Post on 29-Sep-2020
Hedge FundsCHAPTER 5
Concept of Hedge Fund
Hedge Fund investing strategies
Concept of fund of hedge funds
Performance evaluation of hedge funds
Due diligence methodology of hedge funds
Risk management through hedge funds
Hedge fund benchmark
Lessons from hedge fund failures
Hedge Fund
• Hedge Fund, an alternative investment vehicle, is a managed pooled
fund that uses different strategies to invest.
• Hedge funds are for the super-wealthy investors, known as accredited
or sophisticated investors.
• They typically invests in stocks, bonds, commodities or real estates.
• Hedge fund is established as a Limited Liability Partnership. Limited
Partners and General Partners form part of the fund.
Hedge Fund
• The managers of hedge fund charge management fee as well as
incentive fee.
• The typical fee structure of hedge fund is “2 and 20”, i.e., a 2%
management fee and 20% incentive fee.
• Incentive fees can be calculated before or after considering
management fees
• When hedge fund managers collect incentive fees for profits
exceeding the funds previous high, it is known as high watermark.
Hedge Fund
• Hedge fund managers are paid incentive fees after they achieve a specified return known as hurdle rate.
• Hard hurdle rate- Incentive fees is paid on the basis of return in excess of hard hurdle rate.
• Soft hurdle rate- Incentive fees is paid on the basis of total return.
Hedge Fund
• Hedge fund suffers from several biases like survivorship bias, backfill bias and stale price bias.
• Survivorship bias- It occurs when database of hedge funds include information about surviving funds only and exclude the performance of unsuccessful funds which have been dropped from the index.
• Backfill bias- When new hedge fund is added to the index, the past performance of the fund is back filled in the index. Since only successful funds are added to the index the problem of backfill bias arises.
• Stale price bias- Hedge fund typically invest fund in illiquid securities and thereby uses stale prices to mark-to-market their positions.
Concept of Hedge Fund
Hedge Fund investing strategies
Concept of fund of hedge funds
Performance evaluation of hedge funds
Due diligence methodology of hedge funds
Risk management through hedge funds
Hedge fund benchmark
Lessons from hedge fund failures
Hedge Fund Investing Strategies
• Equity long-short - Hedge Fund Managers take Long position in stocks
that are expected to increase in value (i.e. buy an undervalued stock) &
Short the Stocks that are expected to decrease in value (i.e. Short an
overvalued stock).
• Event driven- The Hedge Fund Managers seeks to capitalize on
mispricing of stocks, bonds and other securities before or after a
corporate event like Mergers & Acquisitions, spin-offs, etc
• Distressed securities- The distressed Hedge Fund managers invest in
“below investment grade” securities and later reap the benefits in the
event of economic upturn
Hedge Fund Investing Strategies•Convertible Arbitrage- It involves taking a long position in convertible securities and a simultaneous short position in underlying common stock.
•Equity market neutral- The Hedge Fund Managers take long & short position in stocks with the desire to minimize systematic risk exposures, i.e., a beta of zero is preferred.
•Global Macro- These fund uses long and short positions to profit from a view on overall market direction as influenced by major economic events.
•Fixed Income Arbitrage- Hedge fund managers exploit mispricing based on their view of credit quality, term structure, or bond related variables.
Hedge Fund Investing Strategies•Merger Arbitrage- It typically involves buying Target Company’s stock and shorting the acquirer’s stock.
•Emerging Markets- Hedge fund focuses its major investment in the securities of emerging market countries. Funds generally go long because markets in developing countries disallow short selling.
Concept of Hedge Fund
Hedge Fund investing strategies
Concept of fund of hedge funds
Performance evaluation of hedge funds
Due diligence methodology of hedge funds
Risk management through hedge funds
Hedge fund benchmark
Lessons from hedge fund failures
Fund of Hedge Funds
• It is an investment vehicle that invests in a number of hedge funds.
• They can invest in a hedge fund with a particular investment strategy or in a hedge fund using several investment strategies.
• They charge an additional “1 and 10”, i.e., 1% management fees and 10% incentive fees.
Fund of Hedge Funds
ADVANTAGES
◦ Diversification Benefit
◦ Less survivorship and backfill bias
◦ Lower initial investments
◦ Liquidity
DISADVANTAGES
• Higher fees
• Style drift
• Cash drag to meet liquidity requirements
• Highly correlated with equity markets than an individual funds.
Concept of Hedge Fund
Hedge Fund investing strategies
Concept of fund of hedge funds
Performance evaluation of hedge funds
Due diligence methodology of hedge funds
Risk management through hedge funds
Hedge fund benchmark
Lessons from hedge fund failures
Performance Evaluation of hedge funds
• Hedge Fund Returns- Hedge funds usually provide annualized
holding period return and rolling returns.
• Volatility and downside volatility- Annualized standard deviation
is a common risk measure in hedge fund performance. Apart from
that, Downside deviation is also calculated.
• Performance Appraisal Measures- Sharpe ratio, Sortino ratio and
Gain to loss ratio is used for appraising hedge fund data.
Performance Evaluation of hedge funds
• Correlations- Portfolio diversification is achieved with the help of
correlations.
• Skewness and kurtosis & Consistency are other measures to
evaluate hedge fund performance.
Concept of Hedge Fund
Hedge Fund investing strategies
Concept of fund of hedge funds
Performance evaluation of hedge funds
Due diligence methodology of hedge funds
Risk management through hedge funds
Hedge fund benchmark
Lessons from hedge fund failures
Due Diligence methodology of hedge funds
• Hedge fund due diligence enhances the performance of hedge funds and helps in identifying managers with whom investors can invest.
• Due diligence of hedge funds is required because they are highly unregulated and have low level of operational transparency.
• Quantitative due diligence as well as qualitative due diligence of hedge funds should be carried out.
• Due diligence methodology involves- Defining measurement metrics, Request for information, Analyze the information and evaluating third party service providers.
• Due diligence process is expensive and time consuming.
Concept of Hedge Fund
Hedge Fund investing strategies
Concept of fund of hedge funds
Performance evaluation of hedge funds
Due diligence methodology of hedge funds
Risk management through hedge funds
Hedge fund benchmark
Lessons from hedge fund failures
Risk Management of hedge funds
• Main aim of risk management is not to eliminate risks but to mitigate them relative to expected returns.
• Liquidity risk is hedged by the use of derivative instruments.
• To measure leverage risk, continually monitor off balance sheet items for derivative instruments.
• Hedge fund managers should conduct stress testing and scenario testing to keep market risk in check.
Risk Management of hedge funds
• The credit risk can be managed by diversifying the credit risk and assessing the creditworthiness of counterparty.
• Strong internal control and distinct chief operational officer and investment manager will reduce operational risks.
• Appointing chief compliance officer to ensure that all regulatory rules and policies are adhered to will help manage legal risks of hedge funds.
Concept of Hedge Fund
Hedge Fund investing strategies
Concept of fund of hedge funds
Performance evaluation of hedge funds
Due diligence methodology of hedge funds
Risk management through hedge funds
Hedge fund benchmark
Lessons from hedge fund failures
Hedge Fund Benchmark
The various ways the index providers compose their respective indices are as follows-
•Selection criteria- It basically includes Assets under management, restrictions imposed on new investments and length of track record.
•Style classification- It varies as to how they classify a fund by style.
•Weighting schemes- They are either equally weighted or their weights are based upon assets under management.
•Rebalancing rules- This should be defined for equally weighted indices.
•Investability- It depends upon the frequency of reporting.
Hedge Fund Benchmark
Index providers providing monthly indices are as follows:
•Credit Suisse- It provides benchmarks for different strategies and are weighted based on assets under management.
•HedgeFund.net- This is an equal weighted index and covers around 40 strategies.
•Hedge Fund Research- It provides equal and asset weighted composite hedge fund indexes. It also provides equal weighted sub index based on managers reporting of their hedge fund returns.
Hedge Fund Benchmark
•CISDM- this is equal weighted and covers both hedge funds and managed futures.
•EACM advisors- this is an equal weighted index and covers around 100 strategies.
•Morningstar MSCI- Index is classified according to five basic categories including a composite index. Both equal weighted and asset weighted indexes are available.
Concept of Hedge Fund
Hedge Fund investing strategies
Concept of fund of hedge funds
Performance evaluation of hedge funds
Due diligence methodology of hedge funds
Risk management through hedge funds
Hedge fund benchmark
Lessons from hedge fund failures
Lessons from hedge fund failures
•Risk of using excess leverage- The amount of leverage LTCM utilized
illustrated that a small drop in value of the underlying security can lead to
huge destruction if not properly managed.
•Past is not indicative of future- If a strategy works now or in the Past, it
doesn’t means that the same strategy will work in the future.
Lessons from hedge fund failures
•Hiring an experienced hedge fund consultant- It will greatly reduce the
burden of setting up the hedge fund.
•Successful strategies are copied by competitors- As LTCM achieved excessive
returns their strategies were copied by competitors. As a result, their spreads
became narrower over time.
“Investing should be more like watching
paint dry or watching grass grow. If you
want excitement, take $800 and go to
Las Vegas.”
- Paul Samuelson
THANK YOU