Friday, May 7, 2010

How to Start a Hedge Fund for Dummies

1. He parks the $100 million in one-year Treasury bills yielding 4 per cent.
2. This then allows him to sell for 10 cents on the dollar 100 million covered options, which will pay out if the S&P 500 falls by more than 20 percent in the coming year.
3. He takes the $10 million from the sale of the options and buys some more Treasury bills, which enables him to sell another 10 million options, which nets him another $10 million.
4. He then takes a long vacation.
5. At the end of the year the probability is 90 percent that the S&P 500 has not fallen by 20 percent, so he owes the option-holders nothing.
6. He adds up his earnings — $10 million from the sale of the options plus 4 per cent on the $10 million of T-bills—a handsome return of 15.4 percent before expenses.
7. He pockets 2 percent of the funds under management ($2 million) and 20 percent of the returns above, say, a 4 percent benchmark, which comes to over $4 million gross.
8. The chances are nearly 60 percent that the fund will run smoothly on this basis for more than five years without the S&P 500 falling by 20 percent, in which case he makes $15 million even if no new money comes into his fund, and even without leveraging his positions.

If the market drops more than 20 percent, start over with new fund. Bye-bye old investors, hello new investors.

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