Hedge Funds and Hedge Fund Derivatives


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  • Famous examples : Soros LTCM Madoff Funds size can vary from a few million to many billions Approximately 9000 hedge funds, 15% control 75% of assets under management
  • Correlation to Market : A typical manager may charge fees of "2 and 20", which refers to a management fee of 2% of the fund's net asset value each year and a performance fee of 20% of the fund's profit Can be very dominant – estimates 50% of all trading LSE, 30% of all U.S. fixed-income trading for example Mutual Funds 26 trillion vs. Hedge Funds 2 trillion But trading influence can be substantial due to frequency and volumes traded by Hedge Funds + leverage employed (LTCM was 30x!)
  • Vast difference between couple of disgruntled ex-traders in small hedge fund start-up in rented office And large hedge managers more like banks with significant resources
  • Distressed securities example… Michael Tennenbaum – lender of last resort to distressed companies. very profitable if bankruptcy - seize assets very controversial very high interest rates 20% - unregulated Activist example…Knight Vinke - aggressive stance in its very public campaign for a strategic review at HSBC
  • Nearly 50% of Assets reduction due to withdrawals and losses 800m 40% of Industry AUM
  • Growth of 20% on average 9000 plus funds Largest Hedge Funds
  • FTQ, Carry trade off  Asset Price declines Margin Calls, Redemption orders, Liquidity Madoff end of 2008 – largest investor fraud in history committed by a single person. $65b of estimated losses. Ponzi scheme the "return" to the initial investors is being paid out of the investments of new entrants, and not out of profits only succeeded because of lack of transparency, controls and regulation in industry Lots of Red Flags, 17years of positive performance, no independent oversight at all Prime broker - typically part of a large investment bank Lends money, counterparty to derivative contracts, lends securities for short selling, executes trades, provides clearing, settlement and custody services Lehman was a Prime Broker to many hedge funds
  • Fees down in return for longer lock-up periods 15% of funds control 75% of Industry assets
  • Liquidity Risk Ironically the more liquid funds may lose more value as investors shed risky assets
  • Quantitative + Qualitative
  • Hedge Funds and Hedge Fund Derivatives

    1. 1. Hedge Funds and Hedge Fund Derivatives Date : 19 Feb 2010 Produced by : Angelo De Pol
    2. 2. Contents <ul><li>Introduction </li></ul><ul><li>What are Hedge Funds? </li></ul><ul><li>Who are the Managers? </li></ul><ul><li>Who are the Investors? </li></ul><ul><li>Hedge Fund Strategies </li></ul><ul><li>Funds of Hedge Funds </li></ul><ul><li>Hedge Fund Market </li></ul><ul><li>Hedge Fund Derivatives </li></ul><ul><li>Impact of the Credit Crisis </li></ul><ul><li>Key Risks </li></ul><ul><li>Risk Management </li></ul>
    3. 3. Introduction <ul><li>Personal introduction </li></ul><ul><li>Explain hedge funds & what makes them a unique investment class </li></ul><ul><li>Describe market characteristics, investors and managers </li></ul><ul><li>Review the most common hedge fund derivatives </li></ul><ul><li>Explain how and why the credit crisis impacted the hedge fund industry </li></ul><ul><li>Highlight the key risks of the industry / hedge fund portfolio </li></ul><ul><li>Provide examples of how hedge fund risk is managed </li></ul>
    4. 4. What are Hedge Funds? <ul><li>Umbrella term for collective investment vehicles employing a huge range of different strategies </li></ul><ul><li>Highly specialised…rely on specific expertise of manager </li></ul><ul><li>Largely offered as private investments </li></ul><ul><li>Typically structured as limited partnerships </li></ul><ul><li>Generally set up in tax havens </li></ul><ul><li>Narrow range of investors </li></ul><ul><li>Use of leverage and derivatives is widespread </li></ul><ul><li>Hedge Funds aim to i) Preserve capital , ii) Reduce volatility and risk and iii) Deliver positive returns under all market conditions </li></ul>
    5. 5. Comparison of Hedge Funds vs Traditional Funds $2 trillion $26 trillion Industry Size High Low Strategy Complexity Large Relatively Small Minimum Investment Low Relatively High Transparency Restrictions & Lock-ups Relatively Liquid Liquidity High - based on AUM and Performance Low - Based on AUM Fees Higher Turnover Lower Turnover Trading Presence Yes No Leverage Lower High Correlation to Market Long or Short Long Only Investment Absolute Versus a benchmark Returns Hedge Funds Traditional Funds
    6. 6. Who are the Managers? London Cayman Islands New York <ul><li>Ex bankers typically with investor contacts and trading expertise </li></ul><ul><li>Vary considerably in size - Top 15% control 75% of Industry Assets </li></ul><ul><li>Most managers based in New York, Connecticut and London </li></ul><ul><li>But funds typically registered in tax havens like Cayman Islands </li></ul>
    7. 7. Who are the Investors? <ul><li>High Net Worth individuals, Funds of Fund Managers & Institutional investors </li></ul><ul><li>Minimum Investment size is very high – usually at least $1million </li></ul><ul><li>Acceptance has grown substantially…viable alternative to traditional markets </li></ul><ul><li>Investors seek attractive, stable and non-market correlated returns </li></ul>
    8. 8. Hedge Fund Strategies … help represent the hedge fund universe Breakdown as at end of 2009; Source : CS/Tremont
    9. 9. Hedge Fund Strategies Statistics for 2009
    10. 10. Event Driven Strategy Distressed Securities Merger Arbitrage Special Situations Credit Arbitrage Reg’n D Activist Event Driven Exploits pricing inefficiencies caused by anticipated corporate events. Many variations… Companies near bankruptcy Merging companies Restructuring Corporate Fixed Income Securities Private Equity Active management and influence of companies
    11. 11. Managed Futures Strategy <ul><li>Also called Commodity Trading Advisors (“CTAs”) </li></ul><ul><li>Systematic approach to investing in futures contracts in bond, equity, commodity and currency markets </li></ul><ul><li>Highly quantitative model based trading </li></ul><ul><li>No trader decisions – all model based </li></ul><ul><li>Use mean reversion, trend and pattern recognition models </li></ul><ul><li>Operate in highly liquid markets, providing flexibility </li></ul><ul><li>Models can break down in very volatile markets </li></ul>
    12. 12. Funds of Hedge Funds <ul><li>Invest in other Hedge Funds </li></ul><ul><li>Portfolio diversification main aim (strategy, manager and fund) </li></ul><ul><li>Important and very influential in industry </li></ul><ul><li>Have access to extensive resources and systems </li></ul><ul><li>Regularly rebalance portfolio and perform due diligence </li></ul><ul><li>But additional layer of fees and leverage </li></ul><ul><li>Suffered major blow in crisis as diversification benefit muted </li></ul>
    14. 14. Hedge Fund Market Performance vs. Equities Russia/ LTCM Crisis Equity Bear Market Correlation Increasing Credit Crisis Average Annualised Volatility - Hedge Funds : 6%, Equities : 15%
    15. 15. Hedge Fund Derivatives <ul><li>Demand for more participation and leverage </li></ul><ul><li>Many variations… </li></ul><ul><li>Volatility linked notes, Aries notes,“Best of” options, Enhanced calls... </li></ul><ul><li>Seller gives return on hedge fund basket and gets LIBOR plus spread </li></ul><ul><li>Upside exposure to underlying fund </li></ul><ul><li>Guaranteed principal (at maturity) </li></ul><ul><li>Final return = combination of risky and non-risky asset </li></ul><ul><li>Offer leverage of up to 300% </li></ul><ul><li>Poor performance may result in investor losing entire investment </li></ul><ul><li>Simple products </li></ul><ul><li>Appeal to broad investor base </li></ul><ul><li>Exposed to both upside and downside performance </li></ul>Exotics Leveraged certificates CPPI notes Delta 1 certificates Total Return Swaps Funds of Hedge Funds
    16. 16. What is CPPI? <ul><li>C onstant P roportion P ortfolio I nsurance </li></ul><ul><li>Helps ensure 100% of investor’s capital is protected (at maturity) </li></ul><ul><li>And investor also gets participation in underlying asset growth </li></ul><ul><li>Simple formula based hedging mechanism with set minimum “cushion” </li></ul><ul><li>Determines composition of investment between : </li></ul><ul><ul><ul><li>Risky Asset (e.g. Hedge Fund of Funds) and </li></ul></ul></ul><ul><ul><ul><li>Non- Risky Asset (Cash, Fixed Term Deposits) </li></ul></ul></ul><ul><li>Poor Performance  Deleverage </li></ul><ul><ul><ul><ul><li>Sell Risky Asset to buy more Non- Risky Asset </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Possibly end up with no Risky Asset exposure </li></ul></ul></ul></ul><ul><li>Good Performance  Leverage up Risky Asset exposure </li></ul>
    17. 17. <ul><li>The following graph illustrates how Risky Asset exposure is determined by the CPPI mechanism </li></ul>Reference Portfolio Value The Capital is 100% protected on Maturity Date Cushion 100% Target Exposure = Cushion x Multiplier The Reference Portfolio’s allocation to the Risky Asset is determined by applying a pre-determined Multiplier to the Cushion. The Bond Floor is a fixed line starting at 70% (for example) and reaching the level of protection of 100% by the Maturity Date 70% What is CPPI? Bond Floor
    18. 18. Impact of the Credit Crisis…the perfect storm <ul><li>2000 hedge funds liquidated (25%), industry benchmarks lost 20% </li></ul><ul><li>Industry AUM down $1.2 trillion (42%), massive risk & leverage reduction </li></ul><ul><li>Huge loss of investor confidence and lots of litigation </li></ul>Redemptions Gates & Suspensions Madoff Fraud Lehman Failure Short selling ban Deleveraging
    19. 19. Impact of the Credit Crisis…Performance vs. Equities Hedge Funds : Credit Suisse / Tremont Hedge Fund Index Equities : MSCI World Index Peak Trough -20% -5% -53% -27% <ul><ul><li>Current Drawdown </li></ul></ul>
    20. 20. Hedge Fund Industry Outlook <ul><li>Growth starting to pick up again… </li></ul><ul><li>Industry Assets Under Management (AUM) now $2 trillion </li></ul><ul><li>Before Credit Crisis Growth was around 20% per year </li></ul><ul><li>2009 one of best performing years ever in industry </li></ul><ul><li>But Investors much more demanding now… </li></ul><ul><li>More transparency and liquidity demanded </li></ul><ul><li>Also better controls, risk management and infrastructure </li></ul><ul><li>And of course lower fees </li></ul><ul><li>Industry consolidation… </li></ul><ul><li>Largest managers getting bigger </li></ul><ul><li>Managers targeting more traditional institutional investors </li></ul>
    21. 21. Key Risks Lack of Transparency Poor Liquidity High Leverage Lack of Regulation Operational Risks
    22. 22. Key Risks - Operational Risk Source : Understanding and Mitigating Operational Risk in Hedge Fund Investments: A Capco White Paper Breakdown of Operational Risk Failures Distribution of Reasons for Fund Failures
    23. 23. Key Risks - Hedge Fund Portfolio Risks Concentration <ul><li>Hedge Fund Liquidity is poor </li></ul><ul><li>Hedging effectiveness is reduced </li></ul><ul><li>In stressed markets actual liquidity may be worse </li></ul>Liquidity Risk <ul><ul><li>CPPI notes have built in rebalancing mechanism </li></ul></ul><ul><ul><li>But in stressed markets this mechanism can fail… </li></ul></ul><ul><ul><li>Bank would make-up shortfall </li></ul></ul><ul><ul><li>Collateral has gap risk too </li></ul></ul>Gap Risk <ul><li>High levels of operational risk </li></ul><ul><li>Poor transparency in industry </li></ul><ul><li>Manager, fund and strategy diversification critical </li></ul>
    24. 24. Risk Management Good Manager Relationships Gap Option Hedges Crash Scenario Limits Diversification Active Due Diligence Strong Legal Documentation Conservative Model Reserves <ul><li>Active risk management at all levels is critical </li></ul><ul><li>Market, Credit, Operational and Legal risk management overlap </li></ul><ul><li>Successful risk management is dependent upon : </li></ul>
    25. 25. Risk Management - Crash Scenario Model <ul><li>Bespoke Scenario based model for risk management of hedge fund derivatives portfolio </li></ul><ul><li>Captures : </li></ul><ul><ul><li>Gap risk (important for CPPI products and hedge fund collateral) </li></ul></ul><ul><ul><li>Hedge Fund price risk </li></ul></ul><ul><ul><li>Strategy specific risk </li></ul></ul><ul><ul><li>Some concentration risks </li></ul></ul><ul><li>The level of fund and strategy diversification in the portfolio determines shock size (calculated using variances of the fund and strategy weights) </li></ul><ul><li>The shock is somewhere between general and specific portfolio shock determined by a power function : </li></ul>Where : and are determined by solving and and the power is determined by calibration G = General Shock, S= Specific Shock
    26. 26. Risk Management - Crash Scenario Model Final Shock Power Function Variances
    27. 27. Suggested Research Topics and Sources <ul><li>Non-traditional performance statistics more suitable for Hedge Funds (e.g. moving away from Sharpe ratios) </li></ul><ul><li>Unbiased hedge fund industry benchmarks (industry replication via strategies, investable indices vs. non-investable indices) </li></ul><ul><li>Hedge Fund portfolio risk management techniques and scenario development (to include operational risks, leverage, funding risk and liquidity) </li></ul><ul><li>Implied leverage in the hedge fund industry based upon available performance, costs and strategy information </li></ul><ul><li>Sources </li></ul><ul><li>www.hedgeindex.com </li></ul><ul><li>www.hedgefundresearch.com </li></ul><ul><li>Bloomberg Markets Magazine (Feb 2010) </li></ul><ul><li>www.emagazine.credit-suisse.com (About Us / In Focus / Dossiers / Derivatives & Hedge Funds) </li></ul><ul><li>www.credit-suisse.com </li></ul><ul><li>www.hedgefundintelligence.com </li></ul><ul><li>www.hedgefund.net </li></ul><ul><li>www.greenwich.com </li></ul>