Hedge fund presentation

How to build a hedge fund
Louis Plowden-Wardlaw
23rd
March 2011

How to build a hedge fund
Why are there hedge
funds?
● Investors are always looking for higher returns
● Hedge funds have promised them in exchange for
higher fees
● Traditional asset managers offered relative
returns, benchmarking their return typically
against a bond or equity index
● Hedge fund managers think they developed the
concept of absolute returns ie positive whatever
the market does; for marketing purposes this has
been called alpha to distinguish it from market
return (beta from CAPM theory)
● Arguably this is a bit naive; wealth owners have
generally expected their money managers to avoid
the downs and ride the ups
● Hedge fund managers have used instruments first
developed for hedging for speculating, and have
helped fuel the buyside of the late 80's to present
day wave of globalisation and the financial
innovations developed with increased computing
power
● The trading floor in the wild outside its natural
home in investment banks

Characteristics
What are the
characteristics of a
hedge fund?
● Remuneration structure (2 and 20)
● Use of leverage
● Use of derivatives
● High level of management discretion
● Opacity/mystique
● High returns
● Promise of uncorrelated returns
● Cash substitute
● Large minimum investment
● Hurdle rate
● High water marks
● Cannot advertise

23rd March 2011 Hedge Fund Presentation "How to build a hedge fund" © Louis Plowden-Wardlaw 2011
Evolution (1)
Number of hedge
funds and assets
under management in
sector
● Hard to get precise numbers as by definition
private investment vehicles
● People who track these numbers use different
groups of funds
● But figures from Hedge Fund Research suggest
that between 1990 and 2007 the number of funds
grew from 610 to 9767, and assets under
management from $39billion to $1,700 billion.
● US based at first, Europe proportion of sector
moved from 12% in 2002 to 24% in 2006, Asian
from 5-8% over the same period
● Fees estimated according to The Economist at
$65 billion in 2005
● Whilst there was a pulling back from the industry
after the credit crisis, characterised by heavy
redemptions, FSA as of February 2011 estimates
$1,900 billion managed by the industry
● In 2005, when it was a mere $1,000 billion, the
FSA estimated this comprised 5% of total assets
under management

Evolution (2)
Increasing
importance
● Nonetheless, in 2005 again, the FSA estimated
that hedge funds accounted between 1/3 and ½
NYSE and LSE turnover
● Servicing hedge funds generated 1/8 of
investment banking revenues in broking
commissions and fees ($19bn) and prime
brokerage revenues ($6bn) (again 2004)
● Major liquidity providers (see point 1)
● Largely an investment banking diaspora
● Investment banks themselves engage in
proprietary trading to a major extent – in 2010 for
the first three quarters Goldman Sachs was
obliged to reveal that 18% of its revenue was
proprietary trading derived, as compared to the
figure generally disseminated by them of 10%
● Doing the investment and lending functions the
banks won't do

Relative versus absolute returns
The elusive alpha
● Hedge funds like to say they can achieve positive
returns on their investments whether the markets
go up or down
● Opinion is divided on whether this works
● One of the major selling points for hedge funds as
an asset class is that they are said to be
uncorrelated to other asset classes
● As we have learnt, it is one of the features of an
inter-connected financial system that nearly all
asset classes have come to be correlated when
there are major changes in sentiment
● However it is easy to be too negative; there are
reasons why the asset class is flourishing
● The core of the question is whether higher returns
achieved are higher returns adjusting for the risk
assumed

The sceptical perspective
Sceptics say
● Hedge funds are usually geared; markets of
assets usually go up most of the time slowly, then
correct in a short period. If your investment
manager has multiplied exposure to the upwards
evolution of prices by borrowing, then returns will
be high. Of course when prices correct – usually a
much quicker process, a geared investment will
exacerbate the losses too, and equity that would
be hit on an ungeared strategy could well be
wiped out on a geared strategy. If this isn't
obvious, see cartoon on next page (Washington
Post March 14 2008, Laura Stanton)
● During up periods, superior investment returns are
a function of superior investment insight; during
down periods – well, hey, that's the market!
● Andrew Lo, an MIT econometrician, in 2001 wrote
an article in which he detailed a hypothetical
hedge fund called Capital Decimation Partners.
(Risk Management For Hedge Funds: Introduction
and Overview", Financial Analysts Journal 57, 16-
33.)

The sceptical perspective (2)
CDP and other issues
● Lo postulated a fund that sold out of the money
put options – insurance if you will on declining
stock prices – on the S&P 500 from 1992-99.
● The strategy made a return of 2721.3% when the
S&P made a return of 367.1%
● But would lose all those accumulated returns in
one major market downturn.
● Lots of other ways to benefit from assuming tail
risk for a steady premium where the adverse
event would have a catastrophic effect on capital
● LTCM and 1998 Russian contagion
● Survivorship bias
● Persistence of returns
● Backfilling in indices of performance

A less jaundiced view
There are plenty of
buyers of hedge
funds and academic
research that
supports hedge fund
out-performance
● As already demonstrated, the sector is growing
● More discretion leads to more outperformance
than can be explained by luck ( Role of
managerial incentives and discretion in hedge
fund performance, V Agarwal, N. Daniel and N.
Naik, 2007)
● Others conclude that there is more than luck
involved (Do hedge funds deliver alpha? A
Bayesian and bootstrap analysis Robert
Kosowskia, Narayan Y. Naik, Melvyn Teo)
● So maybe the jury is out, but there is supporting
evidence for superior returns

Taxonomy
No agreed taxonomy,
but shared
characteristics of
flexible instruments to
implement strategies
involving gearing
● Event driven
● Macro
● Convertible arbitrage
● Pair trading
● Black box quantitative model
● Fixed income
● Market neutral
● Statistical arbitrage
● Foreign exchange etc
● (per Agarwal Naik and Daniel) Can be boiled
down to
– Directional
– Relative value
– Security selection
– Multiprocess

The building blocks
Hedge funds are
multi-entity and
usually multi-
jurisdiction constructs
with key functions
outsourced
● Master fund
● Feeder fund(s)
● Investment manager
● Administrator
● Prime broker
● Counterparties
● Lawyers
● Auditors
● Investors
● Regulators
● Depository

Jurisdictions
Where are funds
incorporated and
managed?
● Typically the funds
are incorporated
offshore, and
managed onshore
● Fund jurisdictions
include Cayman
Islands, BVI
● UK, Switzerland and
US are typical
manager jurisdictions

UK investment managers
An important UK
industry
● Usual “permanent
establishment” rules trumped by
Investment Manager Exemption
● The cornerstone of the UK
hedge fund management
industry – leads to standard
structures compliant with these
rules
● Ensures funds not taxed under
UK tax regime if the fund is
trading (different rules apply to
funds making long term
investments)

Institutionalisation
Funds of funds ● Hedge funds associated
with higher risk
● Diversification – number
of investments required
12? 25?
● But extra fee layer eats
at returns – another 1
and 10 layer

The model is catching on
Everyone wants to be
a hedge fund
● A striking example
Porsche v
Volkswagen
●

In 2008
Porsche (a smallish company)
revealed it owned nearly 75% of
VW (a biggish one) with direct
ownership and CFD's
● VW shares up to €1000 from
€250
● Hedge funds short VW lose
€30bn

In 2009
Porsche fail to get 75% they
require and are crippled by
debt taken on in their
audacious attempt
● VW buy controlling stake in
Porsche; Porsche
management resign

Lessons
Leverage ● Maybe it does need
some professional
management
● Or maybe Porsche
just unlucky to be
caught in the credit
crisis...

What do the building blocks do?
Master and feeder
funds
● Master – transacts with counterparties
● Feeders – invest in master fund
● Independent board overseeing service providers
including investment manager
● Feeder – tailored for different investor
consituencies eg US/Europe
● Features of funds
● Fees
● Lock ups
● Redemption periods
● Frequency of valuation
● Hurdle rate
● Share classes
● Risk statements
● Key document: Prospectus

What do the building blocks do? (2)
Administrator
● Shareholders register – take in
subscription monies and pay out
redemption monies
● Valuation
● Correspond with investors
● Independence key
● European hedge funds generally better
at having independent valuation
structurally built in; in house valuation
sometimes practiced but not a great
idea cf Madoff
● Usually offshore
● Key document: Administration
agreement

Prime broker
● Who? Investment bank
● Capital introduction
● Systems
● Trading
● Lending allowing trading on margin
● Faces executing brokers
● Liquidity
● Pre credit crunch – single main PB the
norm; post credit crunch hedge funds
diversify risk
● Key document: Prime brokerage
agreement and relevant counterparty
documentation; give up agreements
with executing brokers

Counterparties
● Who? Banks and brokers
● Give up trades to PB
● Trading
● Access to multiple markets/prices
where PB not strong
● Key document: ISDA's; Credit Support
Annexes; repo and security lending
documentation

Lawyers and auditors ● Reputable law firms and
accountants
● Add seal of approval
● Deal with ongoing issues and
verify returns
● Key document: retainer
documentation

Investment manager ● Invest subscribed monies by
entering trades with PB and
counterparts
● Risk manage within stated
parameters
● Manage liquidity
● Court investors and answer
their questions: marketing
● Key document: investment
management agreement

Investors ● Invest
● Conduct due diligence on
their own account or as
fiduciary for others
● Asset allocate
● Key document: prospectus
and side letter in certain
cases

Depository ● Look after assets
● Links with prime broker
● Issues surrounding
rehypothecation of securities;
are assets held by custodian
on title transfer or charge
basis
● Complexities of sub-custodial
arrangements – extent of
liability
● Client money or not?
● LBIE?

Regulator
● Provides investor confidence
● Fund and manager have different
regulators
● Eg typical Cayman Fund regulated by
light touch Cayman Island Monetary
Authority regime, UK investment
manager authorised by FSA
● FSA historically prided itself on light
touch and concentrating on retail
protection so left hedge fund sector
alone save for attempts to monitor
systemic risk after LTCM
● Key regulator issue – divided regulation
of financial firms creates risks
● Key document: licence/authorisation
and reports

Hedge funds and systemic risk
Post LTCM, there was
a lurking fear that the
growth of the hedge
fund sector
embedded systemic
risk
● LTCM – highly geared, multi trade,
Nobel laureate assured glamour fund
broken by market turbulence in 1998
● LTCM privately rescued – no
government monies
● In fact rather than banks being
exposed to hedge funds, hedge funds
were exposed to banks – cf Lehman as
prime broker
● Well known hedge fund failures
(Madoff, Amaranth) more than capable
of being absorbed by market. The
investors could afford to lose the
money
● In credit crisis it was the unrisky banks
with their embedded leverage that
failed

Nonetheless – EU regulation
UCITS IV and AIFMD ● UCITS – retail
● AIFMD – professional
● Debate 2009-late 2010 – perceived
by London as a rear guard battle to
save the London financial services
industry from a jealous Paris and
Frankfurt
● Final text took on board some of
these concerns, but remains to be
implemented in national legislation,
and is riddled with inconsistencies,
problems and “devil in detail”
points
● At stake are eg the returns made
by European pension funds

AIFMD
What are the
contentious issues?
● Who is caught?
● Marketing
● Protectionism
● Capital requirement
● Remuneration reporting
● Leverage use
● Reporting generally
● Failure to understand markets
● Applying > retail protections to
professional investors
● Migration of industry

The future of the fund management
industry
Are all asset
managers destined to
need to use leverage
to meet return
requirements?
● Is this where hedge
fund managers are
going? Convergence
with the asset
management industry
as a whole?
● Does it stack up
● Can the incentive
structure stand?

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