Hedge Fund Primer


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Hedge Fund Primer

  1. 1. GP Asset Management Hedge Fund Primer
  2. 2. GP Asset Management Hedge Fund Primer What is a Hedge Fund? Alfred Winslow Jones (a Ph.D. in sociology at Columbia University and writer for Fortune) is credited with developing the first hedge fund investment vehicle when he formed A.W. Jones & Co in 1949. Jones's strategy was to invest in individual stocks, taking both long and short positions. The term "hedge fund" has evolved to a point that no universally accepted definition exists. Some funds calling themselves hedge funds may not employ hedging techniques at all. The most common usage of the term is to describe an actively managed investment that seeks absolute returns independent of market conditions. This is typically achieved using one of a broad range of opportunistic investment or trading techniques. Hedge funds stand in contrast to mutual funds, which are long-only vehicles that must remain fully invested at all times. Hedge funds are often structured as limited partnerships, with the general partner being the portfolio manager who makes the investment decisions. How do hedge funds differ from mutual funds? Hedge Fund Mutual Fund Fees Asset and Asset based only performance based Taxes Pass through No tax at fund level Risk & return Manager and Strategy Market Investment An Absolute return A Relative return Objective Liquidity Investment & Daily liquidity redemption limits Strategy Diverse, can use Limitations on leverage leverage and short and short selling selling Marketing Marketing and selling Access to retail market limitations Structure Manager and clients Manager is agent are partners for clients Financial Stocks, bonds, options, Stocks, bonds, cash Instruments futures, currencies, etc. Page 1
  3. 3. GP Asset Management What accounts for the growth of Hedge Funds? The primary factors that account for the growth of Number and assets under hedge funds are: management of hedge funds · Recent bear markets enhance the attractiveness of Number (Line) Sbn assets (Bars) absolute return strategies 9,000 900 · Adding hedge funds to a portfolio of stocks and bonds 8,000 800 improves the efficient frontier, producing more return 7,000 700 per unit of risk 6,000 600 · Hedge funds tend to be non-correlated with traditional asset classes 5,000 500 · Manager's compensation is tied to performance, so the 4,000 400 manager's interests are aligned with 3,000 300 those of investors 2,000 200 · Hedge funds provide a diverse array of strategies and 1,000 100 styles from which to choose 0 0 1991 1993 1995 1997 1999 2001 2003 Disadvantages of hedge funds often cited are: Source: Van Hedge Fund Advisors International Inc., Morgan Stanley, Hedge Fund Research · May be less liquid than other investments · Some have lock-up periods or other restrictive redemption terms · May offer less transparency than other investments · Tend to have higher minimums for initial investments Hedge Fund Strategies Hedge fund strategies are usually broadly divided into three major categories: Event Driven, Relative Value, & Opportunistic, and into sub-categories thereof. Following this is a brief description of each strategy type. Convertible Arbitrage: Convertible arbitrage is a relative value strategy. Convertible Arbitrage strategies attempt to exploit discrepancies in prices of corporate securities that are convertible into common stock. Dedicated short bias or short selling: This is a directional opportunistic strategy with a "bearish" focus. It involves short-selling securities in the hope of buying them back in the future at lower prices. Emerging Markets: This relative value strategy involves investing in equity and fixed-income instruments in emerging markets worldwide. Equity Market Neutral: This relative value strategy offsets long and short equity positions that are beta-neutral, currency-neutral, or both, with a view to minimizing the overall impact of the market on the portfolio. Page 2
  4. 4. GP Asset Management Event Driven: These strategies try to profit from price anomalies resulting from corporate transactions and special situations. The focus is usually on distressed securities, high yield debt, Regulation D or risk arbitrage. Fixed Income Arbitrage: This relative value strategy tries to exploit price inefficiencies between related debt securities. Global Macro: Typifies strategies that try to profit from changes in global economies. These directional macroeconomic strategies may look at how a governmental policy change may impact interest rates and securities. Long-Short Equity: Typically directional equity and equity derivative strategies. They may switch from net long to net short and vice versa depending on the manager's outlook for the market. Managed Futures or CTA Global: These strategies invest in listed financial, commodity and currency markets. The strategies may be trend following or discretionary and use either quantitative fundamental or technical analysis. Multi-Strategy: Where a fund employs multiple strategy types to achieve a profit. Merger Arbitrage: As the title suggests this strategy invests in companies involved in a Merger or Acquisition. The strategy involves going long the targeted company and selling short the stock of the acquiring company. Hedge Fund performance Hedge fund performance tends to be assessed using a number of criteria: Sharpe ratio: The Sharpe Ratio measures the reward per unit of risk. It is calculated by finding the difference between an investment's average monthly performance and the monthly rate of return of a designated riskless alternative (usually the US Treasury Bill rate). This figure is then divided by the variability of the portfolio's returns (Standard Deviation). Other things being equal, an increase in the excess returns of an investment will result in a greater Sharpe Ratio. The Sharpe Ratio gives an idea of how efficiently excess returns have been achieved. A higher ratio indicates higher efficiency. The general rule of thumb is a Sharpe Ratio higher than 1 is desirable. Sortino ratio: Variance is commonly used to measure risk. Variance is the dispersion of an investment's returns from the mean. An investment with monthly returns of -2% and +2% will have the same variance as another investment that is 0% one month and +4% the next. Standard Deviation is the square root of Variance. The Sharpe Ratio uses a non-directionally based measure of volatility to adjust for risk. The result of this could be that if a fund has a month of exceptionally high performance its Sharpe Ratio is penalized. Obviously upside deviation is acceptable and even desirable. This is where the Sortino Ratio comes in. Instead of using Standard Deviation as the denominator, the Sortino Ratio uses downside semi-variance. Thus, the Sortino Ratio only penalizes downward volatility. The Sortino Ratio is therefore a measurement of return per unit of risk on the downside. Page 3
  5. 5. GP Asset Management Treynor ratio: (Sometimes called the Reward to Variability Ratio): Earlier it was explained how the Sharpe Ratio measures the reward per unit of risk. The Treynor Ratio also relates return to risk but instead of total risk the Treynor Ratio uses systematic risk. The Treynor Ratio helps analyze returns in relation to the market risk of the fund. The Treynor Ratio provides a measure of performance adjusted for market risk. Again, the higher the Treynor Ratio, the better the performance under analysis. The Treynor Ratio uses Beta as the volatility measurement. The Treynor Ratio divides the difference of the average return of the fund and the risk-free rate by Beta (market risk) of the fund. Therefore the Treynor Ratio illustrates the return over the risk-free rate per unit of market risk. Calmar ratio: The Calmar Ratio is another return versus risk ratio. The Compound Annualized Rate of Return (usually for the previous 3 years) is the numerator and the denominator is the Maximum Drawdown (again usually for the previous 3 years and given as an absolute value). The Calmar Ratio therefore measures the return versus the drawdown risk. This ratio can be useful to compare potential opportunity gain versus opportunity loss. Omega ratio: This new, increasingly popular ratio attempts to correct for the fact that distribution of hedge fund returns is often skewed. The Omega ratio measures probability of returns falling above a given a threshold. Often more than one threshold is used to reflect different risk profiles (the usual range is from 0% to the risk free rate). At a given return threshold, the Omega ratio specifies the likelihood of beating that return over the likelihood of failing to match it. The Omega is a series of numbers indicating the risk of an investment for different levels of return. An advantage of the Omega Ratio is that it considers all aspects of a probability distribution of returns, not just the mean and standard deviation, but the actual shape of the distribution curve. Hedge fund returns Hedge fund long-term returns Annual returns 1988-2003, % compunded 35 annual return 30 20 25 20 15 15 10 5 0 10 -5 -10 -15 5 -20 -25 2001 2002 2003 0 Van Global Hedge MSCI Lehman Brothers Van Global MSCI World Lehman Brothers Fund Index World Equity Aggregate Bond Index Hedge F. Ind. Equity Aggreg. Bond Ind. Source: Van Hedge Fund Advisors International Inc. Source: Van Hedge Fund Advisors International Inc. Page 4
  6. 6. GP Asset Management Other performance related terms you may come across: Alpha: Alpha measures the excess returns over and above a benchmark produced by a fund manager. This is the portion of returns attributable to the manager's skill. Beta: Beta is a measure of the volatility or systematic risk of a fund in comparison to that of the market. A Beta of 1 indicates that the fund's volatility will move with the market. A Beta greater than 1 indicates that the fund's volatility will be more than that of the market. A Beta of less than 1 means the fund will be less volatile than the market. Volatility: Volatility is usually calculated by using Variance or Standard Deviation of the price or return. A measure of the relative volatility of a fund to the market is its Beta as we discussed earlier. Drawdown: The percentage loss a fund incurs from its peak net asset value to its lowest value. Drawdown is usually expressed as a percentage decline in net asset value. Hurdle Rate: A minimum return that the fund has to make before it can charge its incentive fee. Kurtosis: There are four moments to a probability distribution: the mean, standard deviation, skewness and kurtosis. Kurtosis measures how returns are distributed around the mean. A normal distribution has a kurtosis of 3. When the kurtosis is higher than normal, the distribution is said to be leptokurtic, with a sharper peak than a normal distribution. If the return distribution is flatter, the kurtosis is lower than the normal distribution and is said to be platykurtic. Non-normal distributions reflect a higher number outlier returns, or "fat tails," and thus there is higher probability of loss or gain greater than the mean. Skewness: Returns in a normal distribution are symmetrical around the mean with a skewness of zero. Skewed returns are pushed out to either side of the mean creating a lopsided curve. If returns are pushed to the right, the distribution has positive skewness. Negative skewness represents a probability of losses larger than the mean. Stutzer Index: This index is concerned with the probability of underperforming a specific benchmark on average. It assigns a higher measure to funds that have a lower likelihood of underperforming the benchmark and penalizes negative skewness and high kurtosis for given levels of mean returns and variance. Hedge Fund Risk As mentioned earlier Hedge Funds are generally unregistered private investment partnerships. Hedge Funds may trade in many different markets, have diverse strategies, and trade numerous instruments (including securities, non-securities and derivatives). The regulatory requirements of mutual funds, including requirements to provide certain periodic and standardized pricing and valuation information to investors do not apply to Hedge Funds. Risks include factors specific to hedge funds and other risks that associated investments generally. Examples of risks include: Page 5
  7. 7. GP Asset Management · Hedge Funds are speculative investments which means investors could lose a portion or all of their investment · Hedge Funds may be heavily leveraged · Hedge Fund performance may be volatile · Hedge Funds may have illiquid investments · Counterparty risk, for example a counter party could default on derivative contracts · Size risk, a Hedge Fund may get to large to trade effectively · Strategy drift, a Hedge Fund manager not remain disciplined in trading the strategy originally articulated · There is no secondary market for Hedge Funds · A Hedge Fund manager generally has total trading authority over the Hedge Fund · A Hedge Fund may use a single advisor or employ a single strategy, which could mean a lack of diversification and higher risk · A Hedge Fund may have a complex tax structure · A Hedge Fund may provide no transparency · A Hedge Fund may execute a substantial portion of trades on foreign exchanges or OTC markets · Hedge Funds and their managers/advisors may be subject to various conflicts of interest · Hedge Fund offering documents are not reviewed or approved by federal or state regulators Who invests in Hedge Funds? Hedge funds by investor type In the United States, accredited individuals, % share Endowments institutions, endowments, fund of funds, family 100 2% 5% & Foundations offices and pensions invest in hedge funds. 3% 14% Pension If you can meet one of the following criteria, you 80 25% Funds are an accredited investor: Funds of · You have an individual net worth, or you and 60 22% funds your spouse have a combined net worth, in excess of $1 million. 81% 40 · You had individual income, excluding any income attributable to your spouse, of more than 48% Individuals 20 $200,000 in the previous two years, and you reasonably expect to do the same this calendar year. 0 1992 2002 Source: Hennesse Group and CQA analysis. · You and your spouse had joint income of more than $300,000 in the previous two years and reasonably expect to do the same in this calendar year. Institutions and pension accounts are subject to more complex criteria, and should consult an accountant. Page 6
  8. 8. GP Asset Management Links To further your research the following links may be of interest: http://www.hedgeindex.com http://www.edhec-risk.com http://www.hedgeco.net http://www.investorwords.com http://www.sec.gov About GP Asset Management GP Asset Management (GP) creates and distributes select alternative investment products, currently including the Market Wizards Fund and Magnum Optimized Portfolio Fund. GP's parent company, Global Partners Group (GPG), was founded in 1987 as an institutional equities broker/dealer and market maker. Over the years, GPG added various business lines, becoming a diversified financial services company. Today, GPG excels at recognizing and cultivating exceptional trading talent. It serves as a bridge to new sources of investment capital for seasoned and emerging hedge fund managers. Through its operating subsidiaries and divisions, GPG offers institutional asset management, electronic trading platforms, trade execution services, emerging market debt securities and hedge fund incubation and capital introduction. Legal Disclaimer: THIS SUMMARY IS BASED ON MATERIAL IN OUR POSSESSION OR SUPPLIED TO US, WHICH WE BELIEVE TO BE RELIABLE. WE CANNOT, HOWEVER, GUARANTEE ITS ACCURACY. THIS SUMMARY IS INTENDED FOR INFORMATION PURPOSES ONLY. IT IS NOT AN OFFER OR SOLICITATION WITH RESPECT TO THE PURCHASE OR SALE OF ANY SECURITIES OR FINANCIAL INSTRUMENTS. Compiled by Patrick Gassner, Associate, GP Asset Management Page 7