Growth of hedge funds

The Growth of hedge funds: The reasons for a sustained progress and its effects on the UK investments market

In this research various reasons would be d out which would have led to a sustained progress in the number of hedge funds and the magnitude of the assets that they manage. Researcher would also try and out the effect that this has had on the Investment scenario in the United Kingdom.

Abstract

Our research tried to unravel the reasons behind the popularity of hedge funds as an investment vehicle. The research focused on the different aspects of hedge funds namely investment portfolio, potential and existing investors, regulatory framework, strategies adopted, operational aspects and the return profile of these funds in relation to other assets available for the investor.

The findings obtained from the research were used to determine the reasons for the sustained growth of hedge funds and its popularity in the global and United Kingdom's financial market.

The research also focused on the role played by these funds in the inception and propagation of the present credit crisis. The findings indicate that hedge funds were part of the financial institutions that were involved in compounding the crisis and were also one of the worst effected by the same.

The main findings of the research suggested that hedge funds were preferred investment vehicles of high net worth individuals and other financial institutions having a high risk appetite. The reasons leading to this preference were centered mainly in the lax regulatory framework for these funds. Hedge funds are free from most of the regulatory restrictions faced by other investment vehicles which provides these funds with the freedom of choice of asset categories and hence maximizes the potential returns.

It was also observed that the reasons that lead to hedge funds being popular among the investors also lead to bringing about a structural weakness in the economic and financial system. The recommendations and the possible methods to allow hedge funds to maximize returns and at the same time minimizing the risk of systemic failure were suggested.

The final judgment on the issue was that hedge funds are an integral component of the financial market and are essential for the development of the financial activities all over the world.

It was found that the role played by hedge funds is especially relevant in a country like United Kingdom due to presence of a global business hub in the country and due to presence of free market mechanism.

Finally, this research examines the likely change in the regulatory structure of hedge funds in wake of the global credit crisis which had resulted from accumulation of risky investments by the global financial behemoths; something which the hedge funds specialize in.

Abbreviations

HNI's- High Net worth Individuals

IPO's- Initial Public Offering

LTCM- Long Term Capital Management

S&P- Standard and poor index

Chapter 1-

Introduction

Chapter 1: Introduction

In the past few years with the growth in financial service industry, investors have been offered with a plethora of products and services. There have been multiple avenues for the investors for parking their funds depending on their risk profile and return expectations (Malkiel 2003).

The different investment avenues offer investors with an option to invest in specific or diversified assets. These assets can range from financial assets like stocks, bonds, commodities, foreign exchange to real sector assets like infrastructure, real estate and manufacturing.

Over the past few years, the large financial institutions, high net worth investors and even retail investors have had the choice to outsource their investment decision to some one who specializes in the field on investment and has much more resources and market information than these entities. This helps these “managers” in getting better returns than a normal individual in the market. These “managers” in return charge a particular fee in lieu of their services; this fee depends on things like regulatory conditions, type of competence required for the investment and historical performance of the manager.

These outsourced investment avenues themselves have different nomenclature depending on things like their investment portfolio, types of clients and magnitude of risk undertaken. Some of these different nomenclatures are Mutual Funds, Private Equity, Venture Capital and Hedge Funds.

This research is primarily dealt with hedge funds (Agarwal & Narayan 2005; Lhabitant 2007); analyzes would be made on the pattern of their growth over the past few years, changes in their investment portfolio and the pattern of returns that they have generated. This research would help in examining the effect that these entities have had on the investment scenario all over the globe and specifically in United Kingdom.

Hedge funds are investment funds that allow its investors to take exposure to a wide range of assets and trading activities (Frush 2006; Borla & Masetti 2003). Hedge funds have been permitted by regulators to take risk exposure that other investment funds are not allowed to take.

Hedge funds are generally strategy oriented; a hedge fund has a trading strategy which may involve taking exposure to country risk, arbitrage opportunities, relationship between two assets etc (Black 2004). Hedge funds use several mathematical constructs to devise and implement these strategies (Lhabitant 2004). These strategies can entail investments in assets like stocks, bonds, commodities etc.

The regulatory leeway granted to hedge funds restricts its clientele to a limited set of investors (Whittall 2009; Stefanini, 2006). These investors are generally individuals or associations having high net worth and large appetite for risk. The regulatory leeway allows them freedom on aspects like fee structures, derivative exposures, short selling and liquidity limits.

Unlike what the name suggests, hedge funds don't exactly hedge their risk by taking mutually opposite positions. These funds use hedging methods to increase their risk exposure (Brown et al. 2009). The risk exposure of these funds is also increased by taking a high level of leverage. This high leverage ensures that the hedge fund's exposure is several times the amount it has actually invested.

The main objectives of carrying out a research of this following topic “The Growth of hedge funds: The reasons for a sustained progress and its effects on the UK investments market” is to find out the key success factors for the hedge fund industry, possible sources of risks for this industry and the effect of the hedge fund industry on the financial service market in United Kingdom.

For the purpose of accomplishing these objectives, we have zeroed in on specific research questions that address relevant aspects of the growth of hedge funds. These research questions are presented below:

1. Which has been the major driver of growth: The increase in number of hedge funds or the increase in assets under management per hedge fund? This question tries to out the exact benefit of low regulations. This question also tries and finds out whether the low entry barriers have hindered the performance of individual hedge funds

2. What is the extent of correlation of hedge fund returns with the growth in asset under management under these funds? Also, if there is a correlation what is the direction of causality in this relationship?

3. How has the financial crisis impacted the scope of the hedge fund industry? Is there a possibility of a systemic failure in case of collapse of a large hedge fund (Hartmann, Panetta, Portes, & Ferguson 2008)?

4. Has the growth in hedge funds resulted in more depth in the financial service industry in the United Kingdom? Has the increase in asset under management under hedge funds in United Kingdom led to an increase in assets under other schemes also?

This research aims in figuring out the exact reasons for the popularity of hedge funds among the investors in spite of the high levels of risk exposure that their investments involve.

Hedge funds have been chosen as a topic of research is because of the following reasons:

* The unregulated nature of the investments of hedge funds can result in these funds making returns closer to the theoretical returns. The historical return of these funds would be used to check the accuracy of several theoretical concepts of finance.

* Hedge funds can provide an insight into the diverse trading strategies that can be implemented to generate returns (Phillips 2003). Study of hedge funds can give an insight into these strategies

* Hedge funds investments can be termed as the closest manifestations of the principles of quantitative finance; this fact indicates that study of hedge funds can help us understand quantitative financial methods better.

The expected benefits of our research are presented as follows:

This research tries to check whether there is a need of keeping some regulatory check on the growth of hedge funds to avoid a systemic failure in case of collapse of large hedge funds. Would it be feasible to allow retail investors directly or indirectly to invest in certain hedge funds? This research tries to analyze whether the growth drivers for hedge funds can be utilized for encouraging investments in other fund management methods. The role that hedge funds can play to complement the financial sector and real sector growth in the economy

Role in Present financial Crisis- The analysis of hedge funds will help us in finding out means to prevent the systemic failures that have resulted in the downfall of several financial institutions. During the boom in housing prices in the past 3-4 years, several financial institutions aggressively bought assets like collateralized debt obligations that derived their value from housing prices. In doing so the institutions took an exposure to assets whose credit quality was linked to the credit quality of retail borrowers, several of whom were sub prime. Moreover, the exposure to derivatives led to the actual exposure being magnified several times with the help of leverage. Adverse macroeconomic factors led to a change in the ability of the housing loan takers to service their debt resulting in a fall in housing prices and in turn a sharp fall in the values of the derivatives leading to large losses for institutional investors like hedge funds. The sharp fall in the value of the derivatives and absence of a buyer led to margin calls for hedge funds which in turn made these funds sell their other assets leading to fall in prices of these assets also (these were mainly emerging market assets). In this way there was outflow of funds from most of the asset classes while the fundamental issues were restricted to only the housing market. The point here is that the actions of global financial institutions led to a transmission of this crisis to various sectors of the economy. Through this research carried, researcher will try and find means to prevent such occurrences in the future.

Ability to move the market- Hedge funds has millions of dollars of assets under management; the position that they take with respect to a particular asset can influence the pricing of the asset in the market. An understanding of the trading strategy of a hedge fund can give useful insights into the price behavior of several assets.

Chapter 2-

Literature Review
Chapter 2: Literature Review

To start with, we will analyze the key elements of hedge funds:

First, hedge funds are investment structures that combine the investable surpluses of sophisticated investors. Hedge funds avoid the regulatory scrutiny of the authorities by being accessible only for HNIs (high net-worth individuals). Hedge funds cannot have more than 100 investors with each investor being classified as an entity having a net worth of at least 5 million dollars. Second, portfolios of hedge funds tend to be much more concentrated than other investment vehicles. Hedge funds do not have broad benchmarks owing to them following a “skill-based” investment style. Hedge fund managers are not obliged to maintain asset holdings relative to a benchmark. This allows complete focus on value based securities for their portfolio. Hedge funds have achieved a record growth in their assets under management over the past few years. The growth in assets and the important events in the history of hedge funds that have brought about a change in the growth trajectory of these funds have been depicted as follows:

The shows that the assets under management for hedge funds industry have grown from close to $ 500 billion in 2002 to over $1500 billion in 2008. Research has indicated the following reasons for this sharp growth in the hedge fund assets:

· The main reason for growth of these funds has been attributed to the unregulated nature of these funds. The lack of regulation has made these funds perfect investment avenues for investors having high levels of risk appetite. For other funds, regulatory authorities impose certain restrictions on the investment portfolio to safeguard the interests of the marginal investors (Ding, Shawky, & Tian 2009). In case of hedge funds, the clientele is knowledgeable and well informed about the portfolio of investments and hence they can assess the risk associated with hedge fund investments in a better way. The low level of regulations has also minimized the barriers to entry in this industry resulting in sharp increase in the number of funds (Chen & Chen 2009; Lo, 2008). The unregulated nature of the industry also allows attractive fee structures for the fund mangers; this has also led to a spurt in the number of hedge funds in the industry.

· The stronger performance of hedge funds relative to other assets and investment options has led many investors towards investing in these funds (Eichengreen 1999; Jones 2007)

· The inflow of funds from institutional investors like pension funds, endowments and foundations has led to an increase in trust reposed by Global investors in these assets (Klein & Lederman 1995).

In this literature review, researcher would try and analyze the past research done on several aspects of a hedge fund. The analysis is done as follows:

2.1. Investor Characteristics

The first and foremost characteristic of hedge fund investors is their ability to take high levels of risk. These investors aim for high level of returns, more than those offered by conventional asset classes. This ability to take high risk positions is in turn influenced by the net worth of the investor and the amount of investable surplus that he has.

The investors can be either high net worth individuals or financial institutions. Another characteristic of hedge fund investors is the ease with trying out unconventional trading strategies for the sake of high returns.

2.2. Types of Strategies

Not all hedge funds are based on similar trading strategies; hedge funds follow a particular theme and base their trading strategy on the same. The different trading strategies are associated with different levels of risk and return profiles. A description of these profiles (Ruiz-Carus, nd) is presented as follows:

2.2.1. Aggressive Growth

The main investment area for these funds is equity. These funds try and invest in equity investments providing a high return potential in the form of capital gains. These funds hedge their positions either by shorting equities or benchmark indices. The short or long position is taken depending on the expected earning profile and the general investor sentiment in the market.

2.2.2. Distressed Securities

The hedge funds following this strategy focus, as suggested by the name, on distressed assets. Distressed assets mean the debt, equity and hybrid instruments of companies in solvency or some other financial trouble.

The funds following this strategy purchase these distressed assets at sharp discounted price. This offers them a potential of high upside whereas the downside is limited.

The basic premise on which the distressed investments are based is the belief that the market is unable to specify the true value of the distressed assets. This strategy is benefited by regulations that prohibit most of the other institutional investors from investing in below investment grade securities.

2.2.3. Emerging Markets

The strategy followed by these funds is concentration of investments in emerging market assets like those of countries like India, China and Brazil. The financial markets in these countries are not as developed as those in western countries. This offers the hedge funds with an opportunity to take advantage of the market inefficiencies in these markets.

The volatility of the returns in these markets is also very high; this enables the funds to benefit from use of derivative based strategies. The flip side of investing in these markets is the absence of effective hedges due to regulations governing short selling and absence of depth in these markets.

2.2.4. Funds of Funds

These funds aim to diversify their exposure by investing in different hedge funds and other investment vehicles. The aim is to get the “best of everything” and at the same time minimizing the risk.

The diversification minimizes the risk but also reduces the potential returns. This strategy is followed by investors looking for intermediate levels of returns. The investment horizon for these funds is also higher than the other categories of hedge funds and the return profile is also more stable in nature.

2.2.5. Income Funds

These funds focus on a constant stream of cash flows rather than on capital gains unlike most of the other hedge funds. This objective is achieved by concentration of investment in fixed income assets and dividend yielding stocks. The fixed income assets chosen are generally those having high coupon payments. To get the high coupon rates, the investment has to be done in assets which are not always investment grade; this exposes these funds to a significant amount of credit risk.

2.2.6. Macro Funds

The investment strategy for these funds revolves around taking a call on the possible consequences of macro economic events in different countries (Ridley 2004). The events include a policy change or any other global event that has implications on the financial markets. These funds take investment positions in assets like bonds, currency and equities.

The investments are timed to take event risk like monetary policy announcements, currency devaluation, regulatory announcements etc. The effect of the event is compounded by using means like leveraging or by the use of derivatives.

2.2.7. Market Neutral-Arbitrage

This investment strategy involves taking opposite positions in similar securities. The examples of these situations are cash future arbitrage and reverse cash and carry arbitrage.

The returns of such funds are contingent on the frequency of occurrences of these opportunities and the effectiveness of the execution of these opportunities. These funds concentrate their actions in countries where the financial markets are not efficient and these arbitrage opportunities exist.

2.2.8. Market Neutral- Securities Hedging

This strategy involves taking opposite positions in stocks of companies of the same sector or in related businesses. The opposite positions minimize the market risk and limit the exposure to the characteristics of individual stocks. The key to success in this strategy is picking the right stocks.

2.2.9. Opportunistic

This strategy is based on taking advantage of events like IPOs, Stock buybacks, stock splits, and private placements, take over bids and issuance of bonus shares. The success of this strategy depends on the ability of the fund manger to get access to private information about the companies.

2.2.10. Short Selling

This strategy involves identification of over valued assets and taking up of a short position in these assets. The shorted assets could be equities, commodities, currencies and bonds.

Selection of the appropriate asset is the key to success in this strategy. The biggest risk involved in following this strategy is that the downside from this strategy is virtually unlimited.

The Risk and return profiles for all these strategies according to volatility are presented in the graph below:

The proportion of hedge funds following each of the above mentioned strategies is depicted in the table below:

2.3. Influence on Economy

Till now, past research has been used on some of the basic aspects of hedge funds; now the researcher will try and analyze the past research on the impact that hedge funds can have on the global economy.

Hedge funds have the ability to move the financial markets on their own because of the sheer size of their investable surplus. Hedge funds can use this ability to impact the prices of various asset classes (Amadeo 2009; Zhu 2005). This ability is even more pronounced in the financial markets of developing countries where other investors are relatively smaller in size.

The buying and selling of hedge funds can also bring about significant volatility in the market. Moreover, there buying and selling can artificially inflate or deflate the prices of a particular asset, which in turn can have a significant impact on the global economy. For e.g. the sharp rise in the oil prices observed in the global markets was mainly attributed to buying of crude oil based derivative products by hedge funds. This sharp rise of oil prices in the economy in turn brought about inflationary pressures. To reduce these inflationary pressures, authorities worldwide had to tighten the monetary policy leading to a slowdown in global growth rates.

The above example indicates that hedge funds can have a significant impact, both positive and negative on the world economy. As a result it becomes essential to regulate some of their actions to avoid systemic failure.

The influence of hedge funds in the global stock markets is clearly visible from reports, which indicate that these funds control almost 50% of the trades in the two most developed stock exchanges namely the New York stock exchange and the London Stock exchange.

2.3.1. Case of LTCM

One of the most visible examples of the impact that hedge funds can have on the global economy is manifested in the form of the financial crisis that stemmed from the collapse of LTCM (long term capital management), one of the biggest and reputed hedge funds. The case of LTCM is presented below:

The size of LTCM was close to $126 billion (Amadeo 2009). The fund invested mainly in fixed income securities and currency. The trading strategy of LTCM was based on taking advantage of volatility in the relationship between the bonds and currency of a particular country.

LTCM operated on the premise that there is a long term relationship between these two variables and any divergence from the relationship would be rectified in due course of time.

The problem with LTCM arose when Russia devalued its currency and defaulted on its bonds; this event led to a failure of the assumptions on which LTCM's mathematical model was based. These actions by Russia resulted in an unprecedented fall in American and European equity markets. This resulted in a flow of capital towards US treasuries leading to suppression in their yields. These events led to fall of close to 50% in the capital of LTCM.

The problem spread to the whole system because many banks and pension funds were major investors in LTCM. Disaster was averted by the actions of the chief of United States' Federal Reserve, Alan Greenspan, who persuaded the banks to stay invested in the fund. He also reduced the federal funds rate to ensure that the economic growth stayed on track. LTCM had to be bailed out by tax payer's money; the bailout was done mainly to protect the financial system of the United States rather than for protecting LTCM itself.

This case helps in understanding the extent of impact that hedge funds can have of the global economy.

2.3.2. Positive Influences

Till now, the negative impacts that hedge funds can have on the economy have been seen but hedge funds also have significant positive benefits as well, these benefits are stated below:

· Boon for small companies- Most of the hedge funds base their strategies on picking value investments; they stress on identifying target assets which are not perceived to be of significant value by the market. Most of these assets are stocks and bonds of small companies which yield high rate of returns. This investment helps these companies in being successful and in turn generates income and employment for the people. This can be termed as the direct impact of hedge funds.

· Trickle down benefit- Hedge funds provide a channel for high net worth individuals and financial institutions to deploy their money. This money would have other wise been deployed in safe assets. Hedge funds deploy this money in more risky assets and hence are a source of investment for businesses which find it difficult to get funds. Moreover, the profits generated by the funds are directly or indirectly reinvested in the economy and hence maximize the collective welfare.

· Liquidity in Market- Although hedge funds can manipulate the price of the assets that they invest in, they also help in price discovery by providing liquidity to the market owing to their large size. They also provide depth to the market as they tend to take both long and short positions and hence provide exit options to other investors.

· Growth in emerging markets- Several hedge funds target specific emerging markets as the return profile in these markets is much more attractive than in the developed markets. This attractive return profile originates from inefficiency and presence of arbitrage opportunities in these markets. The flow of funds in these markets benefits the investors and the companies operating in these markets. This results in economic growth and employment in these markets. For e.g. Hedge funds and institutional investors have invested billions of dollars in India over the past few years; these investments are one of the reason for the Indian economy clocking a high growth rate for all these years.

· Role in case of distress assets-Hedge funds are one of the main investors in case of distress assets. Their investments helps these companies avoid bankruptcy and continue their operations. This helps in preserving employment and avoids stakeholder value erosion and in turn keeps the confidence of people high.

2.4. Regulatory Environment

Hedge funds are loosely regulated by the market regulators in different countries. They don't have any restrictions on the kind of assets in which they have to invest and neither do they have to disclose their portfolio to the investors at the end of every month unlike that in mutual funds. Hedge funds also don't have to comply with the regulations pertaining to the reporting of the profitability performance. In short, hedge funds are like a “black box” for the investors and regulatory authorities. The basis for these loose regulations is that the investors in these funds are sophisticated institutions and other high net worth individuals. The regulators believe that these investors can effectively assess the risks associated with the investments that the hedge funds make and hence doesn't feel the need of creating regulations governing the behavior of hedge funds.

The present economic crisis has however shown that investment in toxic assets by large entities like hedge funds can lead to problems for the global economy and can severely hinter the flow of credit in the economy. This has led to a debate over the regulatory framework governing the hedge funds. The study of regulatory framework is essential as the lack of regulations has been one of the key success factors for the success of hedge funds and any change in regulatory scenario could severely influence the role that these funds play in the global markets.

The support for regulatory framework comes mainly from the countries of the European Union like United Kingdom, France and Germany (Cornford nd). The need for regulations arises from the increasing scale of operations of these funds in global financial markets. For e.g. in 2006 hedge funds were observed to control 15% of the debt market volumes in United States, the rose to 47% for emerging market bonds and was even higher for distressed assets and credit derivatives (Cornford nd). This has come in for severe criticism as credit derivatives were marked as one of the reasons for collapse of Global financial markets last year.

Some of the strategies that the hedge funds employ have also come in for severe criticism as they influence the macroeconomic variables of a country. This issue especially cropped up during the South Asian crisis of 1997 when the currencies of some of the South East Asian economies faced severe pressure because of huge short positions taken by hedge funds in these currencies.

On a micro level, event based strategies like taking positions to benefit from a merger or acquisition transaction leads to an increase in the costs involved for the strategic entities involved in these transactions which might lead to erosion of shareholder's value (Parry & Cullen 2001).

Another reason for concern is the increasing involvement of banks as investors in these funds, the increases exposure of banks indirectly exposes the depositors of the banks to the high risk investments of the hedge funds.

All the above reasons have led to an increase in voices asking for stringent regulations for hedge funds to be introduced. An increase in regulation, especially the ones relating to trading strategies and investment portfolios can lead to a reduction of attractiveness of the return profile of hedge funds in relation to other asset classes. The regulators must therefore tread carefully in order to preserve the benefits that are obtained from the hedge fund industry.

2.5. Hedge Fund Industry in United Kingdom

The hedge fund industry has seen a significant rise in United Kingdom's financial market over the last decade or two. Close to 25% of the global hedge funds are based in United Kingdom. The proportion of United Kingdom in the global hedge fund industry is depicted in the table below:

Hedge funds in United Kingdom have not yet achieved the scale similar to their counterparts in United States. This lack of scale can prove to be good for these funds, at least in the short term as the lack of scale has absolved them from the blame of the present financial crisis in United Kingdom (CNBC 2009).

Majority of the hedge funds present in United Kingdom's financial system are not as highly leveraged as their counterparts in the United States of America (Nicholas 2004).

There are however fears and concerns over the possible role that these entities can play in perpetrating another future financial crisis. These fears have led to calls in United Kingdom for regulation of the hedge fund industry.

Chapter 3:

Research Methodology
Chapter 3: Research Methodology

The research methodology for our work has been depicted diagrammatically below:

A brief description would be made each of the components of the research methodology taken one at a time:

3.1 Key concepts in Research
3.1.1 Validity

According to “Schwant (2001) ‘validity refers to the extent to which conclusions drawn in research give an accurate description or explained of what happened'. It actually means in order to say that research findings are valid, it implies that they are true and certain” (Eriksson & Kovalainen 2008). Validity in a research aims to provide researcher with a guarantee that the description or report done is correct. The researcher would need to critically analyse to which extent research techniques and instruments used will measure the issues which researcher has to explore. In this research researcher needs to make sure that there is a relationship between the growth of hedge funds and the impact of this on UK investment market.

3.1.2 Reliability

“Reliability is one of the classic evaluation criteria commonly used in quantitative research” (Eriksson & Kovalainen 2008). It helps in analysing the extent to which, procedure, measure or instrument yields the same result on repeated trials. “It can be assessed by posing the following three questions (Easterby-Smith et al. 2008:109):

1) Will the measures yield the same results on other occasions?

2) Will similar observations be reached by other observers?

3) Is there transparency in how sense was made from the raw data?” (Saunders et al. 2009)

In this research which is been carried out, the question of reliability is related to the establishment of a degree of consistency in the research, therefore the researcher had to make sure that the data gathered about hedge funds could be collected again in a similar study.

3.1.3 Generalisability

Generalisability deals with “the issue of whether the research results can be extended in one way or another into a wider context” (Eriksson & Kovalainen 2008). “Bryman (1988:90) states that ‘with a case study a wide range of different people and activities are invariably examined so that the contrast with survey sample is not as acute as it appears at first glance'.” (Lewis et al, 2007). As Hedge fund is distinct from any other financial instrument, it is not possible to apply results gained to different available instruments in the investment market.

3.1.4 Triangulation

It refers to the use of “different data collection techniques within one study in order to ensure that the data collected are telling you what you think they are telling you” (Saunders et al., 2009). Denzin (1978) identified four types of triangulation.

1. “Source triangulation in which different data sources are used;

2. Investigator triangulation, in which more than one researcher is used;

3. Theory triangulation in which to interpret data more than one perspective is used; and

4. Methodological triangulation in which data gathered is by different techniques” (McMurray et al., 2004)

For this research, the researcher had used methodological triangulation i.e. different methods have been used to ensure that quality data is gathered, and also to minimise the risk of inaccuracy of information.

3.2 Research Families
3.2.1 Quantitative Research

According to Robson (2002) “quantitative data analysis is a field where it is not at all difficult to carry out an analysis which is simply wrong, or inappropriate for your purposes. And the negative side of readily available analysis software is that it becomes that much easier to generate elegantly presented rubbish”. Since this research had few financial components; some of the data gathered had a quantitative nature. This would include s about investors, hedge funds following different strategies; hedge funds and total return of close and similar other numbers. The result of quantitative research can be found in s 4-1 to 4-6.

3.2.2 Qualitative Research

According to Creswell (2007) “qualitative research is defined as an inquiry process of understanding based on distinct methodological traditions of inquiry that explore a social or human problem. The researcher builds a complex holistic picture, analyzes words, reports detailed views of informants, and conducts the study in a natural setting.” The information obtained from hedge fund managers, secondary data research and discussions with investors and regulators is sometimes not sufficient enough to develop a thorough understanding of the problem. Qualitative research is exploratory and unstructured in nature and tries to perform a root cause analysis of different aspects of the hedge fund industry and financial markets as a whole.

3.2.3 Primary Data

Primary data refers to information that is gathered or developed by the researcher specifically for the research project at hand. According to Hussey and Hussey (1997) primary data is the ‘original data' collected, through questionnaires and interviews. For this specific research, the researcher gained primary information by interviewing hedge fund managers, investors and regulators. All the possible research pertaining to the problem can only provide an indicative solution. Moreover, the solution suggested by theoretical constructs and secondary research may not be realistic to the inherent characteristics of the economy and the financial markets.

A discussion with the various hedge fund mangers involved in the real investment situations helps the researchers in understanding the real nature of the problem and the possible approaches in handling the problem. Discussion with these people also helps the researchers in limiting their scope of work and hence save valuable time. Investors in hedge funds and regulators of financial markets have expert and first hand knowledge about the functioning of financial markets and the risks associated with different kinds of investments.

The financial regulators can give a view about the risks that a leveraged structure like hedge fund can pose to the investors and to the economy as a whole. They can also throw some light on the possible nature of regulations that can be introduced without hampering the attractiveness of the hedge funds.

The investors in hedge funds are sophisticated investors and have a great deal of knowledge about the financial markets. They can help the researchers in providing valuable insights into the factors that lead to attractiveness of hedge funds in relation to other investment options. They can also suggest the actions that hedge funds should take to make the service offered by them more attractive. Finally they can provide us with valuable insights on the negative effects that the impending regulations can bring upon the popularity of hedge funds as an investment vehicle.

3.2.4 Secondary Data

On the other hand, there is secondary “which includes both raw data and published summaries” (Saunders et al., 2009). Secondary data is data collected from third part sources like internet, newspapers and other research publications. This data may not exactly relate to the primary objective of the research but provides useful inputs for the research.

Analysis of secondary data is essential for problem development and also developing the final conclusions. The researcher thinks the best suited method of secondary data to use is the one which uses large documentary evidence in the form of published reports, publications, statistics articles from press and the documents collected from various sources. Because of the time constraints researcher had to make sure that the data collected is economical, easily accessible and quick to get.

3.3. Research Techniques

3.3.1 Interviews

According to Kahn & Cannell (1957) interview is a purposeful discussion between two or more people. The use of interview helps in gathering valid and reliable data that are relevant to the questions in the research. A qualitative research interview “seeks to cover both a factual and a meaning level, though it is more difficult to interview on meaning level” (Kvale, 1996). The interviewees that had been chosen by the researcher were the hedge fund managers, investors and regulators. The interviews were on one on one basis and conducted via emails, questionnaires and face to face. At the request of the interviewees, the answers and data collected from them were recorded by note taking rather than tape-recording. The researcher designed a list of interview questions, the has been inserted in the analysis of finding

3.4. Ethical issues

Blumberg et al. (2005) defines ethics as the ‘moral principles, norms or standards of behaviour that guide moral choices about our behaviour and our relationships with other'. In qualitative research several authors discuss ethical consideration, describing the dilemmas they have encountered. “Role, reciprocity and ethical issues must be thought-through carefully in all settings but mainly in areas that are sensitive or taboo”. (Marshall & Rossman, 2006). The researcher cannot anticipate everything, but has to reveal an awareness of, an appreciation for, and a commitment to ethical principles for research. “Basic issues about confidentiality, informed consent, and protecting your interviewees are important cornerstones for empirical data gathering in business research” (Eriksson & Kovalainen 2008).

Ethical principles were considered by carrying out the research project by the researcher. Researcher made sure that interviewees respond out of their own free will, people's time feasibility was respected, as well as their anonymity and privacy. Researcher made sure that the reputation of the market research was not damaged by asking inappropriate, intimate and unfavourable questions. Research ethics also relates to questions about how the researcher formulates and clarifies the research topic.

3.5. Environmental Context of the problem

Environmental context of the problem includes historical data and estimates pertaining to the hedge fund industry and the financial markets in the specific country (United Kingdom in this case).

Environmental context of the problem includes information regarding competitive scenario, regulatory environment, fee structures and the power of investors.

Environmental context of a problem also brings out the various constraints faced by hedge funds in achievement of its objectives and the resources that the funds has for achievement of the same.

3.6. Approach to the problem

The approach to the problem is akin to a structured method that is being developed for accomplishing the objective i.e. to find the solutions to the questions and recommendations for the issues. The approach to the problem consists of the following components:

* Theoretical Framework- Theoretical framework is the set of past research and concepts that are used to derive conclusions obtained from the primary and secondary research carried out by the researcher.

* Analytical Models- Analytical model is a representation of a relationship between a set of variables. The relationship uses quantitative data to bring out a qualitative conclusion. The variables are generally the different aspects of the marketing research problem.

Research Questions- The key to success in a “qualitative business research project is not the method and its use, but researchers ability to formulate and reformulate the research” (Eriksson & Kovalainen 2008). These are just the reworded statements of the specific research problems. The research questions for our research are as follows:

o How are hedge funds different from other conventional pooled investment vehicles like hedge funds?

o What is the most important attribute that the investors consider while allocating their investment towards a particular vehicle?

o What are the areas where Hedge funds perform over other investment alternatives?

o What is the role played by the regulatory environment in determining the attractiveness of hedge funds?

o How would the present economic crisis influence the attractiveness of hedge funds?

o Is it better to follow a passive strategy based on a mathematical algorithm or is it better to follow an active strategy?

Chapter 4:

Analysis of Finding
Chapter 4: Analysis of Finding

In this part of our research, findings obtained are analyzed on basis of which conclusions and recommendations are drawn. These conclusions and recommendations will try and incorporate the significance and the influence of hedge funds from the point of view of all three participants namely Fund mangers, investors and regulators.

Now the researcher will take each objective and try and evaluate the findings that have been obtained using primary and secondary research for that objective. The analysis is done as follows:

O 1: Hedge funds have several differences when compared to other investment vehicles, especially Mutual Funds

Hedge fund can be defined as a regulation free mutual fund. It's not that hedge funds don't have to follow any rules; it's just that these rules are much less profound than those in case of mutual funds.

The main points of difference between hedge funds and mutual funds/private equity funds are explained below:

4.1. Hedge Funds VS Mutual Funds
4.1.1 Fee Structure

The fees charged by mutual funds are a function of the assets under management; the earnings of a mutual fund are totally dependent on the assets under management that a fund has.

Hedge funds also charge a “particular percentage of assets under management as management fees. Apart from this, they also charge a proportion of profits as the fee from the investors” (Jaeger, 2002). This proportion can be as high as 25% of the profits before tax.

Mutual funds can charge the investors fees for sales and marketing of the fund in the form of entry and exit loads. Hedge funds don't have any such form of fees.

4.1.2. Leverage

Borrowings of mutual funds are restricted to taking one off positions in attractive assets or for meeting redemption needs without having to sell of their assets. “ Most mutual funds use debt only to provide short term liquidity to accommodate withdrawals. They also use derivative instruments in lieu of investing in cash securities, not to create leverage” (McCrary 2004).

Hedge funds on the other hand are highly leveraged structures and take up large amount of debt on their books in order to maximize the return for the investors. The leverage for these funds is also high because of the large exposure that these funds have to derivative instruments, which in turn are highly leveraged structures.

4.1.3. Transparency

Mutual funds “publish their income statements i.e. profit & loss and balance sheet for the benefit of all their investors. They however don't disclose the individual positions of their investors” (McCrary 2004). They also publish the details about their aggregate portfolio albeit with some delay.

Hedge funds don't disclose the details of their investments or their trading strategies publicly. They however give information about their portfolio positions to significant investors on an individual basis.

4.1.4. Liquidity

Mutual funds generally offer the best liquidity. “Investors can call their mutual funds, place a sell order and receive a check for the proceeds within a week or less” (Frush, 2006). Mutual funds also give incentive of higher returns to investors to make them stay invested. They however have to maintain sufficient liquidity to take care of redemptions by investors. The liquidity is ensured by keeping some portion of the portfolio in liquid assets and certain amount in cash.

Hedge funds on the other hand keep provisions for higher lock in periods and penalties for early redemption. They allow entry or exit only at certain time of year, monthly, quarterly or annually (McCrary 2004). Moreover, there investment is in high return yielding assets, which are illiquid in most of the cases.

4.2. Hedge Funds VS Private Equity Funds

Now, researcher would look at the difference between hedge funds and private equity investment structures. The main differences are presented as follows:

4.2.1 Legal Structures

Private equity funds are “structured as limited liability partnerships like hedge funds; they are located mostly in offshore tax havens to take advantage of the tax exemptions” (McCrary 2004). In this respect, they are similar to hedge funds.

4.2.2 Fee Structure

Private equity funds have “similar fee structure to hedge funds. They have both a management fee component as well as a profit based incentive” (McCrary 2004). The profit based incentive is obtained only on liquidation of the investments by the private equity firm.

4.2.3 Leverage and Private Equity Investments

Private equity funds also use some leverage to buy assets in excess of their capital. “Funds like leverage buyout funds and venture capital funds use leverage to fund their assets” (McCrary 2004). The extent of leverage is however significantly lesser compared to those employed by hedge funds.

4.2.4 Absolute vs. Benchmarked returns

Hedge fund managers try and make “the returns of their funds independent of equity and bond returns. They try and create strategies that provide returns which are uncorrelated to the performance of these benchmark indices” (McCrary 2004).

Private equity returns are however related to the equity market returns. The reason for this is the linking of returns to a market related exit event. The fund managers try and beat an equity benchmark similar in nature to their investment portfolio over the same time period. Another reason for this benchmarking is the absence of active management in a private equity investment portfolio.

4.2.5 Liquidity

Private Equity “investments have long term tenure; they have a time horizon of 5-7 years” (McCrary 2004). The investments are returned to the investors only after there is an exit from an investment.

Since Private equity investment is a strategic investment, the investment requires detailed analysis before entry and exit. The exit is brought about by specific liquidity event like Initial Public Offering, sale to promoters or sale to a new strategic investor.

O 2: Potential of high returns relative to other investment vehicles is the most important variable

For this objective, a survey was conducted survey among the major investors who were interviewed. The survey revealed the following results:

· More than 60% of the investors regarded higher returns relative to other investment vehicles as the main reason for investing in hedge funds; rest of the factors like taxation, alignment of fund mangers interest and unconventional investment strategies got almost equally favorable responses

O 3: Ability to take exposure to non conventional assets unlike other pooled vehicles like mutual funds makes the investors prefer hedge funds over other vehicles

Most of the hedge funds invest in non conventional assets; this imparts a novelty to them and hence they find approval with “maverick” investors who are willing to experiment with new strategies for the sake of potentially higher returns.

The fee structure of hedge funds provides for a profit sharing based incentive to the fund managers; this plays a major role in alignment of the interest of the fund manager with that of the investor. This feature is also there in private equity investments but the extent of sharing of profits is limited. The feature is completely absent in case of a mutual fund, whose fee structure is based completely on the size of assets under management.

O 4: Alignment of the interest of the fund manger with the interest of the investor is the most important factor

The preference of most of the investors towards high returns as the deciding factors in the choice of the investment vehicle can also be explained by the characteristics of these investors. The types of these investors are depicted in the below:

The graph shows that the major investors in hedge funds are individuals; these individuals are mainly high net worth individuals whose risk appetite is quite high and hence they prefer the investment pool with the maximum possible returns.

O 5: Hedge funds have historically provided higher returns than most benchmark equity indices and have the potential of offering much higher returns than other pooled structures

This objective was tested by comparison of hedge fund returns with the returns given by benchmark equity indices. The hedge fund data used for this comparison is obtained from Hedge Fund Research Inc, which is an information source compiling data from several hedge funds.

The benchmark index used by us is the S&P 500 index. The time period taken into account for our comparison is from 1990 to 2000. The comparison is based on the future value of $ 1000 invested in the year 1990 at a particular point in time.

Hedge funds following different investment strategies are been compared below. The comparison is as follows:

The above graph shows a comparison of hedge funds following a equity long and short strategy with the S&P 500 benchmark. The hedge fund returns have been consistently higher than that of S&P 500. The difference between the returns has intensified over the years.

The steep gap that arises in the years 1999 can be attributed to the recessionary scenarios during that time. These conditions led to a steep fall in benchmark indices whereas the hedge funds were able to give consistent returns on the basis of the short strategy that they were allowed to follow.

The strong performance of hedge funds is visible by a total return of close to 800% for the ten year period under consideration. This is much better than the 400% return given by the S&P index given over the same period.

The above graph shows a comparison of the returns given by hedge funds working on the global macro strategy in relation to the S&P 500. Here also, the returns given by hedge funds are much better than those given by the benchmark equity index.

There is however a decline observed in the returns provided by these hedge funds towards the latter part of 1990s. The reason for the same could be attributed to the occurrence of two events against which these funds had placed a bet. These events were the default by Russian government on its sovereign debt and the bursting of technology bubble.

Another factor that has led to diminishing of returns of these funds is the lack of focus on the part of these funds. These funds have the mandate to invest across assets like currency, commodity, fixed income and equities and across geographies; this generates potential opportunities on one hand but also diminishes the overall returns for these funds. In spite of these issues these funds have outperformed the equity benchmarks.

Now we will look at the returns generated by the short selling hedge funds; these funds aim to take a net short exposure to the equity markets. They try and time their exposure to the instant when the market starts declining

There performance relative to equity benchmarks has been quite poor. The reason for the same could be attributed to a consistent Bull Run observed in our reference time period.

The graph clearly shows the out performance of equity benchmarks. The point to note is that In spite of the consistent Bull Run, these funds have given flat return and not negative returns as expected. This is an important observation since this depicts that the hedge funds can prevent capital erosion even in adverse market conditions.

Now the returns would need to be looked upon by the convertible arbitrage funds; these funds are based on the strategy of going long on a convertible security and going short on the equity component of that security. The returns are generated by the fall in yields of convertible bonds in case of bullish expectations.

The pattern of returns in this case is like that of an option where the downside is capped and the upside is unlimited. The returns generated by such funds relative to the equity benchmark are depicted in the below.

The returns track the returns of equity benchmark for the first part of the 1990s and they outperform the benchmark in the latter part. The important observation from this graph is that these hedge funds have been able to provide a better risk and return profile than the equity benchmarks. This is contrary to the popular perception that hedge funds are riskier investments as compared to conventional equity investments.

The graph shows that these funds have either outperformed the equity benchmark or given similar returns. The important observation is that in spite of merger arbitrages not being a frequent event, the funds have outperformed the S&P index.

The magnitude of this achievement becomes even higher if viewed this in wake of the fact that the given period saw a strong Bull Market in the United States.

The conclusion that have been drawn from the observations and the research done for this objectives is that hedge fund perform much better with respect to the returns generated for the investors. The fact that was also visible is that hedge funds performed reasonably well during the adverse market conditions in relation to the equity benchmarks.

O 6: Mathematical trading strategies perform better than discretionary fund management strategies

Based on the literature reviews and the interviews with the investors and the fund mangers, Algorithm based strategies tend to outperform the pure discretion based strategies. This fact is manifested in the form of superior returns generated by hedge fund investments over other conventional investment schemes.

The point to note here is that although algorithm based strategies are superior, they are based on certain assumptions. Deviation from these assumptions by significant margins can lead to steep fall in returns. These steep falls were manifested in cases like that of Long Term Capital management, where unexpected events like default by Russia on its sovereign instruments lead to huge losses for the fund.

The best way is to combine the mathematical strategies with discretion of the fund manger. This will prevent the occurrence of sharp losses due to failure of assumptions on which the strategies are based.

4.3. Questionnaire for the Expert Interviews

Hair et al (2003) defines interview where the researcher, “speaks” to the respondent directly, asking questions and recording answers. The researcher with regards to the interview conducted asked questions via emails and the answers to which has been noted down below with the questions. Below presented in the table are the details of the interviews held by the researcher.

BANK

Position of the Interviewee

Medium of interview

Branch Manager *

E-MAIL

Hedge fund manager *

E-MAIL

* Special Note

For reasons to protect the interviewees, their names are undisclosed. This is to comply with the wishes of the interviews themselves and also to protect them from reprisal of any kind.

Q1. How are hedge funds different from other conventional pooled investment vehicles like hedge funds?

First of all hedge funds don't have a bench mark, they tend to focus on just making money. Hedge funds can often short sell investments which means selling an investment that doesn't own in order to buy it back at a lower price and therefore benefit from a declined price, so hedge funds can basically make money also when an investment looses value which mutual funds typically cannot do so as they tend to be long owners of security and if price falls they tend to loose money whereas the hedge funds can make money when the security price declines.

Q2. What is the most important attribute that the investors consider while allocating their investment towards a particular vehicle?

Potential of high returns relative to other investment vehicles is the most important variable. The ability to take exposure to non conventional assets unlike other pooled vehicles like mutual funds makes the investor prefer hedge funds over other vehicles. Taxation issues are of prime consideration. Basically these are few of the important factors which an investors look at before selecting the investment vehicle that he/she is going to use for deployment of the funds.

Q3. What are the areas where hedge funds perform over other investment alternatives?

Hedge funds have historically provided higher return than most benchmark equity

Indices and have the potential of offering much higher returns than other pooled structures. Mathematical trading strategies, especially in the wake of present credit crisis situation which perform better than the discretionary fund management strategies gives an edge to hedge funds over other investment alternatives.

Q4. What is the role played by the regulatory environment in determining the attractiveness of hedge funds?

The regulations will in all likelihood impact other investment vehicles as much as they impact hedge funds so the impact as far as investors' choice is concerned is likely to be nullified. The restriction on the investment portfolios of the funds is likely to reduce the chances of potentially high returns for the funds. Bringing in more disclosures for these funds is likely to reduce the uniqueness and competitiveness of these funds. Keeping restrictions on liquidity requirements and leverage ceilings is again likely to reduce the potential returns for the investors.

Q5. Are stringent regulations for hedge funds expected in the wake of the present credit crisis?

The general consensus is that hedge funds played a role in the systemic failure that resulted in the global financial markets after the collapse of sub prime mortgage markets in United States. Hedge funds had taken positions in instruments and securities that derived their value from value of Housing in United States. The fall in prices of these assets led to margin pressures on hedge funds which made them sell the other assets in their portfolio leading to sharp fall in the prices of these assets which furthered the vicious cycle of run on the money. The role of hedge funds was important because of their scale, size of their investments and their geographical reach. The regulators world wide would like to curb these factors in order to prevent the financial markets from being overly dependent on hedge funds or any other single individual entity.

Q6. Is the regulatory framework expected to be uniform across the globe or is it expected to be different in United Kingdom?

The regulatory framework is expected to be more stringent in countries like United States of America when compared to countries like United Kingdom. The reason for this is the lesser role played by hedge funds in compounding the crisis in United Kingdom. The regulatory framework in United Kingdom is more likely to border on “prevention” issues rather than on “cure”.

Q7. Do you foresee a significant deleveraging in your portfolio in the aftermath of credit crisis?

Due to the high volatility present in the assets market, especially in the emerging markets; investors are expected and would be more inclined towards “safe” assets like United States treasuries and commodities like Gold rather than taking high risks and getting less return by investing in hedge funds.

Q8. What do you think that is the strategy that the hedge fund managers should follow during present credit crisis?

Hedge fund mangers are expected to follow conventional strategies for some time so as to consolidate their holdings and to cover up some of the losses that they have suffered during the credit crisis. The strategies of these funds are more likely to be concentrated in fixed income products rather than in equity and other growth oriented assets. In short, we can say that the hedge funds are likely to concentrate on constant stream of cash flows rather than going for Capital appreciation

Conclusions

The conclusions obtained from our research on hedge funds are as follows:

* Hedge funds differ from other investment vehicles like mutual funds and private equity funds. The fees charged by mutual funds are a function of the assets under management; the earnings of a mutual fund are totally dependent on the assets under management that a fund has. Hedge funds charge a profit share apart from the asset management fees. This profit share is quite higher in case of hedge funds when compared to other investment vehicles. Hedge funds are highly leveraged structures and take up large amount of debt on their books in order to maximize the return for the investors. The leverage for these funds is also high because of the large exposure that these funds have to derivative instruments, which in turn are highly leveraged structures. The leverage is minimal in case of other investment vehicles like mutual funds and private equity investments.

* Hedge fund returns are absolute in nature; they are not benchmarked to any standard asset based indices. Other pooled investment vehicles like private equity and mutual funds have their assets benchmarked to some standard index.

· A large proportion of the investors regarded higher returns relative to other investment vehicles as the main reason for investing in hedge funds; rest of the factors like taxation, alignment of fund mangers interest and unconventional investment strategies got almost equally favorable responses

* Most of the hedge funds invest in non conventional assets; this imparts a novelty to them and hence they find approval with “maverick” investors who are willing to experiment with new strategies for the sake of potentially higher returns. The fee structure of hedge funds provides for a profit sharing based incentive to the fund managers; this plays a major role in alignment of the interest of the fund manager with that of the investor.

* The equity based hedge funds show a total return of close to 800% for the ten year period under consideration. This is much better than the 400% return given by the S&P index given over the same period.

* The returns shown by macro based hedge funds are also much better than the returns of the standard equity benchmarks. There is however a decline observed in the returns provided by these hedge funds towards the latter part of 1990s. The reason for the same could be attributed to the occurrence of two events against which these funds had placed a bet. These events were the default by Russian government on its sovereign debt and the bursting of technology bubble. Another factor that has led to diminishing of returns of these funds is the lack of focus on the part of these funds. These funds have the mandate to invest across assets like currency, commodity, fixed income and equities and across geographies; this generates potential opportunities on one hand but also diminishes the overall returns for these funds.

* Algorithm based strategies tend to outperform the pure discretion based strategies. This fact is manifested in the form of superior returns generated by hedge fund investments over other conventional investment schemes. The point to note here is that although algorithm based strategies are superior, they are based on certain assumptions. Deviation from these assumptions by significant margins can lead to steep fall in returns. These steep falls were manifested in cases like that of Long Term Capital management, where unexpected events like default by Russia on its sovereign instruments lead to huge losses for the fund. The best way is to combine the mathematical strategies with discretion of the fund manger. This will prevent the occurrence of sharp losses due to failure of assumptions on which the strategies are based.

* The general consensus is that hedge funds played a role in the systemic failure that resulted in the global financial markets after the collapse of sub prime mortgage markets in United States. Hedge funds had taken positions in instruments and securities that derived their value from value of Housing in United States. The fall in prices of these assets led to margin pressures on hedge funds which made them sell the other assets in their portfolio leading to sharp fall in the prices of these assets which furthered the vicious cycle of run on the money. The role of hedge funds was important because of their scale, size of their investments and their geographical reach. The regulators world wide would like to curb these factors in order to prevent the financial markets from being overly dependent on hedge funds or any other single individual entity

* The regulations will in all likelihood impact other investment vehicles as much as they impact hedge funds so the impact as far as investors' choice is concerned is likely to be nullified, the restriction on the investment portfolios of the funds is likely to reduce the chances of potentially high returns for the funds, bringing in more disclosures for these funds is likely to reduce the uniqueness and competitiveness of these funds and finally keeping restrictions on liquidity requirements and leverage ceilings is again likely to reduce the potential returns for the investors

* The regulatory framework is expected to be more stringent in countries like United States of America when compared to countries like United Kingdom. The reason for this is the lesser role played by hedge funds in compounding the crisis in United Kingdom.

* Investors are expected to prefer “safe” assets like United States treasuries and commodities like Gold due to the high levels of volatility present in the other assets markets, especially in the emerging markets.

* Hedge fund mangers are expected to follow conventional strategies for some time so as to consolidate their holdings and to cover up some of the losses that they have suffered during the credit crisis. The strategies of these funds are more likely to be concentrated in fixed income products rather than in equity and other growth oriented assets. In short, it means that the hedge funds are likely to concentrate on constant stream of cash flows rather than going for Capital appreciation.

Recommendations

The recommendations that that will be presented based on our research have been categorized in three heads; this categorization is based on the segment for which the recommendation might be useful. The different segments and the recommendations for each of these segments have been presented as follows:

6.1. Hedge Fund Mangers

· The fund managers should look out for more innovative strategies based for keeping the investor interest high in these funds. The fund mangers can look at strategies that are direction neutral and are based on volatility. An example of these strategies would be “straddle” and “strangle” strategies constructed using options. These strategies involve taking up of simultaneous long and short positions in a similar asset. The downside is capped by the cost of getting into the strategy; the upside is dependent on the extent of deviation or volatility of the price of the underlying asset. Other strategies that can be looked at are that involving location arbitrage. These strategies are based on taking advantage of differential pricing between similar assets at different trading platforms.

· Fund mangers should ensure transparency by providing regular disclosures to all its investors about the portfolio positions of the fund. This will help in reduction of investor anxiety and prevent unnecessary redemption of funds.

· The fee structure should become more performance oriented to ensure the complete alignment of investors' and the fund mangers' interests. This type of pricing will also help in giving strong competition to other pooled investment vehicles

· The managers should lay equal stress on liquidity; ensuring adequate liquidity will also help in prevention of distress sale of assets in case of a run on the liquidity or margin calls in the market.

6.2. Investors

· Investors should undertake a close review of the portfolio, liquidity position and the historic return performance before initiating an investment in a particular hedge fund.

· Investors shouldn't put all their eggs in the same basket, they should try and diversify with respect to strategies, funds and asset type to minimize the risk exposure

6.3. Regulators

* They should introduce regulations, making disclosures mandatory for the hedge fund entities. The disclosures should include profit and loss statements and portfolio details.

* Regulations must be formulated to ensure that the exposure of a hedge fund to a single asset, single sector and a single company (in case of equity and debt investments) doesn't cross certain critical levels. This will be necessary to avoid systemic failure in case a large hedge fund collapses.

Glossary

Asset management The professional management of various securities (shares, bonds etc.) and assets (e.g., real estate), to meet specified investment goals for the benefit of the investors.

Benchmark Capital It is a venture capital firm responsible for the early stage funding of some very successful startups.

Entities It is something that has a distinct, separate existence, though it need not be a material existence.

Equities Refer to stocks secured by ownership.

Hedge Funds It is an investment fund open to limited range of investors who are permitted by regulators to wide range of investments and trading activities than other investment funds and pays fees to hedge fund managers.

Investors Types of people and companies that regularly purchase equity or debt securities for financial gain in exchange for funding an expanding company vehicles of high net worth individuals and other financial institutions having a high risk.

Liquidity A high level of trading activity, allowing buying and selling with minimum price disturbance. Also, a market characterized by the ability to buy and sell with relative ease.

Mutual Funds It is a professionally managed type of collective investment scheme that pools money from many investors and invests it in stocks, bonds, short-term money market instruments, and/or other securities.

Private equity It is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange.

Portfolio A collection of investments, real and/or financial.

Stock Ownership of a corporation indicated by shares, which represent a piece of corporation's assets and earnings.

Stock buyback Corporations can buy back their own stock in a share repurchase.

Stock splits It increases or decreases the number of shares in a public company.

S & P 500 It is a value-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States.

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