Asset Management

Lecture 18

Outline for today

Hedge funds General introduction Styles

Statistical arbitrage alpha transfer

Historical performance Alphas and betas

Definition

Investment approach Trade any type of security or financial instrument Operate in any market anywhere in the world Unrestricted short-selling and leverage Pure management skill

Fees and liquidity Compensation

Management fee 2% (NAV) Performance fee 20%

High water marks Limited liquidity (lock-ups)

Legal LLC in US or off-shore open-ended investment companies Unregulated private investment vehicles for wealthy individuals and i

nstitutional investors Provide minimal information to investors

Industry Size

Styles

Strategies

DirectionalBets that one sector or another will

outperform other sectorsNon directional

Exploit temporary misalignments in security valuations

Buys one type of security and sells anotherStrives to be market neutral

Classification

Equity Long/Short investing consists of a core holding of long/short equities depending on the outlook. Commonly employ leverage.

Equity Market Neutral investing seeks to profit by exploiting pricing inefficiencies between related equity securities, neutralizing exposure to market risk by combining long and short positions.

Convertible Arbitrage involves purchasing a portfolio of convertible securities, generally convertible bonds, and hedging a portion of the equity risk by selling short the underlying common stock.

Distressed Securities strategies invest in, and may sell short, the securities of companies where the security's price has been, or is expected to be, affected by a distressed situation. This may involve reorganizations, bankruptcies, distressed sales and other corporate restructurings.

Merger Arbitrage, sometimes called Risk Arbitrage, involves investment in event-driven situations such as leveraged buy-outs, mergers and hostile takeovers.

Classification

Emerging Markets funds invest in securities of companies or the sovereign debt of developing or "emerging" countries. "Emerging Markets" include countries in Latin America, Eastern Europe, the former Soviet Union, Africa and parts of Asia.

Event-Driven is also known as "corporate life cycle" investing. This involves investing in opportunities created by significant transactional events, such as spin-offs, mergers and acquisitions, bankruptcy reorganizations, recapitalizations and share buybacks.

Fixed Income Arbitrage is a market neutral hedging strategy that seeks to profit by exploiting pricing inefficiencies between related fixed income securities while neutralizing exposure to interest rate risk.

Relative Value Arbitrage attempts to take advantage of relative pricing discrepancies between instruments including equities, debt, options and futures. Managers may use mathematical, fundamental, or technical analysis to determine mis-valuations.

Classification

Macro involves investing by making leveraged bets on anticipated price movements of stock markets, interest rates, foreign exchange and physical commodities. Involves allocating assets among investments by switching into investments that appear to be beginning an uptrend, and switching out of investments that appear to be starting a downtrend.

Fund of Funds invest with multiple managers through funds or managed accounts. The strategy designs a diversified portfolio of managers with the objective of significantly lowering the risk (volatility) of investing with an individual manager.

Statistical Arbitrage

Uses quantitative systems that seek out many temporary misalignments in prices

Involves trading in hundreds of securities a day with short holding periods

Pairs trading Pair up highly correlated companies with recent

pricing discrepancy Create a market-neutral position

Data mining

Alpha Transfer

Separate asset allocation from security selectionInvest where you find alpha

Hedge the systematic risk to isolate its alpha

Establish exposure to desired market sectors by using passive indexes

Pure Play Example

Manage a $1.5 million portfolio Believe alpha is >0 and that the market is about to fall Capture the alpha of 2% per month

β = 1.20 S&P 500 Index is S0 = 1,440

α = .02 rf = .01

Hedge by selling S&P 500 futures contracts S&P 500 futures contracts: $250 each

( )portfolio f M fr r r r e

Pure Play Example

The dollar value of your portfolio after 1 month:

The dollar proceeds from your futures position:

$1,500,000Hedge Ratio = 1.20 5 Contracts

1,440 $250x

x

$1,500,000 (1 ) $1,500,000 1 .01 1.20( .01) .02

$1,527,000 $1,800,000 x $1,500,000

portfolio M

M

x r r e

r x e

0 1

0 1

0

5 $250 ( ) Mark to market on 5 contracts sold

$1,250 (1.01) Substitute for futures prices from parity relationship

$1,250 1.01 (1 ) Because SM

x x F F

x S S

x S r

1 0

0

0

= S (1 ) when no dividends are paid

$1,250 (.01 ) Simplify

$18,000 $1,800,000 Because S = 1,440

Hedged Proceeds = $1,545,000 +$1,500,000 x

M

M

M

r

x S r

x r

e

3% return Non-systembatic risk

Historical Performance

Historical Performance

Hedge Funds Spring 2008

17

Hedge Fund Alpha

Alfas and betas

Measure fund performance using regression:

Beta measures how fund goes up and down with the market

i rmt measures the return due to market exposure

i measures the excess return, due to manager talent (or luck…)

(i) measures the risk specific to the fund (presumably diversifiable)

Alfas and Betas

You should only pay fees for alpha, the rest you can easily (and more cheaply) obtain with an ETF

To add an hedge fund to a portfolio, we need to know how it correlates with the other assets

Unfortunately, it’s not so easy to measure alphas and betas for hedge funds Asset illiquidity biases betas Time-varying or non-linear exposure of hedge fund

strategies

Hard to spot talent – short histories

Typically hedge funds have histories shorter than 5 years

Uncertainty of mean return is With 15% volatility, 5 year history, 90% confidence

interval for mean return is

To evaluate a manager, you need to understand the economic story very well Risk premia – value, illiquidity, Market inefficiency –

why? what capacity? Competitive advantage of manager

Hard to spot talent – survivorship bias

All hedge funds around seem to be exceptional… And, in fact, all funds alive have had an exceptional performance in the past

Hedge fund indices are based on self-reported performance (with backfill) Only successful funds report, biasing the

performance of the index relative to the performance of an investor who actually put money in a cross section of funds

Survivorship bias in indices of the order of 3% per year (Brown and Goetzmann)