Pine Street Capital Case Solution

1. What is a hedge fund? How do hedge funds differ from mutual funds?

Hedge fund is a pooled investment fund that trades in liquid assets such as stocks, bonds, derivatives, and commodities. They apply both traditional and non-traditional portfolio management techniques such as short selling, swaps, options, arbitrage, and leverage. Hedge funds involve high net worth investors and are risky investment choices.

Mutual funds are investment funds operated by professional money managers that pool money from many investors to invest in bonds, stocks, money market securities, government securities, etc. the portfolio of mutual funds is designed to match the investment objectives specified in its prospectus which is used by investors to decide on appropriate mutual funds to invest in based on their risk and return preferences.

While mutual funds are publicly owned as they collect investments from many investors to invest them in a portfolio of securities, hedge funds are not publicly owned and hedge fund managers invest their own money and can pursue any strategy of their choice. This also makes hedge funds less subject to external scrutiny and regulation compared to mutual funds. Hence hedge fund managers have greater control over the investment and risk management strategies they employ. Unlike mutual funds, hedge funds can use leverage to buy and sell a security in the open market and buy it back at a lower price and can hedge by shorting or using options. Since hedge funds can use debt to finance portfolio assets, they can generate higher returns than mutual funds. However, if the portfolio loses value the leverage can work against the investors, leading to greater loss than an all-equity portfolio such as mutual funds. Thus, risk in hedge funds is also higher than in mutual funds. Hedge funds use derivatives and options to either speculate on risky investments or to limit the overall risk of investments. Hedge positions put can limit the downside of the risk, however, they also limit the potential gains that investors can derive, unlike mutual funds.

2. What risks does Pine Street Capital want to hedge and what risks is Pine Street Capital willing to bear? Why?

Pine Street Capital is a hedge fund specializing in the technology sector and is a market neutral fund thus, it hedges out all market risk. As part of the market neutral strategy adopted by Pine Street Capital, market risk is hedged while the portfolio still contains firm-specific risk. Market risk is the possibility of loss due to factors that affect the entire financial markets such as a change in interest rates and political instability. Eliminating market risk from a long portfolio leaves the portfolio with an alpha of all long positions taken in a portfolio which is the risk that is particular to Pine Street Capital only.