge funds are and how they can help us all to make more money. Most important, it looks at where the industry is headed and what smart investors need to do now to accomplish their investment goals. Table P.1 shows the difference in risk between hedge funds and more traditional investments.

Chapter 1 outlines the hedge fund alternative, including the basic attributes of hedge funds, the major strategies they use to pursue their investment objectives, the comprehensive process of manager evaluation and selection, and some of the complexities associated with hedge fund investing through what is known as a fund of funds (FOFs) or fund of hedge funds (FOHFs).

Chapter 2 explores how to cut through the black box and timely issues related to hedge fund disclosure and transparency, which is the degree to which investors and/or regulators can or should be informed

INNOVATION STRONG EXPLOSIVE

EARLY ADOPTION GROWTH GROWTH


1949: Alfred W. Jones & Co. investment model

1970s & 1980s: gradual growth estimated at $40B:

George Soros

Barton Biggs

Warren Buffet

Michael Steinhardt

Growth drivers:

Financial market conditions

Educated investor & media attention

Increased supply of hedge fund product & distribution

New segment demand (high net worth segments, pensions, Europeans)

Estimated 7,000+ hedge funds worldwide

Estimated $800B in assets.

Estimated hedge funds net inflows worldwide:

$8.0B in 2000

$31.1B in 2001

$72.B in 2003

Figure P.2 History of the hedge fund market.



Hedge Funds

Traditional Investment Portfolios

Implication

Investment style

Exposure to market

Standard format to measure/ report risk

Value at Risk (VaR)

Risk profiles

Defining characteristic. Vary substantially.

Varies from multiples of - 1 (short seller with leverage) to + 1 (long-bias with leverage).

None: different hedge funds map risk differently, often use derivatives.

Limited value: VaR measures differ widely across managers.

Differ considerably: - e.g., take credit risk.

Vary moderately.

All sector/style indices have В to the market of around 1.

Well established-can map mutual fund risks/returns onto standard asset classes.

Of great value-time horizons, confidence levels, asset mixes generally comparable.

Well-defined risk profiles, analytics.

Investor must map risk. Cross-style, -manager aggregation of risk are difficult.

Manager skill important. Process risk more relevant.

Requires detailed individual examination of funds.

Risk analysis applied to long-only managers insufficient for hedge fund managers.

Investor as global risk manager -manages risk selects funds with different styles, exposures.



Liquidity crisis risk

Performance data

Sharpe ratio

Short volatility bias

Interplay of risks

Vulnerable-exacerbated to extent use leverage, less liquid markets/instruments/style.

Subject to a number of risk biases.

Partially applicable-but

does not fully capture hedge fund nonlinearity.

Short options exposure can boost Sharpe ratio, leading to overallocation, higher risk.

Not only the greater variety of risk but, critically, their overall interplay drives risk-adjusted returns.

Equally vulnerable-can affect hedge funds and long-only manager equally.

Subject to far fewer biases.

Fully applicable-developed for long-only linear investments

Limited, if any, options shorting.

Market risk-equity, interest rate and credit risk-drive risk-adjusted returns.

Quantification of interplay of liquidities, risk, leverage, styles, etc., is critical.

Risk of inflated expectations. Requires sophisticated due diligence and monitoring.

Requires detailed individual examination of funds.

Risk of overallocation. Scrutinize high Sharpe. Scrutinize use of short options.

Must scrutinize risk in aggregate.

Intelligent diversification is critical.



about a funds actual investments and investment practices. Current transparency issues relate to both investor demand for increased transparency and pending regulations, which are prompting hedge funds to dramatically rethink approaches to this issue.

Chapter 3, written by two principals from LJHs partner company, Capco, underscores the challenges involved in due diligence and portfolio monitoring by relating the findings of a comprehensive study of over 10 years of hedge fund blow-ups. Investors will learn more about what to watch out for when making a hedge fund investment decision.

Chapter 4 focuses on the single largest category of hedge fund fraud, improper valuation of portfolio holdings. It outlines the red flags investors need to watch out for and tells investors why valuation is a potential industry black eye they need to monitor.

Chapter 5 delves into the issue of size versus performance in the hedge fund industry, a study that points to the need for investors to evaluate managers of all sizes when making hedge fund allocations.

Chapter 6 looks at two fast-growing directional strategies, the global macro strategy and managed futures investing, and outlines how investors can profit from the global economic markets and commodities trading.

Chapter 7 is an overview of distressed securities and merger arbitrage, two of the principal event-driven strategies that present investors with an opportunity to profit from events that occur during the corporate life cycle.

Chapter 8 covers two prominent nondirectional or relative value strategies, convertible bond arbitrage and fixed income arbitrage.

Chapter 9 delves into a third relative value strategy, equity market neutral, which helps investors profit in either up or down markets.

Chapter 10 looks at technology sector investing and how this volatile and dynamic investment sector can lead to profits.

Chapter 11 begins a discussion of geographic sector investing by looking in the current prospects for investing in Europe, a region whose level of international prominence is expanding.

Chapter 12 examines investment opportunities in Asia, where investors have an opportunity to take advantage of Japans tumultuous market, rule changes, and volatility.



Chapter 13 looks at hedge fund indices, including the new investable indices, and helps investors to understand how to track with reasonable confidence the directionality of hedge fund performance.

The glossary contains commonly used hedge fund terms aimed at clarifying oft-used words in the industry.

Before we begin, however, I want to give you a sense of my own background, how I developed my particular take on the world of hedge funds, and why I approach this introduction to the industry a little differently from how others might.

For over a decade now, I have been the president and chief investment officer of LJH Global Investments, an investment advisory firm founded with a focus on introducing the benefits of absolute return investing to high-net-worth individuals, institutions, and their advisors through the creation of custom tailored hedge fund portfolios.

From the beginning, the LJH approach has been to identify and provide access to top hedge fund managers who have passed a rigorous due diligence conducted by a team of hedge fund research analysts who specialize by individual strategy. During the last 10-plus years, we have helped some of the worlds wealthiest families invest in hedge funds and have established ourselves as a leading global hedge fund advisory firm called on by financial services firms as a subadvisor to build, manage, and service FOHF products. We also have served as direct advisors to pension funds, family offices, and other high-net-worth individuals in the construction of individual hedge fund portfolios, and have provided FOHFs products for direct distribution to qualified investors. Our firm was one of the first to develop fund of hedge funds registered with the Securities and Exchange Commission (SEC), an insurance clone product, and an array of structured hedge fund products.

I want to make two points about how this background has both motivated me to write this book and influenced its content.

First, this book is the logical outcome of LJHs commitment to thought leadership in the hedge fund industry, stemming from a belief in the fundamental importance of promoting realistic expectations regarding hedge funds as an asset class. This commitment has been expressed in several ways and in a variety of forums. For over a decade, LJH has hosted an annual client summit where many of the best minds



in the industry gather to discuss and debate timely issues of importance to investors. LJH speakers also address industry issues at investment conferences and before regulatory agencies in the United States and abroad. In 2002 I was the first fund of hedge funds expert ever invited to speak to executives from the Bank of Japan. In the spring of 2003 I was one of the experts invited to testify before the SEC in its most recent reexamination of the hedge fund industry.

In addition to the ongoing publication of a series of thought-provoking and practical white papers on a range of industry issues, LJH experts are also sought out for commentary by financial publications including Forbes, Institutional Investor, the New York Times, Barrons, and the Wall Street Journal, and have appeared on business television shows including CNN, CNBC, and Bloomberg. Outstanding product development combined with these robust, ongoing investor education activities are the keys to thought leadership in our industry.

Second, this book strives to provide the reader with a wealth of information that can be put to practical use. Much of this information is representative of the intelligence that our firm has gleaned from leading hedge fund managers and others within the industry. Making a hedge fund investment is very much an act of trust, and judgment regarding the character of managers to whom one might entrust a significant portion of ones assets is perhaps the most practical element in the entire investment allocation process.



Acknowledgments

This book is a compilation of many of our firms best ideas and would not be possible without the talented team of people who have worked with us through the years. Thank you also to all of the LJH clients for whose hedge fund investing journey we have managed and to the other friends of LJH who have contributed to our firms success. I would also like to thank the numerous hedge fund managers with whom I have spent countless hours over the years. Your stories, firms, expertise, and success are the foundation of our business. Most of all, I wish to express my greatest appreciation to my partner, Charlotte Luer, without whose support, creativity, and energy this book would have never materialized.





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