Investments, 8 th edition Bodie, Kane and Marcus Slides by Susan Hine McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 26 Hedge Funds

26-2 Hedge Funds Characteristics Investment pooling Transparency –Limited liability partnerships –Provide minimal information Investors –No more than 100 “sophisticated” investors Investment strategies –Wide range of investments

26-3 Hedge Funds Characteristics Continued Liquidity –Lock-up periods Compensation structure –Charge a management fee plus a substantial incentive fee

26-4 Hedge Fund Strategies Directional –Bets that one sector or another will outperform other sectors Non directional –Exploit temporary misalignments in security valuations –Buys one type of security and sells another –Strives to be market neutral

26-5 Table 26.1 Hedge Fund Styles

26-6 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 similar companies whose returns are highly correlated but one is priced more aggressively –Create a market-neutral position Data mining

26-7 Alpha Transfer Separate asset allocation from security selection –Invest where you find alpha Hedge the systematic risk to isolate its alpha Establish exposure to desired market sectors by using passive indexes

26-8 Pure Play Example From the Text 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 S 0 = 1,440 α =.02 r f =.01 Hedge by selling S&P 500 futures contracts

26-9 Pure Play Example Continued The dollar value of your portfolio after 1 month: The dollar proceeds from your futures position:

26-10 Figure 26.1 A Pure Play. Panel A, Unhedged Position. Panel B, Hedged Position

26-11 Style Analysis Hasanhodzic and Lo factors: –Equity market conditions –Foreign exchange –Interest rates –Credit conditions –Commodity markets –Volatility

26-12 Table 26.2 Style Analysis for a Sample of Hedge Funds

26-13 Liability and Hedge Fund Performance Hedge funds tend to hold more illiquid assets than other institutional investors Aragon –Typical alpha may be interpreted as an equilibrium liquidity premium than a sign of stock-picking ability Santa Effect –Higher returns reported in December –Stronger for lower-liquidity funds

26-14 Table 26.3 Performance Measures for Hedge Funds

26-15 Figure 26.2 Hedge Funds with Higher Serial Correlation in Returns, an Indicator of Illiquid Portfolio Holdings, Exhibit Higher Sharpe Ratios

26-16 Hedge Fund Performance and Survivorship Bias Backfill bias –Hedge funds report returns to database publishers only if they choose to Survivorship bias –Unsuccessful funds that cease operation stop reporting returns and leave a database –Only successful funds remain

26-17 Hedge Fund Performance and Changing Factor Loadings Hedge funds are designed to be opportunistic and have considerable flexibility to change profiles If risk is not constant –Alphas will be biased if a standard, linear index model is used

26-18 Figure 26.3 Characteristic Line of a Perfect Market Timer

26-19 Figure 26.4 Characteristic Lines of Stock Portfolio with Written Options

26-20 Table 26.4 Index Model Results for Hedge Funds, Allowing for Different Up- and Down-Market Betas

26-21 Black Swans and Hedge Fund Performance Nassim Taleb: –Many hedge funds rack up fame through strategies that make money most of the time, but expose investors to rare but extreme losses Examples: –The October 1987 crash –Long Term Capital Management

26-22 Fee Structure in Hedge Funds Typical hedge fund fee structure –Management fee of 1% to 2% of assets –Incentive fee equal to 20% of investment profits beyond a stipulated benchmark performance Effectively call options on the portfolio with a strike price equal to current portfolio value High water mark –The fee structure can give incentives to shut down a poorly performing fund

26-23 Figure 26.5 Incentive Fees as a Call Option

26-24 Funds of Funds Invest in several other hedge funds Optionality can have a big impact on expected fees –Fund of funds pays an incentive fee to each underlying fund that outperforms its benchmark even if the aggregate performance is poor Diversification can actually hurt the investor in this case

26-25 Funds of Funds Continued Spread risk across several different funds Investors need to be aware that these funds of funds operate with considerable leverage If the various hedge funds in which these funds of funds invest have similar investment styles, diversification may illusory

26-26 Example 26.6 Incentive Fees in Funds of Funds A fund of funds is established with $1 million invested in each of three hedge funds Hurdle rate for the incentive fee is a zero return Each fund charges an incentive fee of 20% The aggregate portfolio of the fund of funds is -5% –Still pays incentive fees of $.12 for every $3 invested Fund 1Fund 2Fund 3Fund of Funds Start of year (millions) $1.00$2.00$1.00$3.00 End of year (millions) $1.20$1.40$0.25$2.85 Gross rate of return 20%40%-75%-5% Incentive fee (millions) $0.04$0.08$0.00$0.12 End of year, net of fee $1.16$1.32$.25$2.73 Net rate of return16%32%-75%-9%