We continue “Ask an Expert” column and the following topic that we would like to cover is to invest in hedge fund market.

For your convenience, we have prepared a video interview where Alkey Kashkinov. Director of alternative investments told us about hedge funds and analyzed the specific of this instrument deeply.

Enjoy watching!

https://www.youtube.com/watch?v=SqTQivoaShA&t=427s

- What hedge funds are and the hedge fund market in general.

-Hedge funds are one of the largest classes of alternative investments. According to data published by the reputable analytical agency Hedge Fund Research, the hedge fund market reached $ 3.2 trillion in the second quarter of 2020.

Today, there are about 10,000 active hedge funds, which are mainly attracted by institutional investors such as pension funds, large managers, sovereign wealth funds of some countries, insurance companies, as well as some wealthy private investors. The bulk of the distribution of hedge funds at headquarters is in the United States and Europe.

- Who can invest in hedge funds?

-Hedge funds are usually available only to certain investors who meet defined criteria: a minimum level of investment knowledge (only qualified investors are allowed) and a minimum investment size (on average, $ 500 thousand dollars).

Hedge funds usually charge an annual management fee and an investment performance fee, which is often indicated as a percentage of profits above the established norm.

However, most hedge funds impose capital withdrawal restrictions for certain periods, the duration of which depends on how long the managers believe it will take to successfully implement their strategies.

- You said "strategies." Could you elaborate on what these strategies are?

-Hedge funds can vary greatly in profitability and risk, depending on the skills of managers and their strategies. Key strategies include equity market strategies, event strategies, relative value strategies, macro and integrated strategies.

For example, in the framework of macro-strategies, managers open positions based on global macroeconomic trends, guided by changes in certain macroeconomic indicators. For example, these may be changes in the key interest rate, indicators of the business activity index, GDP, labor market data and other factors. Bridgewater Associates, the world's largest foundation under the leadership of Ray Dalio, is a well-known example of a macro hedge fund.

As part of event strategies, the manager carries out certain trading operations based on his expectations for some certain events, which are more likely to affect the value of the corresponding asset. For example, corporate merger, bankruptcy, or recapitalization.

With regard to equity market strategies, managers use their own quantitative and qualitative methods of estimating the value of shares and their derivatives to open long and/or short positions. The manager can focus on certain sectors, trade data or fundamental characteristics of companies.

As part of relative value strategies, the manager also assumes, in accordance with his internal metrics, that one instrument is undervalued relative to the other, and thus opens appropriate positions, expecting that this underestimation/inefficiency will be adjusted.

With regard to integrated strategies, it can be assumed from the name that the simultaneous use of several sub-strategies by the managers is assumed. One example of integrated strategies is platform funds, which hire experienced portfolio managers and allocate capital among them, taking into account the attractiveness of sub-strategies and related management results.

Hedge funds can also apply market-neutral strategies that minimize the impact on the portfolio - the general dynamics of the market and depend on the individual characteristics of trading positions.

At the same time, certain hedge funds specialize in trading market volatility in stocks, bonds and currencies, opening positions through relevant derivative financial instruments. In addition, in times of uncertainty and market turbulence, hedge funds are in high demand for investors, applying protective strategies aimed at preserving capital. It is also worth emphasizing that many hedge funds use the credit shoulder when opening positions, which increases profits or, accordingly, potential losses. Hedge funds can quickly change positioning by adapting the portfolio to changing market conditions. Hedge funds can quickly change positioning by adapting the portfolio to changing market conditions.

- Tell me, please, how hedge funds behave in relatively turbulent periods - periods of high volatility, such as in March 2020.

With a wide range of different trading strategies, hedge funds can open both long and short positions in almost all traded instruments and make a profit, both when markets fall and growth. This flexibility is particularly good at times of relatively high market volatility, in which the importance of fundamental factors for individual instruments is often diminished, which may cause their market value to deviate from fair values. This provides active investors and generally professional market participants with many investment opportunities.

With deep market adjustments and declining liquidity, the hedge fund sector may experience consolidation, in which high-risk funds face capital outflows, which negatively affect their investment results. At the same time, large hedge funds with stable returns are in high demand.

- Could you provide an example?

A good example of hedge fund behavior during the market correction is the period from February to March 2020, when world stock indices fell by almost a third in a short time. The global spread of the COVID-19 virus and subsequent administrative restrictions in most countries provoked a recession in the world economy and a large-scale correction of stock indices. The peak of the sale of risk assets occurred in mid-March 2020, when the market had a high liquidity deficit. Despite the profits of some managers, many hedge funds suffered losses in March. Meanwhile, hedge fund losses were significantly less than passive investor losses. For the 1 quarter of 2020, the MSCI ACWI (Morgan Stanley Capital International All Country World Index), representing the global equity market, declined by 21.7%, while the Hedge Fund Research, Inc Fund Weighted Composite index, reflecting the results of hedge funds, decreased by 11.5%.

- What about strategies?

In terms of strategies, during last year's March correction, funds using macro and integrated strategies showed relatively strong results, while funds focusing on event strategies and strategies in the equity market showed relatively weak results. Well, it is worth noting the completely negative results of hedge funds with strategies based on trade on volatility (for the 1st quarter of 2020, the HFRI RV: Volatility Index showed a result of (-5.8%), and the index closed the year with a result (-2.7%))

It is important to note here that against the background of the liquidity deficit, investors withdrew a record $85 billion from hedge funds in March, which amounted to 2.7% of the volume of assets under management. Some hedge funds with liquidity and line-item problems offered investors the opportunity to participate in the correction and restoration of quotes on the more favorable terms on the one hand in the form of reduced commissions, but on the other hand they increased the retention period. A significant drop in risk asset prices in the first quarter of 2020 also prompted previously closed and hard-to-reach hedge funds such as DE Shaw, TCI and others to announce raising additional capital to realize investment opportunities.

The market situation is similar to the pandemic COVID-19 observed during the global financial crisis in 2008-2009, when, with strong growth in volatility, liquidity shortages and sales of risk assets, hedge funds significantly exceeded stock indices (MSCI ACWI -43.5% for 2008, HFRI FWI -19% for 2008).

- What is the role of hedge funds in the portfolio of alternative investments?

The role of hedge funds in the portfolio of alternative instruments is to increase risk-adjusted returns, reduce volatility and diversify with respect to traditional portfolios of stocks and bonds. Hedge funds also provide access to a wide range of low cross-correlation strategies not found in other asset classes.

In addition, the role of hedge funds in the portfolio of alternative instruments is to reduce the “J curve” effect in the framework of investments in private capital and to ensure dynamism in the tactical allocation of assets, taking into account changes in the market and macroeconomic environment.

- How attractive are such investments?

In general, hedge funds as an asset class are an attractive investment from the point of view of portfolio diversification, preservation or growth of capital in times of market turbulence. Despite the fact that many hedge funds, like other risky assets, can suffer significant losses in the event of a sudden surge in volatility, managers have the opportunity to quickly adjust their positioning, which allows funds to compensate for losses in the medium term. With a prolonged period of volatility and dispersion in the stock markets, the returns of active hedge funds often significantly exceed the results of passive investors and managers.

Thank you for the information provided and your time.