Transcript Hedge Funds
HEDGE FUNDS DEFINITIONS No legal meaning Privately offered, professionally managed pooled investment vehicles. Interests in these funds are sold in private offerings primarily to “qualified purchasers” Aim to deliver positive returns under all market conditions while reducing risk and preserving capital DEFINITIONS A subset of alternative investments that incorporate all investment strategies run with an orientation to producing primarily absolute returns using largely marketable securities A private and largely unregistered investment pool that employs sophisticated hedging and arbitrage techniques to trade in the corporate equity and bond markets DEFINITION “Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years, they deliver a one-in-ahundred-year flood.” HISTORY The first hedge fund was set up by Alfred W. Jones 1949 Used short sales, leverage and fees Converted from general partnership to limited partnership in 1952 Publicized in 1966 in article in Fortune magazine Growth from 1986-1993 and following collapse of tech bubble in 2002 Hedge funds did relatively well in 2000 - 2002 CURRENTLY Size has been doubling almost every two years Approximately 9,000 active funds $2 Trillion under management Account for 30% of all U.S. fixed-income trading 80% for distressed debt and high-yield derivatives (LACK OF) REGULATION No public offerings Limited number of investors Only “accredited investors consisting of institutional investors, companies, or high net worth individuals who can ‘fend for themselves’” Must register as investment advisors if managing more than $100 million (new in 2010) (LACK OF) REGULATION Not required to disclose their holdings to investors Not required to report investment results Allowed to advertise only within last 2 years Limited partners must have already formed a relationship with the general partner Allowed to use leverage Usually 2:1 to 10:1 LTCM was at least 25:1 (perhaps more) STRUCTURE Limited Partnership or Offshore Corporation Collection of funds (feeder funds) Each fund designed to optimize taxes for a group of investors Offshore fund for foreign investors and onshore fund for U.S.-taxed investors HEDGE FUND LOCATION Location Percent Assets Cayman Islands 35% United States 32% British Virgin Islands Bermuda Bahamas Luxembourg Asia 8% 8% 4% 3% 4% FEATURES Manager usually has high percentage of his/her assets invested in fund Current trend towards more institutions investing in hedge funds Proportion of institutions to individuals is increasing Popular with endowments ASSET CLASS ALLOCATION BY INSTITUTIONAL INVESTORS Asset Class Percent Allocation Equity 51% Fixed Income 17% Real Estate 4% Hedge Funds 15% Private Equity 3.2% Venture Capital 3.5% Natural Resources 3% Source: NACUBO Endowment Study INVESTMENT STRATEGIES Convertible Arbitrage Merger Arbitrage Going long on an acquisition after the announcement if price doesn’t go up to full offer price and fund manager believes merger will occur or believes a higher price will be offered Long/Short Hedged investing in convertible securities. Typically long convertible bonds and short stock. Going long on underpriced security and short on overpriced security in an industry Dedicated Short Strategy Net short position (usually equities) but not necessarily purely short INVESTMENT STRATEGIES (CONTINUTED) Statistical Arbitrage Event Driven Looks to profit from a mispricing in situations such as mergers, acquisitions, restructuring, or bankruptcy Fixed Income Arbitrage Perceived statistical mispricing of one or more securities according to some quantitative model. Attempts to profit from relative mispricing in related fixed-income securities. For example – on-the-run vs. off-the-run government bonds Market Neutral Strategy Make money on a mispricing whether the market goes up or goes down. Done through the use of a zero-beta portfolio MARKET NEUTRAL STRATEGY You think a stock (or portfolio) is underpriced But you also think the market might drop You want to capture the underpricing without subjecting yourself to the risk of your position losing value along with the market You need to separate the stock-specific bet from the effects of the market CAPTURING POSITIVE ALPHA This is called any of the following: Pure Play Alpha Transfer Portable Alpha Creating a market-neutral portfolio The key is to eliminate the market (systematic) risk CAPTURING POSITIVE ALPHA Example: You have put together a portfolio which you believe will outperform the market by 2% next month. Your portfolio has a beta of 1.0 and you are concerned that the overall market might fall next month The risk-free rate is 1% per month E(R) = Rf + β(Rm – Rf) + α + e You must create an offsetting portfolio with a beta of -1.0 which will offset the effect of a market decline CAPTURING POSITIVE ALPHA You can create a portfolio with a negative beta by: Selling S&P 500 futures contracts Purchasing puts on S&P 500 contracts Shorting a SPDR ETF Each of these creates a beta of -1.0. You Rf can adjust this beta by borrowing or lending at CAPTURING POSITIVE ALPHA You now have a total position with a beta of zero (your investing portfolio with a beta of 1 plus the offsetting portfolio with a beta of -1) E(R) = Rf + β(Rm – Rf) + α + e Your return will be the 1% risk-free rate, the 2% alpha (if you were correct) and any undiversified unique risk that remains (expected value of zero) CAPTURING POSITIVE ALPHA STRATEGY ALLOCATION Strategy Assets ($bln) Percent Assets Number Funds Long/Short Equity Hedge 282 35% 1148 Event Driven 38.6 18% 316 Other 40.7 9% 316 Fixed Income Arbitrage 38.6 18% 166 Global Macro 32.6 8% 146 Emerging Markets 31.7 7% 168 Market Neutral 26.8 6% 212 Convertible Arbitrage 22.2 5% 124 Dedicated Short 1.2 -- 17 Source: Lipper/Tass INVESTMENT PERFORMANCE Very difficult to gauge for certain Voluntary disclosure Survivorship bias Must be Risk-Adjusted Normal risk adjustments don’t always apply Often a strong systemic (sector) risk INVESTMENT PERFORMANCE January 1995 – April 2006 Study Pre-fee annualized return of 12.72% Fee of 3.74% Alpha of 3.04% January 1994 – July 2009 Study Credit Suisse/Tremont Hedge Fund Index Average S&P return of 8.93%; Stand Dev of 8% 500 Average return of 6.46%; Stand Dev of 15.5% INVESTMENT PERFORMANCE A few large firms have tended to have significant positive returns Renaissance 3-year Medallion Fund annual compound return of 62.8% in 2007-2009 TOP HEDGE FUNDS AS OF 10/07 Ranked by Average Annual Return for prior 3 years RAB Special Situations Fund 47.69% The Children’s Investment Fund 44.27% Highland CDO Opportunity Fund 43.98% BTR Global Opportunity Fund, Class D 43.42% SR Phoenicia Fund 43.10% Atticus European Fund 40.76% Gradient European Fund A 39.18% INVESTMENT PERFORMANCE RETURNS BY STYLE FEES AND COMPENSATION Management Fee of 1% - 2% of assets under management (median is 1.5%) Incentive Fee of 20% of profits above a benchmark May be T-bill rate May be zero Some may be higher 5% mgmt. fee and 44% of profits for Renaissance Medallion LIQUIDITY ISSUES Mutual Funds must redeem shares on demand Mutual Funds must calculate NAV daily ETFs are actively traded on exchanges Hedge Funds often invest in illiquid assets that cannot be easily priced due to infrequent trading Models (estimates) are often used to value assets Mark-to-Model Leads to positive serial correlation in returns LIQUIDITY ISSUES Hedge Funds will not necessarily allow withdrawals on demand Usually specific times (quarterly) when investors can withdraw funds Often a lock-up period of up to two years Minimum Investment of $250,000 or more Limited number of investors and dollars Due to diseconomies of scale Managers want long-term investors ACCREDITED INVESTORS Individuals with a net worth of at least $1 million or Earned at least $200,000 each year for the past two years $300,000 with spouse if married Expect to earn the same amount this year Institutional investors with at least $25 million in investments A family-owned company with at least $5 million in investments FUND OF FUNDS Allows for diversification among Hedge Funds Fund manager is responsible for due dilligence of various hedge funds Allows for smaller investments and greater liquidity Additional fee of approx. 1% About 15% of all hedge fund assets managed through fund of funds About 25% of hedge funds are actually funds of funds RISKS “Fat Tails” – High positive returns, but also a possibility to lose everything like LTCM Extremely unlikely in mutual fund Lack of liquidity Lack of information for investors High Leverage Difficult to evaluate performance SKEWED TO THE LEFT R e t u r n s H is t o g r a m C S F B /T r e m o n t E m e r g in g M a r k e ts In d e x : F e b r u a r y 1 9 9 4 - J u n e 2 0 0 5 Number 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 - 2 4 .0 % - 2 2 .0 % - 2 0 .0 % - 1 8 .0 % - 1 6 .0 % - 1 4 .0 % - 1 2 .0 % - 1 0 .0 % - 8 .0 % - 6 .0 % - 4 .0 % - 2 .0 % R e tu r n 0 .0 % 2 .0 % 4 .0 % 6 .0 % 8 .0 % 1 0 .0 % 1 2 .0 % 1 4 .0 % 1 6 .0 % 1 8 .0 % HIGHEST-EARNING HEDGE FUND MANAGERS IN 2007 John Paulson, Paulson & Co. $3 billion+ Philip Falcone, Harbinger Capital Partners $1.5-$2 billion Jim Simons, Renaissance Technologies $1 billion Steven A. Cohen, SAC Capital Advisors $1 billion Ken Griffin, Citadel Investment Group $1-$1.5 billion Chris Hohn, The Children’s Investment Fund $800$900 million Noam Gottesman, GLG Partners $700-$800 million LONG-TERM CAPITAL MANAGEMENT Created in 1993 by John Meriwether Former head of Salomon Brothers’ bond traders Nobel Prize in Economics winners on Board Myron Scholes Robert Merton Primarily used fixed income arbitrage Looked for relative mispricing in government debt Double alpha approach for expected convergence LONG-TERM CAPITAL MANAGEMENT Looked for small mispricings (small gains) that it could magnify with leverage Debt-to-equity ratio of 25/1 $5 billion in equity and $125 billion in debt August 1998 Russia defaulted on some bonds Instead of converging, bets diverged LTCM needed to post margin Investors began withdrawing money LONG-TERM CAPITAL MANAGEMENT Managers still believed in their models but faced a liquidity crisis September 1998 Federal Reserve Bank of NY organized a rescue 14 large commercial banks and securities firms $3.6 billion in capital 90 percent ownership of LTCM BERNARD MADOFF Former chairman of NASDAQ Madoff Securities Hedge fund began in 1980s Largest Ponzi Scheme ever Investors lost approximately $50 billion Delivered consistent returns of 1.0% - 1.5% per month Stated that portfolio selection methods were too complex for others to understand Targeted charities and foundations Long-term investors BERNARD MADOFF 2000 – 2001: Harry Markopolos and Erin Arvedlund each suspected fraud when they examined the fund’s performance WSJ decided not to pursue story that it was a fraud SEC was alerted but did nothing December 2008: Cash shortage forces Madoff to turn himself in