By CA S.

D Mookerjea At ICAI course of MBF On 26th May 2012

It is an investment fund that aggressively manages its portfolio It employs investment techniques like : -- Leveraged positions -- Long & Short positions -- Derivative positions The funds are largely US based & operate globally The objective is to generate high returns while it actually started of as an instrument of hedging Risks

It is operates as private investment partnership that are only open to limited number of investors The minimum investment amount is large & the investments are largely illiquid As these funds cater to sophisticated investors they are largely unregulated In US the investors are accredited - $ 1 million net worth , deep investment knowledge & high annual income---A Mutual Fund of Super rich

Equity positions Long/short -- Positive exposure without leverage (70% long and 30% short ) -- Positive exposure with leverage ( 80% long and 40 % short ) Market neutral -- (50% long and 50% short) -- With beta Either way the desire is to minimize the price volatility & reap benefits through choice of stocks The play can be in regions , industry , sectors or specific market cap stocks

Global Macro Strategies -- Investing globally on currency , commodities futures & options , forward & other derivative instruments -- Funds place directional bets on prices of underlying assets & are highly leveraged -- Also choose the diversity of instruments and regions to make money

Arbitrage --Relative value --Here hedge fund manager is expected to buy securities/bonds which is supposed to appreciate & reverse for securities/bonds supposed to depreciate -- Related securities could be a) stocks & bonds of same company b) stocks of different company but same sector c) stocks of same sector but different territories etc -- Convertible value-Trader take position on convertible bond and stock of the same company -- Distressed value-Hedge funds may do loan & restructuring and take position on BoD for turnaround

Soros Fund Management, is the main advisor of Quantum group of funds Set up as a privately owned hedge fund in Netherlands and in Cayman Islands , it is a group which largely deals in currency and commodities George Soros along with Jim Rogers began this hedge fund in early 1970s Shareholders of the fund were never publicly disclosed although it is believed that Rothschild family & some other wealthy European groups invested $6million in the beginning.

George Soros propounded the Theory of Reflexivity The Theory debunks the classical economic theory of independent demand & supply curve & price It states that the not only demand determines the price but at a point price determines the demand It is a circular relationship of cause & effect There is no equilibrium but a series of changes in demand & supply Example : Banks lent to real estate when prices were rising and when pricing forces became unsustainable, the banks cut the lending(the US model) Many hedge funds has now accepted this theory as trading cornerstone

Armed with the theory of reflexivity , Soros began shorting currencies in a big way Soros began tracking countries with bulging budget deficits like USA and began shorting dollars at reflexivity points He used quantitative tools like trend lines and algorithim But more than that he deeply studied easy money policy, its consequent debt creation and the demand bubble that was forming

By late 1980s he was virtually betting $ 1 billion a day and had spread his quantum funds to all European currencies. The fluctuating interest rates enabled him to take long/short positions in the international bond market The annual earning of the fund was running at 40 % with variety of assets including commodities totaling to nearly 7 billion dollars And then in 1992, Soros broke the Bank of England through his Quantum hedge fund

In 1987, Common Market had an exchange mechanism called European Exchange Rate Mechanism (ERM) & was colloquially known as Snake to which Britain became member In 1992 after German reunification, Soros observed that injection of funds in East Germany pushed up interest rates to an extent that the recession bound Pound began to loose value On Sept 16 1992 , Quantum Fund took a $ 7 million short position on Pound-sterling.

Bank of England tried to defend the pound by buying but failed The Central ERM rate was 2.95 to a mark but by the end of the day had sunk to 2.25 & was going down further Under pressure BoE exited Snake loosing deposits and financial credibility. Quantum Fund had also shorted Lira but had gone long on mark & French Franc At the end of it Quantum Fund collected a profit of $ 2 Billion

In early 1990s,John Meriwether & some of his brilliant collegues in Saloman Brothers completed a model that tended to predict bond spread aberrations & correction probability It actually simplified the operation of a small but complicated portion of the bond market In 1994 Meriwether and his friends left the company & formed LCTM with (amazingly) $ 1.2 Billion start up funds Scholes & Merlon of merlon- Balck-scholes fame were a noble prize winners ( Oct 97) and partners

C0 = Se-dTN(d1) - Xe-rTN(d2) Where: d1 = [ln(S0/X) + (r - d + 2/2)T]/ T And: d2 = d1 - T Black and Scholes reasoned that the options value depended on Five variables: The current market price of the Stock (S), the agreed future price at which the option could be exercised (X), the expiration date of the option (T), the risk-free rate of return in the economy as a whole (r) and the crucial variable - the expected annual volatility of the stock, that is, ther likely fluctuation s of its price between the time of purchase and the expiration date ( - the Greek letter sigma). With wonderful mathematical wizardry, Black & Scholes reduced the price of the option to C0 = Se-dTN(d1) - Xe-rTN(d2)

It was computer based model that fed on arbitrage opportunities in the Bond Market Central strategy was convergence trade where the securities were incorrectly priced in relation to one another LTCM would take long position on under priced security and short position on overpriced ones LTCM would make money when the bonds ,over a time , came to its fair value Factors involved were economic strength, fiscal deficit, Central bank policies , interest rates etc It focused on tiny differences & theatre of operation was International Bond Market , US Bonds , Emerging markets etc

The results in the initial years were spectacular In 1995 the return was 29% , in 1996 59% & in 1997 it still maintained dizzying height of 57 % The Capital had tripled to $ 3.5 billion & the company had reserves of liquid cash LCTM was leveraging at 1:30 ratio Investors & lenders were happy but none knew the finance/risk structure A Hedge fund of 100 employees was ahead of large global corporations

Excess profit breeds excess competition The super profits of LTCM brought other large funds in the arena It took a while for others to figure out the operations but once they did, the field got crowded and LTCM margins were under pressure LTCM took the fatal step to branch out in other areas of commodities , currencies etc But the inexperience and high leveraging coupled with 1998 crash of Russian roubles made LTCM incurr losses to push it into bankrupcy

Limitations of excessive leverage-Holding long term becomes difficult Importance of Risk Management : -- Managers focused on theoretical model & not enough on liquidity risk , gap risk and stress-testing -- The possibility of crisis & flight to liquidity was ignored -- The theory of correlation of long & short position should have been stress tested. -- Exposure to multiple areas with inadequate understanding is a fundamental flaw Lack of Supervision

XYZ Commodities Ltd is a hedge fund dealing in derivatives of oil , copper and iron ore. It specialized inter-country arbitrage but was getting constrained by US policy on Iran Additionally the Fund worked with consultants who did not understand the traders language Timing was of essence as algorithm strategies needed to be developed urgently

Hired IBM to quickly create an algo platform Algo trading strategies were put into platform in record time Created back testing tools to validate the strategies Created visual tools to monitor real time performance Established bench marking of bonus performance