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HEDGE FUND ALPHA A Framework for Generating
and Understanding Investment Performance
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N E W J E R S E Y • L O N D O N • S I N G A P O R E • B E I J I N G • S H A N G H A I • H O N G K O N G • TA I P E I • C H E N N A I
A Framework for Generating and Understanding Investment
HEDGE FUND ALPHA
John M Longo Rutgers University, USA
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British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library.
For photocopying of material in this volume, please pay a copying fee through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA. In this case permission to photocopy is not required from the publisher.
ISBN-13 978-981-283-465-2 ISBN-10 981-283-465-6
All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the Publisher.
Copyright © 2009 by World Scientific Publishing Co. Pte. Ltd.
World Scientific Publishing Co. Pte. Ltd.
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USA office: 27 Warren Street, Suite 401-402, Hackensack, NJ 07601
UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE
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HEDGE FUND ALPHA A Framework for Generating and Understanding Investment Performance
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To my son Tyler, the highlight of my life.
Ten years ago, there were relatively few books about the hedge fund industry. The dearth of prior material may be related to the notoriously secretive nature of hedge funds and to a much smaller asset base relative to the roughly $2 trillion that they control today. At present, there are quite a few good books on hedge funds, but they appear to be clustered around a handful of subtopics. The topics mostly include interviews with successful hedge fund managers, general discussions of hedge fund strategies, and “how to start a hedge fund” books primarily intended for aspiring hedge funds managers. As someone who works in the hedge fund / investment management business and teaches an MBA class on the topic, I perceived a significant gap within the literature. Few books created a framework for generating superior risk adjusted returns, or alpha, and for growing the hedge fund management company in an intelligent manner. These topics are what most hedge fund professionals care greatly about.
The following questions came to my mind as I began to formulate the material for this book:
– How does hedge fund research differ from traditional “long
only” research despite their common goal of achieving alpha? – What is the best way of executing various hedge fund strategies
in order to turn expected returns into real profits? – What hedge fund strategies are best suited to earning alpha in
emerging markets, arguably the most fertile investment frontier for the decades ahead?
– What is the typical lifecycle of a hedge fund strategy?
– What is an intelligent method for evolving from a single strategy fund to a multistrategy fund (or series of funds)?
– What is a rigorous approach for conducting due diligence on a hedge fund?
– Can understanding the psychological aspects of hedge fund managers help explain their actions and performance?
– “Hedge fund risk management” seems to be somewhat an oxymoron given many recent high profile failures, but is there any value that can be added to this topic?
– Is there a systematic approach for managing a successful fund of fund?
– What are the current trends and future outlook for the hedge fund industry?
These and other questions served as the basis for the chapters in this book. Although some of the topics may appear somewhat disjointed and the flow is not as smooth as I would like it to be, they all coalesce around two points: (a framework for) generating and understanding alpha. Hence the title of this book.
I felt I had the outline for a strong book, but faced a problem. How could I credibly talk about generating alpha in China, for example, if I could not read or speak (Mandarin) Chinese? I have been to China more than a dozen times in the past decade, totaling nearly six months of time, but felt that someone who knew the culture intimately and was fluent in Chinese could do a better job than me alone. That is when I decided to find outside authors and co-authors to write portions of this book.
I found additional inspiration in one of the best books, in my opinion, ever written on hedge funds entitled, Hedge Funds: Investment and Portfolio Strategies for the Institutional Investor by Lederman and Klein. Their book also utilized outside experts for selected chapters.
One reviewer on Amazon.com said of the Lederman and Klein book:
“The list of books written on hedge funds is a short one, and this book is certainly the finest on the subject. The professionals who contributed their specialized knowledge are of the highest caliber, and better yet, many of them can
be reached for counsel… I found all of the information to be useable and valuable information with absolutely no filler.”
Similarly, my goal also is to produce a high quality and practical
book with no filler. The primary target audience of this book is those working in the (broadly defined) hedge fund industry, and those contemplating the launch of their own hedge fund. Others, such as securities analysts, regulators, academics, students, and investors, may also find significant value in the material. The chapters are largely self- contained, resulting in some repetition, but also increased convenience for those readers only interested in particular topics.
First, I would like to thank my co-authors of this book, Jorge Barreiro, Erman Civelek, Mitchell Eichen, Jeffrey Glattfelder, Ali Jaffery, Sanjeev Khullar, Yaxuan Qi, Saad Rathore, Irina Samoylova, Wei-Kang Shih, Ben Sopranzetti, and Stephen Spence. Without them this book would not be possible. Second, I would like to thank my colleagues at Rutgers Business School, The MDE Group, and DealMaven / FactSet for their support. DealMaven, acquired by FactSet in January 2008, provided a grant to Rutgers Business School in partial support of this work. I would also like to thank Sheshang Patel, Rahat Azim, and Lim Shujuan for valuable research and editing assistance. Special thanks to Lorraine Fedor for contributing the artwork used for the book cover. Last, but not least, I would like to thank my entire family for their love and support.
John. M. Longo, PhD, CFA Rutgers Business School
Department of Finance & Economics New Brunswick, NJ
Author Biographical Sketches xiii
Part I: Generating Performance
1. Introduction 3 John M. Longo
2. Hedge Fund Research vs. Traditional Research 17 John M. Longo
3. Achieving Hedge Fund Alpha in Brazil 33 Jorge Barreiro and John M. Longo
4. Achieving Hedge Fund Alpha in Russia 51 Irina Samoylova and John M. Longo
5. Achieving Hedge Fund Alpha in India 67 Ali Jaffery and John M. Longo
6. Achieving Hedge Fund Alpha in China 85 John M. Longo, Wei-Kang Shih and Ben Sopranzetti
7. Using Derivatives to Create Alpha 103 Sanjeev Khullar
8. Best Execution of Hedge Fund Strategies 119 Saad Rathore
9. Growth of the Hedge Fund Management Company: Evolving from a Single Strategy Hedge Fund to a Multistrategy Hedge Fund or Multiple Funds 137
John M. Longo
10. Fund of Hedge Funds 153 Jeffrey Glattfelder, John Longo and Stephen Spence
Part II: Understanding Performance
11. The Psychology of Hedge Fund Managers 179 John M. Longo
12. Risk Management for Hedge Funds 193 Saad Rathore
13. Hedge Fund Due Diligence 221 Erman Civelek
14. From Birth to Death: The Lifecycle of a Hedge Fund Investment Strategy 249
John M. Longo and Yaxuan Qi
15. The Future of Hedge Funds: Seven Emerging Trends 265 Mitchell D. Eichen and John M. Longo
1: Internet Sites for Hedge Fund Managers 283
2: Reading List for Hedge Fund Managers 293
3: Sample Manager Background Report 299
AUTHOR BIOGRAPHICAL SKETCHES
Jorge is an analyst in the CFC Strategic Finance Group at Duff & Phelps, a financial advisory and investment banking firm. A graduate of Rutgers Business School, with double majors in Finance and Economics, he was a member of the winning team in the 2008 New York Society of Securities Analysts (NYSSA) Investment Research Challenge. Jorge is fluent in the Portuguese language.