The Complete Guide to Hedge Funds and Hedge Fund Strategies

Global Financial Markets

Global Financial Markets is a series of practical guides to the latest financial market tools, techniques and strategies. Written for practitioners across a range of disciplines it provides comprehensive but practical coverage of key topics in finance covering strategy, markets, financial products, tools and techniques and their implementation. This series will appeal to a broad readership, from new entrants to experienced prac-titioners across the financial services industry, including areas such as institutional investment, financial derivatives, investment strategy, private banking, risk manage-ment, corporate finance and M&A, financial accounting and governance, and many more.

Titles include:

Daniel CapocciTHE COMPLETE GUIDE TO HEDGE FUNDS AND HEDGE FUND STRATEGIES

Guy Fraser-SampsonINTELLIGENT INVESTINGA Guide to the Practical and Behavioural Aspects of Investment Strategy

Michael HünselerCREDIT PORTFOLIO MANAGEMENTA Practitioner’s Guide to the Active Management of Credit Risks

Gianluca OricchioPRIVATE COMPANY VALUATIONHow Credit Risk Reshaped Equity Markets and Corporate Finance Valuation Tools

Michael C. S. Wong and Wilson F. C. Chan (editors)INVESTING IN ASIAN OFFSHORE CURRENCY MARKETSThe Shift from Dollars to Renminbi

Global Financial Markets seriesSeries Standing Order ISBN: 978–1137–32734–5

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The Complete Guide to Hedge Funds and Hedge Fund StrategiesDaniel Capocci

© Daniel Capocci 2013Foreword © William Fung 2013

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First published 2013 by PALGRAVE MACMILLAN

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ISBN 978-1-349-44303-1 ISBN 978-1-137-26444-2 (eBook) DOI 10.1057/9781137264442

To my son Mateo

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vii

Contents

List of Figures xviii

List of Tables xxvii

Foreword xxxiWilliam Fung

Acknowledgements xxxiii

Preface xxxiv

1 What Is a Hedge Fund? 1 1 General definition of hedge funds 1 2 Hedge funds over time 5 2.1 The origin of hedge funds 6 2.2 The growth of the industry from 1949 until today 8 2.3 Breakdown of the industry into investment strategies 12 3 Hedge funds around the world 14 3.1 Hedge funds in the United States and Canada 18 3.1.1 American hedge fund development 19 3.1.2 American hedge fund investment strategy 20 3.1.3 American hedge fund mandate 21 3.1.4 Canada 23 3.2 Hedge funds in Europe 24 3.2.1 Development 24 3.2.2 European hedge fund development 24 3.2.3 European hedge fund investment strategies 25 3.2.4 European hedge fund mandate 25 3.2.5 European hedge fund localization 26 3.2.6 Characteristics of the industry 28 3.2.7 Perspectives 29 3.3 Hedge funds in Asia 29 3.3.1 The development of Asian hedge funds 29 3.3.2 Asian hedge fund investment strategy 31 3.3.3 Asian hedge fund mandate 32 3.3.4 Asian hedge fund localization 32 3.3.5 Hedge funds in Australia: an exception 33 3.4 Hedge fund development in Eastern Europe 34 3.4.1 Eastern European hedge fund localization 36

viii Contents

3.4.2 Eastern European hedge fund investment strategies 36

3.5 Hedge funds in Latin America 37 3.5.1 Hedge fund development in Latin America 37 3.5.2 Latin American hedge fund investment strategies 40 3.6 Future perspective of the industry 40 4 A few big names from the hedge fund industry 45 4.1 George Soros 45 4.2 Julian Robertson 46 4.3 Michael Steinhardt 48 4.4 John Paulson 48 4.5 Louis Bacon 49 4.6 Paul Tudor Jones II 50 4.7 Bruce Kovner 50 4.8 Steve Cohen 51 4.9 Alan Howard 53 4.10 Stephen Feinberg 53 5 Summary 54

2 Hedge Fund Characteristics 55 1 Database providers 55 1.1 The indices – classifications 57 1.1.1 Morningstar CISDM 58 1.1.2 Hedge Fund Research 58 1.1.3 Dow Jones Credit Suisse 59 1.1.4 EurekaHedge 63 1.1.5 Greenwich Alternative 63 1.1.6 eVestment 64 1.1.7 BarclayHedge 64 1.2 The indices – daily indices 65 2 Constitution of a hedge fund 65 2.1 Definition of the fund objective 65 2.2 Investment strategy 66 2.3 Risk profile 66 2.4 Risk selection techniques 67 2.5 Manager 68 2.6 Management methodology 69 2.7 Fund domicile 71 2.8 Distribution 72 3 The structure of a hedge fund 73 4 Hedge funds and risk 75 4.1 Investment risk 76 4.2 Model risk 76

Contents ix

4.3 Manager and industry risk 77 4.4 Portfolio construction risk 78 4.5 Pricing risk 79 4.6 Infrastructure and legal risk 81 4.7 Counterparty risk 82 4.8 The risk of default 82 4.9 The liquidity risk 83 4.10 Operational risk 83 5 Hedge fund investors 88 5.1 Typical investors 88 5.2 Institutional investors 90 6 The constraints 94 6.1 Minimum investment 94 6.2 Liquidity constraints 94 6.3 The limit of total assets under management 98 7 The fees 98 7.1 The classic fee model 99 7.2 High-water mark and the hurdle rate 101 7.3 Fee illustration 103 7.4 Equalization or series of shares 104 8 Short selling 106 9 Leverage 108 10 Gross and net exposition 109 11 Active trading 113 12 Other characteristics of the hedge fund industry 114 12.1 The size of the funds 114 12.2 Common characteristics 116 12.3 The use of leverage 116 12.4 A typical hedge fund 116 12.5 Hedge funds and investment products 118 12.6 The dissolution rate 118 13 Hedge funds and other alternative investment products 119 14 The strengths and weaknesses of hedge funds 120 14.1 The strengths 120 14.1.1 Flexibility of techniques 121 14.1.2 Co-investment by the fund manager 121 14.1.3 Managers’ capabilities 121 14.1.4 Absolute return objective 121 14.1.5 Low correlation with classic investment

products 122 14.2 The weaknesses 122 14.2.1 High attrition rate 122

x Contents

14.2.2 Lack of information 122 14.2.3 Limited liquidity 123 14.2.4 A complex and expensive fee structure 124 14.2.5 Specific risks 124 14.2.6 Legal constraints 124 15 Comparison between funds and managed accounts 124 16 Replication 125 17 New structures 126 17.1 Listed funds 126 17.2 Structured products 127 17.3 Investable indices 131 18 Summary 133

3 Investment Strategies 135 1 General classification 136 2 Equity market neutral 137 2.1 Methodology 137 2.2 Definition of neutrality 140 2.3 Quantitatively managed funds 144 2.4 Risk management 145 2.5 Illustration 145 2.5.1 Theoretical illustration 145 2.5.2 Practical example: Career Education

Corporation and Apollo Group 147 2.5.3 Example: Daimler-Chrysler AG and

Ingersoll-Rand Company 147 2.5.4 TJX Companies and Whole Foods Market, Inc. 148 2.6 Advantages and drawbacks 149 2.7 Performance 151 3 Relative value 156 3.1 Methodology 156 3.1.1 Pair trading 157 3.1.2 Option trading and warrants 158 3.1.3 Capital structure arbitrage 158 3.2 Fixed income arbitrage 158 3.2.1 Risk management 162 3.3 Illustration 163 3.3.1 Relative value – theoretical illustration 163 3.3.2 Relative value – Verizon Communications, Inc. 164 3.3.3 Fixed income arbitrage – Treasury bond 166 3.4 Advantages and drawbacks 167 3.5 Performance 168 4 Mortgage-backed securities 170 4.1 The securities 170

Contents xi

4.2 Methodology 174 4.3 Risk management 175 4.4 Illustration 175 4.5 Advantages and drawbacks 176 4.6 Performance 178 5 Convertible arbitrage 181 5.1 Principles 181 5.2 Methodology: approach 182 5.2.1 Markets 182 5.2.2 Tools 182 5.2.3 Hedging 183 5.2.4 Arbitrage 184 5.3 Methodology: investment strategy 184 5.4 Specific risks 186 5.5 Illustration 187 5.5.1 Seagate Technology 187 5.5.2 BRE Properties 188 5.5.3 TEVA Pharmaceuticals 188 5.6 Advantages and drawbacks 188 5.7 Performance 189 5.8 Convertibles in 2004 and synthetic convertibles 192 6 Event driven 194 6.1 Methodology 195 6.2 Special situations 197 6.3 Activists 197 6.4 Illustrations 203 6.4.1 New Skies Technologies 203 6.4.2 Cumulus Media 204 6.4.3 Eletrobras 205 6.5 Advantages and drawbacks 207 6.6 Performance 207 7 Merger arbitrage 209 7.1 Methodology 209 7.2 Illustrations 212 7.2.1 Counterbids: Alcan/Rio Tinto 212 7.2.2 Counterbid: Graham Packaging/Reynolds

Group 213 7.2.3 Cash deal: Redecard/Itaú 214 7.2.4 Stock-for-stock merger: Giralia Resources/

Atlas Iron 215 7.2.5 Unsuccessful deal: Rhoen-Klinikum/Fresenius 219 7.3 Advantages and drawbacks 220 7.4 Performance 221

xii Contents

8 Distressed securities 223 8.1 Sources of difficulties 223 8.2 Methodology 225 8.3 Illustration 228 8.4 Advantages and drawbacks 229 8.5 Performance 229 9 PIPE funds 232 9.1 Methodology 232 9.2 Types of transaction 236 9.3 Underlying risks 238 9.4 Illustrations 240 9.4.1 Ascent Solar Technologies 240 9.4.2 Quest Minerals and Mining Corporation 240 9.4.3 Puda Coal Inc. 241 9.5 Advantages and drawbacks 242 9.6 Performance 242 10 Volatility Arbitrage 244 10.1 Methodology 246 10.2 Illustrations 247 10.3 Advantages and drawbacks 250 10.4 Performance 251 11 Multi-strategy 251 11.1 Methodology 251 11.2 Illustration 252 11.3 Advantages and drawbacks 254 11.4 Performance 255 12 Asset-based lending 258 12.1 Methodology 258 12.1.1 Stock financing 261 12.1.2 Trade finance 262 12.1.3 Real estate financing 262 12.1.4 Corporate direct 262 12.1.5 Life insurance financing 263 12.1.6 Vehicle loans 264 12.1.7 Other sub-strategies 265 12.2 The risks 266 12.3 Illustrations 268 12.3.1 Trade finance 268 12.3.2 Real estate financing 268 12.3.3 Legal proceedings financing 269 12.3.4 Life insurance financing 270 12.4 Advantages and drawbacks 271

Contents xiii

13 Long/short equity 272 13.1 Methodology 272 13.2 Equity non-hedge 275 13.3 Long/short equity vs. equity market neutral 275 13.4 Illustration 276 13.4.1 Clip Corporation 276 13.4.2 Barnes & Noble, Inc. 276 13.5 Advantages and drawbacks 277 13.6 Performance 278 14 Emerging markets 280 14.1 Methodology 282 14.2 Illustrations 286 14.2.1 Billabong 286 14.2.2 Li & Fung 287 14.3 Advantages and drawbacks 287 14.4 Performance 288 15 Sector funds 291 15.1 Methodology 291 15.2 Illustrations 296 15.2.1 Pediatrix Medical Group 296 15.2.2 Triad Hospitals, Inc. 296 15.2.3 Host Hotels and Resorts, Inc. 297 15.3 Advantages and drawbacks 298 15.4 Performance 299 16 Credit/high yield 303 16.1 Methodology 303 16.2 Correlation trading 306 16.3 Illustration 309 16.4 Advantages and drawbacks 310 16.5 Performance 310 17 Short selling 314 17.1 Methodology 314 17.2 Illustrations 315 17.2.1 Okamura 315 17.2.2 New Century Financial 316 17.3 Advantages and drawbacks 316 17.4 Performance 317 18 Macro 320 18.1 Principles 321 18.2 Methodology 321 18.3 Illustrations 322 18.3.1 Loosening of monetary conditions 322

xiv Contents

18.3.2 Yen–dollar carry trade 324 18.3.3 Sector consolidation 325 18.4 Advantages and drawbacks 326 18.5 Performance 327 19 Commodity trading advisors 330 19.1 Methodology 331 19.2 Short-term traders 333 19.3 Illustrations 334 19.3.1 Trend-following strategy 334 19.3.2 Moving-average strategy 335 19.3.3 Two-entry model 336 19.4 Advantages and drawbacks 339 19.5 Performance 344 20 Fund of funds 347 20.1 Why funds of funds? 347 20.2 Methodology 350 20.3 The choice of a fund of funds 355 20.4 Advantages and drawbacks 357 20.5 Performance 358 21 Other investment strategies 361 21.1 Closed-end fund arbitrage 361 21.1.1 I llustration – Gartmore European

Investment Trust 364 21.1.2 Illustration – JPM Fleming Overseas 365 21.1.3 Advantages and drawbacks 365 21.2 Electricity trading 366 21.3 Option arbitrage 367 21.4 Weather funds 370 21.5 Wine investing 371 21.6 MLP 374 22 Summary 375 Appendix A: Bond rating 375 Appendix B: Convertibles basics 376 Appendix C: Duration, modified duration and convexity 377 Appendix D: Hedge Fund Research Indices construction 379 Appendix E: The Greeks 379

4 Hedge Fund Performance Over Time 382 1 Data 382 1.1 Specific features of hedge fund data 382 1.2 Biases 384 1.3 The indices 386 2 Performance of the hedge fund industry 387

Contents xv

3 Hedge fund performance and volatility by strategy 391 3.1 Statistical analysis 391 3.2 Graphical analysis 396 3.2.1 Beta 396 3.2.2 Risk–return trade-off 400 3.2.3 Extended risk measure 406 3.2.4 Omega 411 3.2.5 Normality triangles 414 3.2.6 Probability return distribution 416 4 Performance during extreme market conditions 420 5 Academic research 427 6 Return decomposition 433 7 Inserting hedge funds into a classical portfolio 436 8 Correlation analysis 438 8.1 Correlation between hedge funds and classical markets 438 8.2 Correlation between hedge fund strategies 443 8.2.1 Monthly data 443 8.2.2 Daily data 449 9 Summary 455

5 Hedge Funds, LTCM and Recent Crises 456 1 Long-term capital management 456 1.1 The situation in September 1998 456 1.1.1 The losses of Soros et al. 457 1.1.2 Fixed-income arbitrage 457 1.2 Long-term capital management 458 1.3 History of the bailout 460 1.4 Why was the fund saved? 463 1.5 The effects and the questions still open 463 1.5.1 The effects 464 1.5.2 Questions still open 464 1.6 Subsequent developments 465 2 Hedge funds and financial crisis 465 2.1 The exchange rate mechanism crisis of 1992 465 2.2 The bond market turbulence of 1994 467 2.3 The Tequila crisis of 1994–95 468 2.4 The Asian crisis of 1997–98 469 2.4.1 The facts 469 2.4.2 The role of hedge fund in the crisis 470 2.4.3 The fundamentals 472 2.4.4 Conclusion 472 2.5 The subprime crisis of 2007 473 2.5.1 The basis 473

xvi Contents

2.5.2 The role of hedge funds 479 2.6 The liquidity crisis that followed the subprime crisis 483 2.7 Conclusion 485 3 Summary 485

6 Hedge Funds, Regulation and Mutual Funds 487 1 Hedge fund regulation 488 1.1 The principles 488 1.2 North America 490 1.2.1 The United States 490 1.2.2 Canada 495 1.3 Europe 497 1.3.1 Alternative UCITS 497 1.3.2 AIF & AIFM 500 1.3.3 United Kingdom 502 1.3.4 Germany 503 1.3.5 Luxembourg 505 1.3.6 Italy 506 1.3.7 Switzerland 506 1.3.8 France 507 1.3.9 Ireland 508 1.3.10 Malta 509 1.3.11 Spain 510 1.4 Australia 511 1.5 Offshore jurisdictions 513 1.5.1 Cayman Islands 515 1.5.2 British Virgin Islands 515 2 Hedge funds vs. mutual funds 516 2.1 Management – prospectus, short selling, leverage,

liquidity and securities used 517 2.2 Associated costs – fees and others 518 2.3 Communication 518 2.4 Typical investors 519 2.5 Asset manager registration 519 2.6 Audit 520 2.7 Directors 520 3 Hedge funds vs. mutual funds: the other main differences 521 3.1 Personal investment 521 3.2 Objectives 521 3.3 Securities used 522 3.4 Investment strategies 522 3.5 Size of the industries 523 3.6 Comparative summary 523

Contents xvii

4 Portfolio diversification 523 5 Summary 527

Conclusion 529

Appendix: The CAIA Association 532

Notes 533

Bibliography 541

Index 553

xviii

List of Figures

1.1 Evolution of the number of hedge funds and their assets under management (1988–2012) 10

1.2 Breakdown of the hedge fund industry by investment strategy (based on the number of funds) as of 31 December 2012 13

1.3 Breakdown of the hedge fund industry by investment strategy (based on assets under management) as of 31 December 2012 14

1.4 Broadening of the ranges of hedge fund strategies 141.5 Geographical breakdown of hedge funds domicile based

on the number of funds as of 31 December 2012 171.6 Geographical breakdown of hedge funds domicile based

on the assets under management as of 31 December 2012 171.7 Geographical breakdown of hedge funds on the basis of

their investment zone as of 31 December 2012 181.8 Geographical breakdown of hedge fund

management companies 191.9 Development of American hedge funds 201.10 Breakdown of American hedge fund assets 201.11 Number of funds by assets under management 211.12 Breakdown of American hedge fund strategies

by investment categories 221.13 Breakdown of the American hedge fund industry

by investment strategy 221.14 Breakdown of the investments of American hedge funds 231.15 The breakdown of Canadian hedge funds

by investment strategy 231.16 Development of European hedge funds 241.17 Breakdown of European hedge fund strategies

by investment category 251.18 Breakdown of European hedge funds by

investment strategy 261.19 European hedge fund investment zone 261.20 European hedge fund manager domicile 271.21 Evolution of the assets under management of hedge

funds and funds of hedge funds domiciled and administrated in Luxembourg (based on the assets) 27

List of Figures xix

1.22 Evolution in the number of hedge fund and fund of hedge funds domiciled and administrated in Luxembourg (based on the number of funds) 28

1.23 Asian hedge funds development 301.24 Breakdown of Asian hedge fund by investment category 311.25 Asian hedge funds breakdown by investment strategy

based on assets under management 321.26 Asian hedge funds investment zone 331.27 Asian hedge funds domicile 331.28 Australian hedge fund industry assets evolution 351.29 Latin American hedge fund industry development 381.30 Domicile of the hedge fund managers investing

in Latin America 391.31 Breakdown of South American offshore hedge funds

by geographical mandate 391.32 Breakdown of South American onshore hedge funds

by geographical mandate 401.33 Breakdown of onshore Latin American hedge funds

by strategy 411.34 Breakdown of offshore Latin American hedge funds

by strategy 411.35 Estimation of the size of various asset classes

(thousands of billions) 421.36 Hedge fund industry evolution 431.37 The future of the hedge fund industry 442.1 Hedge Fund Research hedge fund strategies classification 592.2 Hedge fund constitution (choice of investment strategy) 672.3 Constitution of a fund (determining the profile

or risk accepted) 682.4 Constitution of a fund (alternative risk selection) 682.5a Constitution of a fund (choice of manager) 692.5b Constitution of a fund (management methodology) 702.6 Fund constitution (domiciliation) 712.7 Constitution of a fund (distribution of interest) 722.8 Typical hedge fund structure 732.9 Prime broker services 742.10 Role of the administrator 752.11 Market vs. stock-specific risk for hedge funds and mutual funds 772.12 Main sources of pricing risk for PIPE funds 812.13 Illustration of liquidity risk 832.14 Analysis of hedge fund failure 842.15a Decomposition of hedge fund failure due to operational risk 85

xx List of Figures

2.15b Operational risk illustration 852.16 Official net asset value calculator 872.17 The origin of assets invested in hedge funds 882.18 Breakdown of American investors into hedge funds

(excluding funds of funds) 892.19 Breakdown of non-American investors into hedge funds 892.20 Breakdown of assets of Australian hedge funds and

funds of funds 902.21 The use of hedge funds by institutional investors 922.22 Strategic allocation in percentage of assets by

institutional investors 932.23 Breakdown of hedge fund management fees 992.24 Hedge fund performance fee breakdown 1002.25 Breakdown of the gross performance of a fund 1022.26 High-water mark illustration 1022.27 Gross vs. net performance 1042.28 Implementation of a short sell 1072.29 Closure of a short sell 1072.30 Illustration of the positioning of a manager over time 1142.31 Breakdown of the American hedge fund industry by

assets under management 1152.32 Breakdown of the European hedge fund industry by

assets under management 1152.33 Link between hedge funds and private equity 1202.34 Positioning of structure products in the world

of investments 1282.35 Comparison of the performance of a reference index

and its investable version 1322.36 Diversification tools for hedge fund exposure 1333.1 The neutrality of equity market neutral funds 1403.2 Theoretical illustration of the equity market neutral strategy 1463.3 Evolution of the ratio of Career Education Corporation

to Apollo Group (January 2002–May 2003) 1483.4 Evolution of the ratio of Ingersoll-Rand to Daimler-Chrysler

(September 2002–October 2002) 1493.5 Evolution of the ratio of TJX Companies to Whole

Foods Market, Inc. (February 2003–May 2003) 1503.6 Evolution of US$100 invested in the HFRI Equity Market

Neutral index or the EH: Quantitative Directional index 1533.7 Fixed income arbitrage strategy illustration 1603.8 Example of operation on direct pairs 1633.9 Illustration of a capital structure arbitrage position 165

List of Figures xxi

3.10 Evolution of the price of the bonds 1663.11 Yield spread between the bonds 1673.12 Evolution of US$100 invested in the HFRI

Relative Value index 1693.13 Evolution of the price of mortgage-backed

bonds (April 2003) 1773.14 Cumulative performance and market value of the portfolio 1773.15 Evolution of US$100 invested in the HFR RV: Fixed

Income – Asset Backed 1793.16 Steps to build a convertible arbitrage portfolio 1833.17 Inputs and outputs of the convertible arbitrage strategy 1863.18 Evolution of US$100 invested in the HFRI RV:

Fixed Income – Convertible Arbitrage index 1903.19 Synthetic convertibles 1933.20 The event driven strategy and its sub-strategies 1943.21 Typical investment process of an event driven fund 1963.22 Illustration of the special situations sub-strategy 1973.23 Investment process of a typical activist fund 1983.24 Companies typically considered by activist funds 1993.25 Main problems identified by activists and the

corresponding solutions proposed 2013.26 Evolution of the price of New Skies Technology 2043.27 Evolution of the equity price of Cumulus Media 2053.28 Evolution of the price of the shares of Eletrobras 2063.29 Evolution of US$100 invested in the HFRI RV:

Event Driven (Total) Index – Convertible Arbitrage index 2083.30 Main types of merger arbitrage transactions 2113.31 Evolution of the price of Alcan 2133.32a Evolution of the price of Graham Packaging 2143.32b Evolution of the price of Redecard 2163.33 Evolution of the price of Giralia Resources and Atlas Iron 2193.34 Evolution of the price of Rhoen-Klinikum 2203.35 Evolution of US$100 invested in the HFRI ED:

Merger Arbitrage index 2223.36 The main reasons behind most companies

being in difficulty 2253.37 Analysis of the range by a distressed securities

fund manager 2283.38 Evolution of US$100 invested in the HFRI ED:

Distressed/Restructuring index 2303.39 Illustration of the role of PIPE funds in the life of a company 2333.40 Typical structure of a PIPE transaction 234

xxii List of Figures

3.41 Illustration of a variable conversion rate PIPE transaction 2383.42 Sources of returns for PIPE funds 2383.43 Evolution of US$100 invested in the HFRI ED:

Private Issue/Regulation D index 2433.44 Bull put spread 2483.45 Bear put spread 2493.46 Bull call spread 2493.47 Bear call spread 2493.48 Call calendar spread 2503.49 Call ratio spread 2513.50 Example of the implementation of the

multi-strategy strategy 2533.51 Evolution of US$100 invested in the HFRI RV:

Multi-Strategy index 2563.52 Illustration of the asset-based lending strategy 2603.53 Stock financing illustration 2623.54 Trade finance illustration 2633.55 Real estate financing strategy 2633.56 Illustration of the corporate direct sub-strategy 2633.57 Illustration of life insurance financing 2653.58 Typical structure of the car loans strategy 2653.59 Main ABL sub-strategies 2663.60 Main sources of risks in the ABL strategy 2673.61 Illustration of the trade finance sub-strategy 2693.62 Initial position of the transaction 2693.63 Position after the fund entered the transaction 2703.64 Legal proceedings financing 2703.65 Building of a classic long/short position 2723.66 Illustration of a long/short equity market exposure over time 2743.67 Evolution of the stock price of Clip Corporation

between December 2004 and July 2005 2773.68 Evolution of the stock price of Barnes & Noble

between June 2000 and July 2001 2783.69 Evolution of US$100 invested in the HFRI Equity

Hedge (Total) index 2793.70 The main opportunities and risks of emerging markets 2823.71 Market dynamics of emerging markets 2853.72 Evolution of the price of Li & Fung from

May 2001 to October 2001 2883.73 Evolution of US$100 invested in the HFRI

Emerging Markets (Total) index 2893.74 Performance statistics of the HFRI Emerging Markets

(Total) index and comparative indices 294

List of Figures xxiii

3.75 Share price of Pediatrix between 2006 and 2007 2973.76 Share price of Host Hotels & Resorts, Inc. in 2007 2983.77 Evolution of US$100 invested in the HFRI EH:

Sector – Energy/Basic Materials index 3003.78 Evolution of US$100 invested in the HFRI EH:

Sector – Technology/Healthcare index 3023.79 The main components of a credit analysis 3053.80 Relation between CDO tranches and the default correlation 3083.81 Evolution of the five-year credit default swap of

Interpublic Group in 2005 3103.82 Evolution of US$100 invested in the HFRI RV:

Fixed Income – Corporate index 3113.83 Evolution of the stock price of Okamura Corporation 3153.84 Evolution of the stock price of New Century Financial 3173.85 Evolution of US$100 invested in the HFRI EH:

Short Bias Index 3183.86 Weighted average cost of Central Bank of Turkey funding 3233.87 The Monetary Condition index 3243.88 Evolution of the JPY–USD exchange rate between

November 2001 and December 2001 3253.89 Evolution of the share price of Allianz, Deutsche Bank

and Dresdner Bank in 2000 3263.90 Evolution of US$100 invested in the HFRI EH:

Macro (Total) index 3283.91 Timing of the main sub-strategies 3323.92 CTA strategy illustration 3353.93 Evolution of Russell 2000 ishares in July 2002 3353.94 Evolution of the price of a sugar futures contract,

a slow- and a fast-moving average 3363.95 Gold, 100 troy ounce price in 2011 3383.96 The fund exposure, risk and profits and losses on

the transaction 3393.97 Evolution of US$100 invested in the HFRI EH:

Short Bias index 3453.98 A typical fund of funds structure 3493.99 Fund of funds diversification 3493.100 Sources of ideas 3503.101 Qualitative aspects to consider before investing in a fund 3533.102 Main fund of funds offerings 3563.103 Example of an emerging market fund of funds 3563.104 Example of a multi-strategy fund of funds 3563.105 Evolution of US$100 invested in the HFRI Fund of Funds

Composite index 359

xxiv List of Figures

3.106 Evolution of US$100 invested in the HFRI Fund of funds indices 364

3.107 Evolution of the share price of Gartmore European Investment Trust 365

3.108 Evolution of the share price of JPM Fleming Overseas Investment 366

3.109 The liberalization and development of the electricity market 368

3.110 Standard investment procedure in an electricity trading fund 369

3.111 Evolution of the Liv-Ex 100 Fine Wine index 3723.112 Typical investment strategies in a wine fund 3733.113 Examples of inefficiencies in the wine market 3744.1 Comparison of the main hedge fund databases 3834.2 Evolution of US$100 invested in the HFRI Fund

Weighted Composite index 3884.3 Relative performance of hedge funds with the

MSCI World and the Barclays Global Bond index 3904.4 Evolution of the three-year rolling beta of the HFRI Fund

Weighted Composite index as against the MSCI World 4004.5 Evolution of the three-year rolling beta of the HFRI Fund

Weighted Composite index as against the Barclays Global Bond index 400

4.6 Risk–return profile of hedge fund strategies over the long term ( inception–30 June 2012) 401

4.7 Risk–return profile of hedge fund strategies over the medium term (January 2003–30 June 2012) 403

4.8 Risk–return profile of hedge fund strategies over the shorter term (January 2007–30 June 2012) 404

4.9 Risk (maximum annual loss)–return profile of hedge fund strategies over the long term (inception–30 June 2012) 405

4.10 Measure of risk of hedge funds using an extended risk measure (C = 10) 407

4.11 Measure of risk of hedge funds using an extended risk measure (C = 60) 408

4.12 Risk (extended risk measure)–return profile of hedge fund strategies over the long term (inception–30 June 2012) for a very defensive investor 410

4.13 Risk (extended risk measure)–return profile of hedge fund strategies over the long term (inception–30 June 2012) for a dynamic investor 411

4.14 Omega 412

List of Figures xxv

4.15 Omega of the HFRI Fund Weighted Hedge Fund index and the MSCI World 413

4.16 Omega of the HFRI Fund Weighted Hedge Fund index and the Barclays Aggregate Bond index 414

4.17 Omega of the HFRI ED: Merger Arbitrage index and the MSCI World 414

4.18 Omega of the HFRI ED: Merger Arbitrage index and the Barclays Aggregate Bond index 415

4.19 Normality triangle for the composite Hedge Fund index and the reference indices over the long term (inception–30 June 2012) 415

4.20 Normality triangle for the merger arbitrage index and the reference indices over the long term (inception–30 June 2012) 416

4.21 Probability return distribution of the HFRI Fund Weighted Hedge Fund index and the MSCI World over the long term (1 January 1990–30 June 2012) 417

4.22 Probability return distribution of the HFRI Fund Weighted Hedge Fund index and the Barclays Global Aggregate Bond index (inception–30 June 2012) 418

4.23 Probability return distribution of the HFRI Fund Weighted Hedge Fund index and the HFRI EH: Equity Market Neutral index (inception–30 June 2012) 418

4.24 Probability return distribution of the HFRI Emerging Markets (Total) index and the MSCI World (inception–30 June 2012) 419

4.25 Probability return distribution of the HFRI Fund Weighted Hedge Fund index and HFRI EH: Short Bias index (inception–30 June 2012) 419

4.26 Probability return distribution of the HFRI Fund Weighted Hedge Fund index and the HFRI Macro index (inception–30 June 2012) 420

4.27 Performance during volatile equity markets (January 1990–June 2012) 421

4.28 Performance during volatile bond markets (January 1990–June 2012) 421

4.29 Performance during volatile equity markets (January 1990–June 2012) 422

4.30 Performance during volatile times for hedge funds (January 1990–June 2012) 423

4.31 Performance during strong equity markets (January 1990–June 2012) 424

xxvi List of Figures

4.32 Performance during strong bond markets (January 1990–June 2012) 425

4.33 Performance during strong hedge fund markets (January 1990–June 2012) 425

4.34 Mean correlation between hedge fund indices and the traditional indices 446

4.35 Average correlation between hedge fund strategies and the HFR Global Hedge Fund index 448

4.36 Average correlation between hedge fund strategies 4484.37 Annual correlation between the hedge global index and

the other daily hedge fund indices 4544.38 Annual correlation between the hedge global index and

reference indices 4545.1 Illustration of a position of a hedge fund in the

pound sterling 4675.2 Evolution of the loan to value ratio and the ratio of

mortgage requests with limited documentation 4745.3 Evolution of the ratios of a 100 per cent financed real

estate project and evolution of the ratio of 100 per cent financed real estate projects with limited documentation 475

5.4 Evolution of the key interest rate of the Federal Reserve 4755.5 Estimation of the evolution of the price of

American real estate 4765.6 Securitization of mortgages 4775.7 Comparison of the traditional real estate financing

model and subprime model 4775.8 Estimation of the total exposure to the subprime crisis

by the principal global financial institutions 4806.1 Breakdown of the domicile of offshore hedge funds 5146.2 Inserting directional hedge funds in a portfolio made

up of mutual funds 5266.3 Inserting non-directional hedge funds into a portfolio

made up of mutual funds 527

xxvii

List of Tables

1.1 Breakdown of the hedge fund industry by assets under management 11

1.2 Countries in which hedge funds can be created and/or sold 151.3 Breakdown of the Asia Pacific hedge fund industry 341.4 Australian hedge fund assets breakdown by

investment strategy 352.1 Characteristic of the main hedge fund database providers 562.2 Classification of hedge funds by investment strategy 602.3 Questioning elements on risk management for hedge funds 792.4 Investment strategies and securities exposed to

a high pricing risk 802.5 Analysis of hedge fund valuation process 872.6 Liquidity constraints, a practical case 962.7 Average management and performance fee

by investment strategy 1012.8 The impact of commission on performance 1032.9 Illustration of gross and net exposure 1112.10 Illustration of the positioning of an equity

portfolio over time 1122.11 Use of leverage 1172.12 Characteristics of a typical hedge fund 1172.13 Attrition rate of single hedge funds 1232.14 Estimation of the attrition rate in 2008 1232.15 Characteristics of a typical investable index 1313.1 Hedge fund strategy classification 1383.2 Typical factors of a fundamentally based

quantitative strategy 1443.3 Total returns from a theoretical portfolio 1463.4 Performance statistics of the HFRI EH:

Equity Market Neutral index, the HFRI EH: Quantitative Directional index and comparative indices 154

3.5 Example of a capital structure arbitrage position 1653.6 Performance statistics of the HFRI Relative Value

index and comparative indices 1723.7 Characteristics of various asset-backed products 1743.8 Mortgage-backed bond example 1763.9 Performance statistics of the HFR RV: Fixed Income – Asset

Backed index and comparative indices 180

xxviii List of Tables

3.10 Convertible bonds 1823.11 Performance statistics of the HFRI RV: Fixed Income –

Convertible Arbitrage index and comparative indices 1913.12 Analysis of New Skies Technologies 2033.13 Performance statistics of the HFRI Event Driven (Total)

index and comparative indices 2103.14 Performance statistics of the HFRI ED: Merger Arbitrage

index and comparative indices 2243.15 Performance statistics of the HFRI ED: Distressed/

Restructuring index and comparative indices 2313.16 Types of private transaction 2373.17 Evolution of the number of PIPE and Reg S transactions

and of the amount of money invested 2393.18 Ascent Solar Technologies bridge loan deal characteristics 2403.19 Quest Minerals PIPE transaction in 2004 2413.20 Puda Coal convertible bond deal characteristics 2413.21 Performance statistics of the HFRI ED: Private

Issue/Regulation D index and comparative indices 2453.22 Performance statistics of the HFRI RV: Multi-Strategy

index and comparative indices 2573.23 Typical characteristics of an ABL transaction 2613.24 Long/short equity market exposure over time 2743.25 Performance statistics of the HFRI Equity Hedge

(Total) index and comparative indices 2813.26 Illustration of the emerging markets strategy using

Billabong from January 2001 to December 2001 2873.27 Performance statistics of the HFRI Emerging Markets (Total)

index, the other HFRI regional emerging market indices and comparative indices 292

3.28 Return of the HFRI Emerging Market indices during the Asian and the Russian crises 295

3.29 Performance statistics of the HFRI EH: Sector – Energy/Basic Materials index and comparative indices 301

3.30 Performance statistics of the HFRI EH: Sector – Technology/Healthcare index and comparative indices 304

3.31 Positioning based on correlation views 3093.32 Performance statistics of the HFRI RV: Fixed Income –

Corporate index and comparative indices 3133.33 Performance statistics of the HFRI EH: Short Bias index

and comparative indices 3193.34 Performance statistics of the HFRI Macro (Total) index

and comparative indices 329

List of Tables xxix

3.35 Profit and loss over the year (29 July 2011–30 December 2011) 340

3.36 Risk (29 July 2011–30 December 2011) 3423.37 Performance statistics of the HFRI Macro: Systematic

Diversified index and comparative indices 3463.38 Diversification benefit of a fund of funds 3493.39 Performance statistics of the HFRI Fund of Funds

Composite index and comparative indices 3623A.1 Bond ratings 3764.1 Estimate of survivorship bias 3854.2 Estimate of the instant return history bias 3864.3 Comparison of hedge fund indices 3874.4 Annual return of the Hedge Fund Composite index

compared to that of equities and bonds 3894.5 Comparison between the indices

(January 1990–December 2012) 3924.6 Beta of hedge funds relative to traditional indices

(January 1990 – June 2012) 3984.7 Estimation of the extended risk measure 4094.8 Relative performance of the indices under

various market conditions 4264.9 Four global categories of hedge fund academic studies 4294.10 Multi-factor performance decomposition model 4344.11 Objectives and main conclusion of the performance

decomposition studies 4374.12 Objectives and main conclusions of the study analysing

the impact of inserting hedge funds into a classical portfolio 4394.13 Correlation between hedge funds and classical indices

(January 1990–June 2012) 4414.14 Correlation between hedge funds and traditional indices

(January 2003–June 2012) 4444.15 Correlation between hedge funds and classical indices

(January 2008–June 2012) 4454.16 Correlation between hedge fund strategies

(January 1990–June 2012) 4474.17 Correlation between daily hedge fund indices and

reference indices 4504.18 Annual correlation coefficients between daily hedge

funds indices and references indices 4525.1 Losses of LTCM by market 4635.2 Size and breakdown of the American real estate industry

at the end of the second semester of 2007 478

xxx List of Tables

5.3 Subprime exposure of the main financial institutions 4806.1 The ten largest hedge fund groups and the ten largest

mutual funds in 2012 5246.2 Differentiation factors between hedge funds and

mutual fund 525

xxxi

Foreword

Since the middle of the 20th century, wealthy individuals have invested their capital alongside talented traders in opaque, lightly regulated invest-ment vehicles designed to safeguard investor anonymity and to allow capital accumulation in relative privacy, in contrast to publicly available regulated vehicles such as mutual funds. These exclusive, opaque invest-ment vehicles, managed by eclectic investment professionals, have come to be referred to as hedge funds.

Since the turn of the century, anecdotal evidence has revealed a steady increase in the allocations of institutional investors in hedge funds. Institutional investors, in contrast to private investors, prefer transpar-ency, emphasize corporate governance, and demand regulatory compli-ance from their third-party managers. In addition, they generally prefer moderate risk-adjusted returns, and stress persistency rather than peri-odic out-sized returns and their attendant volatility. This is a significant change in the clientele of the hedge fund industry – a change that affects both the return and risk profile of hedge funds as well as hedge fund managers’ business models.

Despite these changes and the 2008 financial crisis, the hedge fund industry has flourished, accumulating substantial amounts of capital from these diverse investors. What is it about hedge funds that attracts inves-tors and continues to do so consistently over decades? Daniel Capocci’s book gives us important clues to answering this question. It provides val-uable insights into hedge fund strategies and a framework for assessing hedge fund products.

Chapter 1 offers some illuminating vignettes of a number of legendary hedge fund managers, beginning with Alfred Winslow Jones’s fund in 1949. The brief history of these hedge fund legends hints at how success-ful hedge fund managers not only have to navigate through dynamic, and at times stormy, investment environments, but must also evolve their business models to adapt to changing investor demands and regulations. Daniel’s balanced approach, illustrating difficult concepts by way of well-chosen examples and statistical evidence, sets the framework for an effective, comprehensive description of complex hedge fund investment strategies in the subsequent chapters.

The second and fourth chapters of the book take the investors’ per-spective and ask the questions: How have hedge funds performed? And what should I be wary of? Anecdotal evidence suggests that institutional investors prefer large, well-capitalized hedge fund firms. For investors

xxxii Foreword

considering investing in a hedge fund, Daniel provides a helpful check-list of risks they should be aware of – risk factors cover both strategy risk as well as operational risk.

Chapter 3 tackles the core subject of this book: How do hedge fund managers make their money? Or, What is inside their investment tool-box? If coming up with a definition for hedge funds is difficult, describing hedge fund managers’ investment strategies in a succinct fashion without undue reference to quantitative models is, to say the least, even more challenging. Here Daniel artfully applies the same balanced approach of insightful examples interlaced with empirical data on how different strat-egy performs, taking the reader on an insightful tour into the type of investment opportunities that attract hedge fund managers, how portfo-lio positions are crafted, and how the investments are managed over time. Through the first decade of the 21st century there has been a continuing trend for the industry’s assets to be concentrated in the hands of a few mega large hedge fund firms. Hedge fund managers are the quintessence of active management, and are certainly no strangers to applying lever-age to enhance their bets. This rising trend of risk capital being concen-trated in the hands of a small number of leveraged speculators operating in opaque and lightly-regulated investment vehicles inevitably catches the attention of, and at times creates discomfort for, the regulators. In Chapter 5, Daniel takes the reader through some of that decade’s stress-ful events in global capital markets. The chapter examines how hedge funds performed during crisis conditions and their market impact. The last chapter rounds off the text with a discussion on the issues relating to hedge fund regulations.

Overall, this is an excellent ‘go to’ text for answers to many key ques-tions on the hedge fund industry – answers that are presented with a fine balance between rigorous analysis and intuitive, practical examples.

William Fung, Visiting Research Professor of Finance, London Business School, and

Vice chairman, CFA Research Foundation

xxxiii

Acknowledgements

I would like to express my gratitude to my wife Renata Vitórica for her constant support, and to Peter Baker from Palgrave Macmillan for his trust in me.

I would like to thank Jean Bensadoun (York Asset Management Limited), Martin Blum (Ithuba Capital), Andrew Bonita (Bonita Capital Management), David Capocci (Deloitte Luxembourg), Guilherme Carvalho (York Asset Management Limited), Gabriel Catherin (KBL European Private Bankers), Deborah Ceo, Gregory Gregoriou, Maria Dermes (Borsa Italia), Scott Eser (Hedge Fund Research), Fredrik Huhtamäki (Estlander & Partners), Guillaume Jamet (Lyxor Asset Management), Jamie Handwerker (CRM, Llc), Todd Harman (Hedge Fund Research), Marc Mediratta, John Paulson (Paulson), Andrej Rojek (Lydian Asset Management), Joshua Rosenberg (Hedge Fund Research), Bruno Sanglé-Ferrière (Carrousel Capital), Michael Schueller (HVB Alternatives), Patrick Vander Eecken (Pure Capital), Nick Walker (York Asset Management Limited), Diego Wauters (Coriolis Asset Management), and Mark Swickle (Professional Traders Management).

xxxiv

Preface

When I published the first edition of my French book on hedge funds in 2004, I started it with the following sentence:

Today, hedge funds are part of the investment universe of more and more investors, whether they are institutional or private. Not a single week goes by without this term being found in the financial press, either to introduce the concept, to present one or a few of their par-ticularities, to define a strategy, to analyse the regulation in one or a few countries, to present a bankruptcy of a fund or to comment on the performance of the industry or a fund.

The situation has continued to evolve since 2004, and the industry has come of age, with its functioning rules, its events, leaders, successes and failures. The strong equity markets of the 2003–2007 period and the increased level of sophistication of financial products available have enabled the industry to continue its development, and new strategies to emerge or consolidate. The liquidity crisis that affected the entire finan-cial system including hedge funds slowed the industry’s growth, but 2009 performance numbers indicate that the situation has stabilized and that the best managers have been able to reposition themselves and come back to the previous highs in less than a year. At the outset, the interest in these funds – almost unknown until the 1990s – comes from the impres-sive track record of the funds of Soros, Steinhart or Robertson during the 1970s or the 1980s that were reported in financial publications such as Fortune or The Wall Street Journal. From that point onwards, more and more potential investors started to show an interest in hedge funds. But then the failure of Long-Term Capital Management in 1998 damaged the reputation of the whole industry. Since then, hedge funds have often been reported in the press because of a particular positioning (for example the short subprime position taken by some funds), a fraud (such as Madoff) or liquidity or leverage issues.

There were several reasons for the media secrecy that for a long time shrouded this type of fund. The first was that the hedge fund industry was small compared to other types of investment products, and it was only at the start of the 1990s that the number of hedge funds increased significantly. Second, hedge funds historically took a private form in order to profit from maximum freedom in their management, and that private

Preface xxxv

structure precluded any kind of advertising.1 Finally, in most jurisdictions there were constraints not only regarding the kind of investors that could invest in the fund but also regarding minimum investments.

More recently, hedge funds have gained much interest because, after a few years of sustained strong performance, the world market faced an almost unlimited fall between April 2000 and December 2002. From that time, many investors looked for new investment opportunities and, in parallel, the academic and financial press started to be more and more interested in hedge funds that globally performed correctly over this dif-ficult period. This phase included an important educational element. Unlike mutual funds, the performance of hedge funds should be meas-ured by definition in absolute terms and not relative to an index. The original aim of the industry was to offer positive returns despite the evo-lution of the market as a whole. At that time, several academic studies maintained that hedge funds were able to offer returns superior to those offered by classical markets, thanks mainly to their ability to protect the portfolio during financial crisis. This explains why the industry profited from a rapid growth phase over that period of uncertainty and over the years that followed.

Hedge funds as an industry performed strongly until 2007 when the subprime crisis happened. This was an issue for a few funds, but the vast majority were not exposed – and several actually profited from it. The issues started in 2008. The equity strategies were the first to be hit, on the performance side early in the year, as equity markets became vola-tile. Then the markets became tighter when Bear Stern went bankrupt. Liquidity disappeared from the market once Lehman Brothers failed in September. The liquidity squeeze and the ban on short selling of finan-cials were enough to directly hurt the industry in September but even more in October; this was when the bad press on hedge funds reached its peak. Most funds investing in less liquid strategies had to gate (that is, suspend redemptions) and so investors remained stuck in funds or funds of funds without any possibility of exiting for some time. All in all, the cost was considerable – but the industry came out much stronger, and the majority of the funds that survived this difficult period recovered within a year or two. In parallel, the industry continued its development through onshore vehicles like UCITS funds or private regulated European onshore funds. The largest players became stronger, and they continue to attract assets while the hedge funds consisting of two guys in a room have van-ished. The industry has matured; numbers have been correct since then and growth is back to positive terms.

The academic world started to look at hedge funds in 1997; the first important studies on the subject were published at that time. The

xxxvi Preface

pioneers were William Fung and David Hsieh (1997) with their paper called ‘Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds’ and Brown, Goetzmann and Ibbotson (1997) with the paper titled ‘Offshore Hedge Funds: Survival and Performance 1989–1995’. The first authors found that the strategies applied by hedge funds are fundamentally different from those applied by mutual funds. The second team concluded that the majority of hedge fund managers are unable to outperform classical indices. Today, the literature on the subject is important, and several academic journals now specialize in alternative investments; these include the Journal of Alternative Investments and the Quarterly Hedge Fund Journal. The majority of the studies have been pos-sible thanks to the creation of private hedge fund databases; these were started early in the 1990s with the primary objective of providing infor-mation to potential investors.

This book aims to cover hedge funds and the hedge fund industry in detail. I will start the process from scratch by answering the question ‘What is a hedge fund?’ In Chapter 1, I approach the subject with a broad scope. Chapter 2 goes into more detail by focusing on the characteristics of hedge funds; this chapter discusses the tools required to understand the particularities that can appear in the hedge fund world. Chapter 3, the heart of the book, presents every hedge fund strategy and illustrates each of them, first with many figures and tables to convert words into visual concepts, and, then more importantly, with one or more practi-cal examples. Chapter 4 focuses on the performance of hedge funds over time. I report a series of statistics, and cover various time periods to give you a good sense of how the industry functions as a whole and also how strategies tend to perform over time. Chapter 5 covers hedge funds in dif-ficult times. We start with the failure and bailout of Long-Term Capital Management in 1998, before analysing the role and potential impact of hedge funds on the financial markets during the financial crises of the last 20 years. Finally, Chapter 6 has two main objectives. First, the regulation of hedge funds and its evolution. This aspect is of particular importance because regulation is what enables the industry to continue its growth. Second, the differences between hedge funds and mutual funds; these differences cover not only legal niceties but, more importantly, structure and many other points. All in all, the many aspects of the hedge fund world are covered. Once you reach the last page of this book, I trust that your knowledge of this industry will have broadened significantly.