My life in a hedge fund - Université de Fribourg - Universität ...

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My life in a hedge fund - Université de Fribourg - Universität ...

  1. 1. My Life in a Hedge Fund Marc Potters Capital Fund Management
  2. 2. What is a Hedge Fund? <ul><li>Traditional Asset Management </li></ul><ul><ul><li>Long Only </li></ul></ul><ul><ul><li>Equity (Stocks) </li></ul></ul><ul><ul><li>Bonds </li></ul></ul><ul><li>Alternative Investments </li></ul><ul><ul><li>Real Estate </li></ul></ul><ul><ul><li>Private Equity </li></ul></ul><ul><ul><li>Hedge Funds </li></ul></ul><ul><li>Hedge Funds </li></ul><ul><ul><li>At least one of the following: </li></ul></ul><ul><ul><li>Leverage </li></ul></ul><ul><ul><li>Short Positions </li></ul></ul><ul><ul><li>Derivatives </li></ul></ul><ul><ul><li>Profit from Trading </li></ul></ul>
  3. 3. Hedge Fund Industry <ul><li>Number of Hedge Funds </li></ul><ul><ul><li>Total : thousands </li></ul></ul><ul><ul><li>Assets > 1 billion$: ~100 </li></ul></ul><ul><ul><li>Assets > 10 billion$: ~20 </li></ul></ul><ul><li>Total Amount in Hedge Funds </li></ul><ul><ul><li>1 – 1.5 trillion$ (10 12 ) </li></ul></ul><ul><li>Worldwide Stock Market Capitalization </li></ul><ul><ul><li>~40 trillion$ </li></ul></ul><ul><li>Short Lifetime </li></ul><ul><ul><li>Typical lifetime ~ 3y </li></ul></ul><ul><ul><li>Survival bias </li></ul></ul><ul><li>Known Quantitative Funds </li></ul><ul><ul><li>Simmons’ Medallion </li></ul></ul><ul><ul><li>Prediction Company </li></ul></ul><ul><ul><ul><li>Farmer and Packard </li></ul></ul></ul><ul><ul><li>D.E. Shaw </li></ul></ul><ul><ul><li>Citadel </li></ul></ul>
  4. 4. Types of Hedge Funds <ul><li>Long/Short Equity </li></ul><ul><ul><li>Stock Picking + Short </li></ul></ul><ul><li>Event Driven </li></ul><ul><ul><li>Merger </li></ul></ul><ul><ul><li>Distress </li></ul></ul><ul><ul><li>Shareholder Activism </li></ul></ul><ul><li>Convertible Bonds </li></ul><ul><li>Bond/Yield Arbitrage </li></ul><ul><ul><li>e.g. LTCM </li></ul></ul><ul><li>Global Macro </li></ul><ul><li>Others </li></ul><ul><ul><li>Complex Derivatives </li></ul></ul><ul><li>Systematic Quantitative </li></ul><ul><ul><li>Futures Trading (CTA) </li></ul></ul><ul><ul><li>Equity Statistical Arbitrage </li></ul></ul><ul><ul><li>Volatility Arbitrage </li></ul></ul><ul><ul><li>e.g. CFM </li></ul></ul>
  5. 5. Short Selling <ul><li>Buy Shares: Long Position </li></ul><ul><ul><li>Make money if price goes up </li></ul></ul><ul><li>Short Selling: Short Position </li></ul><ul><ul><li>Borrow shares from someone else </li></ul></ul><ul><ul><li>Sell them on market </li></ul></ul><ul><ul><li>Need to buy them back at some future time </li></ul></ul><ul><ul><li>Make money if price goes down </li></ul></ul>
  6. 6. Futures Market <ul><li>Market for Finance Professionals </li></ul><ul><ul><li>Contract size = 50-100k $ </li></ul></ul><ul><li>Many Asset Classes </li></ul><ul><ul><li>Stock Indices </li></ul></ul><ul><ul><li>Government Bonds </li></ul></ul><ul><ul><li>Short Term Interest Rates </li></ul></ul><ul><ul><li>Currencies </li></ul></ul><ul><ul><li>Commodities </li></ul></ul><ul><ul><ul><li>Oil Products </li></ul></ul></ul><ul><ul><ul><li>Grains + Livestock </li></ul></ul></ul><ul><ul><ul><li>Metals </li></ul></ul></ul><ul><li>Symmetric Long/Short </li></ul><ul><li>Small Deposit </li></ul><ul><ul><li>3-5 % of value </li></ul></ul><ul><li>Marked-to-Market Everyday </li></ul><ul><li>Anonymous </li></ul><ul><li>No Counterparty Risk </li></ul><ul><ul><li>Exchange between every transaction </li></ul></ul><ul><li>Electronic Almost Everywhere </li></ul>
  7. 7. Call Option <ul><li>Right to buy an asset at a fixed price X (Strike) at a later time T (Maturity) for a payment upfront C (Premium). </li></ul><ul><li>Premium depends on fluctuations (Volatility) </li></ul><ul><li>Similar to insurance policy </li></ul><ul><li>Black-Scholes Theory </li></ul><ul><ul><li>Option premium and hedge under continuous-time multiplicative Browninan motion </li></ul></ul><ul><ul><li>Unrealistic assumptions </li></ul></ul><ul><ul><li>Used as an effective theory to translate market prices in volatility </li></ul></ul>
  8. 8. Statistical Trading <ul><li>Casino “House” </li></ul><ul><ul><li>Odd/Even 19/37=51.3% </li></ul></ul><ul><ul><li>Many tables, many players, many days </li></ul></ul><ul><li>Hedge Fund </li></ul><ul><ul><li>Diversify in strategies </li></ul></ul><ul><ul><li>Diversify in “space” </li></ul></ul><ul><ul><ul><li>Trade many uncorrelated assets (residuals) </li></ul></ul></ul><ul><ul><ul><li>Avoid global factors </li></ul></ul></ul><ul><ul><ul><ul><li>Market mode </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Global volatility </li></ul></ul></ul></ul><ul><ul><li>Diversify in time </li></ul></ul><ul><ul><ul><li>Short term trading </li></ul></ul></ul><ul><li>Law of Large Numbers </li></ul><ul><ul><li>Average ~ N </li></ul></ul><ul><ul><li>Fluctuations ~ √N </li></ul></ul>
  9. 9. We’ve got computers… <ul><li>Short Term Trading Opportunities </li></ul><ul><ul><li>~100 ms </li></ul></ul><ul><li>Monitor Large Number of Assets Simultaneously </li></ul><ul><ul><li>2000 Stocks </li></ul></ul><ul><ul><li>30000 Options </li></ul></ul><ul><li>Implement Sophisticated Pricing Models </li></ul><ul><li>Patient </li></ul><ul><ul><li>Can wait hours to save a few dollars </li></ul></ul><ul><li>Record Everything They Do </li></ul><ul><ul><li>Audit </li></ul></ul><ul><ul><li>Impact Analysis </li></ul></ul><ul><li>Anonymous </li></ul><ul><li>No Emotion </li></ul><ul><li>No Stress </li></ul>
  10. 10. Ingredients for a Successful Hedge Fund <ul><li>Investment Strategy </li></ul><ul><ul><li>Profit generating strategies </li></ul></ul><ul><ul><ul><li>Predict future prices better than chance </li></ul></ul></ul><ul><ul><li>Trade selection </li></ul></ul><ul><ul><ul><li>Risk control </li></ul></ul></ul><ul><ul><ul><li>Transaction cost analysis </li></ul></ul></ul><ul><ul><li>Trade Execution </li></ul></ul><ul><ul><li>Constant Innovation </li></ul></ul><ul><li>Other Departments </li></ul><ul><ul><li>IT infrastructure </li></ul></ul><ul><ul><li>Marketing </li></ul></ul><ul><ul><li>Back-Office </li></ul></ul><ul><ul><li>Compliance </li></ul></ul>
  11. 11. Predictable Random Walk <ul><li>How can a random walk be predictable? </li></ul><ul><li>Bias (not equal to risk free rate) </li></ul><ul><ul><li>Carry trade: buy currency that pays large interest rate </li></ul></ul><ul><li>Positive Auto-correlation </li></ul><ul><ul><li>Trend following </li></ul></ul><ul><li>Negative Auto-correlation </li></ul><ul><ul><li>Mean reverting </li></ul></ul>
  12. 12. Trend Following <ul><li>Strategy </li></ul><ul><ul><li>Always Long or Short </li></ul></ul><ul><ul><li>Go long if R(t)>R 0 , go short if R(t)<-R 0 , otherwise stay </li></ul></ul><ul><li>Make money on average if random walk is persistent </li></ul><ul><li>Trade statistics is skewed </li></ul><ul><ul><li>Winning trades are longer than loosing trades </li></ul></ul><ul><ul><li>Loosing trades are more frequent </li></ul></ul><ul><li>Daily return statistics is unskewed </li></ul><ul><ul><li>gauge transformation </li></ul></ul>
  13. 13. Risk Control <ul><li>Fat tails </li></ul><ul><ul><li>Non-Gaussian statistics </li></ul></ul><ul><li>Leverage Effect </li></ul><ul><ul><li>Price drops induce volatility </li></ul></ul><ul><li>Volatility fluctuations </li></ul><ul><ul><li>Long range autocorrelations </li></ul></ul><ul><ul><li>Non-trivial kurtosis </li></ul></ul><ul><ul><li>Dynamical leverage </li></ul></ul>
  14. 14. Distribution of Stock Returns
  15. 15. Risk Control <ul><li>Empirical Correlation Matrices </li></ul><ul><ul><li>N assets, T time intervals </li></ul></ul><ul><ul><li>Q=N/T ~ O(1) </li></ul></ul><ul><ul><li>Marcenko-Pastur distribution of eigenvalues </li></ul></ul><ul><ul><li>Small eigenvalues are dangerous for Markowitz </li></ul></ul><ul><ul><ul><li>w ~ C -1 r </li></ul></ul></ul><ul><ul><li>Large eigenvalues may be signal </li></ul></ul><ul><ul><ul><li>Cut-Off cleaning </li></ul></ul></ul><ul><ul><ul><li>M-P dressing of ansatz distribution </li></ul></ul></ul>
  16. 16. Empirical Eigenvalue Distribution
  17. 17. Applications of Correlation Matrices <ul><li>Generalized Pair Trading </li></ul><ul><ul><li>Pair trading: compare a stock with a peer </li></ul></ul><ul><ul><li>Create a “super-peer” using all correlated stocks </li></ul></ul><ul><li>Uncorrelated Residuals </li></ul><ul><ul><li>To get √N diversification need uncorrelated bets </li></ul></ul><ul><ul><li>Invest uncorrelated portfolios with w a =1 </li></ul></ul><ul><li>Measure Your Risk </li></ul><ul><ul><li>Need reliable matrix “out-of-sample” if you optimize </li></ul></ul>
  18. 18. Transaction Costs <ul><li>Broker – Clearer – Exchange fees </li></ul><ul><ul><li>Order of 0.1 to 1 bp (10 -5 - 10 -4 ) </li></ul></ul><ul><li>Bid-Ask Spread </li></ul><ul><ul><li>Order of 1 to 10 bp (10 -4 - 10 -3 ) </li></ul></ul><ul><ul><li>Can do better with smart execution </li></ul></ul><ul><li>Price Impact </li></ul><ul><ul><li>Strongly depends on size </li></ul></ul><ul><ul><li>Dominant cost for large funds </li></ul></ul><ul><li>Financing cost </li></ul><ul><ul><li>0.5 to 1% per year per unit of Leverage </li></ul></ul>
  19. 19. Trade Execution <ul><li>Order Book Dynamics </li></ul><ul><li>Short Term Predictive Models </li></ul><ul><li>Price Impact </li></ul><ul><li>Market Reaction </li></ul><ul><li>Experimental Physics vs Cosmology </li></ul>
  20. 20. Quant Crunch 1998 and 2007 <ul><li>Aug. 1998 </li></ul><ul><li>LTCM Strategies </li></ul><ul><ul><li>Emerging Market Yield </li></ul></ul><ul><ul><li>European Convergence </li></ul></ul><ul><ul><li>Long Term Index Vol </li></ul></ul><ul><ul><li>On-the-run Off-the-run </li></ul></ul><ul><li>Trigger: Russian Dept Crisis </li></ul><ul><li>Aug. 2007 </li></ul><ul><li>Quant Strategies </li></ul><ul><ul><li>High Yield Bonds (credit risk) </li></ul></ul><ul><ul><li>Equity Quantitative </li></ul></ul><ul><ul><li>Equity Stat Arb </li></ul></ul><ul><li>Trigger: Sub-Prime Loan Crisis </li></ul>
  21. 21. Investment Advices <ul><li>Beware of fees! </li></ul><ul><li>Don’t buy complicated products </li></ul><ul><li>Diversify </li></ul><ul><ul><li>Large portfolio or indices NOT a few stocks </li></ul></ul><ul><li>Include dividends in your performance analysis </li></ul><ul><li>Investment managers don’t beat the index </li></ul><ul><li>Buy Index Funds or ETFs </li></ul><ul><li>Reasonable long term targets </li></ul><ul><ul><li>RFR + 3-5% is very good </li></ul></ul><ul><li>Consider impact of taxes </li></ul><ul><ul><li>Retirement accounts, life insurance etc. </li></ul></ul><ul><li>Don’t invest in Hedge Funds </li></ul><ul><ul><li>Unless you know that </li></ul></ul><ul><ul><ul><li>They are smart </li></ul></ul></ul><ul><ul><ul><li>They are not crooks </li></ul></ul></ul><ul><li>Beware of fees! </li></ul>

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