February 1, 2010  Part I Hedge Funds: Overview,  Operational and Risk Management  Jason T. Wallace, FRM, CAIA [email_addre...
Presentation Outline I. Hedge Funds A.  Overview B.  Hedge Fund Risk Management II. Credit and Liquidity Crisis A.  Overvi...
I. Hedge Funds   A.  Overview    Hedge Fund Definition    Industry Overview    Hedge Fund Strategies
What is a Hedge Fund?     Defined more by operational structure than a strategy.   Private Partnerships designed to take...
Industry Overview Origins    Alfred Winslow Jones started the first hedge fund in 1949,  using short selling and leverage...
Industry Overview Growth {www.hedgefundresearch.com, www.eurekahedge.com}    Number of Funds: YE2009 = About 8,000 single...
 
 
Industry Overview Investors    Originally High-Net Worth Individuals.    Strong growth from institutional investors and ...
Hedge Fund Strategies {www.hedgefundresearch.com, www.barclayhedge.com} I. Equity Hedge II. Event Driven III. Macro IV. Re...
Equity Hedge {www.hedgefundresearch.com, www.barclayhedge.com}  1. Equity Market Neutral 2. Equity Long/Short 3. Fundament...
Equity Market Neutral {www.hedgefundresearch.com}       Can employ sophisticated quantitative  techniques.      Can incl...
Event Driven {www.hedgefundresearch.com, www.barclayhedge.com}  1. Activist 2. Credit Arbitrage 3. Distressed/Restructurin...
Distressed/Restructuring {www.hedgefundresearch.com}       Focused on corporate fixed income instruments, primarily on co...
Merger Arbitrage {www.hedgefundresearch.com}       Focused on companies engaged in corporate transactions.      Invested...
Macro {www.hedgefundresearch.com, www.barclayhedge.com}  1. Active Trading 2. Commodity Sectors 3. Currency Trading: Discr...
Macro: Thematic Discretionary {www.hedgefundresearch.com}       Heavily influenced by top down analysis of macroeconomic ...
Relative Value {www.hedgefundresearch.com, www.barclayhedge.com}  1. Fixed Income: Asset Backed 2. Fixed Income: Convertib...
Fixed Income –  Convertible Arbitrage {www.hedgefundresearch.com}       Investment thesis is predicated on realization of...
Volatility Arbitrage {www.hedgefundresearch.com}       Trade volatility as an asset class.      Strategy can be arbitrag...
Commodity Trading Advisors (CTA) {www.hedgefundresearch.com, www.barclayhedge.com}  1. Managed Futures 2. Agriculture Trad...
I. Hedge Funds   B.  Risk Management    Operational and Business Risks    Portfolio and Investment Risks    Examples of...
Types of Risk in Hedge Fund Investments  Operational and Business Risks {www.hedgefundmatrix.com}      Creating and Mana...
Operational and Business Risks  Creating and Managing a Hedge Fund Business {www.hedgefundmatrix.com}     Management and...
Operational and Business Risks  Portfolio Administration and Operational Controls {www.hedgefundmatrix.com}     Trade an...
Operational and Business Risks  Raising Capital and Investor Relations   {www.hedgefundmatrix.com}     Raising Capital ...
Operational and Business Risks  Hedge Fund Structure and Organization {www.hedgefundmatrix.com}     Structure of the Hed...
Types of Risk in Hedge Fund Investments  Portfolio and Investment Risks        Investment Process    (Including Independ...
Portfolio and Investment Risks Investment Process
Portfolio and Investment Risks Portfolio Risk Management    Leverage Risk    Liquidity Risk (Funding Liquidity Risk)    ...
Portfolio and Investment Risks Portfolio Risk Management      Leverage Risk    Balance Sheet Leverage (Assets/Equity)  ...
Portfolio and Investment Risks Portfolio Risk Management      Market Risk    Greek Exposures    Factor Risks (Quantitat...
Example Questions from a Due Diligence Questionnaire Please articulate your Sell Discipline and stop loss rules in place. ...
Examples of Operational and Risk Management Failure Operational Based: Misappropriate, Misrepresentation, Outright Fraud P...
Examples of Operational and Risk Management Failure Operational Based: Misappropriate, Misrepresentation, Outright Fraud ...
Examples of Operational and Risk Management Failure   Portfolio Based:    Long Term Capital Management (LTCM)  Amaranth
Examples of Operational and Risk Management Failure: Bayou Capital Operational Based    Approximately $450 million was ra...
Examples of Operational and Risk Management Failure: Madoff Operational Based    A revered and respected figure in the se...
Examples of Operational and Risk Management Failure: Dreier Operational Based    Allegedly claimed that Solow, a former c...
Examples of Operational and Risk Management Failure: LTCM Portfolio Based    Primary strategy was fixed income arbitrage ...
Examples of Operational and Risk Management Failure: LTCM Portfolio Based   Additionally, as LTCM’s capital base grew, th...
Examples of Operational and Risk Management Failure: LTCM Portfolio Based      Losses in May and June of 1998 of -6.42% a...
Examples of Operational and Risk Management Failure: LTCM Portfolio Based    Finally, as word got out that LTCM was losin...
Examples of Operational and Risk Management Failure: Amaranth Portfolio Based    Amaranth’s energy desk was run by Brian ...
February 1, 2010 Part V. Question and Answer Session Jason T. Wallace, FRM, CAIA [email_address]
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Central Bank Presentation I

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Part 1 of a two-part presentation for an Asian Central Bank covering a Hedge Fund Industry Overview, Operational and Portfolio Risk Management.

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Central Bank Presentation I

  1. 1. February 1, 2010 Part I Hedge Funds: Overview, Operational and Risk Management Jason T. Wallace, FRM, CAIA [email_address]
  2. 2. Presentation Outline I. Hedge Funds A. Overview B. Hedge Fund Risk Management II. Credit and Liquidity Crisis A. Overview B. Crisis Affect on Hedge Funds III. Case Study 1: IV. Case Study 2: V. Question and Answer Session
  3. 3. I. Hedge Funds A. Overview  Hedge Fund Definition  Industry Overview  Hedge Fund Strategies
  4. 4. What is a Hedge Fund?  Defined more by operational structure than a strategy.  Private Partnerships designed to take advantage of flexibility in portfolio construction and strategies.  Distinction from Traditional Asset Management:  Directional Exposure  Investment Vehicles  Multiple Asset Classes  Leverage  Fee Structure  Alignment of Incentives  Investor Requirements
  5. 5. Industry Overview Origins  Alfred Winslow Jones started the first hedge fund in 1949, using short selling and leverage.  The Hedge Fund industry grew in the 1980s and 1990s with names such as Julian Robertson, George Soros, Eddie Lampert, Paul Tudor Jones.
  6. 6. Industry Overview Growth {www.hedgefundresearch.com, www.eurekahedge.com}  Number of Funds: YE2009 = About 8,000 single managers globally, down from a high of over 10,000 in mid 2008. Fund of Funds number 1,100, down almost 15% from mid 2008.  Assets Under Management : YE2009 = $1.47 trillion in single manager Hedge Funds and $440 billion in Fund of Funds. This is down from a high of over $2 trillion and $1.2 trillion respectively, in mid 2008.
  7. 9. Industry Overview Investors  Originally High-Net Worth Individuals.  Strong growth from institutional investors and sovereign funds. Today institutional investors including endowments, foundations, public and corporate pension plans and fund of funds constitute the majority of single manager’s investors.
  8. 10. Hedge Fund Strategies {www.hedgefundresearch.com, www.barclayhedge.com} I. Equity Hedge II. Event Driven III. Macro IV. Relative Value V. Commodity Trading Advisors (CTA)
  9. 11. Equity Hedge {www.hedgefundresearch.com, www.barclayhedge.com} 1. Equity Market Neutral 2. Equity Long/Short 3. Fundamental Growth 4. Fundamental Value 5. Quantitative Directional 6. Sector Specific 7. Geographic Specific 8. Short-Bias 9. Multi-Strategy
  10. 12. Equity Market Neutral {www.hedgefundresearch.com}  Can employ sophisticated quantitative techniques.  Can include Factor-based and Statistical Arbitrage.  Usually the portfolios are structured to be neutral to one or more factors (in dollar or beta terms).  EMN Strategies typically maintain net equity market exposure no greater than +/- 10%.
  11. 13. Event Driven {www.hedgefundresearch.com, www.barclayhedge.com} 1. Activist 2. Credit Arbitrage 3. Distressed/Restructuring 4. Merger Arbitrage 5. Private Issue/Regulation D 6. Special Situation 7. Multi-Strategy
  12. 14. Distressed/Restructuring {www.hedgefundresearch.com}  Focused on corporate fixed income instruments, primarily on corporate credit instruments of companies trading at significant discounts to their value at issuance or obliged (par value) at maturity .  Usually as a result of formal bankruptcy proceeding or financial market perception of near term proceedings.  Managers are typically actively involved.  Based on fundamental credit valuation and asset coverage of securities.
  13. 15. Merger Arbitrage {www.hedgefundresearch.com}  Focused on companies engaged in corporate transactions.  Invested in equity, equity derivatives, and equity related instruments.  Typical “Merg Arb” play is to go long the takeover target and short the acquirer.  A “Reverse Merg Arb” play is to bet against the transaction taking place, in which case the takeover target is sold short and the acquirer is held long.
  14. 16. Macro {www.hedgefundresearch.com, www.barclayhedge.com} 1. Active Trading 2. Commodity Sectors 3. Currency Trading: Discretionary 4. Currency Trading: Systemic 5. Thematic: Discretionary 6. Thematic: Systematic 7. Multi-Strategy
  15. 17. Macro: Thematic Discretionary {www.hedgefundresearch.com}  Heavily influenced by top down analysis of macroeconomic variables.  Can invest in a wide range of asset classes and instruments.  Positions typically are predicated on the evolution of investment themes expected to materialize.  Many times positions are contrarian in nature.  Historically Macro Discretionary funds have outperformed during market turbulence.
  16. 18. Relative Value {www.hedgefundresearch.com, www.barclayhedge.com} 1. Fixed Income: Asset Backed 2. Fixed Income: Convertible Arbitrage 3. Fixed Income: Corporate 4. Fixed Income: Sovereign 5. Volatility Arbitrage 6. Statistical Arbitrage (Convergence/Divergence) 7. Yield Alternatives: Infrastructure 8. Yield Alternatives: Real Estate 9. Multi-Strategy
  17. 19. Fixed Income – Convertible Arbitrage {www.hedgefundresearch.com}  Investment thesis is predicated on realization of a spread between related instruments, one of which is a convertible fixed income instrument.  The traditional “Convert Arb” strategy purchases the convertible debt and sold short the equity of a company.
  18. 20. Volatility Arbitrage {www.hedgefundresearch.com}  Trade volatility as an asset class.  Strategy can be arbitrage, directional, market neutral or a mix.  Directional volatility strategies maintain exposure to the direction of implied volatility in a security, index or asset class.  Arbitrage strategies isolate opportunities between the price of multiple options or instruments containing implicit optionality (dispersion and correlation trading).
  19. 21. Commodity Trading Advisors (CTA) {www.hedgefundresearch.com, www.barclayhedge.com} 1. Managed Futures 2. Agriculture Traders 3. Currency Traders 4. Diversified Traders 5. Financial/Metal Traders 6. Discretionary Traders 7. Systematic Traders
  20. 22. I. Hedge Funds B. Risk Management  Operational and Business Risks  Portfolio and Investment Risks  Examples of Operational and Risk Management Failure
  21. 23. Types of Risk in Hedge Fund Investments  Operational and Business Risks {www.hedgefundmatrix.com}  Creating and Managing a Hedge Fund Business  Portfolio Administration and Operational Controls  Raising Capital and Investor Relations  Hedge Fund Structure and Organization
  22. 24. Operational and Business Risks  Creating and Managing a Hedge Fund Business {www.hedgefundmatrix.com}  Management and Controls  Finance  Compliance  Employees
  23. 25. Operational and Business Risks  Portfolio Administration and Operational Controls {www.hedgefundmatrix.com}  Trade and Reconciliation Procedures  Portfolio Valuations  Non-Trading Transactions  Information Systems and Business Continuity
  24. 26. Operational and Business Risks  Raising Capital and Investor Relations {www.hedgefundmatrix.com}  Raising Capital  On-going Investor Communications
  25. 27. Operational and Business Risks  Hedge Fund Structure and Organization {www.hedgefundmatrix.com}  Structure of the Hedge Fund  Independent Service Providers
  26. 28. Types of Risk in Hedge Fund Investments  Portfolio and Investment Risks  Investment Process (Including Independence of Risk Management)  Portfolio Risk Management
  27. 29. Portfolio and Investment Risks Investment Process
  28. 30. Portfolio and Investment Risks Portfolio Risk Management  Leverage Risk  Liquidity Risk (Funding Liquidity Risk) and Investor Liquidity Mismatch  Credit Risk  Counterparty Risk  Market Risk  Pricing and Valuation Risk  Strategy Model Risk  ‘Risk Model’ Risk
  29. 31. Portfolio and Investment Risks Portfolio Risk Management  Leverage Risk  Balance Sheet Leverage (Assets/Equity)  Embedded Leverage (Derivatives)
  30. 32. Portfolio and Investment Risks Portfolio Risk Management  Market Risk  Greek Exposures  Factor Risks (Quantitative Risk Management)  Interest Rate Risk  Currency Risk  Basis Risk  Liquidity Risk (Market Liquidity Risk and Opacity on Valuation)  Regulatory Risk
  31. 33. Example Questions from a Due Diligence Questionnaire Please articulate your Sell Discipline and stop loss rules in place. Please explain your Hedging Process and Instruments used. Examples of hedges utilized. Measurement of hedge ratios. Frequency of hedges. Please explain your Risk Management Tools and Systems. What Balance Sheet Leverage do you utilize? As calculated by market value of assets / equity capital AUM or margin Average, Max., Min. Leverage constraints. What is your Funding Liquidity Risk? (i.e. cost sensitivity to LIBOR) What Embedded Security or Trade Level Leverage do you have? Please provide the Portfolio Liquidity Profile (as calculated by 90% of fund days-to-liquidate based on 25% of average daily market volume). Discuss Illiquid investments in the portfolio % of AUM
  32. 34. Examples of Operational and Risk Management Failure Operational Based: Misappropriate, Misrepresentation, Outright Fraud Portfolio Based: Poor Investments or Risk Management
  33. 35. Examples of Operational and Risk Management Failure Operational Based: Misappropriate, Misrepresentation, Outright Fraud  Bayou Capital  Madoff  Dreier
  34. 36. Examples of Operational and Risk Management Failure Portfolio Based:  Long Term Capital Management (LTCM)  Amaranth
  35. 37. Examples of Operational and Risk Management Failure: Bayou Capital Operational Based  Approximately $450 million was raised by the group from investors.  Funds were misappropriated for personal use.  Returns were misrepresented.  A fake accounting firm was set up to provide misleading audited results ( outright fraud).
  36. 38. Examples of Operational and Risk Management Failure: Madoff Operational Based  A revered and respected figure in the securities industry, Madoff had held such seats as NASDAQ chair and ran both a broker-dealer and an investment advisory firm.  Madoff set up a shell auditing firm and provided limited transparency to most investors.  The operation was a classic Ponzi scheme, and capital hadn’t actually be invested in securities in many years.  It is estimated that $18 billion was lost.
  37. 39. Examples of Operational and Risk Management Failure: Dreier Operational Based  Allegedly claimed that Solow, a former colleague, was looking to raise $500 million by selling short-term, high-interest notes .  Solow had no knowledge of the situation, and when investors asked to talk to Solow or his firm, Dreier ‘s colleagues posed as members of Solow’s firm.  Dreier forged the audited reports of Solow’s supposed investments.  There were $450 million in loss claims.
  38. 40. Examples of Operational and Risk Management Failure: LTCM Portfolio Based  Primary strategy was fixed income arbitrage like buying cheaper off-the-run bonds (e.g. 29.75y treasury bond) and shorting the more liquid on-the-run bonds (e.g. 30y treasury bond).  Based on historical data there was a high statistical probability that the prices would converge.  However, leverage was needed to see these FI Arb trades made enough money, especially the convergence FI Arb trades.
  39. 41. Examples of Operational and Risk Management Failure: LTCM Portfolio Based  Additionally, as LTCM’s capital base grew, they delved into trades other than FI Arb.  By 1998 the firm had equity of $4.72 billion and had borrowed over $124.5 billion with asset values around $129 billion for a debt to equity ratio of about 25 to 1.  It had off-balance sheet derivative positions with a notional value of $1.25 trillion (primarily interest rate swaps).
  40. 42. Examples of Operational and Risk Management Failure: LTCM Portfolio Based  Losses in May and June of 1998 of -6.42% and -10.1% were unprecedented for the firm. And losses in July were further aggravated by the exit of Salomon Brothers from the Arbitrage business.  When Russia defaulted on their government bonds in the fall of 1998 panicked investors sold Japanese JGBs and European bonds to buy U.S. treasuries.  The FI Arb convergence trades blew out, as values diverged , amounting to huge losses for the firm.
  41. 43. Examples of Operational and Risk Management Failure: LTCM Portfolio Based  Finally, as word got out that LTCM was losing so much money there was a “short squeeze” as market participants further traded the divergence, knowing that enough pain would force LTCM to exit their positions and further extenuate the price movement.  By the end of August the firm had lost $1.85 billion in capital.
  42. 44. Examples of Operational and Risk Management Failure: Amaranth Portfolio Based  Amaranth’s energy desk was run by Brian Hunter.  Placed bullish bets on natural gas in 2005 and when Hurricane Katrina severely impacted natural gas and oil production and refining capacity the trades paid off.  Hunter used 8 to 1 leverage to bet that the price of the March ‘07 and March ‘08 futures contract would increase relative to the price of the April ‘07 band April ‘08 contracts (a “spread trade”).  The spreads collapsed and Amaranth lost $6 billion, $5 billion of which was lost in one week.
  43. 45. February 1, 2010 Part V. Question and Answer Session Jason T. Wallace, FRM, CAIA [email_address]

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