A Primer on WARF’s Hedge Fund Portfolio: More than just a shortlist for Trump’s cabinet Ryan Abrams, CFA, FRM Portfolio Manager

What are hedge funds? From Wikipedia: A hedge fund is an investment fund that pools capital from accredited individuals or institutional investors and invests in a variety of assets, often with complex portfolio-construction and risk-management techniques.[1] It is administered by a professional investment management firm, and often structured as a limited partnership, limited liability company, or similar vehicle.[2][3] Hedge funds are generally distinct from mutual funds as their use of leverage is not capped by regulators and distinct from private equity funds as the majority of hedge funds invest in relatively liquid assets.[4][5]

How does WARF use hedge funds in its portfolio? Two Portfolios – separate beta (market exposure) from alpha (manager skill) Provide exposures to investments that are tactical in nature (trading, security selection), compared with the strategic approach followed in the Beta portfolio (buy-and-hold) Access different risks to improve the risk-adjusted return of the total portfolio and also lower its overall volatility Objective is to add 2% per year to the return of the total portfolio, with 2% standard deviation, regardless of market conditions

Why separate alpha and beta? Easier to understand and control sources and allocation of risk and performance Separate skill from luck Is the long-term allocation of market risk as efficient as possible in terms of balance and cost? Is active management adding value, and are fees charged competitive in terms of what is being delivered?

Portfolio Performance vs. Policy Benchmark (as of Dec 31 2016)

Most hedge funds provide cocktail of exposures: a mix of alpha, as well as market and other betas… WARF attempts to focus on those managers that provide mostly alpha and as little beta as possible.

R = rf + β(rm)+ α

R = β(rm)+ α

y = m(x)+ b

Alpha in long-only management Mutual fund manager generates a return of 15% from owning a portfolio of stocks in a year the market was up 10% – did she create value, or just ride the market? [Assume beta =1.5] R = β(rm)+ α 15% = 1.5*(10%)+ α α = 0  no outperformance

Alpha in hedge fund management Hedge fund manager generates a return of 15% from owning a portfolio of stocks in a year the market was up 10% – did she create value, or just ride the market? [Assume beta = 0.2] R = β(rm)+ α 15% = 0.2*(10%)+ α α = 13%  2% from market; 13% value-added

How do hedge funds reduce/adjust beta? Hedging Example: Exxon Mobil has a beta of 0.80 Trader owns $1,000,000 of stock Hedge by selling short $1,000,000 * 0.8 = $800,000 of market index to obtain beta of zero

How do hedge funds reduce beta? Management of “net exposure” and trading Example: Hedge fund is bullish on Japanese economy holding a long position of $1,000,000 in stock futures during 2016; in 2017 the manager is bearish on the Japanese economy and holds positions of -$1,000,000 in stock futures; portfolio beta averages zero over this period and manager makes money in rising market first year and then falling market the next.

Alpha Portfolio Plan Run regressions and find funds where beta = 0 Give money to diversified set of strategies Profit $$$

Skewness and Kurtosis

Need to understand and avoid hidden “betas” or biases… Hedge mismatches (“basis risk”) Short volatility Short credit spreads Short liquidity Styles – value, growth, momentum Marry quantitative analysis of performance with qualitative analysis of investment strategy and risk management

Avoid blow-up risk: Cumulative probabilities converge to one; avoid remote possibility of certain ruin whenever possible If you choose to play, limit downside through proper sizing Seek positive skewness Diversify!