Fund Management

 

Introduction

Not every investor has the time or expertise to manage their own financial assets. As a result, some investors choose to hire a professional manager to manage their investments in the form of a mutual fund or a hedge fund. These investment allow investors to instantly diversify their portfolio and receive professional management. Mutual funds are typically used by smaller investors, whereas hedge funds are designed for wealthy investors. As hedge funds are limited to those who can afford to lose their investments, hence they are subject to fewer regulations. Let's go deep dive in each of these fund management.

Mutual Funds

• Mutual funds are a pool of money collected from many investors where the funds are used to invest in securities such as stocks and bonds.
• Here the desire to have investment expertise rather than put the time and effort into the investment process themselves.
• Usually here the investing of money is on behalf of relatively small investors.
• The portfolio of investments is operated by a manager whose mandate is to generate income or capital gain for the investors.
• A mutual fund has strict investment objectives which must be followed by the manager all the time. These objectives are laid down in the fund's prospectus.
• When investing in a mutual fund, you may come across two types of fees:
• Front-end load is a fee that the fund charges when you buy shares for the first time. The fee often goes to the brokers that sell the fund to investors. This fee is limited to less than 8.5% of the total investment in the United States.
• Back-end load is the fee that the fund charges when you sell your shares. The amount of back-end load decreases with the duration for which you held the shares in the fund. Back-end load fees are generally an attempt to prevent investors from moving quickly in and out of the mutual fund, which increases the expense ratio of the fund. Often, back-end load fees are for a specified period, such as 6-months or 1-year. Once the investor has met the holding period requirements, back-end load fees typically go away.
• As this accept investments from retail investors they are subjected to higher level of regulation.
• Net Asset Value (NAV)
• The Net Asset Value (NAV) of a mutual fund is the per-unit market value of all its securities and cash, minus its liabilities, divided by the total number of outstanding units.
• NAV is calculated on a daily basis and represents the price at which investors buy or sell units of the mutual fund.  
• Here is the formula to calculate NAV:  
• NAV = Market Value of Assets − Liabilities / Number of Outstanding Units​
• Market Value of Assets, includes the current market value of all the securities held by the mutual fund. For stocks, it is the market value of each stock in the portfolio, for bonds, it is the market value of the bonds and so on.
• Liabilities, represent any outstanding costs or obligations that the mutual fund needs to cover. This could include expenses, fees, or any other outstanding payments.
• Number of Outstanding Units, is the total number of units (shares) issued by the mutual fund that are currently held by investors.
• Example:
• If the total value of the all the assets in the fund is calculated to be $100 million, $50 million as liabilities and if the number of outstanding shares is 2 million, then NAV is $25 per share (=100-50/2).
• If investor wants to invest $1000 they would exactly buy 40 shares (=1000/25) on the relevant trading day.
• It's important to note that NAV is usually calculated at the end of each trading day since mutual funds are typically valued once a day after the market closes. Investors use the NAV to determine the price at which they can buy or sell shares in the mutual fund. The NAV per share is the value at which investors transact with the mutual fund.
• There are different types of mutual funds, such as:
• Index Funds
• Open-End Mutual Funds
• Close-End Mutual Funds
• Exchange Trade Funds
• The main differences between them revolve around how they issue and redeem shares, how they are traded, and their pricing mechanisms.
• There are no tax advantages associated with investments in mutual funds, as though he or she owns the investments of the funds. For example, if the shares are by the fund at USD 70 and sold at USD 90, the investor has a USD 20 capital gain that is subject to taxation.

Index Funds

• An index fund is a specific type of mutual fund that aims to replicate the performance of a particular financial market index. 
• Instead of actively selecting and managing individual securities, index funds designed  to passively track the performance of a specific index, such as the S&P 500, the Dow Jones Industrial Average, FTSE 100 or others.
• Tracking can be done by following:
• Buying all the shares in the index in amounts that reflect their weight in the index
• Choosing a smaller portfolio of representative stocks that have been proven to follow the index
• Using index futures
• Tracking error measures how well a fund tracks its intended index.

Open-End Mutual Funds

• Open-end funds continuously issue and redeem shares based on investor demand. This means that investors can buy or sell shares directly from the fund at the current net asset value (NAV) per share, which is calculated at the end of each trading day. 
• The number of shares and the size of the fund expand and contract as investors chose to buy and sell shares, leading number of shares increase or decrease.
• In an open-end fund, one deals with the funds itself when buying shares.
• Shares can be bought or sold back to the fund at any time, and available for subscription throughout the years.
• They are valued once a day, at 4 p.m in EST. When an investor issues instructions to buy or sell shares, the value calculated at the end of the day which is the next available NAV.
• If an investor who decides to buy share at 10:00am will enter a buy order for a set dollar amount, but they will not know the price at which they will transact until after the market closes. Transactions are executed at the end of the day after NAV calculation. 
• Hence open-end mutual funds have very low price transparency because they trade at the next available NAV. 
• Since shares are transacted at an unknown price, investors cannot use stop order or limit orders.
• When the investors decide that they want to exit their investment in an open-end mutual fund, they can redeem their shares directly from the fund company, who either send them  through cheque or a digital transfer of the value of the investment.
• The total number of shares outstanding goes up as investors buy more shares and goes down as shares are redeemed.
• At a high level, the open-end mutual funds are broken down into four main categories:
• Money markets funds, invest in short-term interest bearing instruments such as treasury bills, commercial paper, certificates of deposit, banker's acceptance and other highly liquid and low-risk instruments. These funds are designed to provide investors with a safe and easily accessible place to park their cash while earning a modest level of interest, hence the risk is lower. For many investors money market funds are alternative to a savings account at a bank, and the return on money market funds is usually higher than on bank deposits. Most money market funds attempt to keep a NAV of $1. When the fund drops below $1 NAV, it is referred to as breaking the buck. Breaking the buck occurs very infrequently. 
• Equity funds, invest solely in stocks. Within this category, one can find index funds that track a broad market index. Equity funds can be divided into two general groups:
• Actively managed fund. An actively managed fund relies on stock selection and timing skills of the fund manager, such as funds that invest in equities with high dividend ratios. Actively managed funds usually have a higher expense ratio than a passively managed fund, where the expense ratio is defined as total expenses divided by total assets. 
• Index or passively managed fund. An index or passively managed fund is designed to track an index, such as the S&P 500 or FTSE 100. The fund buys all the shares in the index in an amount representative of the index’s weight and generally accomplishes this goal. Although index funds attempt to perfectly track the index of stocks, tracking is not perfect, as every index fund has tracking error. Index funds typically have lower expense ratios compared to actively managed funds.
• Bond funds, invest only in fixed income instruments such as sovereign debt, corporate bonds, and asset backed securities.
• Hybrid funds, will blend stock and bond ownership into same fund.
• Taxation of open-end mutual fund:
• In an open-end mutual fund, the investor pays tax as though he owned the securities in which the fund has invested. When the fund receives a dividend, an investor has to pay tax on his share of the dividend, even if the dividend is reinvested in the fund for the investor.
• When the fund sells securities, the investor is made to realize an immediate capital gain or loss, even if the he has not sold any of his shares in the fund.
• Open-end mutual fund have a management fee and a sales charge, which are commonly called as loads. 
• Open-end mutual fund this not listed on a stock exchange, transactions occur directly through the fund.
• Maturity is not fixed and the corpus is variable.

Closed-End Mutual Funds

• Closed-end funds have a fixed number of shares that are issued. 
• These are issued through an initial public offering (IPO). After the IPO, the shares are traded on stock exchanges like individual stocks. After the initial shares no more shares are issued.
• In a closed end mutual fund, trade at market prices, allowing the shares to potentially buy share at a discount or sell at a premium to their NAV. The reason behind this is that shares are publicly traded on an exchange, and therefore the price is a function of supply and demand.
• For closed-end funds, two NAVs can be calculated.
• Price at which the shares of the fund are trading.
• Fair market value: market value of the fund’s portfolio divided by the number of shares outstanding. Usually a closed-end fund’s share price is less than its fair market value. Fees paid to fund managers are considered to be a reason for this.
• Selling price is Premium / discount to NAV.
• Like regular corporations and the shares of the fund are traded on a stock exchange which means they can be bought and sold during any time of the day. But these are available for subscription only during a few specified days and only long positions can be taken.
• Transactions are executed in real time, which means they have better price visibility and can utilize stop orders and limit orders if they so choose.
• Unlike open-ended here do not transact directly with the fund company, rather the shares are bought and sold through brokers or with other investors.
• Here this is listed on an exchange for trading.
• Maturity is fixed, in general 3-5years and corpus is fixed.

Exchange Traded Funds

• ETFs are innovation twist on the open-end and close-end mutual funds. Enabling instance diversification like an open-end fund but they are exchange-traded, which means they trade throughout the day on the open market just as closed-end fund does.
• Created by institutional investors. 
• Most track an index; e.g., SPDR tracks the S&P 500
• Some or all of the shares in the ETF are traded on a stock exchange characteristics of a closed-end fund but differs as institutions can exchange ETF shares for the underlying assets or even deposit new assets in return receive shares, and there is never a material difference between ETF exchange-traded share price and its fair market value (FMV).
• ETFs typically trade at their NAV.
• ETFs can be bought or sold at any time of the day, hence are more liquid. 
• ETFs can utilize stop orders, limit orders and even short sell just like a stock.
• Short selling is a different strategy. In this case, an investor borrows shares of an ETF (or stock) from a broker and sells them on the open market with the hope that the prices will go down.
• Later, they aim to buy back the same number of shares at a lower price, return them to the lender (the broker), and pocket the difference as profit.
• ETF holdings are disclosed twice a day thereby providing investors with more information and tremendous visibility about assets underlying the fund unlike open-end mutual funds which disclose their holdings relatively infrequently.
• ETFs in general have lower expense ratios.

Undesirable Trading Behaviours at Mutual Funds

• Some of the potential undesirable behaviours among mutual funds include late trading, market timings, front running and directed brokerage.
• Late Trading
• Late trading refers to the illegal practice and subject to prosecution of buying or selling mutual fund shares after the market closes, but at the price determined at the close of trading.
• For example, here the orders are accepted after the 4.00pm EST cut off trading time, but gets the NAV (Net Asset Value) calculated based on the closing prices.
• Market Timing
• Market timing is the strategy of trying to predict the future movements in an attempt to make profit from the financial markets by either buy or sell decisions based on short-term price fluctuations in the market. Investors using market timing attempt to enter or exit the market at specific times they believe will be advantageous.
• Although potential concern to regulators if trading exceptions are made for market timing, the act of market timing is not illegal.
• Layman Example:
• Imagine you have a friend named Alex who is trying to use market timing to make money in the stock market.  
• Alex's Belief: Alex believes that stocks are going to go up in the next few weeks because of positive news about a new technology product. So, Alex decides to invest a significant portion of their savings in a mutual fund that tracks the stock market. Market 
• Timing Action: Alex closely follows financial news and economic indicators to predict when the stock market might reach its peak. Alex believes that once the market has peaked, it's likely to go down. Therefore, Alex plans to sell the mutual fund shares just before the expected market decline. 
• Outcome: If Alex's prediction is correct and the market does indeed go up, Alex might make a profit by selling the mutual fund shares at a higher price. However, if the prediction is wrong, and the market does not behave as expected, Alex might end up selling at a loss or missing potential gains if the market continues to rise.
• Market timing is challenging because accurately predicting short-term market movements is difficult, even for experienced investors.
• Front Running
• Front Running involves in trading ahead of a likely price increase or decrease due to a known upcoming trade made by the fund. It may involve the trader's own account or favoured clients or employees.
• Like late trading, front trading is also illegal and is subject to prosecution.
• An example, a broker learns that a large client is about to place a substantial order to buy a specific mutual fund. The broker buys shares of that fund for their personal account before executing the client's order, expecting the price to rise due to the client's upcoming transaction.
• Directed Brokerage
• Directed Brokerage, involves quid pro quo whereby a mutual fund will direct trades to broker in exchange for the broker investing its clients in the mutual fund.
• Although this is not illegal, but strongly discouraged practise.
• Let's see an example, an investment adviser directs a mutual fund to use a particular brokerage firm to execute the fund's trades, possibly because the adviser receives some form of compensation or benefit from that brokerage.

Hedge Funds

• Mutual funds are marketed to all the investors, while hedge funds are restricted to only wealthy and sophisticated investors and institutions, to attract funds from wealthy individuals and large investors such as pension funds.
• Free from regulations and are given more flexibility in terms of investment strategies. Although some restrictions are imposed by their prime broker, the bank that provides hedge funds with financing and trade processing.
• Hedge funds charge investors higher management or operation fee, in general hedge fund fees, are observed as below:
• An annual management fee of 1%-3%  of assets
• An incentive fee of 15%-30% of realized net profits
• But typically a hedge fund fee might be read as “2 plus 20” indicating that the fund charges 2% per year of assets under management and 20% of net profit. 
• In addition to high fees, there is usually a lock up period (cannot withdraw) of at least one year. 
• A lockup period exists for a reason - many hedge fund investments are not easy to unwind on short notice. Some hedge fund investment are illliquid, which means managers cannot sell them quickly and retain a proper value. 
• In addition some hedge fund investments are bet on certain asset mispricing, and those trades can take time to unwind.
• Hedge funds are not listed on an exchange.

Prime Brokers

• Prime brokers act as intermediaries between hedge funds and various financial markets.
• A prime broker is a financial institution (which is often a bank) that provides a suite of services to hedge funds and other institutional clients. 
• These services are designed to facilitate the operational and trading activities and lending of the hedge fund, also provide risk management. 
• Prime brokers further more can carry out stress tests on the hedge fund's portfolio to decide how much it is prepared to lend. The hedge fund can then post its securities with the bank as collateral.
• As mentioned, hedge funds are subject to very little regulations, the prime broker will reduce the borrowing limit of the hedge fund and force it to close out the positions.
• Some hedge fund strategies can be certain to make money in the long term while risking short term losses, if this losses occur prime brokers would require addition collateral.
• Large hedge funds may use more than one prime broker.

Hedge Fund Expected Returns and Fee Structure

As a precondition for imposing high incentives fees, investors may be offered several guarantees. These includes the below:

• Hurdle Rate: This is the minimum return that a hedge fund should produce in order for the incentive fee to be applicable. Generally, investors push for hurdle rates that are as high as possible, sometimes even as high as the return on the S&P 500.
• High-water mark clause: This clause indicates that any previous losses must be recouped by new profits before an incentive fee applies. Prior losses may be comprised of performance losses, management fees and administrative fees. The high-water mark will vary among investors. For instance, if an investor places $100 million with a hedge fund and the fund loses $10 million, then the managers of the hedge fund must make $10 million before incentives kick back in.
• Clawback clause: This clause allows investors to apply part or all of previous incentive fees to offset current losses. A portion of the incentive fees paid by the investor each year is then retained in a recovery account so that it can be used to compensate investors for a percentage of any future losses. 
• Proportional adjustment clause: A proportional adjustment clause states that if the investors suffer loss and simultaneously if funds are withdrawn by investors, the amount of previous losses that have to be recouped is adjusted proportionally. In the example used above, if the investor withdraws $5 million before the hedge fund makes up the losses, the hedge fund may only need to make up $5 million before the incentive fees apply again.

Hedge Fund Strategies

Long and Short Equity

• The long and short equity strategy involves in maintaining long and short positions in equity and equity derivative securities.
• The hedge fund manager buys the long position in a group of stocks that are considered undervalued and selling the short position in a group that are considered overvalued by the market. 
• The hedge fund manager may have a net long bias where the longs are bigger than the shorts or a net short bias where the short are bigger than the longs.
• Referring to a fund as long/short captures the broad picture. There are many different styles underneath this umbrella, including:
• An equity-market-neutral fund where longs and shorts are matched.
• A dollar-neutral fund is an equity-market-neutral fund where the dollar amount of the long position equals the dollar amount of the short position.
• A beta-neutral fund is an equity-market-neutral fund where the weighted average beta of the shares in the long portfolio equals the weighted average beta of the shares in the short portfolio so that the overall beta of the portfolio is zero or totally insensitive to market movements.
• A sector neutrality fund, is where long and short positions are balanced by industry sectors.
• A factor neutrality, is where the exposure to factors like the price of oil, the level of interest rates, or the rate of inflation is neutralized.
• In theory, this strategy could provide strong returns regardless of whether general market conditions are in bull and bear markets if the stocks are picked up after being well researched.

Dedicated Short

• A dedicated short hedge fund is a type of investment fund that primarily focuses on making money from the decline in the value of stocks or other assets. Unlike traditional funds that aim for overall market growth, a dedicated short fund specializes in profiting from falling prices.
• At any given time, it is reasonable to suppose that there are as many overvalued share as undervalued shares. This means that short positions take the lion's share of the fund's overall positions.
• Dedicated short hedge funds are focused exclusively on finding a company that they think is overvalued and sell them short. This strategy exploits the fact that brokers and analysts are hesitant to issue sell recommendations. 
• Examples include:
• Companies with weak financials
• Companies that change their auditors regularly
• Companies that delay filing reports with the SEC
• Companies in industries with overcapacity
• Companies attempting to silence their short sellers
• Due to lack of hedging of overall markets, dedicated short funds do not perform well when markets are performing well.

Distressed Securities

• Distressed Securities deals with trades related to distressed securities by calculating a fair value for these securities considering possible future scenarios and their probabilities.
• Bonds with a rating of BB or lower are referred to as “non- investment grade” or “junk” bonds. Bonds with a credit rating of CCC are known as “distressed”. Bonds with a D rating are in default.
• This is an event driven strategy that tends to focus on companies that are at financial trouble.
• Distressed securities cannot be shorted, so managers look for a debt that is undervalued by the market.
• Managers must be well versed with bankruptcy proceedings, since distressed securities are highly susceptible to this condition.
• Passive managers buy distressed debt when the price is below its fair value and wait. The advantage of a passive approach, compared to an active approach, is that the fund generally places smaller bets on the distressed company. 
• Active managers might purchase a large position in outstanding debt claims so that they have the right to influence a reorganization proposal. The risk with this is that the hedge fund is placing more assets at risk for greater control of the assets in case bankruptcy occurs.
• Funds that employ this strategy impose more stringent lock-up and withdrawal terms.

Merger arbitrage

• Merger arbitrage is a bet that a merger or acquisition deal will take place after it has been announced. 
• The goal is to exploit price inefficiencies that may occur before or after a merger.
• Merger-arbitrage hedge funds are observed to generate steady but not huge returns.
• There are two main types of deals: cash deals and share-for-share exchanges.
• Cash Deal
• Consider a cash deal in which Company A announces that it would acquire all the shares of Company B for $30 per share. 
• The shares Company B were trading at $20 earlier and after the deal is announced its price jumps to $28. 
• The price may not have risen as high as $30 because there is a chance that the deal will not go through and also it may take some time to factor into market prices. 
• Merger-arbitrage hedge funds buy the shares in company B for $28 and wait, so that if acquisition happens at $30 or higher, the fund makes a profit of minimum $2 per share or more respectively. 
• However, if deal does not go through, the hedge fund will take a loss.
• Share-for-share
• Consider a share-for-share exchange in which Company A is willing to exchange one of its shares for four of Company B’s shares. 
• Assume that Company B’s shares were earlier trading at 15% of the price of Company A’s. After the announcement, Company B’s share price might rise to 22% of Company A’s share price.
• A hedge fund following a merger-arbitrage strategy would buy a certain amount of Company B’s stock and at the same time short a quarter as much of Company A’s stock to generates profits if the deal consummates.
• In most cases, a merger announcement is followed by a spike in the stock of the acquiring company and a dip in the stock of the target.
• It should be emphasized that merger arbitrage is not about trading on the inside non public information, as this is illegal. It should access the probability of a merger being successful and the likely final price or exchange ratio in the case of share-for-share, at the time of the merger announcement.

Convertible Arbitrage

• Convertible arbitrage strategy seeks to profit from the discrepancies in a company's convertible securities relative to the company's stock.
• This strategy involves taking long position in a convertible bond and hedging it by taking short position in the underlying stock.
• Convertible bonds could be converted into the equity of the bond issuer at a specified times and price in the future.
• The convertible bond price depends on factors such as the price of the underlying equity, its volatility, the level of interest rates, and the chance of the issuer defaulting.
• A hedge fund using the convertible arbitrage strategy develops a complex model for valuing these convertible bonds so as to extract higher returns from it.
• Many convertible bonds trade at prices below their fair value, so hedge fund managers buy the bond and then hedge their risks by shorting the stock.

Fixed Income Arbitrage

• Fixed Income Arbitrage strategy seeks to profit from the discrepancies in related to fixed income instruments.
• At any given time, some traded bonds are likely to be relatively expensive compared with other similar bonds, which other are relatively cheap. In a fixed-income arbitrage strategy, the hedge fund manager buys bonds that seem relatively cheap and shorts the ones that are relatively expensive.
• One of the strategies followed by hedge fund managers in relation to fixed income arbitrage is a relative value strategy, where they buy bonds that the zero-coupon yield curve indicates are undervalued by the market and sell bonds that it indicates are overvalued.
• Market-neutral strategies are similar except that they have no exposure to interest rate movements.
• Some fixed-income hedge fund managers follow directional strategies where they take a position based on beliefs that certain spread between interest rates, or interest rates themselves, will move in a certain direction. Usually they have a lot of leverage and have to post collateral.
• The risk associated with this strategy is that although the strategy may work out well in the long term, in the short term if the market goes against it, loss has to be faced.

Emerging market strategies

• Emerging market strategies engage in investments in developing countries.
• This involves debt/equity investment in emerging markets, that aims to identify emerging market shares that are overvalued or undervalued.
• In case of equities, managers invest in securities trading on the local exchange, or securities like American Depository Receipts (ADRs). 
• In case of debt, hedge funds invest in either Euro bonds or local currency bonds. 
• The price discrepancies between securities and the underlying shares may give rise to arbitrage opportunities. 

Global macro strategies

• Global macro strategies carry out trades that reflect global macroeconomic trends, in general investment decisions guided by the economic or political outlook of a country. 
• Hedge fund managers spot situations where markets have moved away from equilibrium and place large bets that they will move back into equilibrium. 
• For example, the investment focus may be on foreign exchange rates, interest rates or inflation.
• A deviation from equilibrium could take a long time to correct itself and some hedge funds will not be able to wait out of the trend.
• The main risk is that they may be unaware of when equilibrium will be restored because world markets can be in disequilibrium for long periods of time.

Managed futures strategies

• Managed futures strategies try to predict future movements in commodity prices based on manager’s judgment or trading rules generated by computer programs.
• They make bidirectional bets with long/short positions.
• Managers may use technical analysis which analyzes past price patterns to predict the future; or fundamental analysis which involves calculating a fair value for the commodity from fundamental factors.
• Technical analysis typically comprises back-testing, out-of-sample testing, and other data mining techniques. They test their prediction by performing backtest using their trading rules using historical data. But a key drawback of backtesting is that there is no distinction made between strategies that truly worked based on the proper fundamental analysis or strategies that were successful strictly because of luck and subsequently might not have repeated success. It is also important to test a trading strategy out-of-sample, this means that a historical data used to test a strategy should be separate from the historical data used to develop the strategy.
• Fundamental analysis, when managers employ fundamental analysis techniques, they are attempting to derive a fair value for the commodity based upon so-called fundamental factors. Fundamental factors might include: 
• Market conditions in which the fund is investing. 
• The economy.
• Weather conditions, including projected weather conditions.
• Supply and demand forces. 
• Cross-competition from other commodities

Hedge Fund Performance

• It is common for hedge funds report good returns for a few years and then perform poorly all of a sudden only to close their business eventually. 
• There is a general view that hedge fund returns are like the returns from writing out-of-the-money options: the options cost nothing, but occasionally they become very expensive. 
• The Tass hedge funds database includes only hedge funds that report voluntarily. 
• Excludes small hedge funds and those with poor track records over the years do not report their returns and are therefore not included in the data set. Only good funds are included. The resulting performance analysis is thus inherently biased.
• When returns are reported by a hedge fund, the database is backfilled with the fund’s previous returns. This creates a bias in the returns that are in the data set because only the hedge funds that do well are the ones that disclose their return data. When this bias is removed, it is observed that hedge fund returns are no different from mutual fund returns, especially when their fees are taken into account.
• Measurement bias, participation in hedge funds indices is voluntary. If the fund had good performance, then they will report their results to the index vendor. If not given good results, then they simply do not report their result to the index. Hence there is measurement bias is there in hedge fund indexing.
• Backfill bias refers to the potential distortion in the performance history of a hedge fund caused by including historical performance data for periods before the fund officially reports to a performance database. When returns are reported by a hedge fund, the database is then backfilled with the fund's previous returns. It creates an issue with reliability for hedge fund benchmarks.

Hedge Fund Risks

• Liquidity Risk
• It occurs when the fund invests in illiquid assets.
• Liquidity is the function of the below:
• size of the position
• intrinsic liquidity of the instrument
• Pricing Risk
• Some of the assets are quite difficult to price like derivatives.
• Counterparty Risk
• The manager gets into contracts with dealers, brokers and clearing agents. 
• There is always a risk that these parties will renege on their obligations, putting the funds on the path of unprecedented losses.
• Short Squeeze Risk
• The fund manager may be forced to purchase a security they had sold short sooner than anticipated when the investor from whom the security was borrowed comes calling early.
• Settlement Risk
• One or more parties in a transaction may fail to deliver securities as per the contract.

Hedge Fund Calculation

Formula:

Hedge fund’s fee =  I + M

Here,

I = Investment Fees, ideally 20% (0.2)

M = Management Fees, ideally 2% (0.02)

Example1:

Let's consider a hypothetical hedge fund with a starting Net Asset Value (NAV) of $100 million.

Management Fee Calculation:

1. • Assuming the monthly average AUM (Assets Under Management) is $100 million for the month.
   • Management Fee = (2% × $100 million) / 12 = $166,667 (monthly management fee).

Incentive Fee Calculation:

1. • Assuming the fund generated a 5% return for the month.
   • Management Fee Adjusted Returns = Fund's Monthly Returns - Management Fee
   • Management Fee Adjusted Returns = 5% - 2% = 3%
   • Incentive Fee = 20% × 3% = 0.6%

Total Fees for the Month:

• Total Fees = Management Fee + Incentive Fee
• Total Fees = $166,667 (Management Fee) + 0.6% × $100 million (Incentive Fee)
• Total Fees = $166,667 + $600,000
• Total Fees = $766,667

Example2:

An example of a hedge fund manager’s incentive. As an example of the incentive structure of a hedge fund manager, consider this example. Suppose there is a 40% probability of a 60% profit and a 60% probability of a 60% loss for a hedge fund that charges the theoretical industry-standard fee of “2 plus 20%.”

In this example, the expected return on the investment is -12%.

= 0.4 ∙60% + 0.6 ∙(− 60% ) = − 12%

Interestingly, although the return is negative, the hedge fund manager still earns a fee from managing the money (as is the case with mutual fund managers and most other financial mangers). In this example, the fee income is 13.6% of the assets under management for the case when the fund earns a 60% profit and 2% if the -60% materializes. The probability- weighted fee (expected value) is 6.64%, made up of the 2% management fee and the 4.64% incentive fee. Of course, a mutual fund manager would have also been paid regardless of the return of the fund.

• 60% profit example: the hedge fund’s fee is 2% + 0.2 × 58% (60% - 2%) = 13.6%.
• 60% is probability of profit
• 2% is management fee
• .2 or 20% is incentive fee
• 60% loss example: the hedge fund’s fee is 2% + 0.2 x 0% = 2%.
• The expected (or probability weighted average) fee to the hedge fund is 0.4 × 13.6% + 0.6 × 2% = 6.64%.

The expected return for the hedge fund investors, after accounting for the fees, is -18.64%, as shown in the table below.

•  0.4∙(60%−13.6%)+0.6∙(−60% −2%) = −18.64%

An Example of a High-Risk Investment with a "2 + 20" Fee Structure 

• Returns: 60% and -60% 
• Probability: 40% and 60%
• Expected return to hedge fund: 6.64% 
• Expected return to investors: -18.64% 
• Overall expected return: -12.00%

Example3:

What is the expected payoff for fees if a hedge fund uses a standard 2 plus 20% incentive fee structure with an investment that has a 35% probability of making 55% and a 65% probability of losing 45%.

• The expected return on the investment is −10%.
• = 0.35 ∙55% + 0.65 ∙(−45% ) = −10%
• 55% profit example: the hedge fund’s fee is 2% + 0.2 × 53% (55% - 2%) = 12.6%.
• 60% is probability of profit
• 2% is management fee
• .2 or 20% is incentive fee
• 45% loss example: the hedge fund’s fee is 2% + 0.2 x 0% = 2%.
• The expected (or probability weighted average) fee to the hedge fund is 5.71%.
• = 0.35 × 12.6% + 0.65 × 2% = 5.71%
• The expected return for the hedge fund investors, after accounting for the fees, is -15.71%
• 0.35∙(55%−12.6%) + 0.65∙(−45% −2%) = −15.71%

Mutual Fund VS Hedge Fund

Mutual Fund

• Size of the investor, mutual funds may cater to small or large investors, and typically have different classes of shares depending upon the size of the investor.
• Disclose of investment strategy, mutual funds must be generally transparent with their investment strategy.
• Risk, the risk is dependent upon the allowable investment options stated in the prospectus.
• Fees, usually has management fees as a percentage of assets under management and potentially front-end and/or back-end loaded fees.
• Flexibility, managers has a lots of constraints to deal in their investment strategies, regulatory environment and fund structure. Can invest in various asset classes, including equities, bonds, commodities, and other investment options. One strategy that is prohibited is the use of leverage.
• Regulations, high regulations.
• Redemption, mutual funds or ETFs allow investors to redeem or sell their shares on any given day. Mutual funds may charge a fee for short-term trading or a back-end load fee.
• Paperwork, offered via prospectus.
• Liquidity, investors can withdraw their money any day.
• Reporting of fund value, mutual funds are required to report their NAV at least once per day.
• Self investments, managers does not have to put some of their capital in the fund.
• Advertisement, may advertise freely.
• Listing, maybe listed (close-end funds).
• Assessment, generally easy and objective to measure. 

Hedge Fund

• Size of the investor, typically hedge fund investors must be accredited investors.
• Disclose of investment strategy, hedge funds generally keep their investment strategy proprietary, as they consider this a competitive advantage. Hedge funds must disclose the general nature of their investment activities but keep proprietary components proprietary. Additionally, as long as it is disclosed, hedge funds may switch between investment strategies depending upon management’s view of the economic situation.
• Risk, can range from very risky to completely hedged. Hedge funds are generally considered riskier than mutual funds because of the investment strategies employed.
• Fees, usually higher fees that, including base fees and fees linked to performance of the fund.
• Flexibility, managers has a fewer constraints to deal in their investment strategies, regulatory environment and fund structure. Can use leverage, sell short or even use derivates.
• Derivatives:
• Definition: Derivatives are financial instruments whose value is derived from the value of an underlying asset, index, rate, or other financial instruments. They derive their value from the performance of an underlying entity and include options, futures, forwards, and swaps.
• Examples:
• Options: Contracts that give the holder the right (but not the obligation) to buy or sell an asset at a predetermined price within a specified period.
• Futures: Contracts to buy or sell an asset at a future date for a price agreed upon today.
• Swaps: Agreements where two parties exchange cash flows or other financial instruments over a specific period.
• Key Points:
• Investors use derivatives for various purposes, including hedging against market fluctuations, speculating on price movements, and managing risk in their portfolios.
• While derivatives can be valuable tools, they can also be complex and carry risks, including the potential for significant losses.
• Leverage:
• Definition: Leverage refers to the use of borrowed funds to increase the size of an investment or position beyond what would be possible with one's own capital. It magnifies both potential gains and losses.
• Examples:
• Margin Trading: Borrowing money from a broker to buy securities, with the securities serving as collateral for the loan.
• Options Trading: Using options contracts to control a larger amount of an underlying asset with a smaller upfront investment.
• Key Points:
• Leverage can amplify returns, allowing investors to control a larger position with a smaller amount of capital.
• However, it also increases the risk, as losses are also magnified. If the market moves against the investor, the losses can exceed the initial investment.
• Sell Short:
• Definition: "Selling short" or "short selling" is an investment strategy where an investor sells a financial instrument (such as stocks) that they do not currently own. In a short sale, the investor anticipates that the price of the financial instrument will decline, allowing them to buy it back later at a lower price. The goal is to profit from the difference between the higher selling price and the lower buying price.
• Here's a step-by-step explanation of how short selling works:
• Borrowing the Asset: The investor borrows shares of a stock (or other securities) from a broker with the agreement to return the same number of shares at a later date. This is typically facilitated through the brokerage's margin account.
• Selling the Borrowed Asset: The investor sells the borrowed shares in the open market. This creates a short position, where the investor is effectively "short" the stock.
• Waiting for Price to Decline: The investor hopes that the price of the stock will fall before they have to return the borrowed shares.
• Buying Back the Asset: If the price does decline as anticipated, the investor buys back the same number of shares in the open market at the lower price.
• Returning the Borrowed Shares: The investor returns the borrowed shares to the broker.
• Profit or Loss: The profit or loss is the difference between the selling price (initial short sale) and the buying price (covering the short position). If the stock price drops, the investor makes a profit; if it rises, the investor incurs a loss.
• Examples:
• Let's say an investor believes that Company XYZ's stock, currently trading at $50 per share, is overvalued and will decline in the near future. 
• The investor borrows 100 shares from a broker and sells them in the market, generating $5,000 ($50 x 100 shares) in cash. 
• If the stock price drops to $40, the investor buys back 100 shares for $4,000 ($40 x 100 shares) and returns them to the broker. 
• The investor's profit would be $1,000 ($5,000 initial cash - $4,000 to buy back shares).
• Key Points:
• Short selling involves betting on a decline in the price of an asset.
• It's a strategy that carries significant risks, as there's no limit to how much the price of the asset can rise.
• Short selling is typically done in the context of a margin account, as it involves borrowing assets.
• Short selling is a more advanced investment strategy and is not suitable for all investors. It requires a good understanding of the market, careful risk management, and the ability to react quickly to changing conditions. 
• Additionally, short selling is subject to regulatory rules, and there are restrictions on certain types of short sales to prevent market manipulation.
• Regulations, fewer regulations than mutual funds.
• Redemptions, hedge funds often have long lock-up periods. During lock-up periods, investors cannot withdraw their money.
• Paperwork, offered via private placement memorandum.
• Liquidity, investors can only get their money periodically.
• Reporting of fund value, hedge funds have more flexibility in reporting returns monthly, quarterly, or at some other interval.
• Self investments, as a sign of good faith, the manager is expected to put some of their money in the fund.
• Advertisement, no free to advertise in the public.
• Listing, cannot be listed on an exchange.
• Assessment, generally problematic due to measurement bias and backfill bias.

Credits and References

• GARP, Schweser and Bionic Turtle Notes
• https://www.investopedia.com/
• http://chat.openai.com/ #shout out to the examples helped in learning the concepts in depth.