Gregory Connor, Mason Woo (London School of Economics) - An Introduction to Hedge Funds_trading_+_

Gregory Connor, Mason Woo (London School of Economics) - An Introduction to Hedge Funds_trading_+_

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Unformatted text preview: An Introduction to Hedge Funds Version 3.0 Connor and Woo (2003) Page 1 An Introduction to Hedge Funds By Gregory Connor and Mason Woo London School of Economics September 2003 This article gives a nontechnical overview of hedge funds and is intended for students or practitioners seeking a general introduction. It is not a survey of the research literature, and citations are kept to a minimum. Section 1 discusses the definition of a hedge fund; section 2 gives a short history of the hedge fund industry; section 3 describes hedge fund fees; section 4 categorises hedge fund investment strategies; section 5 briefly analyses hedge fund risk, and section 6 discusses hedge fund performance measurement. Section 7 offers some concluding comments. A bibliography and glossary of terms appear at the end of the article. 1. What is a Hedge Fund? 1.1 Standard definitions of a hedge fund A hedge fund can be defined as an actively managed, pooled investment vehicle that is open to only a limited group of investors and whose performance is measured in absolute return units. However, this simple definition excludes some hedge funds and includes some funds that are clearly not hedge funds. There is no simple and all- encompassing definition. Gregory Connor is a professor of finance and director of the IAM/FMG hedge fund research programme, and Mason Woo is a graduate student in the risk and regulation programme at London School of Economics. We would like to thank Morten Spenner of IAM for helpful comments. An Introduction to Hedge Funds Version 3.0 Connor and Woo (2003) Page 2 The nomenclature “hedge fund” provides insight into its original definition. To “hedge” is to lower overall risk by taking on an asset position that offsets an existing source of risk. For example, an investor holding a large position in foreign equities can hedge the portfolio’s currency risk by going short currency futures. A trader with a large inventory position in an individual stock can hedge the market component of the stock’s risk by going short equity index futures. One might define a hedge fund as an information-motivated fund that hedges away all or most sources of risk not related to the price-relevant information available for speculation. Note that short positions are intrinsic to hedging and are critical in the original definition of hedge funds. Alternatively, a hedge fund can be defined theoretically as the “purely active” component of a traditional actively-managed portfolio whose performance is measured against a market benchmark. Let w denote the portfolio weights of the traditional actively-managed equity portfolio. Let b denote the market benchmark weights for the passive index used to gauge the performance of this fund. Consider the active weights , h, defined as the differences between the portfolio weights and the benchmark weights: h = w – b A traditional fund has no short positions, so w has all nonnegative weights; most market benchmarks also have all nonnegative weights. benchmarks also have all nonnegative weights....
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Gregory Connor, Mason Woo (London School of Economics) - An Introduction to Hedge Funds_trading_+_

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