 Hedge Funds

The Name  Act as hedging mechanism  Investing can hedge against something else  Typically do well in bull or bear market

Mutual Fund  Group of investment vehicles  Professionally managed  Each shareholder gains or loses proportionally

Sector Allocation

Holdings

Fees and Expenses

Depletion of Returns

Similarities and Differences

Sources of Hedging  Direct Hedge  Cross Hedge  Dynamic Hedge  Static Hedge

Direct Hedge  Hedge one asset  Use another asset that trades in a similar fashion  Example: Call option hedge for equity position

Optimal Hedge Ratio  What you need:  Portfolio Volatility  Futures Volatility  Correlation Coefficient  Portfolio Value  Contract Size  Price

Volatility and Correlation  Portfolio and Futures Volatility  Simply a measure of returns variance  Correlation measures strength of relationship between returns of futures and equities

Contract Size and Price  Contract size simply number of shares futures contract represents  Standard is 100 shares per futures contract  Price is simply the cost per futures contract

Optimal Ratio and Hedge  The optimal ratio is simply the combination that minimizes volatility  Found using the cross volatility and correlation (Denoted h*)  The number of futures for optimal hedge is found using h* and the respective values of the contracts and the portfolio

Optimal Hedge Ratio

Cross Hedge  Hedging instrument with unlike instrument  Long preferred stocks  Treasury futures as hedge (Tend to follow each other)  Trace happens approximately 85% of the time

Dynamic Hedge  Similar to aforementioned hedges  Constantly adjusted  Can think of this as ongoing insurance for portfolio  Regularly employed by hedge funds  Adding or subtracting from existing hedge depending on market environment

Static Hedge  Simply call or put options  Keep until maturity  No future adjustment needed  i.e. Hedging for the period until maturity

Fund Strategies  Market Neutral  Convertible Arbitrage  Fixed Income Arbitrage  Distressed Securities  Merger Arbitrage  Hedged Equities  Global Macro  Emerging Markets  Fund of Funds

Market Neutral  Attempt to identify over and undervalued securities  Benchmark typically risk-free rate  Neutralizes the portfolio’s exposure to market risk  Combination of long and short position  Usually have beta of zero  Benchmark typically risk-free rate, due to beta

Convertible Arbitrage  Attempt to exploit mispricing in convertible securities  Convertible bonds, convertible preferred stock, etc.  Buy or sell these securities and then fully or partially hedge risk  Make money  Coupon on convertible bond  Expected volatility of underlying asset increases  Price of underlying asset increases

Fixed Income Arbitrage  Identify overvalued and undervalued fixed income  In anticipation of changes in term structure of credit quality  Generally neutralized against market risk due to long and short positions  Duration is equal to zero

Duration  How long it takes, in years, for the price of a bond to be repaid by its internal cash flows  Represents price sensitivity to IR changes  Zero Coupon Bond – Duration equal to TTM  Vanilla Bond – Duration < TTM

Duration of Zero Coupon  Bought at discount, full price paid out at end, no coupons  Fulcrum represents where the price paid for the bond and the cash flows are equal

Duration of Vanilla Bond  Annual coupons, say 5 year maturity  Last payment includes face value of bond

Duration Formula

Continuously Compounded

Let’s Try an Example

Bond Prices  New bond prices can be easily assessed with duration  Using the change in interest rate, duration, and present value

Why is this important?  Hedge funds constantly asses risk in fixed income arbitrage  Duration risk is an important factor  Higher duration means more duration risk  Zero coupons have highest duration risk

Distressed Securities  Debt and Equity of companies near bankruptcy  Legal risk is transferred from HNWI to hedge fund  Many HNWI are prevented from investing in these types of companies  Most funds long due to lack of liquidity

Merger Arbitrage  Captures price spread before and after transaction  Acquisition, Merger, JV, Spin-Off  Usual strategy  Buying stock of target company  Shorting stock of acquiring company

Hedged Equity  Attempt to identify overvalued and undervalued equity securities  Not market neutral, many times very concentrated  Usually have net long exposure to equity markets

Global Macro  Take advantage of systematic moves in global markets  Concentrate on major market trends  Managers many times use derivatives, options and futures

Emerging Markets  Focus on emerging and less mature markets  Short selling is not permitted  Most funds are long

Fund of Funds  Invests in a number of underlying hedge funds  Typically more accessible to individual investors  Greater liquidity  Two layers of fees for investors  Typically invest in hedge funds  Some are even more diversified

AUM Growth

Industry Trends 14-15

Industry Breakdown

Performance by Fund Type

Leverage Ratios by Fund Type