Hedge Funds - AIWMI · Hedge Fund •Hedge Fund, an alternative investment vehicle, is a managed...

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.

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.

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.

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.

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.

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.

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.


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.


•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.


•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.


•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

Hedge Funds - AIWMI · Hedge Fund •Hedge Fund, an alternative investment vehicle, is a managed...

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