Dynamis Fund case study
The brokerage’s motivation in recommending energy investments can be explained by the high commission that could be earned. Hedge funds charge a fee for assets under management and incentive fees based on a certain percentage of the profits earned. With good stock picking, the brokerage would be able to earn profits in both up and down markets. A regional broker would want to offer hedge funds because they are only lightly regulated and thus the fund managers can use more advanced investment strategies such as a leveraged and derivatives positions.
It Is stated In their selling memorandum that their mission Is to exploit Investment opportunities In publicly traded companies in the energy sector.
Hence, the fund seeks to generate above average returns relative to both S Energy composite and the broader market through a variety of investment instruments. Also, the fund’s use of various strategies will be designed to minimize risk while maximizing potential return, again increasing the commission that could be paid to the hedge fund managers.
This potentially high level of compensation helps the brokerage retain talented brokers and specialists, raising the reputation of the firm. Furthermore, investing In energy funds serves as a diversification tool. This is because from historical records, energy prices have had a high correlation with inflation.
In times of rolling Inflation, energy funds have been found to perform better than the market. Thus, they are able to act as a source of risk diversification. This explains the presence of a market for such energy funds.
In addition, energy funds have been a very popular fund with investors. The high dependence on oil in all parts of the world has made energy stocks a hedge for emerging market portfolios.
With a demand for such energy stocks, a regional brokerage will want to cash in on this opportunity and offer energy funds. In order to cater to a larger crowd of investors, the brokerage firm will offer energy hedge funds to sophisticated investors and energy mutual fund to general public who will like to invest in energy fund, but are unable to do so given their smaller amount of capital.
Investing in energy funds is often complicated and risky, given the volatility of such commodities. Brokerage firms have a fiduciary responsibility to research on such funds before recommending them to their clients. They have to ascertain if the investments are suitable for the clients based on their age, investment experience and tolerance for risk.
In view of this, investors prefer a firm that can provide them with personalized services suited to their needs and risk tolerances.
To be able to get these services, most of these investors go to regional brokerage firms. Such regional brokerages can deliver the attention to their clients due to their small size. Thus, with such demand in energy funds, regional brokerage firms would be able to make a profit out of offering such instruments. It will allow them to better position homeless in the market. 2.
Why did S&S start a hedge fund in addition to its energy portfolio The Energy portfolio is essentially a long equity fund for investors to buy stocks.
It is stated that in their selling memorandum that the Energy Portfolio will seek to earn above average returns by investing in smaller and medium-size companies that are growing earnings and cash flow in a dramatic way. Therefore, it can only stand to gain when the market goes up. On the other hand, the introduction of the hedge fund will provide benefits to both its investors and the fund manager in the following ways: 2 For the investors, the hedge fund acts as a better investment for reaping returns in both bull and bear markets by having both long and short positions.
Also, hedge funds are lightly regulated as compared to mutual funds and thus the fund managers can pursue more advanced and a wider range of strategies including leverages, derivatives, short sales, options and futures contracts. The flexibility in managing the hedge funds allows fund managers to exploit opportunities within the energy sector.
The potentially higher returns attract investors with higher risk tolerance. Hedge funds cater to sophisticated investors who earn a minimum amount f money annually and have a certain amount of net worth, along with investment knowledge.
It helps to cater to the needs of the sophisticated investors and target a substantially different market from the mutual funds. This is in line with S&S’s corporate strategy of providing the best possible service to its retail customers and continuing to grow the asset management business. As for the fund managers, a hedge fund provides a radically different incentive package tan ten typical mutual Tuna. I en Tees pal Dye Investors are enlarge as compared to that for mutual funds, including additional fees that mutual funds do to charge.
There are no restrictions on the fees a hedge fund manager can charge, as compared to mutual fund fees which are regulated and transparent. The energy hedge fund charges a 1% management fee, which is for the same service that the management fee covers in mutual funds. This fee alone may form a substantial part of the fund manager’s profit, thus making the management of the hedge fund attractive to manager. In addition to the management fee, incentive fees are charged based on 20% of the fund’s profits. It serves to reward the fund manager for the stock picking ability and for good performance.
The potentially high returns that hedge fund offers from the wider range of investment strategies also increases the potential incentives that the fund manager gets, explaining the main reason for starting the Energy Hedge Fund.
3 3. Does the fee structure for the Dynamism hedge fund make sense? Comment on the differences in the compensation between the energy portfolio and the Dynamism fund. The fee structure of the Dynamism Fund includes management fees as well as performance fees. Management fee is equivalent to 1% of assets under management while performance fee is equivalent to 20% of profits earned by the hedge fund.
The performance incentive will only be allocated unless any previous losses have been recouped, implying the existence of a high-water mark. Also, there exist a hurdle rate of 10% and the full 20% profit incentive to be allocated to the fund manager begins only at 12.
5% return. The main difference between the fee structure of hedge funds and mutual funds woo a De ten Implementation AT ten performance Tee. Hedge Tunas are more actively managed than mutual funds and this performance fees can be seen as additional compensation to the fund managers for the additional efforts involved.
Hedge funds eve higher flexibility than mutual funds and hedge fund managers are allowed the use of short selling, leverage as well as derivatives, from plain vanilla options to very exotic instruments. L Also, the incentive fees act as an attraction to lure talented managers so as to deliver high returns to the clients. 2 In a research appear, it was also found that incentive fee provides managers with strong incentive schemes: the higher the incentive fee, the better the fund performance.
In fact, a 1% increase in incentive fee will increase the average monthly return by 1. 3%.
It is necessary to determine if this fee structure can indeed help deliver superior profits that are demanded. In theory, the fee structure helps align investors’ goal to that of the fund manager since the fund managers’ income is tied to the profits of the fund. Also, the high-water mark ensures that investors Past present and future, Rene M Stall, 2007 Are hedge funds fees too high? , François-Serge Liability, 2007 3 On the Performance of Hedge Fund, Being Liana, 1998 4 do not lose out since any losses have to be recouped before the performance fees can be charged. It also ensures that managers engage in limited risky activities.
Without the high-water mark, the managers gain from the upside but do not suffer from the downside and this does not lead to goal congruence. However, in the case of huge losses, goal alignment will be out since fund manager can simply abandon the fund and start another fund since the high-water mark will prevent the manager from earning the incentive fees in the coming periods. Furthermore, towards the end of an evaluation period, managers have incentives to increase the variance of the portfolio and take on more risks when the asset value of the fund is not far below the high water mark, in order to receive the performance fees 4.
The cyclical nature and volatility in the energy sector also makes the usage of high water marks an unfair means of compensation to the investment managers of energy hedge fund. By capping the fund managers’ compensation to the profits will prevent managers from simply increasing the portfolio and assets under management so as to increase management fees.
To determine if the fee structure has been useful to investors, we look at the returns of the hedge funds over a period of time to determine its performance.
The Hennessey Hedge Fund Index actually outperformed other indexes such as the S&P500, NASDAQ and DOD Jones Industrial Average. A thousand dollars invested in the hedge fund index would have grown to SUDSY, 647 as compared to $5,299 if invested in the S&P500. 5 Apart from its superior returns, the annulled standard deviation of the Hennessey Hedge Fund Index is lower than most of the Indexes toner tan ten Barclay Aggregate Bono Index I . Nils would Inhalant Tanat hedge funds are good value for money since investors are getting the most from their investments.
Also, it is indicative that hedge funds are able to minimize the investment risk as well. 5 High-Water Marks and Hedge funds management contracts, Guatemalan, Engineers, Ross, 2003 http://www. Homogeneousness. Com/indices/returns/idolatrous. HTML Evidently, in times of bearish market, empirical data has shown that while hedge funds did suffer negative returns, they fared far better than the S&P500.
6 Since the performance fees compensate the managers of hedge funds for their efforts and form a substantial portion of their income, would the management fees be excessive as a result?
Regressing the S&S Energy Portfolio returns on the three indexes would yield the Toweling equation. The right hand side of the equation can be used as the multi index benchmark to measure the performance of the portfolio manager. By substituting the various returns of the SPOILS, SPOILS and SPOILS indexes over the time period into the equation, we would get a list of returns for this new benchmark. Further regression of the original energy portfolio returns on this new list of returns for the new benchmark would yield the following result.
R, Correlation R square Multi Index Benchmark 0.
88513 0. 78342 0. 5943 0. 5933 0. 5864 Table AAA-2 As shown in table AAA-2 above, this new multi index benchmark will serve as a better benchmark since it has a higher R and R square value.
A larger portion of the energy portfolio returns has been explained by this new benchmark. Problems of Multi-lender Benchmark The returns of the three indexes used above are correlated and hence the model eight not be that accurate.
In fact, given that the SPOILS, SPOILS and SPOILS are indexes that track the performance of oil-related companies, it is highly possible that returns are highly correlated. Numerically, the correlation between the SPOILS and the SPOILS index 0. 7761 that of the SPOILS and SPOILS 0.
5892. Given this high correlation, the multi index benchmark will not be an accurate predictor for future hedge fund results. To create a more accurate benchmark, the variables have to be non-correlated and independent. This leads to the next benchmark that will be