Hedge Fund Strategies 101

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Money Talks
Hedge Fund Strategies 101
August 2018
www.cadencetranslate.com

In this business, if you’re good, you’re right six times out of ten.
- Peter Lynch
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▫ What a hedge fund is
▫ How hedge funds make money
▫ Variations on hedge fund strategy
▫ Tricky terminology used when describing
hedge funds
Today, you
will learn:
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For interpreters, translators, and
transcribers in attendance...
Words formatted like this are
especially important

Why me? ▫ Five years on the buy side before Cadence
▫ Serviced hedge funds beginning in 2006
▫ Working with hedge funds every week
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Where do
hedge
funds fit in?
Source: Wall Street Prep (https://www.wallstreetprep.com/knowledge/finance-
careers-overview/)6

Do hedge funds
own Starbucks?
(NASDAQ:SBUX)
SBUX is the ticker and can be used in casual or formal conversation to specifically identify the stock (as opposed to the company or the
brand).
Source: NASDAQ (https://www.nasdaq.com/symbol/sbux/institutional-holdings)
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Whose
money is it
anyway?
Source: Wall Street Prep (https://www.wallstreetprep.com/knowledge/finance-
careers-overview/)8

Let’s see how hedge funds react
towards investing in Starbucks...

Key Trading
Strategies
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Long/Short
Algorithmic
(“quant”)
Arbitrage Event-driven

Key trading
strategies
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Long/Short
Algorithmic
(“quant”)
“I like Starbucks, so I buy SBUX”

Long vs. Short Long
Make $$ when the stock goes up
Short
Make $$ when the stock goes down
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Long vs. Short can
also be thought of as
outperformance or
underperformance
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Long/short
can also be
used for
hedging
“I think oil prices are going to go
down. But just in case they don’t, I’m
long BP and XOM.”
- An analyst who wants to hedge
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...or it can be
used for more
exposure to a
trend
“No one is going to the movies. Buy
NFLX and sell AMC.”
- An analyst who wants more
exposure
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Completing
a “long”
trade
▫ Analyst takes idea to portfolio
manager/investment committee
▫ Upon approval, analyst hands off to in-house
or third-party trader (the latter is known as
prime brokerage)
▫ Trader executes trade, possibly in blocks, by
finding a seller among the float
▫ The trade has a cost basis
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Completing
a “short”
trade
▫ Analyst takes idea to portfolio
manager/investment committee
▫ Upon approval, analyst hands off to in-house
or third-party trader
▫ Trader finds two counterparties: one willing
to buy the shares (“Buyer”) and one willing to
temporarily give up possession of their
shares (“Lender”)
▫ Trader takes possession of shares from
Lender and immediately sells them to buyer
▫ Later, the Lender demands shares be
returned, which requires the hedge fund to
cover their position
▫ The hedge fund simply buys shares on the
open market to cover their position
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They can also use
technical analysis
CapEx as a % of sales
has dipped in the last
four quarters, so we
see future EPS growth
capped at 3%.”
- Example stock call
Managers get
conviction from
fundamental analysis
“I’ve visited 50
Starbucks stores. 49 of
the managers reported
YoY comps in the
teens. Strong buy.”
- Example stock call
A note on
research
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Key Trading
Strategies
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Long/Short
Algorithmic
(“quant”)
“I’ll buy SBUX if Watson says so”

Algorithmic/
quant trading
▫ Using data to make short-term investment
decisions
▫ Only role of humans is to (1) provide logic to
algorithms and (2) provide trading limits
▫ Sometimes called HFT (high-frequency
trading)
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Key things to
understand
▫ Holding period of a position can be seconds
(versus years in long/short)
▫ Strategy made possible by technology
(speed-to-execute) and ever-shrinking
trading costs
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Real life
example of a
quant
algorithm
“If a stock has gone up recently, buy
more of it. If a stock has gone down
recently, sell it.”
FYI, this strategy is known as momentum trading, and can
sometimes be used pejoratively (“that is just a momentum trade”).
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Real life
example of a
quant
algorithm
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Using Python computer code:

An insane
labor market
for “quants”
▫ “Quants” are good at data manipulation and
coding
▫ Their understanding of the underlying
companies and markets is secondary to their
math and coding abilities
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What can
go wrong?
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Key trading
strategies
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Long/Short
Algorithmic
(“quant”)
“I can buy coffee beans for $10 in Guatemala, pay $2 to store
them for 6 months, and sell them for $15 to buyers looking to
lock in supply today.
Wait, what is Starbucks?”

Arbitrage ▫ Take advantage of a temporary pricing
anomaly.
▫ Buy something in one market and
simultaneously sell it in another.
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How I made
money from
arbitrage as
a 14-year-old
▫ Once in a while, magician robes sold for 80
gold in one town and 100 in another
▫ Transportation between towns was instant
and required 5 gold worth of magic
ingredients
▫ I could hold 20 robes and a full cycle took
about 15 minutes
▫ Profit
= Proceeds - cost basis - transaction fees
= 100 * 20 - 80 * 20 - 5
= 395 gold / 15 minutes
= 1,580 gold per hour28

▫ Hard to find arbitrage in equities without
resorting to derivatives
▫ Easier to find in commodities
▫ Existence of arbitrage opportunities is
(incredibly) short-term
Arbitrage in
practice
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Arbitrage is
information being
unevenly
distributed.
Therefore, a cottage
industry to
accelerate access to
information exists
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Source: Spread Networks (http://spreadnetworks.com/network-map/) and the amazing book Flash Boys by Michael Lewis
▫ Value proposition: Reduce round-trip data
speed between Chicago and NYC from 17
milliseconds to 13. (A blink = 100ms)
▫ Cost to build: $300 million
▫ Initial revenue: $2.8 billion

Key trading
strategies
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Long/Short
Algorithmic
(“quant”)
“We think Starbucks is going to buy its biggest rival in Japan.
The shares of that competitor are gonna jump when they
announce the acquisition”

Event-driven ▫ Anticipate M&A, bankruptcy, clinical trial,
legislative outcomes
▫ Trades only happen on outcomes that could
‘pop’ in the next month
▫ Long if you think market doesn’t price in
likelihood, short if you think market
overestimates likelihood
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A guessing
game
▫ Event-driven strategies are simply a matter
of probability
▫ Easy part: choose an outcome and estimate
EPS impact
▫ Hard part: figuring out much is baked in to
the current stock price.
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Example
You believe a
rumor that
Facebook will be
unblocked in
China starting
October 1st.
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Example
You believe a
rumor that
Facebook will be
unblocked in
China starting
October 1st.
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Does this
information
affect my
view on the
stock?
What trading
strategies
take
advantage of
this info?
● Facebook has 2.23 billion users (2Q-2018)
● Street estimate for 2020 is 2.50 billion
● You believe that, by 2020, 400 million users
in China and 200 million users outside
China could join Facebook
● This info suggests the stock is underpriced
● Market cap is currently $625B
● Market cap per user is 625 / 2.23 = $280
● If the market consensus is “missing” 400
million Chinese users, the market cap
should ‘pop’ to 625 + 0.4*280 = $737B
● If we buy today and policy gets announced
in a month, that’s a 517% IRR

Event-driven is
often used as
part of a multi-
strategy fund
and not a
standalone
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Key trading
strategies
37
Long/Short
Algorithmic
(“quant”)
“I like
Starbucks, so I
buy SBUX”
“I’ll buy SBUX if
Watson says
so”
“I can buy coffee beans for
$10 in Guatemala, pay $2
to store them for 6
months, and sell them for
$15 to buyers looking to
lock in supply today.
Wait, what is Starbucks?”
“We think Starbucks is
going to buy its biggest
rival in Japan. The shares
of that competitors are
gonna jump when they
announce the acquisition”

Wrapping it up...
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▫ Some are HIGHLY reliant on understanding
the underlying companies (long/short,
event-driven); others are black boxes
(algorithmic, arbitrage)
▫ Equities are just one of many potential asset
classes for these strategies
▫ Technology and lower trading costs made all
of this possible
Hedge funds
use different
strategies
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▫ You’ve learned what a hedge fund is
▫ You’ve learned different ways hedge funds
make money
▫ You’ve learned important terminology likely
to come up
To recap...
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Want to
learn more?
Read the Wall
Street Journal
or Financial
Times
Read my
accompanying
blog post on
the topic
Attend our next
webinar on
private equity
(tentative date: August
27, 2018)
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Thank you!
Visit our Linguist Academy page to receive regular updates on
upcoming webinars and other educational resources.
www.cadencetranslate.com/learn

CREDITS
Special thanks to all the people who
made and released these awesome
resources for free:
▫ Presentation template by
SlidesCarnival
▫ Photographs by Unsplash
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