Hedge Fund Stategies

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Thomas Kirchner is The Deal Sleuth

Hedge Fund Strategies

http://thedealsleuth.wordpress.com/


© 2008 by Thomas Kirchner

Disclaimer: By reading this e-book you accept that:

This e-book is educational and does not constitute an advertisement, offer to sell a security or other solicitation.

Securities are mentioned in this e-book as examples only, are not recommended and may or may not be suitable for you.

The e-book has been made available for informational purposes only. It contains information obtained from third party sources considered reliable but that may be inaccurate.

Investment strategies mentioned herein may not be appropriate for your individual circumstances. Always seek advice from your broker or investment adviser before investing.

If you do not agree to these terms, please close the e-book now.

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Acknowledgments: The idea for this e-book is Ron Charnock’s, whom I also thank for helping with its design. Many thanks to Anthony Von Mickle for giving me the opportunity to present its content at an event of “The Investment Forum LLC”.





Let's start with some name dropping.

This is John Paulson, who runs a hedge fund firm by the name of –you guessed it – Paulson & Co. His claim to fame is his pay check for 2007: he is reported to have made $3.7 billion. That's “billion” with a “b”.

He earned this payout by making a profit of $15 billion for his investors last year. His flagship fund generated a return of 599%.

No wonder he looks happy.





This is George Soros, who runs a hedge fund firm by the name of Soros Fund Management.

He looks unhappy.

Maybe because Paulson stole the #1 spot in paychecks for last year. Soros made $800 million less than Paulson, only $2.9 billion.

But no worries. Soros became famous in 1992 when he broke the bank of England, netting him $1 billion.

A billion dollars was considered a lot of money at the time.





This is Christopher Hohn.

He is a relative pauper, apparently worth only a few $100 million. He gave away most of his money to a children charity.

What makes him join the list of billionaires is not his income, but rather his losses.

The hedge fund he manages reportedly lost $1 billion in a single month, June 2008. The size of his hedge fund went from $8 billion to $7 billion.

Let's make clear that Hohn is a very smart guy. He graduated 5th in his class from Harvard Business School. But even smart people can generate spectacular losses. Just remember Long Term Capital Management. Not one, but two Nobel laureates ran this hedge fund that collapsed in 1998.

Thomas Kirchner as The Deal Sleuth




HEDGE FUNDS ARE “ALTERNATIVE” INVESTMENT STRATEGIES

Hedge funds are generally associated with big amounts of money, big checks, and big bets. Hedge funds are considered evil unregulated speculators who push stocks to highs, or crash them.

In this e-book, we will take a different look at hedge funds. One of the best ways to look at them is to examine the investment strategies that they employ.

Chart 1 – Source Most readers will be familiar with the style boxes. You have probably seen this in you 401(k) plan's literature or elsewhere. This is how investors traditionally have viewed the market. It is a very simple concept: You can invest in large, medium or small companies that either are cheap, grow quickly or are somewhere in between. It is not a very sophisticated approach to investing. It goes back to research done a good two decades ago by two academics and has not changed ever since. Arguably, the markets have changed.

Hedge funds take a radically different view of investing. Rather than focusing on characteristics of the companies, they have completely different strategies, many of which are quite sophisticated. The chart below shows a classification of different hedge fund strategies. Unlike the style boxes of traditional investing, there is no generally accepted standard classification for hedge fund strategies.

Chart 2 – Fuss, Kaiser and





HEDGE FUNDS HAVE THREE DIFFERENT STYLES AND STRATEGIES

There are three different styles: arbitrage, event-driven and directional. Different strategies are part of each style.

Arbitrage Benefits from price discrepancies of otherwise similar securities

Equity Market Neutral - Buy one stock and sell short another. For example, sell short an overvalued stock and buy an undervalued oneFixed-Income- Buy high yielding bonds and sell short similar bonds with low yieldsConvertible Arbitrage - Hedge convertible bonds with stock

Event-Driven Takes advantage of mal pricing of corporate events

Merger Arbitrage - Capture difference between market price and acquisition priceDistressed Securities - Buy bonds of companies in bankruptcy and take ownership when a firm emerges from bankruptcySpecial Situations - The above plus investments in other corporate events such as liquidations or spin-offs

Directional Trade ups and downs in the market

Equity Long-Short - Go long or short stocksManaged Futures - Invest in commoditiesGlobal Macro - Buy or sell short any asset anywhere in the world based on where the manager thinks the market is heading

Although these strategies are usually referred to as “hedge fund” strategies, they are not only used by hedge funds. A better term is “alternative” investment strategies, to distinguish them from the traditional investments that most 401(k) investors are limited to.





THE EVOLUTION OF HEDGE FUND STYLES OVER TIME

If we look at which strategies most hedge funds were invested in in 1990, we see that (Global) Macro accounted for almost three quarters of all hedge fund assets. If you recall, Global Macro is a directional strategy where the manager tries to anticipate the movement of different markets. The perception that we have today about hedge funds goes back to the early 1990s, when big trades on market direction were what most hedge funds did all day long.

Chart





The situation has changed significantly since then. In early 2007, (Global) Macro accounted for just under 5% of all hedge fund assets. Hedge funds are now much more evenly spread out among the different strategies.

Chart

Source of both charts: HSBC Private

Hedge funds are now much more evenly spread out among all strategies





WHAT MAKES HEDGE FUNDS DIFFERENT If you ask a hedge fund manager about what they do, they will tell you their strategy, performance and one other aspect that sets them apart from traditional managers: they depend little on the overall direction of the market. In financial parlance, they have a low correlation to the market. Most investors focus most and foremost on the return of an investment. However,

an increasing number of investors are looking to find investments that not only have a decent return, but also one that is independent of the market as a whole. One that zigs when the market zags. The reason is that such investments help to stabilize the overall portfolio and reduce the gyrations in the net worth that investors experience whenever the market goes through a rough period. The table shows hedge fund returns for the

period 1987-2006 collected by Hennessee. There are many firms that collect hedge fund data, and each has slightly different numbers; however, they all show the same effect that we will see in the Hennessee data.

StyleMarket Neutral Index 7.95 4.86Fixed Income Index 13.79 22.65Convertible Arbitrage Index 9.66 7.35Event Driven Index 16.02 12.46Merger Arbitrage Index 11.29 9.42Distressed Index 16.52 12.38Opportunistic Index 14.66 10.66Long/Short Equity Index 13.64 9.01Global/Macro Index 14.84 16.5Hennessee Hedge Fund Index 13.59 9.28S&P 500 9.24 16.15DJIA 9.87 13.96Russell 2000 9.5 18.19NASDAQ 10.16 30.59

7.34 5.24

1987-2006AverageAnnualReturn

1987-2006StandardDeviation

Lehman Brothers Int. Gov. Corp. Bond Index





A convenient way to visualize the table is a risk/return chart. The best place to be is the top left of the diagram: produce a high return with little risk. This is the holy grail of investing, and as the chart shows, nobody has achieved it yet.Chart





HEDGE FUND SIZE DOES MATTER …

Risk/return is just one of the tradeoffs of investing, For hedge funds, there is another dimension that complicates the analysis. Larger hedge funds tend to have a lower performance than smaller ones.

Chart

The chart shows that large funds with more than $1 billion is assets have on average a return that is 2% lower than that of smaller funds with just a few million dollars in assets. This effect does not normally appear in traditional or index investments. In traditional investments, markets are very large and there is almost no practical limit to how much an investors can allocate. For alternative strategies, however, there is often a limit to how much can be invested in the most profitable opportunities. Or conversely, a limited number of very profitable investments is available and additional assets must be invested in lower yielding opportunities.





HEDGE FUNDS ARE NOT FOR EVERYBODY

So why isn't everybody in hedge funds?

There are many restrictions that keep most investors out.

Most hedge funds are private partnerships that are not registered with the SEC and can not be offered to the public. The SEC limits the sale of such risky structures to those who can afford to lose their entire investment. That means that you need at least $1 million in liquid assets, or an income of $300,000, if you want to invest. (The SEC is looking at raising these limits)

Another restriction comes from the high minimum investment that these funds require. Often, you have to invest at least $1 million. So even if you meet the SEC requirements, you would still have to put all of your assets at risk just to get in. That hardly would be prudent.

Finally, many investors are put off by the high fees charged by hedge fund managers. The typical fee structure consists of a 2% management fee, plus 20% of profits. We will see an example with numbers in a moment. That compares to average mutual fund fees of less than 1.5%, and mutual funds do not normally take a percentage of profits.

Therefore, hedge funds are beyond the reach of most investors.





BUT WAIT – WALL STREET’S SOLUTION

Where there are fees, there is an investment banker.

Wall Street firms have developed a solution that makes hedge funds a little more accessible to the public through so-called funds of hedge funds. A fund of hedge funds is simply another fund that collects smaller investments from a large number of investors and then invests into hedge funds. By spreading the minimum investment over more investors, each can make a smaller investment than what a typical hedge fund would require. Many funds of hedge funds have minimum investments of $50,000 or less.

The drawback of funds of hedge funds is that they will charge additional fees. We mentioned earlier that hedge funds charge a 2% management fee and 20% of profits. A fund of hedge funds will charge an additional 1% fee and 10% of profits.

A simple calculation shows that with so many fees, little is left for investors.1. Hedge Fund Fees

Return on Strategy 15%Management fee (2%)

13%Performance fee (20% of 13%) (2.6%)Net performance 10.4%

2. Fund of Funds FeesReturn on Hedge fund 10.4%Management fee (1%)

9.4%Performance fee (10% of 9.4%) (0.94%)Net performance to investor 8.46%

?

This example assumes that a hedge fund manager generates a 15% return, before fees. If you invest directly into the hedge fund, you will see a net return after fees of 10.4%. However, if you invest through a fund of hedge funds, you net performance will be just under 8.5%.

Therefore, funds of hedge funds are probably not a good way to keep up with the Jones'. Or Paulson's.





MUTUAL FUNDS WITH HEDGE FUND STRATEGIES

Fortunately, there are simpler solutions. Whenever there is a problem, someone will solve it.

Mutual funds have been slow to fill the gap, but there is an increasing number of mutual funds that use alternative (hedge fund) strategies. The following list provides a few examples of fund ticker symbols for each of the strategies that were discussed earlier.

Arbitrage

Equity Market Neutral BPTRXFixed-Income MWSTXConvertible Arbitrage CVSIX

Event Driven

Merger Arbitrage ARBFXDistressed Securities FMRAXEvent-Driven PAEDX

Directional Strategies

Equity Long-Short ALPHXManaged Futures PCRDX/SuperFundMacro HSGFX

For most investors, these funds are the best way to participate in alternative strategies without the drawbacks of hedge funds. All of the funds shown above are regulated and fully transparent.





LOOKING AT EVENT-DRIVEN STRATEGIES

We will now change gears and discuss one of the alternative strategies that the author is familiar with from his day to day work in more detail. We will focus on activist investing and merger arbitrage.

The diagram below shows a hypothetical company's stock price as it goes from not performing very well to being bought out.





GRAPH POINT 1 When a company's stock price does not so well, it become a value investment. This means that it is cheap relative to earnings. The problem with value investments is that sometimes, value stocks remain value forever. This is called a “value trap.”

GRAPH POINT 2 Fortunately, in many instances, the board of directors of a cheap stock will decide that they will sell the firm rather than having a cheap stock. When they plan to do so, they will issue a press release that can sound cryptic, such as “we are searching for strategies alternatives,” or “we have established a special committee of the board.” In other instances, and activist investor will get involved. These are investors who try to increase the stock price of a value stock, often by getting representation of the board with the goal of getting the firm to sell itself. In either case, the stock usually makes a small jump.

GRAPH POINT 3 Eventually, if there is an actual merger announces, the stock will make a big jump on the day of the announcement.

GRAPH POINT 4 At this point, the stock becomes a merger arbitrage investment.

Merger arbitrage tries to capture the small difference between the buyout price of a stock, and the price at which it is trading just before the buyout.Once a merger is announced, the stock makes a big jump. However, it does not rise to the price of the buyout right away. As long as there is still the risk that the merger does not happen, it will trade below the buyout price. A merger arbitrage investor will purchase the stock shortly after the announcement, and hold it until the buyout is complete. The difference between the buyout price that the arbitrageur receives and the price paid is the profit from the strategy. This profit is generally small in absolute terms. However, it is earned over a relative short time, so that the annualized return can be very attractive.





WHAT’S MERGER ARBITRAGE?

Merger arbitrage tries to capture the small difference between the buyout price of a stock, and the price at which it is trading just before the buyout.

Time

First DayJump

ArbitrageProfit

MergerAnnouncement

StockPurchase

MergerCloses

Price

Time

First DayJump

ArbitrageProfit

MergerAnnouncement

StockPurchase

MergerCloses

Price

Once a merger is announced, the stock makes a big jump. However, it does not rise to the price of the buyout right away. As long as there is still the risk that the merger does not happen, it will trade below the buyout price. A merger arbitrage investor will purchase the stock shortly after the announcement, and hold it until the buyout is complete. The difference between the buyout price that the arbitrageur receives and the price paid is the profit from the strategy. This profit is generally small in absolute terms. However, it is earned over a relative short time, so that the annualized return can be very attractive.





MERGER ARBITRAGE IS A STRATEGY WITH LOW VOLITILITY One of the important characteristics of alternative strategies is their low dependence on the overall direction of stock prices. The low volatility of the

strategy is best illustrated by a couple of examples. First, we have a chart of the daily price changes of Admiralty Bancorp for a period of a little over one year. It can be seen very clearly when the merger announcement was made. Prior to the merger announcement, Admiralty Bancorp's stock was fluctuating widely from day to day. Once the merger had been announced, there were almost no fluctuations.

This effect can also be seen in a price chart. Before Mars made its acquisition of Wrigley public, the stock of Wrigley experienced large ups and downs. After the announcement, it moved in a very narrow range.





Aggregate monthly returns of merger arbitrage funds tracked by Hennessee confirm that volatility of these funds is lower than that of other investments. The merger arbitrage funds fluctuate much less than the S&P 500 or bonds. They are also positive in more months

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HERE’S HOW IT MIGHT LOOK

To see how a portfolio behaves when we add merger arbitrage to it, we constructed two portfolios: a traditional one that consists only of an S&P 500 and a bond index fund, and an alternative one that includes also the Pennsylvania Avenue Event-Driven Fund. For the S&P, we use the index fund with the ticker symbol SPY, and for the bond fund, the index fund with ticker AGG. Both are exchange traded funds, abbreviated “ETF”.

Alternative Strategy Portfolio

SPY (S&P 500 Index Fund AGG (Lehman Bond Index Fund) PAEDX (Penn Ave Event-Driven Fund)

Traditional Strategy Portfolio

SPY (S&P 500 Index Fund AGG (Lehman Bond Index Fund)

This chart shows different combinations of assets of the two portfolios. For example, the traditional portfolio consists primarily of the bond fund for low levels of risk. As we increase the allocation of the S&P 500 index fund, its risk increases, and so does its return. The lower line shows different levels of risk and return that can be achieved by varying the ratio of stocks and bonds in the traditional portfolio. The upper line is constructed by the same principle. It depicts different levels of risk and return that can be achieved by changing the ratio of the S&P, the bond fund and the event-driven fund. The main point of this diagram is to show that at a given level of risk, say 1%, the alternative portfolio will achieve a much higher return than the traditional portfolio. It should be noted that weekly data was used to construct this chart.





WHAT CAN GO WRONG?

Each merger is different, and an arbitrageur must examine each carefully to understand where the risks lie. Most recently, the biggest risk has been financing. Many buyers have seen their financing withdrawn as the credit markets have deteriorated.

Anti-trust risk is present mainly in large mergers. However, anti-trust enforcement has been relatively lax over the last few years, and has resulted in few transactions being held up.

Shareholder opposition can derail a merger because in most cases, shareholders must vote before the transaction can go ahead. Sometimes, large investors do not agree with management's strategy and will seek to block the transaction. They are not often successful but can wreck havoc on an arbitrageur.

Political risk is a relatively new phenomenon that came to the public's consciousness when the acquisition of a number of ports by Dubai World was blocked for purely political reasons.

Material Adverse Change is the flavor of the day. As the economy deteriorates, buyers sometimes try to get out of mergers well after they have signed the agreement. The merger agreements contain a clause that defines under what circumstances changes in the business or economic conditions justify a termination of the merger.

Fraud fortunately happens rarely, but Enron investors will remember that Dynegy terminated its acquisition of Enron when the full scale of misconduct at Enron became apparent.

Each merger is different … examine each carefully to understand where the risks lie





SO WHAT’S NEXT …

The recent merger boom came to an abrupt end when the credit crisis set in, and numerous transactions have since failed when banks withdrew their financing commitments. Banks were more concerned with their survival than maintaining long-term relationships with their customers. As a result, even merger contracts with solid legal foundations turned out to be worthless. Private equity funds acquire companies mainly with borrowed funds, and as they are now unable to borrow, many have withdrawn.

Fortunately, the slack has been picked up by strategic acquirers. Those are companies that buy other companies. In the last few years, they had been locked out of mergers by the ability of private equity funds to obtain cheap loans. Now, they are buying each other again. We are also seeing an increase in the acquisition of U.S. companies by foreign buyers. Much of this has to do with the low value of the dollar, which makes it very inexpensive for foreigners to buy firms here.

Overall, there is plenty of activity that keeps merger arbitrageurs busy.

Adding alternative strategies to your portfolio should increase its return and lower its risk.However, before you start investing, a few words of caution are in order:

You may already have indirect exposure to alternative strategies if you participate in a pension plan. Many pension trustees have begun investing heavily in hedge funds recently. If you add some to your own portfolio, you may inadvertently double up.

Diversify! Only invest what you can afford to lose.

The moral is that these types of investments are not for everyone. You should consult a financial adviser before investing.





infoABOUT THE AUTHOR

Thomas F. Kirchner, CFA is the founder and manager of the

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Pennsylvania Avenue Funds and its investment adviser, Pennsylvania Avenue Advisers LLC. He is responsible for the day-to-day management of the Pennsylvania Avenue Event-Driven Fund (PAEDX). He also serves as the President and a Trustee of the Fund. From 1996 to 1999 he worked as a Bond Trader and Financial Engineer for Banque Nationale de Paris S.A. From 1999 to 2004, he was retained by Fannie Mae, a mortgage firm, as a Financial Engineer. Mr. Kirchner holds a B.Sc. from King's College, University of London, a Diplôme from the Institut d'Etudes Politiques de Paris, and an MBA from the University of Chicago Graduate School of Business. He has earned the right to use the Chartered Financial Analyst designation. He writes a blog about mergers that receive little press coverage at The Deal Sleuth http://thedealsleuth.wordpress.com/

BORN ON DATE

This document was created on January 21, 2009 and is based on the best Information available at that time.

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