Hedge Funds Investing

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Investing In Hedge Funds: Risks and Rewards Jack Mosevich

Transcript of Hedge Funds Investing

Investing In Hedge Funds: Risks and Rewards

Jack Mosevich

Contents

I. History, Definition and Overview

II. Types of Hedge Funds

III. Historical Performance

IV. Benefits of Investing in Hedge Funds

V. Risk Measurement and Risk Management

VI. Strategies for Investment

History, Definition and Overview

• First Hedge Fund: Alfred W. Jones

• In 1949 he raised $100,000 (40K his own) and added short positions to his stock portfolio to hedge overall market risk.

• He also levered by borrowing and later required a performance fee from his investors

• As of 1984 there were around 20 hedge funds in existence

History, Definition and Overview• DEFINITION: A HEDGE FUND IS A PRIVATE INVESTMENT

PARTNERSHIP

• MANY ARE NOT HEDGED

• THEY ARE NOT REGULATED BY THE SEC

• INVESTORS MUST BE “QUALIFIED” REGARDING NET WORTH AND INCOME

• ARE NOT ALLOWED TO ADVERTISE

• LONG, SHORT, LEVERAGED AND DERIVATIVES POSITIONS MAY BE TAKEN

• USUALLY A HIGH MINIMUM INVESTMENT

History, Definition and Overview

• FEES:• MANAGEMENT (1 TO 2%)

• INCENTIVE (10 TO 40%) NORMALLY ON RETURN IN EXCESS OF A HURDLE RATE (T-BILLS)

• HIGH WATERMARK: RETURNS BELOW HIGH WATERMARK MUST BE MADE BACK BEFORE INCENTIVE FEE APPLIES

• THESE INCENTIVES MAY RESULT IN TAKING ON EXCESSIVE RISK

History, Definition and Overview

• ARE CURRENTLY 8000 FUNDS. -rivaling mutual funds and listed US stocks

• $1.3 TRILLION UNDER MANAGEMENT

• BECOMING PART OF TRADITIONAL INVESTMENT PORTFOLIOS

• BENCHMARKS (Indexes) HAVE BEEN CREATED,IN ADDITION TO RETURN AND RISK TARGETS

• INCREASING EMPHASIS ON RISK/RETURN MEASURES AND RISK BUDGETING

History, Definition and Overview• Over half have <$50mm assets

• 80% of Hedge Funds have <$200mm in assets

• Out of the 8000 hedge funds, 116 account for half of the industries assets

• Half do not survive the first 5 years

• Less then 2% of all hedge funds are 10 years or older

• There is a wide dispersion in returns.

History, Definition and Overview

• INVESTMENT OBJECTIVES ARE MOST OFTEN ABSOLUTE RETURN AND RISK TARGETS, NOT BENCHMARKS

• ABSOLUTE RETURN IS “PORTABLE ALPHA”

• INDEXES HAVE BEEN CREATED, SOME INVESTIBLE

• THERE CAN BE PROBLEMS WITH SURVIVAL BIAS, BACKFILLING AND CEASATION OF REPORTING

TYPES OF HEDGE FUNDS(STRATEGIES)

• ARE AROUND 20 BASIC STRATEGIES

• SOME OVERLAP AND CAN CHANGE THROUGH TIME

• SOME ARE NOT EASILY DEFINED

• WE WILL COVER THE MOST POPULAR STRATEGIES

TYPES OF HEDGE FUNDS• Capital Structure Arbitrage

Relative value approach, attempts to capture pricing inefficiencies among various tranches of debt or equity of the same or related companies.

• Convertible ArbitragePurchase different securities of the same issuer such as the common stock and convertible bonds, one position being long, the other short.

• CTA’s / Managed FuturesCommodity Trading Advisors. Trade commodity futures, options and foreign exchange; often highly leveraged; trend following .

TYPES OF HEDGE FUNDS• Distressed Securities

Buy the equity or debt of companies that are in or facing bankruptcy, reorganization, distressed sales hoping that company will recover. Securities purchased are debt, equity, warrants.

• Emerging Markets Invest in the securities of companies or sovereign debt from "emerging" or developing countries.

• Event Driven Take positions in companies with "special situations": depressed stock; event offers significant potential market interest such as company merging with or acquired by another company; reorganizations; recapitalization, bad news which temporarily depress stock, which is shorted

TYPES OF HEDGE FUNDS• Fixed Income Arbitrage

Plays the spread between similar fixed income securities. Often highly leveraged and market neutral (e.g. duration neutral) types: yield curve arbitrage, corporate-treasury arbitrage, muni-treasury arbitrage, cash versus futures

• Funds of Funds Invests in a basket of different hedge funds. Benefit is to have experts choose the funds and also get into funds closed to new investors. There is a second layer of fees.

• Long/Short Equity Buy securities expected to perform well and sell short securities expected to perform poorly. Often either net long or net short depending on market view

• Global Macro or just MacroInvestment is based on shifts in global economies. Derivatives are often used to speculate on currency and interest rate moves.Investments may be in stock markets, bond markets or commodities . Top-down approach

TYPES OF HEDGE FUNDS

• Market Neutral Any strategy that attempts to eliminate market risk and be profitable in any market condition; equity or fixed income.Example: beta=0 for “double alpha”

• Market Timing Attempts to time the market by allocating assets among different investments such as between mutual funds and money markets.

• Multi-Strategy A single hedge fund that runs several different strategies in-house. Different from a fund of funds in that the money is kept in-house as opposed to being farmed out. Thus more nimble

TYPES OF HEDGE FUNDS

• Regulation D Private investments made in public companies in need of financing.

• Merger Arbitrage Also known as “Risk Arbitrage". Invest in event-driven situations, such as leveraged buy-outs, mergers, and hostile takeovers. Example: purchase stock in the firm expected to be taken over and sell short stock of the acquiring company.

• Short Bias Any manager who consistently has a "net short" exposure to the market. Includes short only funds.

TYPES OF HEDGE FUNDS• Special Situations

Consists of some type of event driven strategy. Opportunistically trade in any type of security that deemed to be a "special situation."

• Statistical Arbitrage Invest in equities believed to behave in a way that is mathematically describable. Quantitative techniques look for miss-pricings. Often market neutral

• VC / Private Equity Invest in venture capital or private equity

• Sector Funds

TYPES OF HEDGE FUNDS• AN EXAMPLE IN DETAIL: CONVERTIBLE ARBITRAGE

• A Convertible Bond is a Hybrid: It pays a coupon and PAR at Maturity

• It gives the holder the right but not obligation to convert to a fixed number of shares of the issuer at a fixed price and date (s)

• Convertible arbitrage: Purchase the bond and hedge by shorting the shares

• If the shares fall in price the bond “convertible shares” price fall is offset by the short position. Thus the principle risk is hedged. What is left is a stream of income. (This is the theory)

TYPES OF HEDGE FUNDS• AN EXAMPLE IN DETAIL: CONVERTIBLE ARBITRAGE

• Being bonds, convertibles are subject to interest rate risk: rising rates may severely reduce their value. This risk is often hedged too by shorting Treasuries

• Many Convertibles are callable. If rates drop the bonds may be called and shares issued or cash paid. This could mean a substantial loss to the fund.

• Interest rate and equity volatility can effect the value of the call option and thus the bond

• Finally, there is credit risk (default, spread risks)

• In summary these managing risks and earning a good return require in-depth expertise.

TYPES OF HEDGE FUNDS• Another Example: Market Neutral Equity

• Goal: Long attractive stocks, Short stocks expected to under-perform

• Create a portfolio with a beta of zero

• The attractive stocks hopefully result in a long position with positive alpha

• The un-attractive stocks have negative alphas so shorting them results in another position with positive alpha

• Hence the name “double alpha”

TYPES OF HEDGE FUNDS• Market Neutral Equity

• In order to create a beta neutral portfolio an ex-ante risk model such as BARRA or Northfield is required

• Need a predicted alpha for each stock and an optimizer to construct the portfolio: to be beta neutral as well as neutral on other risk factors (size, industry, growth, value etc.)

• This cannot be accomplished in one’s head: weight alone does not measure risk

TYPES OF HEDGE FUNDS• FINAL EXAMPLE: MERGER ARBITRAGE

• COMPANY ‘B’ WILL BE, OR MAY BE, TAKEN OVER BY COMPANY ‘A’

• WHEN THE MERGER IS ANNOUNCED B’s SHARE PRICE RISES AND A’s DROPS

• SEVERAL WAYS IN WHICH TO PROFIT: SHORT A’s SHARES AND GO LONG B’S SHARES OR GO LONG B’S SHARES WHEN THE MERGER IS ANNOUNCED AND SELL THEM WHEN (IF) THE MERGER OCCURS

• THIS IS ALSO CALLED RISK ARBITRAGE

TYPES OF HEDGE FUNDS• SUPPOSE B WILL BE TAKEN OVER BY A FOR 40$ PER SHARE.

CURRENT PRICE IS 25$ PER SHARE

• ON THE DAY OF ANNOUNCEMENT B’s PRICE GAPS TO 39.25$

• THE HEDGE FUND POTENTIAL PROFIT IS 75 CENTS PER SHARE(THEY COULD PREDICT AND PURCHASE AT 23$, MAYBE)

• THE RETURN IS THUS 1.9%

• IF THE DEAL FAILS THE SHARE PRICE WILL FALL BACK TO 25$ FOR A LOSS TO THE HEDGE FUND OF 14.25$, MANY TIMES THE POSSIBLE PROFIT

• THERE ARE FAMOUS EXAMPLES OF DEALS FALLING THROUGH: GE TAKEOVER OF HONEYWELL, BRITISH TELECOME TAKEOVER OF MCI

• THESE COST HEDGE FUNDS HUGELY

HFRI Fund Weighted Composite Index

YEAR YTD S&P 5002006 3.80 0.812005 9.28 4.852004 9.03 10.702003 19.55 28.412002 -1.45 -21.982001 4.62 -11.852000 4.98 -9.031999 31.29 20.891998 2.62 28.341997 16.79 31.861996 21.10 23.821995 21.50 37.201994 4.10 1.331993 30.88 9.971992 21.22 7.491991 32.19 30.231990 5.81 -3.06

HISTORICAL RETURNS(HEDGE FUND RESEARCH)

HISTORICAL RETURNS(HEDGE FUND RESEARCH)

p0 00

8.97%10.69%10.91%Since Inception Avg

4.04%0.37%8.43%5 Year Avg Annual

21.89%1.86%49.86%5 Year Cumulative

23.56%16.42%11.56%3 Year Avg Annual

88.64%57.79%38.83%3 Year Cumulative

33.75%17.26%19.75%2 Year Cumulative

19.77%10.38%11.45%1 Year

5.00%2.65%3.23%1 Month

FTSE All World IndexS&P 500

Hedge Fund IndexNet Performance

CS/TREMONT INDEXES

0.2812.03%6.55%8.44%2.71% Managed Futures

0.8810.30%12.19%15.23%4.18% Long/Short Equity

0.9511.11%13.74%12.15%3.37% Global Macro

0.853.75%6.36%1.97%1.42% Fixed Income Arbitrage

1.14.21%7.80%4.85%1.63% Risk Arbitrage

1.216.12%10.57%10.85%3.32% Multi-Strategy

1.616.45%13.57%13.93%2.52% Distressed

1.485.70%11.63%11.91%2.92% Event Driven

2.312.94%9.97%7.24%1.40% Equity Market Neutral

0.3416.44%8.81%22.77%5.76% Emerging Markets

-0.3117.29%-2.26%6.13%-2.98% Dedicated Short Bias

1.184.78%8.80%0.94%2.75% Convertible Arbitrage

0.987.88%10.91%11.45%3.23%CS/TREMONT Index

SharpeStd DevAvg Ann1 YearYTDIndex / Sub Strategies

CS/TREMONT

DRAWDOWN GRAPH

Benefits of Investing in Hedge Funds

• Hedge Funds are an alternative to traditional investment strategies which are designed to offer investors the potential for:

Sophisticated, less restricted portfolio management-Absolute return driven-few restrictions on security types, constraints-novel investment approaches-hedged positions in many cases

Attractive risk adjusted returns

Often positive returns in negative markets

Benefits of Investing in Hedge Funds

Diversification & Reduced volatility

-shifts portfolio to the NW quadrant.

-lower standard deviation

Reduced correlation to traditional investment vehicles

-i.e. HFR index has a .49 correlation to the S&P 500

Risk Measurement and Management

Qualitative Risk Issues:

Illiquidity -Long lock-up periods that range from 6 months to 10 years

-60 to 90 day notice required to withdraw money after the lock-up

Lack of Transparency -Not required to provide prospectuses.

-Manager is not required to divulge all holdings or trades.

May employ leverage

-Leverage can magnify losses

Relatively high fees -Typically 1% annual management fee

-Manager is entitled to 20% of profits above a high watermark. -Avg. mutual fund fee is 80bps to 2.50%

Tax Inefficiencies -Most are limited partnerships with K-1s

Rapid Growth -Has made it difficult for investors to carefully identify, select, and monitor single manager hedge fund

Risk Measurement and Management

Relatively high fees

Tax Inefficiencies -Most are limited partnerships with K-1s

Rapid Growth -Has made it difficult for investors to carefully identify, select, and monitor single manager hedge fund

Risk Measurement and Management

• FAMOUS EXAMPLE: LONG TERM CAPITAL

• LTCM FOUNDED IN 1994

• CORE STRATEGY:RELATIVE VALUE ARBITRAGE (SPREADS)

• SMALL PROFITS SO LEVERAGE WAS USED (25 TO 1 AT FIRST)

• 1997: CAPITAL GREW TO $7 BILLION

• BALANCE SHEET $125 BILLION

• OFF-BALANCE SHEET POSITIONS HAD NOTIONAL AMOUNT OF $1.25 TRILLION (DERIVATIVE POSITONS)

• 1995,1996 NET RETURNS WERE 40%

• 1997 CONVERGENCE TRADES HAD LESS “JUICE” : RETURN WAS 17%

• TO MAINTAIN LEVERAGE $2.7 BILLON RETURNED TO INVESTORS

• ASSETS KEPT AT $130 BILLION, LEVERAGE WAS 28 TO 1

Risk Measurement and Management

• IN JUNE 1998 MORTGAGE BACKS TURNED NEGATIVE AND LTCM LOST 16%

• THEN AUGUST 17 RUSSIA DEFAULTED ON DEBT

• CREDIT AND LIQUIDITY SPREADS ACROSS ALL MARKETS WIDENED

• TCM LOST $550 MILLION ON AUGUST 21

• BY THE END OF AUGUST THEY WERE DOWN 52%

• ASSETS WERE KEPT AT $126 BILLION FOR LEVERAGE OF 55 TO 1

• ON SEPT 21 LOST ANOTHER $550 MILLION

• EVENTUALLY BY END OF SEPTEMBER THE LOSS TO INVESTORS WAS 92%

• THE MAIN LOSSES CAME FROM INTEREST RATE SWAPS AND EQUITY DERIVATIVES

• THE NEW YORK FED HAD TO ORGANIZE A BAILOUT TO PROTECT THE FINANCIAL MARKETS

Risk Measurement and Management

• LESSONS?

• EVEN GENIUS FAILS

• RISK MANAGEMENT WAS UTILIZED BUT NO SYSTEM IS PERFECT

• HUMANS, NOT MARKETS, ARE THE MAIN SOUCES OF RISK

Risk Measurement and Management

• Statistical Properties of Hedge Fund Returns:

• Low correlations to broad markets

• Lower volatility then equities

• Diverse security types, investment approaches and hedging strategies

• Not (log) Normally distributed

• Often suffer from significant Skewness and Kurtosis.

• Standard deviation may be an inadequate measure of risk

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II. The Statistical Properties of Hedge Fund Returns

• A Normal distribution is characterized only by its first two moments:

mean (µ) and variance (σ2)

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II. The Statistical Properties of Hedge Fund Returns

• Hedge funds returns are not Normally distributed and possess non-zero Skewness, i.e. the distribution is asymmetric

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II. The Statistical Properties of Hedge Fund Returns

• Hedge funds returns also have non-zero Kurtosis, i.e. their distribution is more peaked than Gaussian

III. Traditional and Alternative Risk/Return Measures

• Sharpe Ratio• Maximum Drawdown• Calmar Ratio• Sterling Ratio• Sortino Ratio• Value at Risk• Traynor Ratio• Stutzer Ratio• Omega and Sharpe Omega• Kappa

ACTUAL MONTHLY RETURN SERIES

Frequency

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-6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7

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Frequency

• The traditional ranking scheme for portfolios is the Sharpe ratio

• The Sharpe ratio is motivated by Modern Portfolio Theory, it assumes:

• Return of portfolios is Normal• Investor is free to distribute funds over

the portfolio and a risk free asset

Risk Free Rate

III. Traditional and Alternative Risk/Return Measures

• The Sharpe ratio is the slope of the tangent in Markowitz

III. Traditional and Alternative Risk/Return Measures

III. Traditional and Alternative Risk/Return Measures

• Downside risk can go undetected if conventional measures (TE, Sharpe, or Std Dev) are used

• This applies to traditional investments too

• Over long investment periods maximizing Sharpe may reduce returns

• A different ranking scheme is due to Sortino

• Sortino measures the probability "width" of returns below the benchmark “r”

• r=minimum acceptable return

III. Traditional and Alternative Risk/Return Measures

• Another ranking scheme is called Omega

• F(x) is the cumulative distribution function

• Omega measures the entire distribution and does not assume a type of distribution

• r is the minimum acceptable return.

III. Traditional and Alternative Risk/Return Measures

III. Traditional and Alternative Risk/Return Measures

Kazemi, Schneeweiss and Gupta have shown that Omega equals the ratio of the price of a call option to a put option (not risk neutral world):

They further define the Sharpe-Omega ratio which is similar to the Sharpe ratio vs the threshold r:

• A generalized ranking scheme called Kappa has been proposed by Kaplan and Knowles

• For n=1 Kappa is Omega-1• For n=2 Kappa is Sortino

III. Traditional and Alternative Risk/Return Measures

• Stutzer proposed a different ranking scheme

• The Stutzer index measures how fast the probability of a return below the benchmark r goes to zero.

III. Traditional and Alternative Risk/Return Measures

Di Pierro and Mosevich proved that

for Normally distributed returns

Sharpe, Sortino, Kappa, Omega and Stutzer

imply the same ranking and therefore they are all

Equivalent, meaning that they result in the same rankings.

III. Traditional and Alternative Risk/Return Measures

IV. Ranking using various Measures

• For non-Normal distributions the implied rankings are different

• Which is better?

• By examining stability for various schemes and thresholds we have an idea of the confidence of the rankings

• If returns exhibit long term auto-correlation rankings may be suspect

Strategies for Investment

• Hedge funds are often thought of as a separate asset class

• They can also be thought of as a group of different strategies

• For asset allocation we might be better off thinking of traditional asset classes as sources of beta and hedge funds as sources of alpha

Strategies for Investment

• So the question is: should one include hedge funds in a portfolio and if so which strategies and what quantities?

• A possible ambiguity: a 20% allocation to an un-leveraged hedge fund is essentially the same as a 10% allocation to a 2-1 leveraged fund. Thus a blanket “%” must be treated carefully

Strategies for Investment

• View hedge funds as sources of portable alphas

• Allocate according to the desired alpha given one’s policy (risk adjusted) such as IR

• Policy needs to explicitly state a range of allocation to hedge funds

• Typically 10 to 20%

• The expected alpha and risk will be a function of the leverage employed in the funds

Strategies for Investment• Another issue is the choice of hedge funds in which to

invest

• This is actually not easy since so many strategies are very specialized

• Due diligence meetings may need to be held with prospective manages if a potential investment is quite large

• Fund of funds is perhaps the best way to quickly invest

• For small investments ($50,000) studying the offering documents and prospectus may be adequate

Strategies for Investment

• THE FUTURE OF HEDGE FUNDS:

• RETAIL OFFERINGS WILL BE APPEARING FOR SMALLER INVESTORS

• IS A MATURING MARKET

• MORE TRANSPARENCY WILL BE OFFERED

• MUTUAL FUNDS ARE ADOPTING SOME HEDGE FUND STRATEGIES

• REGISTRATION AND REGULATION IS COMING