Hedge Funds Pitch Consulting Assignment
United Nations Pension Fund (UNPF) Brief History
According to UNPF, a Hedge fund was first created by Alfred Winslow Jones in 1949, where he combined several characteristics that define hedge funds even in today’s business environment. In this view, Alfred Winslow Jones sold short-term stocks as he projected a decline in price while acquiring more long-term stock that expected price increase by using leverage to purchase these additional funds.
Alfred Winslow Jones avoided the Investment Company Act 1940 requirements by creating a limited partnership with 99 investors (Lieberman, 2018). As a result, Jones took 20% of the profits generated from the ‘hedge fund’ and charged management fees of the fund that saw several imitators use the model, especially the limited partnership structure and management fee as proposed by Jones.
Thus, Hedge funds seek to address the inefficiencies in the market. UNPF has four types of hedge funds: long-short equity, macro, fixed-income arbitrage, and event-driven hedge fund (Hartley, 2019).
Status of the Hedge Funds Industry
In today’s business environment, the hedge fund industry has not performed well for the last decade, with more positive projections expected in 2021 (Ellen & Li, 2022). In the current state, the hedge funds continue to grow, but they continue to adapt to greater use of technology in their operations, lower management fees, and enhanced access to retail investors.
For instance, 50 hedge funds produced over 24% gains in 2020 while the S&P 500 generated about 18.40% gain with collectively 5-year net returns of 14.81%, while the S&P 500 had an annual return of 15.22%. In this view, the hedge fund industry’s return over 2020 was 6.41% which shows that the industry is doing well based on the prevailing economic conditions resulting from the Covid-19 pandemic (Ellen & Li, 2022).
The hedge fund performance in the last decade has not been rewarding, but it has managed to record impressive performance, and its growth and performance are expected to continue ballooning in 2022, which will fuel significant change in the next decade.
Pros and Cons of Hedge Funds
Flexibility
Compared to Mutual funds, hedge funds are articulated as more flexible as the Securities and Exchange Commission (SEC) does not focus or concern itself on hedge funds (Ellen & Li, 2022). In this view, hedge funds are not traded publicly, making them flexible as there are no regulations that regulate the performance of hedge funds. Additionally, hedge funding may adopt strategies such as short-term selling, leverage investment, and derivatives across several investments without limitations or regulations (Hartley, 2019).
Hence, through shorting or short selling, hedge funding can gain profits from the declining price of a security, a stock, or a bond in the market. Thus, hedge funds are flexible as investors could take advantage of the declining price and adopt shorting to make profits as the gain in the rise of price in their investment option.
Good Performance
Based on the current status of hedge funds and the S&P 500, hedge funds have a promising trend in 2022 compared to other investment options (Ellen & Li, 2022). With the hedge fund’s aggressive investment strategy, investors can gain higher returns based on the fund’s investment strategies, including short selling, leverage buying, and use of derivatives in its operations.
Hedge funding often perform better in the market as it does not have market uncertainty as other investments. It allows fund managers to short sell for declining prices, borrow to invest, or leverage busying and derivative use (Jorion, 2021). Therefore, hedge funds have a sustainable competitive advantage compared to other investments that are not flexible and high regulated with SEC compared to hedge funding activity.
Diversification
With the highly volatile investment markets, hedge funding offer investors an opportunity to add diversification and significantly reduce risk in the investment options. As diversification investment, hedge funding articulated long/short strategy, tactical trading, and event-driven that offer investors a positive investment portfolio (Hartley, 2019).
As a result, hedge fund managers can reduce risks, allowing investors to obtain instant diversification in the market’s investment portfolio. Thus, hedge funds offer their investors’ instance diversification, reducing risks associated with the bond market and conventional equity.
Hedge Fund Fees
For managers to operate a hedge fund for the investor, there is a fee structure referred to as ‘2 and 20’, which can be expensive in the long run. In the structure, investors have to pay a 2% management fee for a 20% fund manager hedge fund; usually, a performance fee of profits gained in a year (Jorion, 2021). Therefore, hedge fund fees are costly in the investment strategies as with or without profits; one has to pay 2% as a management fee and give up 20% of the total profits made from an investment.
Hedge Funds are Less Liquid
The concentration investment strategy of hedge funds exposes the funds to huge losses compared to mutual funds. In this context, investors often lock up money for a year, which leads to significant losses if they happen. The use of leverage strategy further increases the risk involved with hedge funds as an investment strategy as the borrowed money if a failure occurs in hedge fund transaction, it could be a double loss (Hartley, 2019).
Therefore, hedge funds are considered long-term investment options that require investors to lock up vast sums of money for a year or more in anticipation of good returns, which is not always the case.
Based on the current state of the hedge fund industry, especially in the economic recovery from the Covid-19 pandemic, risk reduction benefits in stocks or bonds allow a significant reduction of overall portfolio risk in the market. The concept of surplus optimization in the hedge funds minimizes the expected shortfall (SF) with a ten-year asset portfolio (Ellen & Li, 2022).
As a result, 7% of the pension percentage of the pension fund should be allocated to hedge funds as a strategic investment option in minimizing risk investment portfolios in the market. With a hedge allocation of 2%, the improved SF is about 1% while the extreme loss is at 5%; in the same context, a hedge fund allocation of 7% improved SF expected is close to 5%, while its extreme loss probability is at 12% (Jorion, 2021). Therefore, allocating a 7% pension fund to hedge is effective as it minimizes risks with an investment option of stock and bond hedge fund strategies.
Successful managers such as Chris Hohn’s TCI or Ray Dalio’s Bridgewater associates provide better opportunities for the pension allocation to the hedge fund to be a success and enhance profit marking. To effectively understand hedge fund in this context, the basic structure of the hedge fund doctrine should be adhered to for better hedge fund returns. One of the critical operational issues that hedge fund allocation face is the flexibility of unregulated that makes its investment portfolio in the pension fund (Ellen & Li, 2022). For UNPF to build a hedge fund allocation, it should consider the pension’s users in its operations.
Second And Separate from The Above
To effectively invest the $50,000,000 on two hedge funds for the period of five-year lockup, first, it’s essential to establish the two hedge funds as limited partners to enhance the flexibility of the funds from the regulations of SEC in their operations. It is essential to understand the 2 and 20 rule in managing these hedge funds as the returns will be viewed on an annual basis, which means that 2% management fee of these two hedge funds and 20% for profits gained in the investment portfolio.
I propose a short/long hedge fund strategy in the investment portfolio to allow flexibility to withdraw the money if something truly catastrophic happens. Second, we need to consider the hedge fund structure or model that will entail; the fund, which is the entity holding the securities where an investor participated. The fund allocation needs to consider the general partner for the hedge, the fund responsible for day-to-day operation, and the fund’s investment manager (Student).
The available investment capital of $50,000,000 will be invested in two hedge funds, including credit-focused hedge funds with convertible bonds with two choices:
- Issue 25MM shares at $10; however, it is essential to note that share price could decline, let’s say $47; as a result, the return of the investment could be: $25MM*$47=1.175B
- Issue the 5-year lockup debt as 5%, resulting in an interest cost =$50MM*5=$250MM annually that will translate to 1B or refinancing over the first 5years.
To maximize the returns on the hedge funds, the fund should adopt the ‘Multi-Strategy Hedge Funds.’ The Multi-strategy hedge funds offer the hedge fund a number of benefits including; multiple strategies within one fund, developing over time (5-year lockup), having attractive returns with low volatility, and enhancing capital allocation its returns can be muted. However, the Multi-strategy funds have one limitation: they require chasing hot trends/ideas that may not yield many returns for the investment portfolio.
With the multi-strategy hedge funding, the management fee will be 1.4% and 16% for the profits gained annually based on the current state of the hedge fund industry, which is promising compared to the last decade and is performing better than the S&P 500. Additionally, the five-year lockup offers the easy management of the hedge fund as I can use multiple strategies within one fund, enhancing the working conditions.
While hedge fund management is not a new phenomenon in the investment market, to effectively acquire ten employees with consultancy services sort from the best hedge fund managers, including but not limited to: Chris Hohn’s TCI or Ray Dalio’s Bridgewater Associates. As this is a short/long hedge fund, there will be no modeling after the existing one as the 50MM hedge funds are aimed at the 5-year lockup. The multi-strategy hedge funds are longer-term investments caused by attractive returns with low volatility.
I am uniquely qualified for this opportunity as I am hungry for knowledge with exceptional knowledge on hedge funding and hedge fund strategies. I will effectively execute the task while learning from the best hedge fund managers in the industry, such as Chris Hohn’s TCI or Ray Dalio’s Bridgewater Associates.
References
Ellen He, Y. and Li, T., 2022. Social Networks and Hedge Fund Activism. Review of Finance.
Hartley, J.S., 2019. Liquid Alternative Mutual Funds versus Hedge Funds: Returns, Risk Factors, and Diversification. The Journal of Alternative Investments, 22(1), pp.37-56.
Jorion, P., 2021. Hedge Funds and Financial Misreporting. The Oxford Handbook of Hedge Funds, p.393.
Lieberman, D.L., 2018. Hedge Funding and Impact Investing: Considerations for Institutional Investors. The Journal of Investing, 27(2), pp.47-55.
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