Pictet Alternative Advisors SA

An introduction
to hedge funds
April
2018

Hedge funds gained a reputation for

preserving investors’ capital and generating
relative outperformance in market crises.
Carefully selected hedge funds provide
an alternative investment exposure with
diversification and enhanced return
potential over the long term.
 Contents

2 Executive summary

3 Part I - Hedge funds in perspective

The beginning of hedge funds
Definition of hedge funds
The hedge fund industry today
Hedge fund strategies
Arbitrage
Equity hedge
Tactical trading

8 Part II - Investing in hedge funds

The case for hedge funds
Investors’ concerns
Myth and reality
The value-added of hedge funds
Fund of hedge fund model

12 Part III - Pictet: a strategic partner for hedge funds

Pictet Group
Pictet Alternative Advisors SA
Investment philosophy
Portfolio construction
– Manager selection
– Strategy allocation
– Risk management

14 Glossary

An introduction to hedge funds

1
 Executive Summary

Hedge funds gained a reputation for preserving understand the manager’s investment strategy and
investors’ capital and generating relative outper- assess whether it is likely to be successful in a given
formance in market crises. Carefully selected hedge macroeconomic environment.
funds provide an alternative investment exposure Our team of hedge fund investment professionals
with diversification and enhanced return potential helps clients to understand these demanding aspects
over the long-term. and offer a set of hedge fund investment solutions.
At Pictet Alternative Advisors SA, in addition to Clients may choose from Pictet’s various commingled
an extensive know-how of other alternative assets funds of hedge funds, diversified across several pro-
such as private equity and real estate, we have been minent managers, or opt for a tailor-made mandate.
selecting hedge funds for private and institutional In each case, our investment philosophy is based
clients since the 1990s. on the same key investment principles and rules,
Selecting the best hedge fund managers means derived from best industry practices and our long ex-
that we invest in only a small portion of all the funds perience. We search for the best talents and allocate
we screen worldwide. Finding hedge fund managers capital according to our macroeconomic views. Our
who are able to achieve genuine, provable and repea- portfolio construction integrates the three main ele-
table performance requires extensive research and ments of our investment process: strategy allocation,
skill, as well as careful qualitative and quantitative manager selection and risk management.
monitoring.
Correctly assessing sources of risk is perhaps
even more important than analysing sources of per-
formance. Operational, credit and market risks are
just a few aspects that need to be grasped before any
investment in a hedge fund. Investors need to fully

An introduction to hedge funds

2
 Part I
Hedge funds in perspective

The beginnings of hedge funds In addition, hedge funds often

It is generally said that the first share the following characteristics:
known hedge fund was an investment
——They are often formed as an unre-
partnership established more than
gulated investment pool and are
60 years ago by Alfred Winslow Jones.
generally domiciled offshore.
He sought to separate the two risks
inherent in investing in stocks: ——They measure their performance in
1) Market risk defined as the general absolute terms (i.e., independent of
change in stock prices due to market market direction and uncorrelated
influences and 2) Specific risks related to any benchmark).
to factors particular to each individual
——They usually charge a performance
stock.
fee.
The first hedge fund was launched Jones’ partnership held a short
in 1949 position in a basket of stocks as ——They require high minimum in-
insurance against a downturn in the vestments.
market, “hedging” to some extent
——Their subscription and redemption
the systematic risk. Jones’ fund was
policies are fairly restrictive and
unique in that it combined unconven-
may even impose lock-up periods
tional characteristics such as market
or gates.
neutral exposure and incentive fees.
According to Warren Buffett, ——Hedge fund managers usually in-
however, the first person to manage vest their own capital along with
a hedge fund was none other than their clients.
Benjamin Graham, who used long, as
well as short positions and charged an
incentive fee as early as the mid-1920s.
Benjamin Graham is considered by
many to be the father of financial ana-
lysis and value investing.

Definition of hedge funds

There are various definitions in use,
but broadly speaking, a hedge fund
is any type of investment company or
private partnership that uses the fol-
lowing instruments and techniques:
——Long or short positions across asset
classes.
——Derivatives, such as options (call or
put), futures, swaps, etc.
——Financial leverage.

An introduction to hedge funds

3
The industry has grown more than The hedge fund industry today growth, rising from around 500 hedge
20-fold in the past decade
The hedge fund industry is generally funds in 1990 to approximately 8,335
estimated to have grown from about at the end of December 2017.
USD 40 billion in assets under mana- So far, the number of new funds has
gement in 1990 to over 3.0 trillion in continued to grow despite approxima-
December 2017. tely 10% of hedge funds closing each
However, it is believed that the year because of their inability to raise
amount of assets actually managed far sufficient assets or deliver satisfactory
exceeds the figures officially reported. performance.
No standard classification of
Nevertheless, although assets continue
hedge fund strategies
to grow significantly, the size of the
hedge fund industry remains small
compared to the mutual fund industry
and global financial markets.
In terms of the number of funds,
the industry has experienced similar

HED G E FUND INDUS TRY G ROW TH

3500
9000

8000
3000

7000
2500

6000

2000
5000

4000 1500

3000
1000

2000
500
1000

0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017

Number of Funds (ex FoFs) Assets

Source: HFR Global Hedge fund industry report - Q4 2017

An introduction to hedge funds

4
 Hedge fund strategies Arbitrage
There are many ways of classifying the Relative value
investment strategies of hedge fund Relative value is an investment strate-
managers. Moreover, some managers gy that aims to exploit pricing inef-
combine several strategies in what are ficiencies between related financial
instruments such as stocks or bonds.
AUM BRE AK D OW N BY HED G E FUND S TR ATEG IE S Relative value managers will value the
fundamentals of related instruments
and go long and/or short expecting
prices to converge towards a norm. As
managers profit from the convergence
1990 2017
of relatively small differentials, this
strategy can be leveraged in order to
enhance returns.

Relative Value (15%) Relative Value (26%) Volatility arbitrage

Equity Hedge (41%) Equity Hedge (29%) Volatility arbitrage trades the implied
Event Driven (11%) Event Driven (26%)
volatility versus the historical volati-
Macro (33%) Macro (19%)
lity on the same asset across different
strike prices or maturities expecting
Source: HFR Global hedge fund report - Q4 2017
an increase in the fluctuations of the
underlying security’s price.
often referred to as “multi-strategy
funds”. The table illustrates the three Statistical arbitrage
broad strategic approaches of hedge Managers using this strategy seek
funds and the underlying investment to profit from pricing inefficiencies
strategies. identified using mathematical models.
Statistical arbitrage strategies are
HED G E FUND S TR ATEG IE S based on the premise that prices will
return to their historical norms.
Arbitrage Equity Hedge Tactical Trading
Fixed-income arbitrage
Relative Value Long Short Equity Global Macro This strategy seeks to exploit mis-
– Volatility Arbitrage – Market Neutral pricings developed between related
– Statistical Arbitrage – Short Sellers classes of fixed income securities
such as yield curve and credit spread
trading, often neutralising exposure
Fixed Income Distressed Commodity Trading to interest rate risk.
– Credit Arbitrage Advisors (CTA)
– Capital Structure Arbitrage
– Convertible Arbitrage
Credit arbitrage
Credit arbitrage seeks to take advan-
Event Driven Emerging Markets tage of pricing inefficiencies between
– Merger Arbitrage the credit sensitive securities of diffe-
– Special Situations rent issuers.
Instruments commonly traded in-
clude CDOs (collateralised debt obliga-
tions) and CDSs (credit default swaps).
Source: Pictet Alternative Advisors SA

An introduction to hedge funds

5
 Capital structure arbitrage an undervalued stock. A manager can
Capital structure arbitrage aims to either be a generalist or focused on
profit from the pricing inefficien- specific regions, sectors, industries or
cies across the issuing firm's capital market capitalizations. They can also
structure with the expectation that specialize in types of stocks such as
the pricing disparity between the two value and growth.
securities will converge.
Market neutral
Convertible arbitrage Market neutral managers seek to ex-
This strategy captures inefficiencies ploit investment opportunities unique
in the pricing of convertible securities to some specific group of stocks while
relative to its underlying stocks. maintaining a neutral exposure to
Typically, a manager goes long broad groups of stocks defined for
the convertible bond and shorts its example by sector, industry, market
common stock, effectively hedging capitalization, country or region.
the equity risk. Credit default swaps These portfolios minimise market
then allow the credit exposure to be risk by being simultaneously long and
hedged. short, and produce one single source
of returns (the rule of one alpha).
Equity Hedge
Long/short equity Short sellers
This style accounts for the majority Short selling seeks to profit from
of the strategies used by hedge fund declines in the value of stocks. The
managers today. This directional strategy consists in borrowing a stock
strategy combines both long and and selling it on the market with the
short positions in stocks with a simple intention of buying it back later at a
objective to minimize exposure to the lower price. By selling the stock short,
market. A manager would typically
short an overvalued stock and go long

ANNUALISED RISK / RE TURN BY S T Y LE ( APRIL 19 9 4 - FEBRUARY 2018)

12

Global Macro S&P 500 TR

10 Distressed Hedge
CS Ln/Sh Eq HF USD
Annualised return (%)

Broad HF Index
MSCI World TR USD
8 Multi Strategy Event Driven
Emerging Markets
Convertible Arbitrage MSCI Emerging Markets TR USD
EURO STOXX 50 NR EUR
Barclays Global Agg TR
6 Fixed Income Arbitrage
Market Neutral
Managed Futures

Topix TR
2
S&P GSCI TR

0 5 10 15 20 25
Annualised volatility (%)

Traditional indices Hedge fund strategies

Source: Lipper, Credit Suisse Hedge Fund Indices in USD, data as at 28.02.2018

An introduction to hedge funds

6
the seller receives interest on the cash fixed-income, currency and equity
proceeds resulting from the sale. If the markets through either direct invest-
stock advances, the short seller takes ments or futures and other derivative
a loss when buying it back to pay back products.
the lender.
CTA
Distressed CTA stands for Commodity Trading
This investment strategy generally Advisor and is also known as a Ma-
consists of buying securities of compa- naged Futures strategy. This strategy
nies in bankruptcy proceedings and/ essentially invests in futures contracts
or in the process of restructuring the on financial, commodity and currency
debt portion of their balance sheets. markets around the world. Trading
The complexity of such operations decisions are often based on proprie-
often creates mispricing opportunities tary quantitative models and technical
and hence a potential to profit when analysis.
prices converge.
Emerging markets
Event driven Emerging markets' trading strategies
Event driven strategies seek to exploit include global macro and CTA mana-
relative mispricings between securities gers who rapidly adjust the risk profile
whose issuers are involved in mergers, of a portfolio to short term market
divestures, restructurings or other conditions, regardless of long-term
corporate events. The strategies can be convictions, with a bias on emerging
leveraged to enhance returns. markets. Such tactical moves can be
made either judgementally or with a
Merger arbitrage systematic approach, and may be based
Also known as risk arbitrage, this on a wide range of data, from econo-
strategy invests in merger situations. mic fundamentals to pure technical
The classic merger arbitrage strategy indicators.
consists in buying the stock of the
target company while simultaneously
selling short the stock of the acquiring
company.

Special situations
Also known as corporate life cycle,
this strategy focuses on opportunities
created by significant transactional
events, such as division spin-offs,
mergers, acquisitions, bankruptcies,
reorganisations, share buybacks and
management changes.

Tactical trading
Global macro
Global macro managers make in-depth
analyses of macroeconomic trends
in order to arrive at their investment
strategy, taking positions on the

An introduction to hedge funds

7
 Part II
Investing in hedge funds

The case for hedge funds they work, the more he can set aside
One of the biggest misconceptions myths and misconceptions and capi-
about hedge funds is that they must talise on the advantages that hedge
take excessive risks in order to gain funds offer.
higher returns. The best hedge funds
are specialists at minimising risk Investors’ concerns
and make it an integral part of their Misconceptions about hedge funds
investment plan. Conscientious risk often arise from their complex nature
Over the long-term, hedge funds management serves to limit losses and and the lack of transparency that still
tend to generate better promotes more consistent, generally prevails in this industry. Investors
risk-adjusted returns than
higher risk-adjusted returns. often regard hedge funds as “black
traditional asset classes
Hedge funds can serve an important boxes” that are risky by nature but
and valuable role in a well-diversified offer high potential returns. For these
portfolio, especially since hedge funds reasons, first-time investors tend to
tend to reduce market risk by pro- opt primarily for long/short equity
viding downside protection in bear strategies whose investment style is
markets and upside participation in similar to that of traditional invest-
bull markets. The more an investor ment funds.
understands hedge funds and how

PERFORMAN CE OF FOHF S VS MAIN INDICE S (19 9 0 =10 0)

700

600

500

400

300

200

100

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

HFRI Fund of Funds Composite Index

Bloomberg Barclays Global-Aggregate Total Return Index Value Hedged USD
MSCI World Net Total Return USD Index

Source: Bloomberg and MPI, data as at 30.03.2018

An introduction to hedge funds

8
 Myth and reality
We list some of the most recurrent
myths and explain why, in our view,
these are indeed myths.

Hedge funds are often Myth Reality

misunderstood Hedge funds are very risky and The primary objective of hedge funds is to
highly volatile preserve capital by minimising volatility,
which has historically been much higher on
stock markets than with hedge funds

Hedge funds lack transparency in their Nowadays, most hedge funds provide
portfolios and organisation investors with monthly reports containing
appropriate financial details. Pressure from
institutional investors has helped to increase
transparency

Hedge funds use significant leverage Less than 30% of hedge fund managers
employ a leverage effect greater than
2x (source: Van Hedge Fund Advisers
International)

Hedge funds are always unregulated Although true for many offshore hedge
investment vehicles funds, numerous investment managers are
regulated by local authorities such as the
SEC in the US and the FSA in the UK. Hedge
funds regulation is a widely discussed matter
among financial authorities in today’s world

Hedge funds offer no economic Hedge funds offer a valid alternative to

added value traditional asset classes by allowing investors
to optimise the return of their portfolios and
the cost of capital

Hedge fund blow ups result in systemic The failure of LTCM was related to a
risks (example: the failure of LTCM) combination of human failure, inappropriate
risk management techniques and greed
(leverage up to 28x). It was also the failure
of large investment banks which sometimes
provided unlimited leverage, incorrectly
assessing the risks embedded in LTCM’s
strategy

Hedge funds are a main cause of market There is no evidence that hedge funds are
downturns and volatility linked to stock market crises. Hedge funds
only represent a very small amount of total
investments worldwide

Hedge funds are only for wealthy This idea belongs to the past. Today, even
private investors retail clients can invest in hedge funds via
fund of hedge funds.

Source: Adapted from the journal of Global Financial Markets, Vol 2, No 4, Winter 2001 pp. 34-46

An introduction to hedge funds

9
 The added value of hedge funds hedge funds can contribute signifi-
As presented in Part I, the hedge fund cantly to portfolio diversification.
industry is characterised by a breadth Their low correlation to equity bear
of different trading strategies and markets, their participation in market
Hedge funds improve portfolio manager styles. Individually, they upsides and low volatility profile
diversification offer a diverse source of risk-adjusted assists in reducing a portfolio’s overall
returns depending on the trading risk exposure while contributing to
environment and economic expecta- the portfolio’s return.
tions. Together, hedge funds target the The following section highlights
long-term preservation of capital the main differences between traditio-
regardless of broad market moves. In nal investments and hedge funds.
a portfolio context, an allocation to

Traditional investments Hedge funds

Financial Managers have limited access Managers have a wide range of

instruments to sophisticated instruments financial instruments and investment
and hedging techniques such as techniques to choose from, allowing
short selling or derivatives trading them to reduce risks and take
owing to the restrictive regulatory advantage of pricing inefficiencies
environment

Performance Performance is largely dictated by Performance is driven by investment

drivers the direction of traditional markets style and the manager’s ability
to employ it within any market
environment

Performance Managers have a relative return Hedge fund managers aim to

objectives objective and aim to outperform achieve risk-adjusted absolute
a benchmark, hence providing returns regardless of the market
little protection in times of market environment, rather than simply
downturns tracking or attempting to outperform
a classic benchmark

Exposure In most cases the portfolio is The manager is free to choose the
fully invested investments and weightings with full
discretion

Pricing Fee income depends on the Fees are based both on the assets
amount of assets in the portfolio, under management and the fund’s
and managers are rewarded absolute performance. Most of the
for increasing assets under hedge fund manager’s remuneration
management is tied to performance. Generally,
fees are higher than in the rest
of the industry. Most hedge fund
managers stop raising new money if
they perceive further growth as being
detrimental to the fund’s strategy

Liquidity Investments are usually very liquid Most hedge funds allow for monthly
subscription and quarterly
redemption. Some funds impose
lock-up periods as well as gates.
The liquidity offered to hedge fund
investors often reflects the liquidity
of the underlying investments in a
given strategy

Alignment of Regulations may prohibit managers Managers invest part or all of their
interests from investing in the same own assets in their funds and hence
securities or funds as their clients bear the same risks as their clients

Incorporation Investment vehicles are often Hedge funds are incorporated

domiciled in regulated jurisdictions in offshore jurisdictions which
sometimes lack specific regulations

An introduction to hedge funds

10
 Fund of hedge funds model several managers competent in a given
A widely recognised benefit of a fund strategy (a thematic portfolio) serving
of hedge funds (FoHF) is the diversifi- a specific purpose in an investors’
cation effect which comes from mini- asset mix.
mising the idiosyncratic risks inherent Structurally, investors benefit from
to investing directly in a handful of partnering with an asset manager that
single managers. has been selecting hedge funds and
Simulations show that a higher constructing portfolios for a variety
number of funds reduces volatility and of different clients over different eco-
drawdowns leading to an improved nomic cycles. This highly resource in-
preservation of capital. FoHFs provide tensive process, developed over time,
an access to a wider universe of hedge allows asset managers to optimise the
funds that may otherwise be closed to terms (liquidity, operational work-
new investors, or that are “under the flows, transparency, reporting). Finally,
radar” and not available to the broader FoHFs allow investors to bypass the
investor community. Finally, a FoHF substantial minimum investment
allows an allocation to a range of generally required by individual funds.
hedge fund strategies (a multi-strategy
portfolio) in one single vehicle or to

CORREL ATION BET WEEN DIFFERENT HEDGE FUND STR ATEGIES (APRIL 19 9 4 - FEBRUARY 2018)

Convertible Distressed Emerging Market Event Fixed Global Long/Short Multi Managed
Arbitrage Markets Neutral Driven Income Macro equity Strategy Futures
Arbitrage

Convertible
Arbitrage

Distressed

Emerging
Markets

Market
Neutral

Event
Driven

Fixed
Income
Arbitrage
Global
Macro

Long/Short

Multi
Strategy

Managed
Futures

0.75% to 1.0 0%  0.5 0% to 0.75%

0. 25% to 0.5 0%  0.0 0 % to 0. 25%  - 0. 25% to 0.0 0 %

Source: Lipper, Credit Suisse Hedge Fund Indices in USD, data as at 28.02.2018

An introduction to hedge funds

11
 Part III
Pictet: a strategic partner for hedge funds

Pictet Group billion in its funds of hedge funds

Founded in 1805 in Geneva, Pictet is and tailor- made mandates. The entire
a leading asset manager in Europe for division is located in Geneva and
both private and institutional investors. employs around 59 people.
As at July 2017, assets under mana-
gement and in custody totalled around Investment philosophy
USD 498 billion (CHF 478 billion; PAA’s mission is to provide investors
EUR 405 billion). with hedge fund solutions offering
Pictet Group employs more than both capital preservation and absolute
4,000 people worldwide, including performance. Over the years, PAA has
900 investment professionals, ana- developed key investment principles
lysts, economists and strategists. and rules based on best industry
practice and solid experience, which
Pictet Alternative Advisors SA today lie at the heart of our investment
Pictet's Alternative Advisors depart- philosophy.
ment (PAA) is a division of the Pictet PAA follows four simple principles
Group responsible for investments in in its investment philosophy. A risk
hedge funds, private equity funds and aware approach, driven from the bot-
real estate funds. Applying a rigorous tom-up, focusing on human capital,
investment process, PAA today ma- with a long-term time horizon.
nages approximately USD eleven

OUR IN V E S TMENT PHILOSOPH Y HELP S US MAK E NO C OMPROMISE AND

S TAY FO CUSED

RISK AWARE
HUMAN CAPITAL
Only take risks
People before
we understand
processes
Diversified sources
Alignment of interests
of risk

INDEPENDENT
MINDS

BOTTOM UP
LONG TERM
High convictions
Farm new talents
Thorough understan-
True partnerships
ding of investment
through continuity
processes

Source: Pictet Alternative Advisors SA

An introduction to hedge funds

12
 Portfolio construction regions. Together, they enable the
Our portfolio construction inte- team to establish a medium term
grates the three main elements of allocation to hedge fund strategies.
our investment process. The process Risk management in hedge funds
creates the discipline necessary to base is not limited to analysis of volatility,
our decisions on facts, rather than on but also focuses on higher moments
sentiment which is critical in a people of the return distribution as well as
business. measurement of time-varying betas.
In its manager selection, PAA PAA employs sophisticated risk ma-
targets hedge fund managers who nagement tools throughout the entire
exhibit exceptional skills in their field investment process from selecting and
of expertise. Thorough due diligence monitoring managers to controlling
enables us to identify managers with risk levels in each portfolio. Portfolio
whom long-term relationships can be risk is controlled by means of two
nurtured in an independent and risk different multi- factor approaches,
conscious manner. namely principal component analysis
We draw on a network Strategy allocation at PAA depends (statistical factors) and dynamic style
of professionals built on a strategic and a tactical allocation. analysis (pre-defined factors).
up over the years
Our strategic allocation acts as our
long-term neutral exposure in a multi-
strategy portfolio of hedge funds.
In contrast, our tactical allocation
reviews and monitors the major factors
and risk drivers of hedge fund returns
and draws upon Pictet’s research com-
mittees to assess top tier information
across all asset classes and geographic

MANAG ER SELEC TION – 4 S TEP PRO CE S S

Hedge fund universe Sourcing Manager selection Approved funds

c. 8'400 funds c.1,300 funds c.230 funds c. 132 funds

• Exclusion criteria • Pictet partners • Due diligence Continuous monitoring

– insufficient size, • Hedge funds – Qualitative
liquidity • Industry consultants – Quantitative
or track record • Prime brokers
– Operational
– specific strategies • Competitors

Source: Pictet Alternative Advisors SA

An introduction to hedge funds

13
 Glossary and useful terms

Administrator Collateralised debt Derivatives

The financial institution, generally a obligation (CDO) Financial instruments or contracts
bank, responsible for all the adminis- Sophisticated financial tools that whose value depends on the value of
trative duties required to manage a repackage individual loans into a pro- their underlying securities, assets, or
fund. duct that can be sold on the secondary variables. Examples of derivatives are
market. options, warrants, futures, forwards,
Alpha and swaps.
Investment performance that is not Convertible bond
explained by market returns. Alpha A bond that gives the holder the Drawdown
measures skill and may be derived option of converting into shares The fall in the value of a unit or share
from security-picking ability, suitable of the company at certain times at in a fund from peak to trough in a
rotation of management styles or sec- predetermined prices during the given interval of time.
tors or market timing (see also “Beta”). life of the bond.
Exposure
Arbitrage Correlation The amount of assets that a fund has
The simultaneous purchase and sale The degree to which two variables invested on a market in relation to the
of a security on different markets in fluctuate in sync with one another. fund’s total assets.
order to profit from a temporary dis- Correlation is always expressed
crepancy in prices. between –1 and +1, with –1 being Financial leverage
completely inversely correlated, 0 Investments made in excess of capital
Benchmark meaning no correlation and +1 being available, expressed as a percentage of
A gauge of performance of a predeter- completely correlated. net asset value.
mined set of securities or funds used
for comparison purposes. Such sets can Credit default swap (CDS) Future
be based on indices or specially-custo- An instrument that enables the risk A contract that provides for the sale
mised to suit an investment strategy. of default to be transferred from the of financial instruments or physical
holder of the fixed income security to commodities for future delivery on a
Beta the seller of the swap. commodity exchange.
Investment performance that can be
explained by market returns (see also Custodian Gamma trading
“Alpha”). The financial institution that is A trading technique in which the
responsible for the management and manager bets that the implicit
Black box safekeeping of a fund’s securities. volatility of an option is different
A proprietary computerized trading from the expected volatility of the
system whose formulas and calcu- underlying asset.
lations are not disclosed or readily
accessible. Users enter information Gate
and the system utilizes pre-program- Restriction limiting the amount of
med logic to return output to the user, withdrawals from the hedge fund
which may include trading signals and during the redemption period.
other data.

An introduction to hedge funds

14
 Incentive fee Short selling
Manager compensation based on the A trading strategy whereby an investor
performance of the investment. sells a security that he does not own.
The holder of a short position benefits
Liquidity when the price falls. Unlike a long
The degree to which a financial position, a short seller is in theory
instrument can be sold or converted exposed to unlimited loss.
to cash. A liquid market describes a
market characterised by sufficient Sortino ratio
trading volumes to allow for buying A measure of risk-adjusted return
and selling with minimum price calculated by subtracting the risk-
disturbance. free rate from the annualised return
and then dividing by the downside
Lock-up period deviation of returns.
Window of time during which
investors of a hedge fund are not Stop-loss
allowed to redeem or sell shares. A trading instruction in which, once a
pre-determined percentage loss on any
Long one position has occurred, it triggers
A trading or investment strategy either a review of the position or its
whereby the investor owns a security immediate closing.
and benefits when its price rises.
Top-down
LTCM An analysis method in which the
Long-Term Capital Management. manager first analyses macroeconomic
A well-known hedge fund whose trends and then picks securities
collapse in 1998 shook world financial that might be affected by them (see
markets. bottom-up).

Management fee Volatility

Manager compensation based on A measure of the variability of return
assets size. of a financial instrument or market.
For a fund, volatility is a measure
Prime broker of risk, generally expressed by the
A broker that offers more services than standard deviation of the fund’s
a classic broker. Such prime broking monthly returns, at an annual rate.
services might include backoffice
operations, trade reconciliation,
financing, recordkeeping or custodian
activities.

Sharpe ratio
A measure of risk-adjusted return
calculated by subtracting the risk-
free rate from the annualised return
and then dividing by the standard
deviation of returns.

An introduction to hedge funds

15
Disclaimer

This document is not intended change rates may have a positive or

for persons who are citizens of, negative effect on the value, the
domiciled or resident in, or entities price or the income of the securi-
registered in a country or a juris- ties or the related investments
diction in which its distribution, mentioned in this document.
publication, provision or use would Past performance must not be
violate current laws and regula- considered an indicator or gua-
tions. In particular, investment rantee of future performance, and
funds or any other collective pla- the addressees of this document
cement instruments which have are fully responsible for any invest-
not been authorised for public of- ments they make. No express or
fering in the investor’s country of implied warranty is given as to fu-
domicile may only be offered as ture performance. Investors shall
private placements to qualified in- conduct their own analysis of the
vestors. Additional investment res- risks (including any legal, regula-
trictions may be provided for in the tory, tax or other consequence) as-
official offering documentation sociated with an investment and
(available upon request). should seek independent profes-
The information and data furnished sional advice.
in this document are disclosed for The content of this document is
information purposes only; the Pic- confidential and can only be read
tet Group is not liable for them nor and/or used by its addressee. The
do they constitute an offer, an invi- Pictet Group is not liable for the
tation to buy, sell or subscribe to se- use, transmission or exploitation of
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An introduction to hedge funds

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