Private exchange funds

On pg 108, schweser book2 it says " Private exchange funds consists of one or more individuals with the same low basis stock forming a patnership with another outside investor who purchases the same stock" . Then it says they use derivatives to unsystematic risk. My question is " Why would you form a patnership with individuals owning the same stock and then use derivatives to hedge? Why cant you do the same thing on your own? My real questions is : What is the primary benefit of Private exchange fund, because it seems you are loosing diversification benefits. Any help is appreciated

You are trying to find somebody who is in a similar situation, not owning the same stock position. The reading “same low basis stock” means that his stock position also has low cost basis. Example, Bob----$100 million worth of MSFT Sam—$100 million worth of GE Dan—$100 million worth of PFE Ron—$100 million worth of GS All of those stock are low cost, yet they all want to diversify…how? Private exchange fund is one of the way. Bob, Sam, Dan, Rod got together and put all their stock together to create a $400 million worth of portolio and each party has 25% ownership in the portfolio(fund). They can use derviates to heged out some unsystematic risk of the newly created portfolio. Now, instead having all their money in one stock, each party has 25% interest in a “diversified” portolio. This is just a simple example to illustrate the idea…actual detail can vary. I hope this helps. Thanks

Now I’m REALLY confused. Initially, in your example you mention Bob, Sam, Dan, and Ron. But later, you suddently refer to “Rod”. Who is this Rod person? and what happened to Ron?

I am sorry, typo error. I meant Ron.!! Bob, Sam, Dan Ron. There is no Rod. Sorry about that.

I had this exact same question earlier on, but never got a solid answer. ws, isn’t what you are describing a “public” exchange fund? The private exchange fund, at least the way it is decribed in both text and schweser is how amit described it. you find another party, who is not a family member, and can engage in hedging activity. i haven’t reviewed this in a while but the benefits are still unclear.

sht. who is this danron now? sorry. i’m a child.

What is described is a private exchange fund, usually Rob, Sam, Dan, Ron don’t know each other. Most cases their investment manager will go out find people who can complement their client’s portfolio. Rob works with XYZ investment advisor, Rob has this high concentration risk. Sam also works with XYZ investment advisor, Sam has this high concentration risk. So XYZ investment advisor suggested Rob and Sam get togther. Once again, I am over-simpliying this.

I find this very confusing. If a Rob or Ron pops up on exam day I’m screwed.

have you read the section on public and private exchange funds in the text this year? they have what you are describing under public exchange funds. the purpose of the fund you are describing makes total sense to me, but they go and describe what amit is describing under private exchange funds. thus the confusion…

my understanding: public exchange fund: you can put together 5 people with DIFFERENT low basis holdings to diversify together by pushing together their holdings. private exchange fund: you put together 5 different people with THE SAME low basis holdings to diversify together… maybe gives you better economy of scale, etc, to work on hedging strategies, such as options

was confused about both private and public, understood this one… The only question is which one.

WS, I am still confused.The example you sited is for public exchange fund. private exchange fund is created with people with the SAME stock ( low basis)

The only difference between a private and public exchange fund at least in my experience in work is that a private exchange fund uses private securities (closely held, non listed) while a public exchange uses listed securities. I do remember reading this in CFA though and it being explained a bit differently.

This is from what I understand: For private exchange funds, it deals only with privately-held shares (at low cost basis) of the SAME security (this is highly important differentiator between public vs. private exchange funds). So, investors (unrelated investors) with a large position of low basis privately-held shares come together to form a fund in order to diversify their portfolio of holdings. How you ask? Well, by creating a private exchange fund (of the SAME security), these investors have the ability to monetize their position. The monetization of their position can only happen after hedging their positions because by hedging you protect against downside, which effectively makes the position act like cash/money i.e., a monetized position. The investors can now borrow against their monetized position to buy other securities in order to diversify their holdings (i.e., their now larger position acts as collateral to borrow money to buy other assets because of the hedging activity and monetization)! Remember, the only reason we are talking about private exchange funds to begin with is to come up with a way investors (in this case private investors), can diversify their large low-basis position. There was a question above as to why then can’t an individual just do it himself? Of course he can hedge his own position, however, the larger the pool of privately held shares, the greater amount you can monetize (i.e., greater amount of collateral), allowing greater amount you can borrow, and hence, the greater the amount of money to purchase different assets towards for diversification! Phew…I hope I didn’t confuse anyone lol.

j3ffr3y, why would somebody lend me greater amount than my initial investment.e.g if I have $1000 worth of stock and investor B has $1000 worth ( total collateral $2000), why would somebody allow me to borrow lets say $1500 when my investment is only $1000. What if investor A also wants to borrow money? Will somebody lent investor A another $1500?

Amit, it’s not the individual investor that borrows the money, it’s the partnership that borrows the money using the total $2000 pooled investments from the two investors as collateral. So essentially, once you pool your single low basis security together with other unrelated investors, you form a partnership and you use the combined total holdings as collateral to borrow money. So to sum up, not one single person borrows, but the partnership borrows against the entire collateral. So to answer your first question directly, it’s not that you’re borrowing more than your individual contribution, but rather, you borrow against the pooled contribution. At least this is what I understand.