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Hedge Funds: Examining the Potential Benefits and Risks of Hedge Fund Investing Robert Howie Shalin Bhagwan, Leon Beukes, ...
Contents <ul><li>Introduction </li></ul><ul><li>Literature Review </li></ul><ul><li>Investor Activity </li></ul><ul><li>Ex...
What are hedge funds? <ul><li>Not easy to define concisely </li></ul><ul><li>Large universe </li></ul><ul><li>Some are by ...
Other (non-defining) characteristics <ul><ul><li>Performance related fees </li></ul></ul><ul><ul><li>Less regulated </li><...
Academic Research <ul><li>Several major academic groupings established </li></ul><ul><li>Variable quality of research, foc...
Survivorship Bias <ul><li>Hedge fund data: </li></ul><ul><ul><li>Diverse range of investment techniques, fairly large disp...
Survivorship Bias <ul><li>No studies measuring bias of fund of hedge fund indices </li></ul><ul><ul><li>Substantially lowe...
Modelling Hedge Funds <ul><li>Academic research confirms, without exception, that returns are non-normal </li></ul><ul><ul...
Total Investment in Hedge Funds Source: HFR Industry Reports
Institutional Allocations to Hedge Funds (2003) Source: HFR Industry Reports
Institutional Share of Hedge Fund Capital Flows Source: HFR Industry Reports
Product Offerings <ul><li>Standard offerings </li></ul><ul><li>Structured products </li></ul><ul><ul><li>Principal protect...
Expected returns from hedge funds <ul><li>Simple model for hedge fund returns: </li></ul><ul><li>gross return = 67% (cash ...
Expected returns from hedge funds <ul><li>If gross return is positive: </li></ul><ul><ul><li>net return = (gross return – ...
Expected returns from fund of funds
Impact of fees <ul><li>If cash returns are 4.5% and gross IR = 1.6 </li></ul><ul><ul><li>Fees are 4.1% p.a. for fund + 1.5...
Hedge Fund Risks <ul><li>Investment risks fairly well documented </li></ul><ul><li>Non-investment risks can be significant...
Evaluation of Operational Risk <ul><li>Necessarily qualitative, covering </li></ul><ul><ul><li>Background checks </li></ul...
Benchmarking <ul><li>Measurement of value added should not constrain manager </li></ul><ul><li>Benchmark must represent ne...
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  1. 1. Hedge Funds: Examining the Potential Benefits and Risks of Hedge Fund Investing Robert Howie Shalin Bhagwan, Leon Beukes, Harjeet Cheema, Con Keating, Khurram Mirza, Ian Morley, Yasmin Saltuk
  2. 2. Contents <ul><li>Introduction </li></ul><ul><li>Literature Review </li></ul><ul><li>Investor Activity </li></ul><ul><li>Expected returns from hedge funds </li></ul><ul><li>Non-Investment Risks </li></ul><ul><li>Benchmarking Hedge Fund Investments </li></ul>
  3. 3. What are hedge funds? <ul><li>Not easy to define concisely </li></ul><ul><li>Large universe </li></ul><ul><li>Some are by no means “hedged” </li></ul><ul><li>Key characteristics </li></ul><ul><ul><li>Heavily skill-based </li></ul></ul><ul><ul><li>Investment flexibility </li></ul></ul><ul><ul><li>May employ short-selling and use leverage </li></ul></ul><ul><ul><li>Focus on “absolute returns” or “cash plus” </li></ul></ul>
  4. 4. Other (non-defining) characteristics <ul><ul><li>Performance related fees </li></ul></ul><ul><ul><li>Less regulated </li></ul></ul><ul><ul><li>Less transparent </li></ul></ul><ul><ul><li>Small fund and organisation size </li></ul></ul><ul><ul><li>High minimum investment </li></ul></ul><ul><ul><li>Relatively illiquid </li></ul></ul><ul><ul><li>Fund manager co-invests with investors </li></ul></ul><ul><li>Many hedge funds do not have these characteristics </li></ul>
  5. 5. Academic Research <ul><li>Several major academic groupings established </li></ul><ul><li>Variable quality of research, focusing on: </li></ul><ul><ul><li>Distribution of hedge fund returns </li></ul></ul><ul><ul><li>Biases in hedge fund data </li></ul></ul><ul><ul><li>Understanding and modelling drivers of returns </li></ul></ul>
  6. 6. Survivorship Bias <ul><li>Hedge fund data: </li></ul><ul><ul><li>Diverse range of investment techniques, fairly large dispersion </li></ul></ul><ul><ul><li>Voluntary submission of data = selection bias </li></ul></ul><ul><ul><ul><li>Most index providers only include data for a fund after it enters index </li></ul></ul></ul><ul><li>Estimated survivorship bias in hedge fund data: </li></ul><ul><ul><li>Ackermann et al. (1999): negligible bias </li></ul></ul><ul><ul><li>Brown et al. (1999): c. 3% p.a. </li></ul></ul><ul><ul><li>Liang (2000): 2-3% p.a. </li></ul></ul><ul><ul><li>Fung et al. (2004): 2-3% p.a. </li></ul></ul>
  7. 7. Survivorship Bias <ul><li>No studies measuring bias of fund of hedge fund indices </li></ul><ul><ul><li>Substantially lower given the lower failure rate? </li></ul></ul><ul><ul><li>Similar to mutual fund universes? </li></ul></ul><ul><ul><ul><li>Academic studies on survivorship bias in mutual fund data have estimated 0.2% - 1.4% p.a. </li></ul></ul></ul>
  8. 8. Modelling Hedge Funds <ul><li>Academic research confirms, without exception, that returns are non-normal </li></ul><ul><ul><li>Standard mean/variance analysis is invalid </li></ul></ul><ul><li>Calculated stability coefficient (1.67) questions existence of 2 nd moment </li></ul><ul><ul><li>Multivariate regression possibly inappropriate </li></ul></ul><ul><li>Modelling is non-trivial </li></ul><ul><ul><li>Research is in its infancy </li></ul></ul>
  9. 9. Total Investment in Hedge Funds Source: HFR Industry Reports
  10. 10. Institutional Allocations to Hedge Funds (2003) Source: HFR Industry Reports
  11. 11. Institutional Share of Hedge Fund Capital Flows Source: HFR Industry Reports
  12. 12. Product Offerings <ul><li>Standard offerings </li></ul><ul><li>Structured products </li></ul><ul><ul><li>Principal protected products </li></ul></ul><ul><ul><li>Leverage products </li></ul></ul><ul><li>Potential role in “alpha transport” and “liability benchmark strategies” </li></ul>
  13. 13. Expected returns from hedge funds <ul><li>Simple model for hedge fund returns: </li></ul><ul><li>gross return = 67% (cash return) + 19% (equity return) + 14% (high yield return) + tracking error </li></ul><ul><li>Historical standard deviation of tracking error is 6.4% </li></ul><ul><ul><li>With gross Information Ratio = 1.6 </li></ul></ul>
  14. 14. Expected returns from hedge funds <ul><li>If gross return is positive: </li></ul><ul><ul><li>net return = (gross return – 1.3% p.a.) (1 - 19.3%) </li></ul></ul><ul><li>If net return is positive: </li></ul><ul><ul><li>net fund of fund return = (net return – 1% p.a.) (1 - 5%) </li></ul></ul>
  15. 15. Expected returns from fund of funds
  16. 16. Impact of fees <ul><li>If cash returns are 4.5% and gross IR = 1.6 </li></ul><ul><ul><li>Fees are 4.1% p.a. for fund + 1.5% for fund of funds </li></ul></ul><ul><li>If gross IR is zero </li></ul><ul><ul><li>Fees are 2.1% p.a. for fund + 1.1% for fund of funds </li></ul></ul><ul><li>High gross IR required to generate attractive net of fee returns </li></ul>
  17. 17. Hedge Fund Risks <ul><li>Investment risks fairly well documented </li></ul><ul><li>Non-investment risks can be significant </li></ul><ul><ul><li>Operational failings </li></ul></ul><ul><ul><li>At worst, fraud </li></ul></ul><ul><li>Operational risks occur in </li></ul><ul><ul><li>Manager </li></ul></ul><ul><ul><li>Fund </li></ul></ul><ul><ul><li>Third parties </li></ul></ul>
  18. 18. Evaluation of Operational Risk <ul><li>Necessarily qualitative, covering </li></ul><ul><ul><li>Background checks </li></ul></ul><ul><ul><li>Conflicts </li></ul></ul><ul><ul><li>Administration and trading </li></ul></ul><ul><ul><li>Pricing </li></ul></ul><ul><ul><li>Third parties </li></ul></ul><ul><ul><li>Legal structure and documentation </li></ul></ul><ul><ul><li>Reporting </li></ul></ul><ul><li>Special skills needed </li></ul>
  19. 19. Benchmarking <ul><li>Measurement of value added should not constrain manager </li></ul><ul><li>Benchmark must represent neutral position of manager : </li></ul><ul><ul><li>Stated objectives </li></ul></ul><ul><ul><li>Composite of market indices </li></ul></ul><ul><ul><li>Hedge fund indices </li></ul></ul>
  20. 20. Questions?

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