6. Hedge Funds

Pooled investment vehicle using flexible strategies -> leverage, short selling, derivatives

Absolute returns with low market correlation

Privately offered or regulated -> depending on jurisdiction

Private, unlisted & unregulated

Performance compensation

Diverse trading strategies

Active management due to complex & opportunistic strategies

Low correlations with traditional assets (diversifying)

Ability to take advantage of both long and short ideas

Potential high risk-adjusted returns

Post GFC investor flows towards larger funds

• Large funds perceived less risky —> better risk management & control systems

• High costs of DD

HF borrows shares to sell on the market, aiming to repurchase them later at a lower price

HF pays substitute dividends to the lender while the shares are on loan

HF receives a rebate on posted collateral (interest rate minus stock-loan fee)

Exposes HF to unlimited losses / used for alpha generation or hedging

Macro and Managed Futures Funds

Event-Driven Hedge Funds

Relative Value (Arb)

Equity Hedge Funds

Macro

Managed Futures

Activist

Merger Arbitrage

DIstressed

Event-Driven Multistrat

Convertible

Volatility

Fixed Income

Relative Value Multistrat

Long-short

Market Neutral

Short Selling

Equity Strategies

Event-driven and rel. value strategies

Absolute Return

Diversified

Equity long/short

Short bias

Market risk

High SD

High correlation with equity market

Events: distressed securities, merger arb, multistrat

Rel. value: convertible bonds, volatility, fixed income, multistrat

Primary risk: event risk

Large negative skew

High kurtosis

Small profits & occasional large losses (short vol)

Equity market neutral

Market defensive FoFs

Low SD

Very small skew

Low kurtosis

Skill based strategy

Global macro, systematic diversified

Multistrategy / FoFs

Low drawdowns in crisis

Positive skew

Diversification benefits

Avoid second layer fees

Greater transparency & flexibility

Superior risk management

Self selection of managers

Manager selection skills

Reduced operational risk

Broader diversification

Negative publicity from controversial events

HF might profit from crises

Little evidence of HF causing crises -> amplify market declines

Asset-Weighted Indices

Equal-Weighted Indices

Biased towards larger funds (AUM) -> larger funds have bigger influence on index

Better reflect market performance -> as most capital in larger funds

Most consistent traditional market indices -> traditional are market-cap weighted; these are AUM weighted

Each fund has equal impact -> disregard AUM

Preferred by index providers -> reflect all strategies fairly

Representativeness

Data biases

Fee bias

Style Drift

Investability

Measures how well an index reflects full HF universe

Limited coverage can distort results

Survivorship bias -> only funds that survived

Selection bias -> funds choose whether to report

Backfill bias -> only add past good returns

Liquidation bias -> stop reporting before final performance

Participation bias -> Enter/exit databases strategically

Successful managers raise fees

New investors earn lower net returns than early investors

Managers deviate from stated strategy

Unreliable style-based analysis

Top-performing funds are closed

Investable indices include only funds open to capital -> exclusion of top performers

Regulatory exemptions when conditions are met -> private fund limits investor base and will not become public

Private funds exempt from mutual fund rules

Dividend payment does not change total value

Simply turns part of total value into cash

Stock that is heavily shorted

Hard to borrow -> high borrowing costs for short sellers

Broker forces return of a borrowed stock

Short seller must close position

Risks not shown on financial statements

Exapmples: Hidden liabilities, derivatives, guarantees

Only investment strategies to earn HF-returns

Use liquid assets and quantitative models

Charge lower fees

Discretionary Traders

Systematic Traders

Subjective / opinion-based trading

Rely in judgment / experience about value and outlook

Use of fundamental analysis

Objective decisions -> technical analysis

Follow pre-defined rules & models

Quant or black-box traders

Fundamental Analysis

Technical Analysis

Looks at underlying supply/demand factors

Focus on economic, financial & industry values

Looks at economic, financial, and industry factors

Assumes price pattern reflect market behavior

Opportunistic

Top-down analysis of global events

Investing based on macro forecast

Currency devaluation bet

Monetary policy bet

Thematic investing

Market

Event

Leverage

Systematic, rule-based trading of futures / forwards

Trend-following in…

• commodities

• Rates

• FX

Model risk

Regulatory risk

Lack of trends

Governed by Commodities Exchange Act (CEA) 1974 -> requires reporting & disclosure

U.S. regulator -> CFTC

Self-regulatory body -> NFA for CPOs & CTAs

Post 08 -> OTCs through Dodd-Frank & EMIR in EU

Public commodity pools

Private commodity pools

Individually managed accounts

Mount Lucas Management Index (MLM)

reflects systematic trend-following returns in future markets

Fundamental

Technical

Momentum -> trend-following

Mean reversion -> bet prices return to avg

Global macro

Relative value -> arbitrage

Multistrat

High Frequency (seconds/minutes -> no managed futures)

Short-term -> intraday - 1 month

Medium-term -> 1-6 months

Long-term -> 6 months+