1. Alternative Investments Portfolio Management
Part II

2. The Hedge Fund Industry
First hedge fund started by Alfred Jones in 1949
“Hedge”: Long-short strategy to hedge/neutralize market exposure
Similar beta exposure on both sides; the two betas cancel each other out
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3. Biggest players
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4. Growth of the top 100
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5. Example long-short fund
Global market neutral
September 2012
Long
Short
Predicted Beta
1.47
1.41
Number of positions
111
122
Median Market Cap
$5.6B
$5.2B
Largest position
3.5%
3.1%
Top 10 positions
25.1%
23.1%
North America
62.2%
81.5%
Europe
15.7%
17.4%
Asia
35.9%
40.7%
Emerging Markets
11.6%
4.7%
R-square vs MSCI AC World: 0.00
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6. Example long-short fund
Summary of Terms
Launch Date
March 2008
Target Risk
5-8%
Leverage
Typical %, maximum 400%
Domicile
Cayman Islands
Fee
1* and 20
Lock-up
None
Redemption Charge
0.50% if within first 12 months
Currency Options
USD/EUR/JPY
Prime Brokers
Credit Suisse/Goldman Sachs
Administrator
Bank of New Mellon
Auditor
PwC
Counsel
Bringham McCutchen LLP
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* Once the fund size reaches $250m, MER will go up for new investors

7. Return comparisons 2008 (%) 2009 (%) DJIA -31.9 22.7 NASDAQ -40.0 45.4
2008 (%)
2009 (%)
DJIA
-31.9
22.7
NASDAQ
-40.0
45.4
S&P 500
-37.0
26.5
FTSE 100
-48.2
43.0
CAC 40
-43.8
33.2
DAX 30
-43.3
27.8
Nikkei 225
-28.7
15.9
MSCI/EM
-53.3
78.5
CS Equity Market Neutral Index
-2.8
4.1
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8. The Hedge Fund Industry
Structure
Single funds
Multi-strategy funds
Opportunistic choice of strategy depending on outlook
Fund of (hedge) funds
Fund allocates its cash to several other hedge funds to be managed
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9. Support Services Prime brokerage Legal counsel Auditor
Support services for funds offered by investment banks, such as fund accounting and reporting, financing, trade execution, securities lending, start-up advice
Legal counsel
Auditor
Custodian/administrator
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10. Trouble with the law
Indictment of Galleon Capital in 2009, SAC Capital in July 2013…etc. led some prime brokers to put in “pre-judgement” clauses in their prime brokerage agreements
Pre-judgement – allegation/investigation by a regulatory or law-enforcement body
They allow the banks to pull financing
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11. Characteristics of Hedge Funds
Hedge funds today no longer defined by “hedging”, but by their organizational and structural characteristics:
Transparency
Hedge funds are set up as private partnerships (e.g., LLP), and hence not governed by many SEC regulations. Registration is typically overseas, e.g., Cayman Islands, Bermuda
Policy debate because of transparency and fraud risks
Unlike mutual funds, disclosure and reporting is voluntary
Clientele
Traditionally to institutional investors and high net worth clients
Now, minimum can be as low as $25,000 for some funds
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12. Characteristics of Hedge Funds
Investment strategies
Mutual fund strategies are well-defined and narrower, e.g., U.S. small-cap, EAFE value
Hedge funds invest in a wider range of assets, and strategies are less predictable and more opportunistic
Liquidity
Lock-up periods and redemption notices
Ranges from 0 month to 3 years (the more illiquid the assets, the longer the period)
Use of leverage
Ranging from moderate ( %) to high (300%+)
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13. Characteristics of Hedge Funds
Compensation structure
2&20 common, 1&10 additional fees for fund-of-funds
Asymmetric compensation potentially problematic
High-water mark: If a manager loses money over a period, the manager must get the fund above the high-water mark (previous peak) before receiving a performance fee again
High fee structure
Not justified if a fund provides mostly beta exposure
Maybe justified as an insurance premium if a fund adds significant diversification benefit
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14. Characteristics of Hedge Funds
Target return
Absolute return strategy – not benchmark driven (benchmark agnostic)
Target is “cash plus”: Ranges from LIBOR + 3% to LIBOR + 8%, depending on the strategy
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15. Style of Hedge Fund Strategies
Broad categories
Directional: Making active bets about the performance of a market/sector versus another
Non-directional: Exploit temporary mispricing in securities. Not betting on broad market/sector movements, but rather on relative valuation
Price anomalies may be small, so funds are often highly leveraged to magnify gains
In a financial crisis, values may continue to diverge (e.g., because of flight to quality, U.S. Treasuries continue to be overvalued heavy losses for LTCM)
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16. DJ Credit Suisse 10 Classifications
Convertible arbitrage
Hedged investing in convertible securities: Long convertible bonds, and short stock if bond is undervalued (taking advantage of pricing inefficiency in the convertible bond market)
Dedicated short bias
Net short position, usually in equities
Emerging markets
Exploit market inefficiencies in emerging markets. Typically long- only, because short-selling is not feasible in many of these markets
Equity market neutral
Long/short positions. Balances sector, market cap and other exposure to neutralize market (or beta) exposure
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17. DJ Credit Suisse 10 Classifications
Event drive
Attempts to profit from corporate events such as mergers and acquisitions, restructuring, bankruptcy, or reorganization
Long/short equity
Long and short depending on outlook, not meant to be market neutral. May establish a concentrated regional or sector focus
Managed futures
Financial (e.g., stock), currency, or commodity futures. May make use of technical rules or less judgemental approach
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18. DJ Credit Suisse 10 Classifications
Fixed income arbitrage
Attempts to profit from price anomalies in related fixed income securities. Examples: “On-the-run” vs. “off-the run” Treasuries. The former is more liquid and more expensive than the latter. Long Term Capital Management (LTCM): Long off-the-run and short on-the-run
Global macro
Long and short positions in capital or derivative markets across the world. Portfolio positions reflect views on broad market conditions and major economic trends
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19. DJ Credit Suisse 10 Classifications
Multi-strategy
Used to also include: Fund of funds (FOF)
Typically holds 10 – 30 hedge funds
Performs due diligence on investors’ behalf (BUT did not catch Madoff)
DJ and Credit Suisse joined forces in Prior to that, the index was called the CS/Tremont Hedge Fund index (in textbook)
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20. Strategy performance not stable
Annual returns
Managed Futures and Dedicated Short Bias only two strategies with positive returns in 2008
Only two strategies with negative returns in 2009
Source: CS/Tremont
Least positive return
Least negative return
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21. Hedge Fund Benchmarks DJ Credit Suisse, CISDM*, HFR, MSCI Barra
Only a few have daily data, most are monthly
Weighting scheme: equal (HFRX) or asset-based (DJCS)
Not all are investable (i.e., can one buy a fund that tracks the hedge fund index? Hedge fund replication models?
Only some list actual funds used in the index
Selection criteria for inclusion
Track record: typically 2 years
AUM: typically $50 million
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* Centre for International Securities and Derivatives Market

22. Problems with Hedge Fund Indices
Survivorship bias
Managers with poor track record exit the database
~ 11% of hedge funds become defunct per year
Results in upward bias when historical returns are based on only survivors. This bias has been estimated to be 1.5% to 3% per annum
Stale prices bias
Problem with assets that do not trade often. Correlation with other assets may appear lower than otherwise
Backfill bias
A hedge fund joins an index. Will supply past data (backfill) only if track record is good
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23. Hedge Fund Performance
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24. Hedge Fund Performance
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25. More recent performance
CFA Institute
Conference Proceedings
Quarterly December 2012
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26. Liquidity and Hedge Fund Performance
Hasanhodzic and Lo (2007)
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27. A Positive Relationship
Using data from the previous table:
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28. Is It Just A Liquidity Premium?
Serial correlation in returns: An indicator of less liquid markets
If an asset is not actively traded, the hedge fund manager must estimate its value to calculate returns. Tendency to smooth out value estimates or only gradually mark prices to true market values
Aragon (JFE,2007) shows that once lock-up periods and redemption notice periods are controlled for, the alpha turns insignificant
Excess returns of funds with lockup restrictions are 4 to 7% per year higher than those of non-lockup funds
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29. Hedge Funds and the Sharpe Ratio
Not appropriate when investment returns are asymmetrical
Biased upward by illiquid holdings, when returns are serially correlated
Has not been found to predict future returns
Can be gamed by lengthening measurement interval, compounding monthly returns but calculating standard deviations without compounding, writing out-of-money calls and puts (and collecting the premiums), and smoothing returns
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30. Other Performance Evaluation Concerns
Measuring volatility
Annualized standard deviation - monthly standard deviation  12
Underestimate volatility if monthly returns are serially correlated
Hedge fund returns have more skewness and kurtosis than other investments
For example, strategies that take on default risk, liquidity risk, or other forms of catastrophe risk (negative skewness)  higher Sharpe ratio until the risk is realized
Harvey and Siddique (JF 2000) show that stocks with negative skewness generate higher average returns
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31. Hedge Fund Due Diligence
Due diligence includes
Structure (legal entity, manager, domicile, registration, personnel, support providers)
Strategy (style, instruments, benchmark, niche, holdings)
Performance data (all funds, since inception)
Risk (measurement, controls, use of leverage)
Research (changes due to past findings, efforts, budget and personnel)
Administration (lawsuits, turnover, disaster recovery)
Legal (fee structure, lock-up, subscription maximum and minimum, drawback)
References (professional, other investors)
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32. Another comparison of performance
CFA Institute
Conference Proceedings
Quarterly December 2012
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