Hedge Funds
Types and Risk Levels
Categories and Common Factors
Categories based on differences in risk types and levels
Risk Types – Market Risk, Credit Risk, Event Risk
Common Factors – Illiquid investments, Due Diligence Needed, Qualified Investors, Incomplete Markets, Leverage
Categories
Macro
Global
Relative Value
Merger Arbitrage
Convertible Bond Arbitrage
Fixed Income
Currency
Long Only
Long/Short
Short Only
Categories II
Real Estate
REITs
Mortgage Bond Securities
Asset Backed Securities
CDOs – Collateralized Debt Obligations
Private Equity
Venture Capital
Closed End Mutual Funds
Interim End Mutual Funds
Commodity Funds
Managed Funds
Event Risk Funds
Market Risk and Credit Risk
Many funds have hidden market risk within their category. For instance, if there are more events when the stock market increases, then some event risk funds will have returns that are highly correlated with the S&P 500.
Many funds use a business model with leverage, therefore, many funds carry a great deal of credit risk. For instance, Lehman Brothers 2008, is a good example of this business model failing during a credit crisis.
Transparency
There is a problem with transparency. If you have a winning strategy and you let the shareholders (called limited partners) know what you are doing (and when), some of the shareholders could imitate the strategy for themselves and all other shareholders are worse off. The returns to the strategy could decrease if others imitate your portfolio.
Transparency
On the other hand if you do not have transparency the limited partner (shareholder) cannot make an informed judgment about risk and return in the hedge fund. The Limited Partners do not have a great deal of power over the General Partner in terms of performance.
The most influential power the limited partner has is to NOT invest additional funds into the hedge fund
Overcommitment Ratio – Investors (Limited Partners) commit more than they have because they believe they will obtain more funds and they invest based on the fund performing well. If the fund’s performance slips the “promised” or committed money does not appear when needed. This is the power limited partners have over general partners. Committed future money is not given.
Incentive Fees Vary depending on Type of Hedge Fund
Typical contract might be 1% of AUM and 20% above the preferred return.
In addition, Lock Up Periods – cannot withdraw any money for the first 13 months or 5 years
Ask when you can withdraw your money in advance. You notify them 45 or 90 days in advance when you want to withdraw PART of your money.
Limits on how much you can withdraw at any time prior to liquidation of the fund. For instance, only % may be withdrawn at any one time and withdrawals may be given on 4 times a year or once a year.
Private Equity and Venture Capital may vary even more.
Venture Capital and Private Equity
Bad Leaver Clause
Good leaver Clause
Claw Back and Escrow
Hurdle Rate
J Curve
Cost Averaging and Naïve Allocation
Vintage Year and Diversification
Carried Interest
Merger Arbitrage
Buy Target Stock
Short sell the bidders stock
If deal goes thru you collect the difference between the prices you bought at and the final merger price.
Merger bids can change, mergers can fail due to financing and regulation.
Convertible Arbitrage
Convertible Bonds
Buy the bond
Short the stock
Convertible Preferred Stock
Buy the preferred stock
Short the stock
Credit Spread SWAPs
Yields on a bond may decrease because the company is doing better than expected. If interest rates fall what happens to the price of the stock?
Yields could get worse if the company is performing worse than expected. What happens to your bonds when your interest rate rises?
Convergence SWAPs
Yields on 2 bonds may perform similar over long time periods. The yields may be farther apart than normal so you “bet” they will converge in the near future. Fixed Income market
Prices of 2 securities or commodities may perform similar over long time periods, you may “bet” they converge to the normal spread. Equity and Commodity Markets
REITs and Real Estate Funds
Illiquid – high cash flows from rent, etc.
No high cash flows for vacant land or vacant buildings.
Possible conflict of interest between management and owners
Financial Leverage
Correlation and long market cycles
Local knowledge Important
Zoning Important
Long Only Funds
Credit Risk
I
I
I
I
I
0 Cash--1 FI --2 V--3 Ind -- 4 G--5 PE
Market Risk
FI is fixed income, V is value fund, Ind is index, G is growth and PE is private equity (7-10 year lockup).
Hedge Funds Long/Short
Credit Risk
6
5 LTCM, Bear, Lehman
4 I arb
3 C arb Macro
2 M arb/Evt
1 MN E L/S S
0 ---- 1 MT-------2 --------3 ------- 4 -------- 5
Market Risk
I arb is income arbitrage, C arb is convertible arb., M arb is merger arb., Evt is event risk arb., MN is market neutral, S is short funds, E L/S is Equity Long and Short funds.
Three Fundamental Questions for Investors
What is the investment objective of the fund?
What is the investment process of the hedge fund manager?
What makes the hedge fund manager so smart (In other words, does he/she have better information or do they process the information better?)?
On Shore, Off Shore or Both?
Location of fund relevant for taxes.
Hedge Fund Manager
Master Trust Account (tax neutral site)
Off Shore On Shore US Hedge Fund
Foreign Investors US Residents
Ownership has to be documented. Key persons must be revealed.
Registrations/Laws
Maybe registered with the SEC as an investment adviser under Investment Adviser Act of 1940. Then the adviser must file annually Form ADV with SEC with financial and structural information on the fund.
Might be registered with the National Futures Association and CFTC (Commodity Futures Trading Commission as a Commodity trading adviser(CTA) or a Commodity Pool Operator (CPO). NFA is a self regulatory body for the managed futures industry and is approved by CFTC to handle all registrations for CTAs and CPOs.
Benchmark vs. Hurdle Rate
If the value of assets in a fund cannot be priced continually in a liquid market, then a benchmark may not be appropriate or available to use for comparison or contract terms. In such a case the Hurdle Rate or Preferred Return will be stated in the contract. This is one reason many hedge funds are considered absolute return vehicles. Their value is not compared to a relative index and they may be expected to make profit even when other markets are down.
Sourc of Investment Ideas and Competitive Edge
Manager skill comes from ideas, where does this manager obtain ideas?
Research department for the fund may generate ideas
In which types of markets do the strategies used in the fund perform better?
Drawdowns
A drawdown is a decline in the Net Asset Value of a fund (NAV).
Drawdowns occur in the mutual fund industry, also. However in mutual funds it is usually a syptom of the market decreasing.
Hedge fund drawdowns are frequently caused by firm specific risk or credit risk, not just market risk.
Drawdowns and Skill
If you claim to be an absolute fund without a benchmark, then a drawdown indicates you lacked skill in that environment. The skills argument is a two edged sword. You cannot find a benchmark to grade me, so the hurdle rate or drawdown is the only way left to grade the manager.
Expected Returns and Sharpe Ratios
1990-2000 Monthly
Strategy E ( R) Std dev Sharpe Skew K
E L/S % % .525 .113
S .2% % .088
G/Macro % % .396 .153 .1
C arb .96% % .501
Evt % % .45
M arb % % .446
FI arb .74% % .2
RV arb % % .589
MN .89% .93% .47 .3
M timing % % .421 .109
S & P 500 % % .19
HY Index .78% % .157
HY is high yield, G/Macro is global macro, S is short, E L/S is equity long and short, RV is relative value.
Skew and Kurtosis
Skew is the third moment of the distribution and kurtosis is the fourth moment.
Normal distributions can be defined with the first two moments only (mean and standard deviation).
Sharpe ratio captures the first two moments, not the third and fourth.
Sharpe ratio not appropriate as only measure for hedge funds.
Skew and Kurtoses II
S&P 500 has positive kurtosis this means the return distribution has fatter tails than the normal distribution. In other words, more outliers or extreme values occur more frequently in the stock market than would be predicted by the normal distribution.
A negative value for Kurtosis would indicate slimmer tails (fewer outcomes than the normal distribution would predict).
Only market timing funds have negative Kurtosis, indicating they manage this type of risk.
Kurtosis
Note that Global Macro, Equity market neutral and market timing funds have lower kurtosis than the S&P 500 indicating they have slimmer tails than the S&P 500. So these funds have fewer extreme outliers than the S&P 500.
Equity Long/Short and Short Selling funds have about 20% more kurtosis. So they have a few more outlier events.
The arb strategies (Mergers, relative value, convertible, event driven, etc.) have from twice the kurtosis to 10 times as great kurtosis. So these funds will have twice to 10 times as many outliers.
Skewness
A negative skew indicates the mean is to the left (lower than) of the median of the distribution. This means there are more frequent large returns to the left of the distribution (negative returns) and more small and medium returns to the right of the distribution.
Large negative returns occur more frequently than large positive returns, indicating a bias to the downside.
Skew
A positive skew indicates the opposite.
The mean is to the right of the median and there are more frequent large positive returns than negative returns.
Positive skew demonstrates a bias to the upside.
The S&P 500 has a negative skew of
Four types of funds have positive skew: Market timing, Macro, Short Only and L/S.
Skew II
Market Neutral funds have negative skew, but less skew than the S&P 500.
Five fund types have larger negative skew than the S&P 500: Relative Value arbitrage, Fixed Income arb, Convertible arb, Merger arb and Event Driven arbitrage funds. These funds have approximately 2-7 times the skewness of the S&P 500 indicating they have more small positive returns and a few large losses. They have more large losses than the S&P 500.
Positive Skew should be one measure of Manager Skill
Leptokurtosis
Leptokurtosis means Downside tails occur more frequently.
Examine Global Macro funds – lower skew and lower kurtosis. This means the managers as a whole provided positive skew with smaller or slimmer downside tails than the S&P 500. This is evidence of manager skill.
Convertible Arbitrage
75% of the time they have returns about 1% per month. This consistency may be a measure of skill. There is event risk (credit risk) and this is reflected in the negative skew and large kurtosis . The leverage in these funds drives the skewness and kurtosis.
Platykurtosis
Tails thinner than the normal distribution: market timing funds. These funds tend to avoid the outlier events in the stock market.
Hedge Funds and Market Risk
Three types of funds have risk profiles that are no worse than the S&P 500: equity long/short, global macro and short selling.
Hedge Funds and Credit Risk
To limit credit risk choose arbitrage funds (merger, convertible, fixed income, event driven, etc.) that limit leverage to 2 to 1.
Hedge Funds that have low market and low credit risk
Market Neutral funds
Market timing funds
Of course, DIVERSIFICATION across hedge fund types is better than only using one category.
