Investing In Hedge Funds: Risks and Rewards
Contents <ul><li>History, Definition and Overview </li></ul><ul><li>Types of Hedge Funds </li></ul><ul><li>Historical Perf...
History, Definition and Overview <ul><li>First Hedge Fund: Alfred W. Jones </li></ul><ul><li>In 1949 he raised $100,000 (4...
History, Definition and Overview <ul><li>DEFINITION: A HEDGE FUND IS A PRIVATE INVESTMENT PARTNERSHIP </li></ul><ul><li>MA...
History, Definition and Overview <ul><li>FEES: </li></ul><ul><li>MANAGEMENT: 1% TO 2% OF ASSETS </li></ul><ul><li>INCENTIV...
History, Definition and Overview   <ul><li>ARE CURRENTLY 8000 FUNDS.  </li></ul><ul><ul><ul><li>-rivaling mutual funds and...
History, Definition and Overview <ul><li>Over half have <$50mm assets </li></ul><ul><li>80% of Hedge Funds have <$200mm in...
History, Definition and Overview <ul><li>INVESTMENT OBJECTIVES ARE MOST OFTEN ABSOLUTE RETURN AND RISK TARGETS, NOT BENCHM...
TYPES OF HEDGE FUNDS (STRATEGIES) <ul><li>ARE AROUND 20 DIFFERENT STRATEGIES </li></ul><ul><li>SOME OVERLAP AND CAN CHANGE...
TYPES OF HEDGE FUNDS <ul><li>Capital Structure Arbitrage </li></ul><ul><ul><li>Relative value approach, attempts to captur...
TYPES OF HEDGE FUNDS <ul><li>Distressed Securities  </li></ul><ul><ul><li>Buy the equity or debt of companies that are in ...
TYPES OF HEDGE FUNDS <ul><li>Fixed Income Arbitrage  </li></ul><ul><ul><li>Plays the spread between similar fixed income s...
TYPES OF HEDGE FUNDS <ul><li>Market Neutral  </li></ul><ul><ul><li>Any strategy that attempts to eliminate market risk and...
TYPES OF HEDGE FUNDS <ul><li>Regulation D   </li></ul><ul><ul><li>Private investments made in public companies in need of ...
TYPES OF HEDGE FUNDS <ul><li>Special Situations  </li></ul><ul><ul><li>Consists of some type of event driven strategy. Opp...
TYPES OF HEDGE FUNDS <ul><li>AN EXAMPLE IN DETAIL: CONVERTIBLE ARBITRAGE </li></ul><ul><li>A Convertible Bond is a Hybrid:...
TYPES OF HEDGE FUNDS <ul><li>AN EXAMPLE IN DETAIL: CONVERTIBLE ARBITRAGE </li></ul><ul><li>Being bonds, convertibles are s...
TYPES OF HEDGE FUNDS <ul><li>Another Example: Market Neutral Equity </li></ul><ul><li>Goal: Long attractive stocks, Short ...
TYPES OF HEDGE FUNDS <ul><li>Market Neutral Equity </li></ul><ul><li>In order to create a beta neutral portfolio an ex-ant...
TYPES OF HEDGE FUNDS <ul><li>FINAL EXAMPLE: MERGER ARBITRAGE </li></ul><ul><li>COMPANY ‘B’ WILL BE, OR MAY BE, TAKEN OVER ...
TYPES OF HEDGE FUNDS <ul><li>SUPPOSE B WILL BE TAKEN OVER BY A FOR 40$ PER SHARE. CURRENT PRICE IS 25$ PER SHARE </li></ul...
HISTORICAL PERFORMANCE 9.15  1.98 -0.97 0.5    HFRX Relative Value Arbitrage Index 4.26 2.8 3.72 0.89    HFRX Merger Arbit...
CS/TREMONT INDEXES 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...
0.28 12.03% 6.55% 8.44% 2.71%    Managed Futures 0.88 10.30% 12.19% 15.23% 4.18%    Long/Short Equity 0.95 11.11% 13.74% 1...
 
DRAWDOWN GRAPH
Benefits of Investing in Hedge  Funds <ul><li>Hedge Funds are an alternative to traditional investment strategies designed...
Benefits of Investing in Hedge  Funds <ul><ul><li>Diversification & Reduced volatility </li></ul></ul><ul><ul><li>-shifts ...
Risk Measurement and  Management <ul><li>Qualitative Risk Issues: </li></ul><ul><li>Illiquidity </li></ul><ul><li>  -Long ...
Risk Measurement and  Management <ul><li>Relatively high fees </li></ul><ul><li>  -Typically 1% annual management fee </li...
Risk Measurement and  Management <ul><li>FAMOUS EXAMPLE: LONG TERM CAPITAL </li></ul><ul><li>FOUNDED IN 1994 </li></ul><ul...
Risk Measurement and  Management <ul><li>IN JUNE 1998 MORTGAGE BACKS TURNED NEGATIVE AND LTCM LOST 16% </li></ul><ul><li>T...
Risk Measurement and  Management <ul><li>LESSONS? </li></ul><ul><li>EVEN GENIUS FAILS  </li></ul><ul><li>RISK MANAGEMENT W...
Risk Measurement and  Management <ul><li>Statistical Properties of Hedge Fund Returns: </li></ul><ul><li>Low correlations ...
II. The Statistical Properties  of Hedge Fund Returns <ul><li>A Normal distribution is characterized only by its first two...
II. The Statistical Properties  of Hedge Fund Returns <ul><li>Hedge funds returns are not Normally distributed and possess...
II. The Statistical Properties  of Hedge Fund Returns <ul><li>Hedge funds returns also have non-zero  Kurtosis , i.e. thei...
ACTUAL MONTHLY RETURN SERIES
III. Traditional and Alternative  Risk/Return Measures <ul><li>Sharpe Ratio (Ann Ret-Rf) / Stdev(Ret) </li></ul><ul><li>Ma...
<ul><li>The traditional ranking scheme for portfolios is the  Sharpe ratio </li></ul><ul><li>The Sharpe ratio is motivated...
<ul><li>The Sharpe ratio is the slope of the tangent in Markowitz </li></ul>III. Traditional and Alternative  Risk/Return ...
III. Traditional and Alternative  Risk/Return Measures <ul><li>Downside risk can go undetected if conventional measures (T...
<ul><li>A different ranking scheme is due to  Sortino </li></ul><ul><li>Sortino measures the probability &quot;width&quot;...
<ul><li>Another ranking scheme is called  Omega </li></ul><ul><li>F(x) is the cumulative distribution function </li></ul><...
III. Traditional and Alternative  Risk/Return Measures Kazemi, Schneeweiss and Gupta have shown that Omega equals the rati...
<ul><li>A generalized ranking scheme called  Kappa  has been proposed by Kaplan and Knowles </li></ul><ul><li>For n=1 Kapp...
<ul><li>Stutzer proposed a different ranking scheme </li></ul><ul><li>The  Stutzer index  measures how fast the probabilit...
TWO EXAMPLES 4.470 KURTOSIS -1.749 SKEWNESS 1.638 SHARPE 2.85 OMEGA 0.005 R= 0.290 KURTOSIS 1.191 SKEWNESS 1.690 SHARPE 1....
<ul><li>Di Pierro and Mosevich proved that </li></ul><ul><li>for Normally distributed returns </li></ul><ul><li>Sharpe, So...
IV.   Ranking using various Measures <ul><li>For non-Normal distributions the implied rankings are different </li></ul><ul...
Risk Measurement and  Management <ul><li>Adding hedge funds to traditional portfolio may lower skewness and increase kurto...
FUND OF FUND RISK MANAGEMENT <ul><li>Risk management is cited by many funds of funds as second in importance only to the i...
FUND OF FUND RISK MANAGEMENT <ul><li>Ex-ante factor and style analysis models at both the fund and strategy level  can aid...
V.  Risk Budgeting for Funds of Funds A  risk budget  specifies how each component of an asset management process contribu...
Risk Budgeting for Funds of Funds <ul><li>Note that tracking error does not measure downside risk </li></ul><ul><li>Other ...
V.  Risk Budgeting for Funds of Funds <ul><li>Information Ratio: IR =  (RP – RB) / TE </li></ul><ul><li>Also as fundamenta...
V.  Risk Budgeting for Funds of Funds <ul><li>An information ratio budget can also be created: </li></ul><ul><li>Excess Re...
V.  Risk Budgeting for Funds of Funds <ul><li>The application of risk budgeting to funds of funds: </li></ul><ul><li>Alloc...
V.  Risk Budgeting for Funds of Funds <ul><li>Fund of Funds: An Example </li></ul><ul><li>Portfolio Risk Target: 10.0% </l...
V.  Risk Budgeting for Funds of Funds <ul><li>A risk budget can start with a neutral budget, such as equal contributions t...
V.  Risk Budgeting for Funds of Funds <ul><li>Extensions: </li></ul><ul><li>In the case of no benchmark: create a “Kappa” ...
Strategies for Investment <ul><li>Hedge funds are often thought of as a separate asset class </li></ul><ul><li>They can al...
Strategies for Investment <ul><li>So the question is: should one include hedge funds in a portfolio and if so which strate...
Strategies for Investment <ul><li>One way to answer this is to view hedge funds as sources of portable alphas and to alloc...
Strategies for Investment <ul><li>THE FUTURE OF HEDGE FUNDS: </li></ul><ul><li>RETAIL OFFERINGS WILL BE APPEARING FOR SMAL...
Strategies for Investment <ul><li>Another issue is the choice of hedge funds in which to invest </li></ul><ul><li>This is ...
Due Diligence <ul><li>A very important part of investing in hedge funds is due diligence </li></ul><ul><li>This is also pe...
Due Diligence <ul><li>The due diligence questionnaire is very comprehensive and covers the following: </li></ul><ul><li>Fu...
Due Diligence <ul><li>Fund information: </li></ul><ul><ul><ul><li>Contact Information </li></ul></ul></ul><ul><ul><ul><li>...
Due Diligence <ul><li>Fund Information </li></ul><ul><ul><ul><li>Current Assets </li></ul></ul></ul><ul><ul><ul><li>Capaci...
Due Diligence <ul><li>Background of professionals </li></ul><ul><ul><ul><li>Title and areas of responsibility </li></ul></...
Due Diligence <ul><li>Markets in which invested </li></ul><ul><ul><ul><li>Domestic </li></ul></ul></ul><ul><ul><ul><li>Int...
Due Diligence <ul><li>Instruments utilized </li></ul><ul><ul><ul><li>Listed equities </li></ul></ul></ul><ul><ul><ul><li>D...
Due Diligence <ul><li>Strategies utilized </li></ul><ul><ul><ul><li>Statistical Arbitrage </li></ul></ul></ul><ul><ul><ul>...
Due Diligence <ul><li>Sources of return </li></ul><ul><ul><ul><li>Portfolio concentration/exposure limits </li></ul></ul><...
Due Diligence <ul><li>The “edge” offered by the investment team </li></ul><ul><ul><ul><li>Unique skills </li></ul></ul></u...
Due Diligence <ul><li>Risk Management </li></ul><ul><ul><ul><li>How much leverage is employed/limits </li></ul></ul></ul><...
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Investing in Hedge Funds

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Investing in Hedge Funds

  1. 1. Investing In Hedge Funds: Risks and Rewards
  2. 2. Contents <ul><li>History, Definition and Overview </li></ul><ul><li>Types of Hedge Funds </li></ul><ul><li>Historical Performance </li></ul><ul><li>Benefits of Investing in Hedge Funds </li></ul><ul><li>Risk Measurement and Risk Management </li></ul><ul><li>Strategies for Investment </li></ul>
  3. 3. History, Definition and Overview <ul><li>First Hedge Fund: Alfred W. Jones </li></ul><ul><li>In 1949 he raised $100,000 (40K his own) and added short positions to his stock portfolio to hedge overall market risk. </li></ul><ul><li>He also levered by borrowing and later required a performance fee from his investors </li></ul><ul><li>As of 1984 there were around 20 hedge funds in existence </li></ul>
  4. 4. History, Definition and Overview <ul><li>DEFINITION: A HEDGE FUND IS A PRIVATE INVESTMENT PARTNERSHIP </li></ul><ul><li>MANY ARE NOT HEDGED </li></ul><ul><li>THEY ARE NOT REGULATED BY THE SEC </li></ul><ul><li>INVESTORS MUST BE “QUALIFIED” REGARDING NET WORTH AND INCOME </li></ul><ul><li>ARE NOT ALLOWED TO ADVERTISE </li></ul><ul><li>LONG, SHORT, LEVERAGED AND DERIVATIVES POSITIONS MAY BE TAKEN </li></ul><ul><li>USUALLY A HIGH MINIMUM INVESTMENT </li></ul>
  5. 5. History, Definition and Overview <ul><li>FEES: </li></ul><ul><li>MANAGEMENT: 1% TO 2% OF ASSETS </li></ul><ul><li>INCENTIVE: 10% TO 40% ON RETURNS IN EXCESS OF A HURDLE RATE (T-BILLS) </li></ul><ul><li>HIGH WATERMARK: RETURNS BELOW HIGH WATERMARK MUST BE MADE BACK BEFORE INCENTIVE FEE APPLIES </li></ul><ul><li>THESE INCENTIVES MAY RESULT IN TAKING ON EXCESSIVE RISK </li></ul>
  6. 6. History, Definition and Overview <ul><li>ARE CURRENTLY 8000 FUNDS. </li></ul><ul><ul><ul><li>-rivaling mutual funds and listed US stocks </li></ul></ul></ul><ul><li>$1.3 TRILLION UNDER MANAGEMENT </li></ul><ul><li>BECOMING PART OF TRADITIONAL INVESTMENT PORTFOLIOS </li></ul><ul><li>BENCHMARKS (Indexes) HAVE BEEN CREATED,IN ADDITION TO RETURN AND RISK TARGETS </li></ul><ul><li>INCREASING EMPHASIS ON RISK/RETURN MEASURES AND RISK BUDGETING </li></ul>
  7. 7. History, Definition and Overview <ul><li>Over half have <$50mm assets </li></ul><ul><li>80% of Hedge Funds have <$200mm in assets </li></ul><ul><li>Out of the 8000 hedge funds, 116 account for half of the industries assets </li></ul><ul><li>Half do not survive the first 5 years </li></ul><ul><li>Less then 2% of all hedge funds are 10 years or older </li></ul><ul><li>There is a wide dispersion in returns. </li></ul>
  8. 8. History, Definition and Overview <ul><li>INVESTMENT OBJECTIVES ARE MOST OFTEN ABSOLUTE RETURN AND RISK TARGETS, NOT BENCHMARKS </li></ul><ul><li>ABSOLUTE RETURN IS “PORTABLE ALPHA” </li></ul><ul><li>INDEXES HAVE BEEN CREATED, SOME INVESTIBLE </li></ul><ul><li>THERE CAN BE PROBLEMS WITH SURVIVAL BIAS, BACKFILLING AND CEASATION OF REPORTING </li></ul>
  9. 9. TYPES OF HEDGE FUNDS (STRATEGIES) <ul><li>ARE AROUND 20 DIFFERENT STRATEGIES </li></ul><ul><li>SOME OVERLAP AND CAN CHANGE THROUGH TIME </li></ul><ul><li>SOME ARE NOT EASILY DEFINED </li></ul><ul><li>WE WILL COVER THE MOST POPULAR STRATEGIES </li></ul>
  10. 10. TYPES OF HEDGE FUNDS <ul><li>Capital Structure Arbitrage </li></ul><ul><ul><li>Relative value approach, attempts to capture pricing inefficiencies among various tranches of debt or equity of the same or related companies. </li></ul></ul><ul><li>Convertible Arbitrage </li></ul><ul><ul><li>Purchase different securities of the same issuer such as the common stock and convertible bonds, one position being long, the other short. </li></ul></ul><ul><li>CTA’s / Managed Futures </li></ul><ul><ul><li>Commodity Trading Advisors. Trade commodity futures, options and foreign exchange; often highly leveraged; </li></ul></ul><ul><ul><li> trend following . </li></ul></ul>
  11. 11. TYPES OF HEDGE FUNDS <ul><li>Distressed Securities </li></ul><ul><ul><li>Buy the equity or debt of companies that are in or facing bankruptcy, hoping that company will come out of bankruptcy. </li></ul></ul><ul><li>Emerging Markets </li></ul><ul><ul><li>Invest in the securities of companies from &quot;emerging&quot; or developing countries. </li></ul></ul><ul><li>Event Driven </li></ul><ul><ul><li>Take positions in companies with &quot;special situations&quot;: depressed stock; event offers significant potential market interest such as company merging with or acquired by another company; reorganizations; bad news which temporarily depress stock, which is shorted </li></ul></ul>
  12. 12. TYPES OF HEDGE FUNDS <ul><li>Fixed Income Arbitrage </li></ul><ul><ul><li>Plays the spread between similar fixed income securities. Often highly leveraged </li></ul></ul><ul><li>Fund of funds </li></ul><ul><ul><li>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. </li></ul></ul><ul><li>Long/Short Equity </li></ul><ul><ul><li>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 </li></ul></ul><ul><li>Global Macro </li></ul><ul><ul><li>Investment is based on shifts in global economies. Derivatives are often used to speculate on currency and interest rate moves </li></ul></ul>
  13. 13. TYPES OF HEDGE FUNDS <ul><li>Market Neutral </li></ul><ul><ul><li>Any strategy that attempts to eliminate market risk and be profitable in any market condition; equity or fixed income. </li></ul></ul><ul><ul><li>Example: beta=0 for “double alpha” </li></ul></ul><ul><li>Market Timing </li></ul><ul><ul><li>Attempts to time the market by allocating assets among different investments such as between mutual funds and money markets. </li></ul></ul><ul><li>Multi-Strategy </li></ul><ul><ul><li>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 </li></ul></ul>
  14. 14. TYPES OF HEDGE FUNDS <ul><li>Regulation D </li></ul><ul><ul><li>Private investments made in public companies in need of financing. </li></ul></ul><ul><li>Merger Arbitrage </li></ul><ul><ul><li>Also known as “Risk Arbitrage&quot;. 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. </li></ul></ul><ul><li>Short Bias </li></ul><ul><ul><li>Any manager who consistently has a &quot;net short&quot; exposure to the market. Includes short only funds. </li></ul></ul>
  15. 15. TYPES OF HEDGE FUNDS <ul><li>Special Situations </li></ul><ul><ul><li>Consists of some type of event driven strategy. Opportunistically trade in any type of security that deemed to be a &quot;special situation.&quot; </li></ul></ul><ul><li>Statistical Arbitrage </li></ul><ul><ul><li>Invest in equities believed to behave in a way that is mathematically describable. </li></ul></ul><ul><li>VC / Private Equity </li></ul><ul><ul><li>Invest in venture capital or private equity </li></ul></ul><ul><li>Sector Funds </li></ul>
  16. 16. TYPES OF HEDGE FUNDS <ul><li>AN EXAMPLE IN DETAIL: CONVERTIBLE ARBITRAGE </li></ul><ul><li>A Convertible Bond is a Hybrid: It pays a coupon and PAR at Maturity </li></ul><ul><li>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) </li></ul><ul><li>Convertible arbitrage: Purchase the bond and hedge by shorting the shares </li></ul><ul><li>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) </li></ul>
  17. 17. TYPES OF HEDGE FUNDS <ul><li>AN EXAMPLE IN DETAIL: CONVERTIBLE ARBITRAGE </li></ul><ul><li>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 </li></ul><ul><li>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. </li></ul><ul><li>Interest rate and equity volatility can effect the value of the call option and thus the bond </li></ul><ul><li>Finally, there is credit risk (default, spread risks) </li></ul><ul><li>In summary managing these risks and earning a good return require in-depth expertise. </li></ul>
  18. 18. TYPES OF HEDGE FUNDS <ul><li>Another Example: Market Neutral Equity </li></ul><ul><li>Goal: Long attractive stocks, Short stocks expected to under-perform </li></ul><ul><li>Create a portfolio with a beta of zero </li></ul><ul><li>The attractive stocks hopefully result in a long position with positive alpha </li></ul><ul><li>The un-attractive stocks have negative alphas so shorting them results in another position with positive alpha </li></ul><ul><li>Hence the name “double alpha” </li></ul>
  19. 19. TYPES OF HEDGE FUNDS <ul><li>Market Neutral Equity </li></ul><ul><li>In order to create a beta neutral portfolio an ex-ante risk model such as BARRA or Northfield is required </li></ul><ul><li>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.) </li></ul><ul><li>This cannot be accomplished in one’s head: weight alone does not measure risk </li></ul>
  20. 20. TYPES OF HEDGE FUNDS <ul><li>FINAL EXAMPLE: MERGER ARBITRAGE </li></ul><ul><li>COMPANY ‘B’ WILL BE, OR MAY BE, TAKEN OVER BY COMPANY ‘A’ </li></ul><ul><li>WHEN THE MERGER IS ANNOUNCED B’s SHARE PRICE RISES AND A’s DROPS </li></ul><ul><li>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 </li></ul><ul><li>THIS IS ALSO CALLED RISK ARBITRAGE </li></ul>
  21. 21. TYPES OF HEDGE FUNDS <ul><li>SUPPOSE B WILL BE TAKEN OVER BY A FOR 40$ PER SHARE. CURRENT PRICE IS 25$ PER SHARE </li></ul><ul><li>ON THE DAY OF ANNOUNCEMENT B’s PRICE GAPS TO 39.25$ </li></ul><ul><li>THE HEDGE FUND POTENTIAL PROFIT IS 75 CENTS PER SHARE(THEY COULD PREDICT AND PURCHASE AT 23$, MAYBE) </li></ul><ul><li>THE RETURN IS THUS 1.9% </li></ul><ul><li>IF THE DEAL FAILS THE SHARE PRICE WILL FALL BACK TO 25$ FOR A LOSS TO THE HEDGE FUND OF 14.25$, MANY TIMES THE POSSIBLE PROFIT </li></ul><ul><li>THERE ARE FAMOUS EXAMPLES OF DEALS FALLING THROUGH: GE TAKEOVER OF HONEYWELL, BRITISH TELECOME TAKEOVER OF MCI </li></ul><ul><li>THESE COST HEDGE FUNDS HUGELY </li></ul>
  22. 22. HISTORICAL PERFORMANCE 9.15 1.98 -0.97 0.5   HFRX Relative Value Arbitrage Index 4.26 2.8 3.72 0.89   HFRX Merger Arbitrage Index 14.61 -0.32 6.67 0.22   HFRX Macro Index 18.74 6.93 2.81 -0.54   HFRX Event Driven Index -2.38 0.33 0.21 0.15   HFRX Equity Market Neutral Index 14.47 2.19 4.19 0.35   HFRX Equity Hedge Index 20.9 8.95 1.21 -0.68   HFRX Distressed Securities Index 8.85 -0.14 -5.69 0.57   HFRX Convertible Arbitrage Index 26.00 9.00 3.00 0.00 S&P 500 11.95 3.2 -0.02 -0.11 HFRX Absolute Return Index 13.39 2.69 2.72 0.17 HFRX Global Hedge Fund Index TOTAL TOTAL TOTAL ROR HFRX Index 2003 2004 2005 Feb   Hedge Fund Research with permission HFRX GLOBAL AND STRATEGY INDICES
  23. 23. CS/TREMONT INDEXES 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 Index S&P 500 Hedge Fund Index Net Performance
  24. 24. 0.28 12.03% 6.55% 8.44% 2.71%    Managed Futures 0.88 10.30% 12.19% 15.23% 4.18%    Long/Short Equity 0.95 11.11% 13.74% 12.15% 3.37%    Global Macro 0.85 3.75% 6.36% 1.97% 1.42%    Fixed Income Arbitrage 1.1 4.21% 7.80% 4.85% 1.63%       Risk Arbitrage 1.21 6.12% 10.57% 10.85% 3.32%       Multi-Strategy 1.61 6.45% 13.57% 13.93% 2.52%       Distressed 1.48 5.70% 11.63% 11.91% 2.92%    Event Driven 2.31 2.94% 9.97% 7.24% 1.40%    Equity Market Neutral 0.34 16.44% 8.81% 22.77% 5.76%    Emerging Markets -0.31 17.29% -2.26% 6.13% -2.98%    Dedicated Short Bias 1.18 4.78% 8.80% 0.94% 2.75%    Convertible Arbitrage 0.98 7.88% 10.91% 11.45% 3.23% CS/TREMONT Index Sharpe Std Dev Avg Ann 1 Year YTD Index / Sub Strategies CS/TREMONT
  25. 26. DRAWDOWN GRAPH
  26. 27. Benefits of Investing in Hedge Funds <ul><li>Hedge Funds are an alternative to traditional investment strategies designed to offer investors the potential for : </li></ul><ul><ul><li>Sophisticated, less restricted portfolio management </li></ul></ul><ul><ul><li>-Absolute return driven </li></ul></ul><ul><ul><li>-few restrictions on security types, constraints </li></ul></ul><ul><ul><li>-novel investment approaches </li></ul></ul><ul><ul><li>-hedged positions in many cases </li></ul></ul><ul><ul><li>Attractive risk adjusted returns </li></ul></ul><ul><ul><li>Often positive returns in negative markets </li></ul></ul>
  27. 28. Benefits of Investing in Hedge Funds <ul><ul><li>Diversification & Reduced volatility </li></ul></ul><ul><ul><li>-shifts portfolio to the NW quadrant. </li></ul></ul><ul><ul><li>-lower standard deviation </li></ul></ul><ul><ul><li>Reduced correlation to traditional investment vehicles </li></ul></ul><ul><ul><li>-i.e. HFR index has a .49 correlation to the S&P 500 </li></ul></ul>
  28. 29. Risk Measurement and Management <ul><li>Qualitative Risk Issues: </li></ul><ul><li>Illiquidity </li></ul><ul><li> -Long lock-up periods that range from 6 months to 10 years </li></ul><ul><li> -60 to 90 day notice required to withdraw money after the lock-up </li></ul><ul><li>Lack of Transparency </li></ul><ul><li> -Not required to provide prospectuses. </li></ul><ul><li>-Manager is not required to divulge all holdings or trades. </li></ul><ul><li>May employ leverage </li></ul><ul><li> -Leverage can magnify losses as well as profits </li></ul>
  29. 30. Risk Measurement and Management <ul><li>Relatively high fees </li></ul><ul><li> -Typically 1% annual management fee </li></ul><ul><li> -Manager is entitled to 10% to 20% of profits above a high watermark. </li></ul><ul><li> -Avg. mutual fund fee is 80bps to 2.50% </li></ul><ul><li>Tax Inefficiencies </li></ul><ul><li> - Most are limited partnerships with K-1s </li></ul><ul><li>Rapid Growth </li></ul><ul><li> - Has made it difficult for investors to carefully identify, select, and monitor single manager hedge fund </li></ul>
  30. 31. Risk Measurement and Management <ul><li>FAMOUS EXAMPLE: LONG TERM CAPITAL </li></ul><ul><li>FOUNDED IN 1994 </li></ul><ul><li>CORE STRATEGY:RELATIVE VALUE ARBITRAGE (PLAYING SPREADS) </li></ul><ul><li>SMALL PROFITS SO LEVERAGE WAS USED (25 TO 1 AT FIRST) </li></ul><ul><li>1997: CAPITAL GREW TO $7 BILLION </li></ul><ul><li>BALANCE SHEET $125 BILLION </li></ul><ul><li>OFF-BALANCE SHEET POSITIONS HAD NOTIONAL AMOUNT OF $1.25 TRILLION </li></ul><ul><li>1995,1996 NET RETURNS WERE 40% </li></ul><ul><li>1997 CONVERGENCE TRADES HAD LESS “JUICE” SO RETURN WAS 17% </li></ul><ul><li>TO MAINTAIN LEVERAGE $2.7 BILLON RETURNED TO INVESTORS </li></ul><ul><li>ASSETS KEPT AT $130 BILLION, LEVERAGE WAS 28 TO 1 </li></ul>
  31. 32. Risk Measurement and Management <ul><li>IN JUNE 1998 MORTGAGE BACKS TURNED NEGATIVE AND LTCM LOST 16% </li></ul><ul><li>THEN AUGUST 17 RUSSIA DEFAULTED ON DEBT </li></ul><ul><li>CREDIT AND LIQUIDITY SPREADS ACROSS ALL MARKETS WIDENED </li></ul><ul><li>TCM LOST $550 MILLION ON AUGUST 21 </li></ul><ul><li>BY THE END OF AUGUST THEY WERE DOWN 52% </li></ul><ul><li>ASSETS WERE KEPT AT $126 BILLION FOR LEVERAGE OF 55 TO 1 </li></ul><ul><li>ON SEPT 21 LOST ANOTHER $550 MILLION </li></ul><ul><li>EVENTUALLY BY END OF SEPTEMBER THE LOSS TO INVESTORS WAS 92% </li></ul><ul><li>THE MAIN LOSSES CAME FROM INTEREST RATE SWAPS AND EQUITY DERIVATIVES </li></ul><ul><li>THE NEW YORK FED HAD TO ORGANIZE A BAILOUT TO PROTECT THE FINANCIAL MARKETS </li></ul>
  32. 33. Risk Measurement and Management <ul><li>LESSONS? </li></ul><ul><li>EVEN GENIUS FAILS </li></ul><ul><li>RISK MANAGEMENT WAS UTILIZED BUT NO SYSTEM IS PERFECT </li></ul><ul><li>HUMANS, NOT MARKETS, ARE THE MAIN SOUCES OF RISK </li></ul>
  33. 34. Risk Measurement and Management <ul><li>Statistical Properties of Hedge Fund Returns: </li></ul><ul><li>Low correlations to broad markets </li></ul><ul><li>Lower volatility then equities </li></ul><ul><li>Diverse security types, investment approaches and hedging strategies </li></ul><ul><li>Not (log) Normally distributed </li></ul><ul><li>Often suffer from significant Skewness and Kurtosis. </li></ul><ul><li>Standard deviation may be an inadequate measure of risk </li></ul>
  34. 35. II. The Statistical Properties of Hedge Fund Returns <ul><li>A Normal distribution is characterized only by its first two moments: </li></ul><ul><li>mean (  ) and variance (  2 ) </li></ul>
  35. 36. II. The Statistical Properties of Hedge Fund Returns <ul><li>Hedge funds returns are not Normally distributed and possess non-zero Skewness , i.e. the distribution is asymmetric </li></ul>
  36. 37. II. The Statistical Properties of Hedge Fund Returns <ul><li>Hedge funds returns also have non-zero Kurtosis , i.e. their distribution is more peaked than Gaussian </li></ul>
  37. 38. ACTUAL MONTHLY RETURN SERIES
  38. 39. III. Traditional and Alternative Risk/Return Measures <ul><li>Sharpe Ratio (Ann Ret-Rf) / Stdev(Ret) </li></ul><ul><li>Maximum Drawdown </li></ul><ul><li>Calmar Ratio (Ann Ret-Rf)/Max Draw-Down) </li></ul><ul><li>Sterling Ratio (Ann Ret-Rf)/(Max DD-10%)) </li></ul><ul><li>Sortino Ratio (Ann Ret-Rf)/(Downside Dev) </li></ul><ul><li>Value at Risk, Conditional VaR </li></ul><ul><li>Treynor Ratio (Ann Ret-Rf)/beta) </li></ul><ul><li>Stutzer Ratio </li></ul><ul><li>Omega and Sharpe Omega </li></ul><ul><li>Kappa </li></ul>
  39. 40. <ul><li>The traditional ranking scheme for portfolios is the Sharpe ratio </li></ul><ul><li>The Sharpe ratio is motivated by Modern Portfolio Theory, it assumes: </li></ul><ul><li>Return of portfolios is Normal </li></ul><ul><li>Investor is free to distribute funds over the portfolio and a risk free asset </li></ul>III. Traditional and Alternative Risk/Return Measures Risk Free Rate
  40. 41. <ul><li>The Sharpe ratio is the slope of the tangent in Markowitz </li></ul>III. Traditional and Alternative Risk/Return Measures
  41. 42. III. Traditional and Alternative Risk/Return Measures <ul><li>Downside risk can go undetected if conventional measures (TE, Sharpe, or Std Dev) are used </li></ul><ul><li>This applies to traditional investments too </li></ul><ul><li>Over long investment periods maximizing Sharpe may reduce returns </li></ul>
  42. 43. <ul><li>A different ranking scheme is due to Sortino </li></ul><ul><li>Sortino measures the probability &quot;width&quot; of returns below the benchmark “r” </li></ul><ul><li>r=minimum acceptable return </li></ul>III. Traditional and Alternative Risk/Return Measures
  43. 44. <ul><li>Another ranking scheme is called Omega </li></ul><ul><li>F(x) is the cumulative distribution function </li></ul><ul><li>Omega measures the entire distribution and does not assume a type of distribution </li></ul><ul><li>r is the minimum acceptable return. </li></ul>III. Traditional and Alternative Risk/Return Measures
  44. 45. 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:
  45. 46. <ul><li>A generalized ranking scheme called Kappa has been proposed by Kaplan and Knowles </li></ul><ul><li>For n=1 Kappa is Omega-1 </li></ul><ul><li>For n=2 Kappa is Sortino </li></ul>III. Traditional and Alternative Risk/Return Measures
  46. 47. <ul><li>Stutzer proposed a different ranking scheme </li></ul><ul><li>The Stutzer index measures how fast the probability of a return below the benchmark r goes to zero. </li></ul>III. Traditional and Alternative Risk/Return Measures
  47. 48. TWO EXAMPLES 4.470 KURTOSIS -1.749 SKEWNESS 1.638 SHARPE 2.85 OMEGA 0.005 R= 0.290 KURTOSIS 1.191 SKEWNESS 1.690 SHARPE 1.36 OMEGA
  48. 49. <ul><li>Di Pierro and Mosevich proved that </li></ul><ul><li>for Normally distributed returns </li></ul><ul><li>Sharpe, Sortino, Kappa, Omega and Stutzer </li></ul><ul><li>imply the same ranking and therefore they are all </li></ul><ul><li>Equivalent, meaning that they result in the same rankings. </li></ul>III. Traditional and Alternative Risk/Return Measures
  49. 50. IV. Ranking using various Measures <ul><li>For non-Normal distributions the implied rankings are different </li></ul><ul><li>Which is better? </li></ul><ul><li>No explicit answer but by examining stability for various schemes and thresholds we have an idea of the confidence of the rankings </li></ul><ul><li>If returns exhibit long term auto-correlation rankings may be suspect </li></ul>
  50. 51. Risk Measurement and Management <ul><li>Adding hedge funds to traditional portfolio may lower skewness and increase kurtosis </li></ul><ul><li>State dependent correlation; correlations change </li></ul><ul><li>Risk is persistent (high Hurst exponent) </li></ul><ul><li>Risk may be understated because of reporting practices, stale prices or auto-correlation </li></ul>
  51. 52. FUND OF FUND RISK MANAGEMENT <ul><li>Risk management is cited by many funds of funds as second in importance only to the integrity and abilities of fund managers </li></ul><ul><li>Despite this, reported use of quantitative techniques for monitoring risk exposure to factors such as liquidity, volatility, leverage, credit, traditional markets and extreme events is not very widespread. </li></ul><ul><li>Techniques from traditional investments such as linear multi-factor models are not applicable to most strategies due to the non-linear exposures of hedge funds to these risk factors (the option-like nature of returns). </li></ul>
  52. 53. FUND OF FUND RISK MANAGEMENT <ul><li>Ex-ante factor and style analysis models at both the fund and strategy level can aid in estimating contributions to risk </li></ul><ul><li>Properly computed correlations of individual managers to each other, to strategies and between strategies is critical in assessing exposures and diversification </li></ul><ul><li>Peer group and hedge fund index correlation, tracking error and information ratio analysis, will in all likely-hood be more and more demanded by institutional clients. </li></ul><ul><li>Risk budgeting is a good framework for construction of the fund of funds portfolio </li></ul>
  53. 54. V. Risk Budgeting for Funds of Funds A risk budget specifies how each component of an asset management process contributes to the risk or tracking error of a portfolio. Example: A global equity portfolio . 6% tracking error target will typically have a risk budget as follows 4% security selection 4% sector / industry allocation 2% currency allocation Note that assuming no correlation among components we have:
  54. 55. Risk Budgeting for Funds of Funds <ul><li>Note that tracking error does not measure downside risk </li></ul><ul><li>Other risk budget approaches for pension funds include contributions to risk from individual external managers, liabilities etc. </li></ul>
  55. 56. V. Risk Budgeting for Funds of Funds <ul><li>Information Ratio: IR = (RP – RB) / TE </li></ul><ul><li>Also as fundamental law of active management : </li></ul><ul><li>IR = TC * IC * √B </li></ul><ul><li>IC , the Information Coefficient is the correlation between actual security returns and the manager’s prediction of returns. </li></ul><ul><li>TC , the Transfer Coefficient is the reduction in possible returns due to constraints. TC is often larger for hedge funds than for long only. </li></ul><ul><li>B , the Breadth, is the number of independent bets taken on forecasts of excess return. </li></ul>
  56. 57. V. Risk Budgeting for Funds of Funds <ul><li>An information ratio budget can also be created: </li></ul><ul><li>Excess Return Target: 4.2% </li></ul><ul><li>Tracking Error Target: 6.0% </li></ul><ul><li>Information Ratio Target: 0.7 </li></ul><ul><li>Information Ratio Budget: </li></ul><ul><li>Security Selection 0.50 </li></ul><ul><li>Sector Selection 0.35 </li></ul><ul><li>Currency Management 0.35 </li></ul>
  57. 58. V. Risk Budgeting for Funds of Funds <ul><li>The application of risk budgeting to funds of funds: </li></ul><ul><li>Allocate risk across strategies or </li></ul><ul><li>Allocate risk across managers (specific funds) </li></ul><ul><li>The use of index comparisons will undoubtedly be required by consultants and institutional clients which will lead to risk budgeting of tracking error and information ratios </li></ul><ul><li>The non Gaussian nature of hedge funds will require the use of more advanced techniques </li></ul>
  58. 59. V. Risk Budgeting for Funds of Funds <ul><li>Fund of Funds: An Example </li></ul><ul><li>Portfolio Risk Target: 10.0% </li></ul><ul><li>Strategies : Risks </li></ul><ul><li>Distressed: 4.8% </li></ul><ul><li>Merger Arbitrage: 3.3% </li></ul><ul><li>Convertible Arbitrage 3.5% </li></ul><ul><li>Equity Long / Short 7.5% </li></ul>
  59. 60. V. Risk Budgeting for Funds of Funds <ul><li>A risk budget can start with a neutral budget, such as equal contributions to risk from each strategy or manager. </li></ul><ul><li>The components of the budget can then be changed on a regular basis to reflect views. </li></ul><ul><li>It is important to realize that exposures based on weights alone are not adequate. </li></ul><ul><li>Can assume zero covariance among strategies / funds or specifically utilize covariance in a weighted portfolio </li></ul>
  60. 61. V. Risk Budgeting for Funds of Funds <ul><li>Extensions: </li></ul><ul><li>In the case of no benchmark: create a “Kappa” budget such that management components contribute to a Kappa target. </li></ul><ul><li>In the case of a benchmark: compute the Kappa of the active portfolio (portfolio-benchmark) and use this as the target. </li></ul>
  61. 62. Strategies for Investment <ul><li>Hedge funds are often thought of as a separate asset class </li></ul><ul><li>They can also be thought of as a group of different strategies </li></ul><ul><li>For asset allocation we might be better off thinking of traditional asset classes as sources of beta and hedge funds as sources of alpha </li></ul>
  62. 63. Strategies for Investment <ul><li>So the question is: should one include hedge funds in a portfolio and if so which strategies and what quantities? </li></ul><ul><li>First note 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 </li></ul>
  63. 64. Strategies for Investment <ul><li>One way to answer this is to view hedge funds as sources of portable alphas and to allocate according to the desired alpha given ones policy, which needs to explicitly state a range of allocation to hedge funds </li></ul><ul><li>The expected alpha and risk will be a function of the leverage employed in the funds </li></ul>
  64. 65. Strategies for Investment <ul><li>THE FUTURE OF HEDGE FUNDS: </li></ul><ul><li>RETAIL OFFERINGS WILL BE APPEARING FOR SMALLER INVESTORS </li></ul><ul><li>IS A MATURING MARKET </li></ul><ul><li>MORE TRANSPARENCY WILL BE OFFERED </li></ul><ul><li>MUTUAL FUNDS ARE ADOPTING SOME HEDGE FUND STRATEGIES </li></ul><ul><li>REGISTRATION AND REGULATION IS COMING </li></ul>
  65. 66. Strategies for Investment <ul><li>Another issue is the choice of hedge funds in which to invest </li></ul><ul><li>This is actually not easy since so many strategies are very specialized and there are so many funds </li></ul><ul><li>Due diligence questionnaires need to be filled out and meetings held with prospective manages before an investment is made </li></ul><ul><li>Funds of funds are perhaps the best way to quickly invest </li></ul><ul><li>For small investments ($50,000) studying the offering documents and prospectus may be adequate </li></ul>
  66. 67. Due Diligence <ul><li>A very important part of investing in hedge funds is due diligence </li></ul><ul><li>This is also performed for traditional investments but requires more expertise in the case of hedge funds </li></ul><ul><li>Two broad areas requiring investigation are the investment process and accounting/operations </li></ul><ul><li>Normally a due diligence questionnaire is filled out by the hedge fund manager and one or more site visits are made </li></ul>
  67. 68. Due Diligence <ul><li>The due diligence questionnaire is very comprehensive and covers the following: </li></ul><ul><li>Fund information </li></ul><ul><li>Background of professionals </li></ul><ul><li>Markets in which invested </li></ul><ul><li>Instruments utilized </li></ul><ul><li>Strategies utilized </li></ul><ul><li>Sources of return </li></ul><ul><li>The “edge” offered by the investment team </li></ul><ul><li>Risk Management </li></ul>
  68. 69. Due Diligence <ul><li>Fund information: </li></ul><ul><ul><ul><li>Contact Information </li></ul></ul></ul><ul><ul><ul><li>Attorney/Legal Advisor </li></ul></ul></ul><ul><ul><ul><li>Prime Broker/Custodian </li></ul></ul></ul><ul><ul><ul><li>Auditor/Accounting </li></ul></ul></ul><ul><ul><ul><li>Compliance function </li></ul></ul></ul><ul><ul><ul><li>Minimum Investment </li></ul></ul></ul><ul><ul><ul><li>Fees </li></ul></ul></ul><ul><ul><ul><li>Management </li></ul></ul></ul><ul><ul><ul><li>Incentive </li></ul></ul></ul><ul><ul><ul><li>Hurdle </li></ul></ul></ul><ul><ul><ul><li>High Water Mark </li></ul></ul></ul><ul><ul><ul><li>Liquidity </li></ul></ul></ul>
  69. 70. Due Diligence <ul><li>Fund Information </li></ul><ul><ul><ul><li>Current Assets </li></ul></ul></ul><ul><ul><ul><li>Capacity </li></ul></ul></ul><ul><ul><ul><li>History of liquidations </li></ul></ul></ul><ul><ul><ul><li>Performance </li></ul></ul></ul><ul><ul><ul><li>Drawdown History </li></ul></ul></ul><ul><ul><ul><li>Historical Track Record </li></ul></ul></ul><ul><ul><ul><li>Investments of partners </li></ul></ul></ul>
  70. 71. Due Diligence <ul><li>Background of professionals </li></ul><ul><ul><ul><li>Title and areas of responsibility </li></ul></ul></ul><ul><ul><ul><li>Years at fund </li></ul></ul></ul><ul><ul><ul><li>Years experience in the field </li></ul></ul></ul><ul><ul><ul><li>Previous positions </li></ul></ul></ul><ul><ul><ul><li>References </li></ul></ul></ul>
  71. 72. Due Diligence <ul><li>Markets in which invested </li></ul><ul><ul><ul><li>Domestic </li></ul></ul></ul><ul><ul><ul><li>International </li></ul></ul></ul><ul><ul><ul><li>Fixed Income </li></ul></ul></ul><ul><ul><ul><li>Equity </li></ul></ul></ul><ul><ul><ul><li>Commodities </li></ul></ul></ul>
  72. 73. Due Diligence <ul><li>Instruments utilized </li></ul><ul><ul><ul><li>Listed equities </li></ul></ul></ul><ul><ul><ul><li>Derivative Securities </li></ul></ul></ul><ul><ul><ul><li>Swaps/CDS’s </li></ul></ul></ul>
  73. 74. Due Diligence <ul><li>Strategies utilized </li></ul><ul><ul><ul><li>Statistical Arbitrage </li></ul></ul></ul><ul><ul><ul><li>Quantitative </li></ul></ul></ul><ul><ul><ul><li>Investment Professional (s) </li></ul></ul></ul><ul><ul><ul><li>Portfolio construction: </li></ul></ul></ul><ul><ul><ul><li>Optimizer </li></ul></ul></ul><ul><ul><ul><li>Heuristic </li></ul></ul></ul><ul><ul><ul><li>Hedging </li></ul></ul></ul><ul><ul><ul><li>Exposure (beta, duration) </li></ul></ul></ul>
  74. 75. Due Diligence <ul><li>Sources of return </li></ul><ul><ul><ul><li>Portfolio concentration/exposure limits </li></ul></ul></ul><ul><ul><ul><li>Security Selection </li></ul></ul></ul><ul><ul><ul><li>Asset allocation </li></ul></ul></ul><ul><ul><ul><li>Currency exposure </li></ul></ul></ul><ul><ul><ul><li>Long/Short biases </li></ul></ul></ul><ul><ul><ul><li>Average turnover </li></ul></ul></ul><ul><ul><ul><li>Market conditions where the fund performs best/worst </li></ul></ul></ul>
  75. 76. Due Diligence <ul><li>The “edge” offered by the investment team </li></ul><ul><ul><ul><li>Unique skills </li></ul></ul></ul><ul><ul><ul><li>Unique strategies </li></ul></ul></ul><ul><ul><ul><li>What separates the fund from peers </li></ul></ul></ul>
  76. 77. Due Diligence <ul><li>Risk Management </li></ul><ul><ul><ul><li>How much leverage is employed/limits </li></ul></ul></ul><ul><ul><ul><li>How is hedging employed/what is hedged </li></ul></ul></ul><ul><ul><ul><li>Is there diversification </li></ul></ul></ul><ul><ul><ul><li>How are risks calculated (e.g. contribution to risk) </li></ul></ul></ul><ul><ul><ul><li>Is a risk model employed </li></ul></ul></ul><ul><ul><ul><li>How is operational risk managed </li></ul></ul></ul><ul><ul><ul><li>Is there a risk manager </li></ul></ul></ul>
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