A fund of hedge funds, as the name suggests, invests in a portfolio of hedge funds not in any underlying security, in order to minimize idiosyncratic risk. Funds of hedge funds select hedge fund managers and construct portfolios based upon those selections.

The split strike convergence is a strategy that involves buying the index, selling calls to give up some of the potential upside gains, and buying puts to protect against the potential losses on the long index position. Madoff’s strategy simply termed as ‘‘split-strike convergence,’’ simply means buying the S&P 100 index and giving up some of the upside for downside protection.

The definition of a high net worth individual is highly fluid and changes with geography, nationality, and passage of time. Every country has its own regulations. Although there is no precise definition of how rich someone must be to fit into this category, high net worth is generally quoted in terms of having liquid assets of a particular number.

An accredited investor is an individual who either has a net worth greater than $1 million and has an income in the past two years that exceeds $200,000 a year and expects to continue this way or holds assets greater than $5 million. An accredited investor is a person or institution that meets certain requirements for the purpose of purchasing securities that are not offered to the general public.

A high-net-worth individual (HNWI) is a person with liquid assets above a certain figure. Wealthy individuals must pass either an accredited investor test or a qualified purchaser test to qualify to be high net-worth individuals.

A qualified purchaser is defined as either of the following:

– An individual who owns at least $5 million in investments.
– A family-held business that owns at least $5 million in investments.
– A business that has discretion of at least $25 million in investments.
– A trust that is sponsored by qualified purchasers.

The basic goal of every family office is to pool the resources of an extended family under one umbrella to achieve higher levels of wealth management. The family office uses in-house as well as outsourced resources to meet the financial goals as well as the tax obligations of the family.

Family offices serve the dual function of managing the wealth from a return as well as a tax perspective. These family offices then decide to invest in traditional equity and bond markets as well as in the alternative investment space of hedge funds.

Pension funds, high net worth individuals (HNWs), banks, and endowments are usually termed as the end-investors into hedge funds. These are large institutional investors that have billions of dollars to deploy and often define the investment trends of the future.

U.S. endowment funds are nontaxable vehicles established to contribute toward the future funding requirements of colleges and universities. The university endowments raise money from a combination of legacies, gifts, and government grants. They also rely on prudently deploying this capital to generate superior investment returns.

Alfred Jones started his first hedge fund trading equities, where he would buy some stocks and sell short some other stocks. This strategy came to be known as the Long/Short Equity strategy. Long/short equity is an investment strategy that seeks to take a long position in underpriced stocks while selling short overpriced shares.

Analyzing markets in greater depth by studying interest rate yield curves, volatility cubes, and correlations between related markets and securities to determine cheapness is referred to as relative value analysis refers. This analysis almost exclusively involves derivative instruments like options, futures, and swaps.

Global macro entails a global, top-down analysis of the macroeconomic conditions. It bases its holdings primarily on the overall economic and political views of various countries or their macroeconomic principles. Global macro funds build portfolios around predictions and projections of large-scale events on the country-wide, continental, and global scale, implementing opportunistic investment strategies to capitalize on macroeconomic and geopolitical trends.

The art of predicting market price movements based on systems is referred to as systematic trading. Systematic trading is highly mathematical and the trading decisions are made by computer-based algorithms rather than human intervention.

A fixed-income arbitrage strategy refers to exploiting pricing inefficiencies between related fixed-income securities. Fixed-income arbitrage seeks to profit from temporary price differences that may occur in bonds and other interest-rate securities. This kind of arbitrage can be risky unless the issues are extremely similar.

Relative value between government bonds of different maturities is referred to as the yield curve relative value. Yield curve relative value is a subset of the relative value arbitrage strategy.

In order to determine cheap or expensive securities, the relative value hedge fund manager will analyze the following:

– Yield curves between securities.
– Volatility cubes between securities.
– Correlation matrices between securities.
– Historical spreads between securities.

After determining cheap and expensive securities, a relative value hedge fund manager will then take a long position in the cheap security and a short position in the expensive security. Doing this means that he is betting that the short-term dislocation in prices is a manifestation of the supply and demand flows and that the market will soon return to some level of equilibrium.

Equity market neutral refers to the relative value between stocks of two companies in the same sector. Equity-market-neutral is a hedge fund strategy that seeks to exploit investment opportunities unique to some specific group of stocks while maintaining a neutral exposure to broad groups of stocks.

The relative value between a stock and the embedded value of a stock option in the company’s convertible bond is referred to as convertible arbitrage. Convertible arbitrage is a trading strategy that typically involves buying a convertible security and selling the underlying common stock.

A fund manager hires a reputable legal firm to help with the following:

– Setting up the hedge fund legal structure.
– Complying with securities and derivatives regulatory matters.
– Drafting operating agreements, marketing arrangements, trading documentation, exchange listing, internet usage.
– Handling tax and ERISA matters.

An investment manager wishing to start a hedge fund will need the right mix of trading success, industry experience, and business know-how in order to make it as a hedge fund manager in what has become a highly competitive industry. The success of a hedge fund is defined by the following:

– The expertise of the manager.
– The manager’s ability to pick the appropriate service providers.

A typical hedge fund manager will usually start out with $25 million to $50 million. He will use his own savings, raise capital from friends and family, as well as from his previous employer. If they are unable to raise enough capital from their previous employers or through the usual friends and family network, these managers have the choice of starting with a very small amount of capital or approaching one of the several commercial seeders.

A commercial seeder will provide the aspiring hedge fund manager with startup operating capital as well as trading capital. The usual seed investment provided by these commercial seeders is in the tune of $25 to $50 million. In return, the seeder will assume a certain percentage ownership stake in the hedge fund.

The following is listed in the offering memorandum (OM) and they all need to be looked at very carefully by the investor and his/her lawyer:

– Redemption restrictions.
– The hedge fund manager’s background.
– The fund’s strategy.
– The fee structure.
– Risk disclosures.

The fund manager’s background should list his education and trading experience along with details of the schools he attended, previous employers, and date. It takes specific education and experience to become a profitable hedge fund manager, hence the offering memorandum will outline whether the manager and his team possess the necessary skills.

Stop loss limits and their management are the core piece of any risk management methodology. Stop losses have to take into account the following:

– Market liquidity
– Bid-offer spreads
– Gap risk
– Position sizing
– Loss of anonymity

In normal functioning markets, liquidity is ample, bid-offer spreads are tight, and gap risk is low enough that a trader can get away with large position sizes.

The layers of middlemen who have made fortunes trying to match investors with the appropriate hedge fund managers are in the form of consultants, advisors, fund of funds, and third-party marketers. The middlemen’s main responsibility has been to understand the hedge fund strategies and make the hedge funds less opaque to the end investors.

Hedge funds are operated from several countries around the world, however, hard to determine the actual number of hedge funds in existence. This is because hedge funds are not required to register with any regulatory body like the SEC.