Chapter 20 Hedge Funds 20-1

Hedge Funds vs Mutual Funds Public info on portfolio composition Unlimited Must adhere to prospectus, limited short selling & leverage, limited derivatives usage Info provided only to investors < 100, high dollar minimums No limitations Mutual FundsHedge Funds Transparency Investors Strategies 20-2

Hedge Funds vs Mutual Funds 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 Mutual FundsHedge Funds Liquidity Fees 20-3

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 20-4

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? 20-5

Hedge Fund Styles Insert Table 20.1 here or ex.cgi?page=hedge_fund_styles or ID=15 ex.cgi?page=hedge_fund_styles ID=

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. 20-7

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. 20-8

Pure Play Example We have captured the alpha and hedged out the market risk. (Unsystematic risk remains.) 20-9

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

20.5 Performance Measurement for Hedge Funds 20-11

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 S&P500 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

Fund Performance and Survivorship Bias Survivorship bias is a problem in performance measurement of risky hedge funds –Those that don’t survive don’t report results that are used in estimating average performance. Backfill bias –Hedge funds report returns to publishers only if they choose to

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

Evaluating Hedge Fund Fees which 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)

Black-Scholes Value of Incentive Fee Suppose a hedge fund’s 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 S 0 = $100, X = $105,  =30%,T = 1 year, & r f = LN 1.05 = 4.88% is $ (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

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

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 Madoff’s $50 billion Ponzi scheme