Hedge Funds

1
Chapter 20

• Hedge Funds

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Hedge Funds vs Mutual Funds
Mutual Funds Hedge Funds

• Transparency
• Investors
• Strategies

• Info provided only to investors
• lt 100, high dollar minimums
• No limitations

• Public info on portfolio composition
• Unlimited
• Must adhere to prospectus, limited short selling
  leverage, limited derivatives usage

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Hedge Funds vs Mutual Funds
Mutual Funds Hedge Funds

• Liquidity
• Fees

• Redeem shares on demand
• Fixed percentage of assets typically 0.5 to 2

• Multiple year lock up periods typical
• Fixed percentage of assets typically 1 to 2
  plus incentive fee 20 of gains above threshold
  return

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Directional Non-Directional Strategies

• Directional strategies
• A position that benefits if one sector of the
  market outperforms another, an unhedged bet on a
  price movement
• For example, buy bonds in anticipation of an
  interest rate decline

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Directional Non-Directional Strategies

• Non-Directional strategies
• Attempt to arbitrage a perceived mispricing
• Typically a risky arbitrage
• For example, spread between corporates and
  Treasuries is believed to be too large so you buy
  the corporates and short the Treasuries.
• Market neutral with respect to overall interest
  rates.
• Which type of strategy is riskier, Directional or
  Non-Directional?

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Hedge Fund Styles

• Insert Table 20.1 here or http//www.hedgeworld.co
  m/education/index.cgi?pagehedge_fund_styles or
  http//www.magnum.com/About.aspx?RowID15

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Statistical Arbitrage

• Statistical arbitrage
• Uses quantitative math models and often automated
  trading strategies that attempt to identify small
  mispricings in multiple securities.
• Involves placing small bets in hundreds of
  different securities for short holding periods
  (minutes).
• Require fast trading and low transactions costs.
  
• Pairs Trading
• Find two twin stocks short the high priced one
  and buy the low priced one.
• Do this for many pairs, rely on law of large
  numbers.

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Fundamental risk and mispriced securities

• Problem
• A fund finds a positive alpha stock but expects
  the overall market to fall.
• Solution
• Buy the stock and sell stock index futures to
  drive effective stock beta to zero,
• This is a market neutral pure play,
• When combined with a passive strategy this is
  called alpha transfer.

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Pure Play Example

• We have captured the alpha and hedged out the
  market risk. (Unsystematic risk remains.)

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Style and Factor Loadings

• Many fund strategies are directional bets and may
  be evaluated with style analysis (see Chapter
  18),
• Directional investments will have nonzero betas,
  called factor loadings,
• Typical factors may include exposure to stock
  markets, interest rates, credit conditions and
  foreign exchange.

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• 20.5 Performance Measurement for Hedge Funds

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Fund Alphas and Sharpe Ratios

• Hasanhodzic and Lo (2007) find that style
  adjusted alphas and Sharpe ratios are
  significantly greater than the measures for the
  SP500 for a large sample of hedge funds.
  Changing nowadays!
• This implies
• Hedge fund managers are highly skilled OR
• Aragon (2007) controls for illiquidity of hedge
  funds with lockup periods and other redemption
  restrictions and finds the alphas become
  insignificant.
• Related work by Sadka (2008) shows that hedge
  funds must generate significantly larger returns
  to offset liquidity risk.

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Fund Performance and Survivorship Bias

• Survivorship bias is a problem in performance
  measurement of risky hedge funds
• Those that dont survive dont report results
  that are used in estimating average performance.
• Backfill bias
• Hedge funds report returns to publishers only if
  they choose to.

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Tail Events and Performance

• Many hedge funds employ mathematical models that
  rely on near term historical price data.
• Their strategies performance takes the form of a
  written put option.
• Writing a put option is a way to capture the put
  premium and is appropriate in low volatility
  markets.
• In high volatility markets they face large
  losses, out of pocket if markets fall and large
  opportunity costs if markets rise.
• When the more rare large market moves (tail
  events) do occur hedge fund performance is not
  likely to appear as strong and they may suffer
  large losses.

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Evaluating Hedge Fund Feeswhich is very high but
coming down recently

• Typical hedge fund fees includes a fixed
  management fee between 1 and 2 of assets plus
  an incentive fee usually equal to 20 or more of
  investment profits above a benchmark performance
  return.
• Incentive fees are analogous to call options on
  the portfolio with a strike price equal to the
  current portfolio value x (1 benchmark return).

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Black-Scholes Value of Incentive Fee

• Suppose a hedge funds returns have an annual ?
  30
• The annual incentive fee is 20 of the return
  over the risk free money market rate.
• The fund has a net asset value of 100 per share
  and the annual risk free rate is 5.
• The implicit exercise price of the incentive fee
  is 100 x 1.05 105
• The Black-Scholes value of a call option with S0
  100, X 105, ? 30 ,T 1 year, rf LN
  1.05 4.88 is 11.92. (See Chapter 16 for
  details on option prices)
• Incentive fee is equal to only 20 of the value
  over 105 so the current value of the incentive
  fee 20 x 11.92 2.38 per share or 2.38 of
  net asset value.
• Coupled with 2 management fee yields total fees
  of 4.38, much larger than mutual funds.

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Fees and the High Water Mark

• High Water Mark
• Funds that experience losses in one period may
  not be able to charge any incentive fee until the
  prior period losses are regained.
• This complicates estimating the value of the
  incentive.
• Gives managers an incentive to close the fund and
  start over when large losses occur.

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Funds of funds

• Funds of funds invest in one or more other hedge
  funds.
• Serve as feeder funds to ultimate hedge fund
• Allows investors to easily diversify across hedge
  funds.
• May be a bad deal because of extra layer of fees.
• Earned a bad reputation when it became apparent
  that many large fund of funds were major
  investors in Bernard Madoffs 50 billion Ponzi
  scheme.

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