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  • How to build a hedge fund

    Louis Plowden-Wardlaw23rd March 2011

  • How to build a hedge fund

    Why are there hedge funds?

    Investors are always looking for higher returns

    Hedge funds have promised them in exchange for higher fees

    Traditional asset managers offered relative returns, benchmarking their return typically against a bond or equity index

    Hedge fund managers think they developed the concept of absolute returns ie positive whatever the market does; for marketing purposes this has been called alpha to distinguish it from market return (beta from CAPM theory)

    Arguably this is a bit naive; wealth owners have generally expected their money managers to avoid the downs and ride the ups

    Hedge fund managers have used instruments first developed for hedging for speculating, and have helped fuel the buyside of the late 80's to present day wave of globalisation and the financial innovations developed with increased computing power

    The trading floor in the wild outside its natural home in investment banks

  • Characteristics

    What are the characteristics of a hedge fund?

    Remuneration structure (2 and 20)

    Use of leverage

    Use of derivatives

    High level of management discretion

    Opacity/mystique

    High returns

    Promise of uncorrelated returns

    Cash substitute

    Large minimum investment

    Hurdle rate

    High water marks

    Cannot advertise

  • 23rd March 2011 Hedge Fund Presentation "How to build a hedge fund" Louis Plowden-Wardlaw 2011

    Evolution (1)

    Number of hedge funds and assets under management in sector

    Hard to get precise numbers as by definition private investment vehicles

    People who track these numbers use different groups of funds

    But figures from Hedge Fund Research suggest that between 1990 and 2007 the number of funds grew from 610 to 9767, and assets under management from $39billion to $1,700 billion.

    US based at first, Europe proportion of sector moved from 12% in 2002 to 24% in 2006, Asian from 5-8% over the same period

    Fees estimated according to The Economist at $65 billion in 2005

    Whilst there was a pulling back from the industry after the credit crisis, characterised by heavy redemptions, FSA as of February 2011 estimates $1,900 billion managed by the industry

    In 2005, when it was a mere $1,000 billion, the FSA estimated this comprised 5% of total assets under management

  • 23rd March 2011 Hedge Fund Presentation "How to build a hedge fund" Louis Plowden-Wardlaw 2011

    Evolution (2)

    Increasing importance

    Nonetheless, in 2005 again, the FSA estimated that hedge funds accounted between 1/3 and NYSE and LSE turnover

    Servicing hedge funds generated 1/8 of investment banking revenues in broking commissions and fees ($19bn) and prime brokerage revenues ($6bn) (again 2004)

    Major liquidity providers (see point 1)

    Largely an investment banking diaspora

    Investment banks themselves engage in proprietary trading to a major extent in 2010 for the first three quarters Goldman Sachs was obliged to reveal that 18% of its revenue was proprietary trading derived, as compared to the figure generally disseminated by them of 10%

    Doing the investment and lending functions the banks won't do

  • 23rd March 2011 Hedge Fund Presentation "How to build a hedge fund" Louis Plowden-Wardlaw 2011

    Relative versus absolute returns

    The elusive alpha Hedge funds like to say they can achieve positive returns on their investments whether the markets go up or down

    Opinion is divided on whether this works

    One of the major selling points for hedge funds as an asset class is that they are said to be uncorrelated to other asset classes

    As we have learnt, it is one of the features of an inter-connected financial system that nearly all asset classes have come to be correlated when there are major changes in sentiment

    However it is easy to be too negative; there are reasons why the asset class is flourishing

    The core of the question is whether higher returns achieved are higher returns adjusting for the risk assumed

  • 23rd March 2011 Hedge Fund Presentation "How to build a hedge fund" Louis Plowden-Wardlaw 2011

    The sceptical perspective

    Sceptics say Hedge funds are usually geared; markets of assets usually go up most of the time slowly, then correct in a short period. If your investment manager has multiplied exposure to the upwards evolution of prices by borrowing, then returns will be high. Of course when prices correct usually a much quicker process, a geared investment will exacerbate the losses too, and equity that would be hit on an ungeared strategy could well be wiped out on a geared strategy. If this isn't obvious, see cartoon on next page (Washington Post March 14 2008, Laura Stanton)

    During up periods, superior investment returns are a function of superior investment insight; during down periods well, hey, that's the market!

    Andrew Lo, an MIT econometrician, in 2001 wrote an article in which he detailed a hypothetical hedge fund called Capital Decimation Partners. (Risk Management For Hedge Funds: Introduction and Overview", Financial Analysts Journal 57, 16-33.)

  • 23rd March 2011 Hedge Fund Presentation "How to build a hedge fund" Louis Plowden-Wardlaw 2011

  • 23rd March 2011 Hedge Fund Presentation "How to build a hedge fund" Louis Plowden-Wardlaw 2011

    The sceptical perspective (2)

    CDP and other issues Lo postulated a fund that sold out of the money

    put options insurance if you will on declining stock prices on the S&P 500 from 1992-99.

    The strategy made a return of 2721.3% when the S&P made a return of 367.1%

    But would lose all those accumulated returns in one major market downturn.

    Lots of other ways to benefit from assuming tail risk for a steady premium where the adverse event would have a catastrophic effect on capital

    LTCM and 1998 Russian contagion

    Survivorship bias

    Persistence of returns

    Backfilling in indices of performance

  • 23rd March 2011 Hedge Fund Presentation "How to build a hedge fund" Louis Plowden-Wardlaw 2011

    A less jaundiced view

    There are plenty of buyers of hedge funds and academic research that supports hedge fund out-performance

    As already demonstrated, the sector is growing

    More discretion leads to more outperformance than can be explained by luck ( Role of managerial incentives and discretion in hedge fund performance, V Agarwal, N. Daniel and N. Naik, 2007)

    Others conclude that there is more than luck involved (Do hedge funds deliver alpha? A Bayesian and bootstrap analysis Robert Kosowskia, Narayan Y. Naik, Melvyn Teo)

    So maybe the jury is out, but there is supporting evidence for superior returns

  • 23rd March 2011 Hedge Fund Presentation "How to build a hedge fund" Louis Plowden-Wardlaw 2011

    Taxonomy

    No agreed taxonomy, but shared characteristics of flexible instruments to implement strategies involving gearing

    Event driven

    Macro

    Convertible arbitrage

    Pair trading

    Black box quantitative model

    Fixed income

    Market neutral

    Statistical arbitrage

    Foreign exchange etc

    (per Agarwal Naik and Daniel) Can be boiled down to

    Directional Relative value Security selection Multiprocess

  • 23rd March 2011 Hedge Fund Presentation "How to build a hedge fund" Louis Plowden-Wardlaw 2011

    The building blocks

    Hedge funds are multi-entity and usually multi-jurisdiction constructs with key functions outsourced

    Master fund

    Feeder fund(s)

    Investment manager

    Administrator

    Prime broker

    Counterparties

    Lawyers

    Auditors

    Investors

    Regulators

    Depository

  • 23rd March 2011 Hedge Fund Presentation "How to build a hedge fund" Louis Plowden-Wardlaw 2011

    JurisdictionsWhere are funds incorporated and managed?

    Typically the funds are incorporated offshore, and managed onshore

    Fund jurisdictions include Cayman Islands, BVI

    UK, Switzerland and US are typical manager jurisdictions

  • 23rd March 2011 Hedge Fund Presentation "How to build a hedge fund" Louis Plowden-Wardlaw 2011

    UK investment managers

    An important UK industry

    Usual permanent establishment rules trumped by Investment Manager Exemption

    The cornerstone of the UK hedge fund management industry leads to standard structures compliant with these rules

    Ensures funds not taxed under UK tax regime if the fund is trading (different rules apply to funds making long term investments)

  • 23rd March 2011 Hedge Fund Presentation "How to build a hedge fund" Louis Plowden-Wardlaw 2011

    Institutionalisation

    Funds of funds Hedge funds associated with higher risk

    Diversification number of investments required 12? 25?

    But extra fee layer eats at returns another 1 and 10 layer

  • 23rd March 2011 Hedge Fund Presentation "How to build a hedge fund" Louis Plowden-Wardlaw 2011

    The model is catching on

    Everyone wants to be a hedge fund

    A striking examplePorsche v Volkswagen

  • 23rd March 2011 Hedge Fund Presentation "How to build a hedge fund" Louis Plowden-Wardlaw 2011

    In 2008 Porsche (a smallish company) revealed it owned nearly 75% of VW (a biggish one) with direct ownership and CFD's

    VW shares up to 1000 from 250

    Hedge funds short VW lose 30bn

  • 23rd March 2011 Hedge Fund Presentation "How to build a hedge fund" Louis Plowden-Wardlaw 2011