Transcript Hedge Funds - Tulane University

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A subset of alternative investments that
incorporate all investment strategies run with
an orientation to producing primariloy
absolute returns using largely marketable
securities
A private and unregisterd investment pool that
employs sophisticated hedging and arbitrage
techniques to trade in the corporate equity
markets
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“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 inestors redeem and
go to someone else who has recently been
making money. Every three or four years, they
deliver a one-in-a-hundred-year flood.”
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The first hedge fund was set up by Alfred W. Jones
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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
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Hedge funds did relatively well in 2000 - 2002
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Size has been doubling almost every two years
One measurement of 11,000 active funds in
2008
$2.4 Trillion under management (various
measurements)
Account for 30% of all U.S. fixed-income
trading
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80% for distressed debt and high-yield derivatives
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Do not fall under the Investment Company Act
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No public offerings
Limited number of investors
Do not fall under Securities Act of 1933
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Only “accredited investors consisting of institutional
investors, companies, or high net worth individuals
who can ‘fend for themselves’”
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Not required to disclose their holdings to
investors
Not required to report investment results
May not advertise
Limited partners must have already formed a
relationship with the general partner
Allowed to use leverage
Usually 2:1 to 10:1
 LTCM was 500:1 by one report
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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
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Location
Percent Assets
Cayman Islands
35%
United States
32%
British Virgin Islands
Bermuda
Bahamas
Luxembourg
Asia
8%
8%
4%
3%
4%
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Manager usually has high percentage of
his/her assets invested in fund
Current trend towards more institutions
investsing in hedge funds
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Proportion of institutions to individuals is increasing
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
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Convertbile Arbitrage
Merger Arbitrage
Long/Short
Dedicated Short Strategy
Statistical Arbitrage
Market Neutral Strategy
Event Driven
Fixed Income Abritrage (High Yield or Mortgage
Backed)
Managed Futures
Emerging Markets
Sector Funds
Relative Value Arbitrage
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
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
166
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Very difficult to gauge for certain
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Voluntary disclosure
Survivorship bias
Backfill bias
Must be Risk-Adjusted
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Normal risk adjustments don’t always apply
Often a strong systemic (sector) risk
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January 1995 – April 2006 Study
Pre-fee annualized return of 12.72%
 Fee of 3.74%
 Alpha of 3.04%
 Excess returns shared roughly equally between
hedge fund managers and their investors
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Conve
rtible
Arbitra
ge
Distres
sed
Securit
ies
Emerg
ing
Market
s
Equity
Hedge
Equity
Market
Neutra
l
EventDriven
Fixed
Incom
e
Arbitra
ge
Fixed
Incom
e
Convt
Bonds
Fund
of
Funds
Macro
Merge
r
Arbitra
ge
Market
Ti
Relativ
e
Value
Arbitra
ge
Dec 1993
15.22
32.54
87.10
27.94
11.11
28.22
16.64
23.60
26.32
53.31
20.24
24.18
27.10
Dec 1994
-3.73
3.84
7.65
2.61
2.65
6.00
11.94
-0.62
-3.48
-4.30
8.88
3.49
4.00
Dec 1995
19.85
19.73
9.02
31.04
16.33
25.11
6.08
19.17
11.10
29.32
17.86
12.58
15.66
Dec 1996
14.56
20.77
35.69
21.75
14.20
24.84
11.89
18.24
14.39
9.32
16.61
13.47
14.49
Dec 1997
12.72
15.40
19.85
23.41
13.62
21.23
7.02
17.60
16.20
18.82
16.44
13.57
15.93
Dec 1998
7.77
-4.23
-36.39
15.98
8.30
1.70
-10.29
7.53
-5.11
6.19
7.23
24.82
2.81
Dec 1999
14.41
16.94
40.06
44.22
7.09
24.33
7.38
36.94
26.47
17.62
14.34
26.17
14.73
Dec 2000
14.50
2.78
-9.39
9.09
14.56
6.74
4.78
-11.17
4.07
1.97
18.04
11.79
14.43
Dec 2001
13.37
13.28
11.51
0.31
6.71
12.18
4.81
3.30
2.80
6.87
2.76
4.09
8.92
Dec 2002
9.07
5.28
-0.03
-4.71
0.98
-4.30
8.77
-13.07
1.01
7.42
-0.86
-3.26
5.42
Dec 2003
9.93
29.58
32.41
20.53
2.46
25.33
9.35
17.52
11.62
21.44
14.39
15.38
9.72
Dec 2004
0.97
18.21
16.92
7.66
4.63
14.23
5.15
8.60
6.39
4.72
3.51
3.68
5.03
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Management Fee of 1% - 2% of assets under
management (median is 1.5%)
Incentive Fee of 20% of profits above a
benchmark
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May be T-bill rate
May be zero
No incentive fees in mutual funds
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Mutual Funds must redeem shares on demand
Mutual Funds must calculate NAV daily
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
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Hedge Funds will not necessarily allow
withdrawls on demand
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Usually specific times (quarterly) when investors can
withdraw funds
Often a lock-up period of up to two years
Minimum Investment of $200,000 or more
Limited number of investors and dollars
Diseconomies of scale
 Managers want long-term investors
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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
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“Fat Tails” – High positive returns, but also a
possibility to lose everything like LTCM
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Extremely unlikely in mutual fund
Lack of liquidity
Lack of information for investors
High Leverage
Difficult to evaluate performance
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 %
Style Correlations
Distressed
Distressed Index
Equity
Market
neutral
Emerging
Markets
Even
Multi
Fixed Income
Macro
HF Index
Futures
FoF
1
0.5823
0.363
0.9357
0.7509
0.3117
0.3161
0.5796
-0.1267
0.661
0.5823
1
0.2464
0.6653
0.6665
0.2751
0.419
0.6535
-0.0991
0.7399
0.363
0.2464
1
0.3918
0.3658
0.1133
0.2098
0.3364
0.1231
0.4441
Event Driven Index
0.9357
0.6653
0.3918
1
0.9317
0.3881
0.3824
0.6691
-0.1741
0.7577
Multi-Strategy Index
0.7509
0.6665
0.3658
0.9317
1
0.4289
0.4279
0.6878
-0.1948
0.7616
Fixed Income Arbitrage Index
0.3117
0.2751
0.1133
0.3881
0.4289
1
0.4541
0.4476
-0.0685
0.426
Global Macro Index
0.3161
0.419
0.2098
0.3824
0.4279
0.4541
1
0.8587
0.2445
0.6453
Hedge Fund Index
0.5796
0.6535
0.3364
0.6691
0.6878
0.4476
0.8587
1
0.1264
0.9082
-0.1267
-0.0991
0.1231
-0.1741
-0.1948
-0.0685
0.2445
0.1264
1
0.1171
0.661
0.7399
0.4441
0.7577
0.7616
0.426
0.6453
0.9082
0.1171
1
Emerging Markets Index
Equity Market Neutral Index
Managed Futures Index
Fund of Funds
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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%
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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
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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
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This is called any of the following:
Pure Play
 Alpha Transfer
 Portable Alpha
 Creating a market-neutral portfolio
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The key is to eliminate the market (systematic)
risk
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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 suspect
that the overall market will fall next month
The risk-free rate is 1% per month
E(R) = Rf + β(Rm – Rf) + α + e
You must create a portfolio with a beta of -1.0
which will offset the suspected market drop
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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
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Each of these creates a beta of -1.0.
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You can adjust this beta by borrowing or lending at
Rf
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You now have a total position with a beta of
zero
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)