the hedge fund
Part 1: Review of Hedge Funds … and structured products
Luis A. Seco Sigma Analysis & Management University of Toronto RiskLab
© Luis Seco. Not to be distributed without permission.
A hedge fund example
© Luis Seco. Not to be distributed without permission.
A hedge fund example
© Luis Seco. Not to be distributed without permission.
A hedge fund example
© Luis Seco. Not to be distributed without permission.
A hedge fund example
© Luis Seco. Not to be distributed without permission.
A hedge fund example
© Luis Seco. Not to be distributed without permission.
The snow swap !
!
!
!
Track the snow precipitation in late fall and early spring; If the precipitation is high, the ski resort pays to the City of Montreal a prescribed amount. If the precipitation is low, the City pays the resort another pre-determined amount. The dealer keeps a percentage of the cash flows. © Luis Seco. Not to be distributed without permission.
A hedge fund example
© Luis Seco. Not to be distributed without permission.
The snow swap
Snow City
$10M
No snow
© Luis Seco. Not to be distributed without permission.
Resort
The snow fund !
! !
!
Modify the snow swap so the City pays when precipitation is low in the city, and the resort pays when precipitation is high in the resort. The fund takes the “spread risk”, and earns a fee for the risk. Say the “insurance claim” is $1M. The fund would charge 20% commission, but assume to take the spread risk. Setting aside $2M, and charging $200K, the fund could – Lose nothing: 75% – Make $2M: 12.5% – Lose $2M: 12.5%
!
Expected return=10%. Std=50%
© Luis Seco. Not to be distributed without permission.
A diversified fund: a hedge fund. !
! ! !
If we do the swap across 100 Canadian cities: Expected return:10% Std: 5%. Better than investing in the stock market.
© Luis Seco. Not to be distributed without permission.
So we create the snow fund… … with some of the best known ski resorts: ! ! ! ! ! ! ! !
Blue Mountain (Toronto) Mountain Creek (New Jersey) Panorama Mountain Village (Calgary) Snowshoe Mountain (West Virginia) Steamboat Ski Resort (Hayden, Denver) Stratton Mountain Resort (Vermont) Tremblant (Montreal) Whistler Blackcomb (Vancouver)
… and then: © Luis Seco. Not to be distributed without permission.
Intrawest goes Bankrupt
© Luis Seco. Not to be distributed without permission.
Hedge Fund: definition !
! ! !
! !
An investment partnership; seeks return niches by taking risks, which they may hedge or diversify away (or not). Unregulated Bound to an Offering Memorandum Seeks returns independent of market movements Reports NAV monthly Charges Fees: 1-20 © Luis Seco. Not to be distributed without permission.
The investment structure Investor 1
Investor 2
Investor 3
Investor 4
Investor n
The Fund legal structure
The Bank Prime Broker
The Administrator The Management company “the hedge fund”
© Luis Seco. Not to be distributed without permission.
Share value !
Starting from the Net Asset Value observations (NAV) of the Fund Ni on a monthly basis, and the number of outstanding shares ni, we define the share value Si as Si= Ni /ni
© Luis Seco. Not to be distributed without permission.
Hedge Fund Fees !
!
!
The management company charges about 1% of the NAV. The fund issues payments to the management company usually monthly or quarterly. The management company usually charges about 20% of the net gains to the fund for a given period, usually a year. The payment occurs at year-end, usually. As investors come in and out of the fund, performance fees become complex and often give rise to unfair allocations. © Luis Seco. Not to be distributed without permission.
The free-ride syndrome
VAMI
Investor A
Investor B
© Luis Seco. Not to be distributed without permission.
Hurdle !
!
!
Some hedge funds only receive a performance fee if their return exceeds a certain objective (hurdle rate). This can be fixed (say 7%) or variable (LIBOR, for example) Other times, they only receive a performance fee proportional to the excess return with respect to the hurdle rate. Others –most- do not have a hurdle. © Luis Seco. Not to be distributed without permission.
Properties of hedge funds !
They can be illiquid. – Lock-ups. – Redemption restrictions.
! ! ! ! !
They give rise to valuation issues. Capacity restrictions. Vulnerable to attacks. Legal risk. …etc…
© Luis Seco. Not to be distributed without permission.
Databases
© Luis Seco. Not to be distributed without permission.
Hedge Fund Information !
!
!
Hedge funds are private partnerships, and hence have no obligation to report except to their own investors. Moreover, publication can be considered illegal marketing. But databases exist.
© Luis Seco. Not to be distributed without permission.
Data Issues (discussion) ! ! ! ! !
www.hedgefundresearch.com www.hedgefund.net www.hedgefund-index.com www.barclaygrp.com www.eurekahedge.com
© Luis Seco. Not to be distributed without permission.
Database issues ! !
Include funds with certain characteristics Many hedge funds do not want to report into them – Good funds with ample assets do not want to be subject to database requirements. – Closed funds have no incentive to report.
!
!
Backfill bias: Hedge funds select when they enter the database Survivorship bias: defunct funds do not appear in databases.
© Luis Seco. Not to be distributed without permission.
Hedge Fund Strategies
© Luis Seco. Not to be distributed without permission.
Asset growth
Asset growth by strategy
Strategy asset composition
Assets/firm size
Investments w/o hedge funds
+10% -6%
© Luis Seco. Not to be distributed without permission.
Hedge fund diversification !
Hedge funds are uncorrelated to traditional markets, and internally uncorrelated also.
Correlation histogram for Dow stocks Correlation histogram for hedge funds © Luis Seco. Not to be distributed without permission.
Sample Hedge Fund report
© Luis Seco. Not to be distributed without permission.
Sample HF report – part 2
© Luis Seco. Not to be distributed without permission.
Hedge Fund Indices
© Luis Seco. Not to be distributed without permission.
Hedge Fund indices !
!
!
They offer fund-of-fund investments that try to track the performance of the hedge fund sector (global and style specific) investing in liquid funds with high capacity. The result is often a fund that tracks nothing and lags performance. In contrast with equity indices, investors in a fund don’t like it when their fund is included in an index. © Luis Seco. Not to be distributed without permission.
Hedge Fund Indices ! !
Investable Non-investable
© Luis Seco. Not to be distributed without permission.
Historical comparative analysis
Pro-Forma
© Luis Seco. Not to be distributed without permission.
Correlation analysis
© Luis Seco. Not to be distributed without permission.
Style correlations
© Luis Seco. Not to be distributed without permission.
X/I correlations
© Luis Seco. Not to be distributed without permission.
alpha and beta
alpha
beta © Luis Seco. Not to be distributed without permission.
Linear regression Dependent variable
Independent variable
Regression coefficients © Luis Seco. Not to be distributed without permission.
Independent error
Linear regression
© Luis Seco. Not to be distributed without permission.
Return attribution: HFRX vs HFRI
© Luis Seco. Not to be distributed without permission.
Fund of Funds
© Luis Seco. Not to be distributed without permission.
Fund of Funds !
!
A Fund whose assets are invested in a collection of hedge funds. The fund manager usually seeks: – style diversification – manager -business risk- diversification.
© Luis Seco. Not to be distributed without permission.
The investment structure: fund of funds Investor 1
Investor 2
Investor 3
Investor 4
The Fund legal structure
Investor n
HF1 HF2 HFn
The Administrator The Management company “the hedge fund”
© Luis Seco. Not to be distributed without permission.
Types of fund-of-funds !
Multi-strategy fund-of-funds. – Un-leveraged: lowest risk, lowest return, highest Sharpe ratio. Institutional investors tend to prefer these. For others, their tame performance often pales in comparison with more aggressive investments
– Leveraged: higher risk, higher return, higher Sharpe ratio. Popular for Unsophisticated investors !
Single strategy fund-of-funds. – To follow fashionable trends. – To fit a risk profile (liquidity, capacity, transparency, etc.). Most popular with managed futures.
!
Indices. – Popular with option writers and other structurers.
© Luis Seco. Not to be distributed without permission.
Types of fund of funds !
Number of hedge funds they invest in: – 10 – 100
!
Management style – Qualitative – Quantitative
!
Business proposition – They manage the portfolio – They market the portfolio
© Luis Seco. Not to be distributed without permission.
Pros and cons ! !
!
!
!
Pros Market risk diversification Business risk diversification Outsourcing of monitoring and duediligence process, which most smaller investors cannot afford Access: minimum investments, lockups, etc.
! ! ! !
Cons Fees Transparency Increased business risk
© Luis Seco. Not to be distributed without permission.
Investing in Hedge funds Portfolio construction Hedge Fund products
© Luis Seco. Not to be distributed without permission.
The Investment Process: two steps Forensic accounting (DD):
Portfolio Theory: ! Markowitz with individual hedge fund returns as underlying assets. ! Efficient frontiers for optimal performance. ! Limits for concentration issues.
© Luis Seco. Not to be distributed without permission.
Structured products Options (CPPI). Guaranteed products. Debt products: CFO.
© Luis Seco. Not to be distributed without permission.
Leveraged products: loans Example: !
Investor provides $25M.
!
Lender provides $75M.
!
$100M is invested in a hedge fund portfolio.
!
The investment pays interest to the lender, and returns the principal at maturity.
!
The investor keeps the rest.
© Luis Seco. Not to be distributed without permission.
Leveraged products: options/warrants. Investors purchase a call option, with a reference hedge fund portfolio as underlying ! They offer non-path dependent returns ! Assets actually invested in hedge funds vary with the delta of the option ! Hedge fund shares are unlisted. ! Illiquidity of the hedge fund portfolio gives rise to higher implied volatilities, which are hard to value. Hedging becomes very difficult. © Luis Seco. Not to be distributed without permission.
Guaranteed notes !
There are two main reasons for a guarantee: – Regulatory environments – Risk perceptions (not to confuse with risk appetite)
!
!
Some guarantees are provided by well-rated banks. Others are not (Portus). Guarantees are obtainable by setting aside an interest-earning portion of the assets, and investing the remainder at higher levels of leverage, through a variety of different instruments. © Luis Seco. Not to be distributed without permission.
Anatomy of a guarantee Guarantees principal in the future:
Obtains exposure to the Hedge Funds
How much is needed is determined by • Interest rates • Maturity date of the note
© Luis Seco. Not to be distributed without permission.
CFO’s
SPV/Trust
Bond Investor (1) Bond Investor (2)
Guarantees principal
Fund Pool
© Luis Seco. Not to be distributed without permission.
Bond Investor (3)
Anatomy of a CFO
© Luis Seco. Not to be distributed without permission.
Bond defaults
© Luis Seco. Not to be distributed without permission.
Luis A. Seco Sigma Analysis & Management University of Toronto RiskLab
© Luis Seco. Not to be distributed without permission.
A hedge fund example
© Luis Seco. Not to be distributed without permission.
A hedge fund example
© Luis Seco. Not to be distributed without permission.
A hedge fund example
© Luis Seco. Not to be distributed without permission.
A hedge fund example
© Luis Seco. Not to be distributed without permission.
A hedge fund example
© Luis Seco. Not to be distributed without permission.
The snow swap !
!
!
!
Track the snow precipitation in late fall and early spring; If the precipitation is high, the ski resort pays to the City of Montreal a prescribed amount. If the precipitation is low, the City pays the resort another pre-determined amount. The dealer keeps a percentage of the cash flows. © Luis Seco. Not to be distributed without permission.
A hedge fund example
© Luis Seco. Not to be distributed without permission.
The snow swap
Snow City
$10M
No snow
© Luis Seco. Not to be distributed without permission.
Resort
The snow fund !
! !
!
Modify the snow swap so the City pays when precipitation is low in the city, and the resort pays when precipitation is high in the resort. The fund takes the “spread risk”, and earns a fee for the risk. Say the “insurance claim” is $1M. The fund would charge 20% commission, but assume to take the spread risk. Setting aside $2M, and charging $200K, the fund could – Lose nothing: 75% – Make $2M: 12.5% – Lose $2M: 12.5%
!
Expected return=10%. Std=50%
© Luis Seco. Not to be distributed without permission.
A diversified fund: a hedge fund. !
! ! !
If we do the swap across 100 Canadian cities: Expected return:10% Std: 5%. Better than investing in the stock market.
© Luis Seco. Not to be distributed without permission.
So we create the snow fund… … with some of the best known ski resorts: ! ! ! ! ! ! ! !
Blue Mountain (Toronto) Mountain Creek (New Jersey) Panorama Mountain Village (Calgary) Snowshoe Mountain (West Virginia) Steamboat Ski Resort (Hayden, Denver) Stratton Mountain Resort (Vermont) Tremblant (Montreal) Whistler Blackcomb (Vancouver)
… and then: © Luis Seco. Not to be distributed without permission.
Intrawest goes Bankrupt
© Luis Seco. Not to be distributed without permission.
Hedge Fund: definition !
! ! !
! !
An investment partnership; seeks return niches by taking risks, which they may hedge or diversify away (or not). Unregulated Bound to an Offering Memorandum Seeks returns independent of market movements Reports NAV monthly Charges Fees: 1-20 © Luis Seco. Not to be distributed without permission.
The investment structure Investor 1
Investor 2
Investor 3
Investor 4
Investor n
The Fund legal structure
The Bank Prime Broker
The Administrator The Management company “the hedge fund”
© Luis Seco. Not to be distributed without permission.
Share value !
Starting from the Net Asset Value observations (NAV) of the Fund Ni on a monthly basis, and the number of outstanding shares ni, we define the share value Si as Si= Ni /ni
© Luis Seco. Not to be distributed without permission.
Hedge Fund Fees !
!
!
The management company charges about 1% of the NAV. The fund issues payments to the management company usually monthly or quarterly. The management company usually charges about 20% of the net gains to the fund for a given period, usually a year. The payment occurs at year-end, usually. As investors come in and out of the fund, performance fees become complex and often give rise to unfair allocations. © Luis Seco. Not to be distributed without permission.
The free-ride syndrome
VAMI
Investor A
Investor B
© Luis Seco. Not to be distributed without permission.
Hurdle !
!
!
Some hedge funds only receive a performance fee if their return exceeds a certain objective (hurdle rate). This can be fixed (say 7%) or variable (LIBOR, for example) Other times, they only receive a performance fee proportional to the excess return with respect to the hurdle rate. Others –most- do not have a hurdle. © Luis Seco. Not to be distributed without permission.
Properties of hedge funds !
They can be illiquid. – Lock-ups. – Redemption restrictions.
! ! ! ! !
They give rise to valuation issues. Capacity restrictions. Vulnerable to attacks. Legal risk. …etc…
© Luis Seco. Not to be distributed without permission.
Databases
© Luis Seco. Not to be distributed without permission.
Hedge Fund Information !
!
!
Hedge funds are private partnerships, and hence have no obligation to report except to their own investors. Moreover, publication can be considered illegal marketing. But databases exist.
© Luis Seco. Not to be distributed without permission.
Data Issues (discussion) ! ! ! ! !
www.hedgefundresearch.com www.hedgefund.net www.hedgefund-index.com www.barclaygrp.com www.eurekahedge.com
© Luis Seco. Not to be distributed without permission.
Database issues ! !
Include funds with certain characteristics Many hedge funds do not want to report into them – Good funds with ample assets do not want to be subject to database requirements. – Closed funds have no incentive to report.
!
!
Backfill bias: Hedge funds select when they enter the database Survivorship bias: defunct funds do not appear in databases.
© Luis Seco. Not to be distributed without permission.
Hedge Fund Strategies
© Luis Seco. Not to be distributed without permission.
Asset growth
Asset growth by strategy
Strategy asset composition
Assets/firm size
Investments w/o hedge funds
+10% -6%
© Luis Seco. Not to be distributed without permission.
Hedge fund diversification !
Hedge funds are uncorrelated to traditional markets, and internally uncorrelated also.
Correlation histogram for Dow stocks Correlation histogram for hedge funds © Luis Seco. Not to be distributed without permission.
Sample Hedge Fund report
© Luis Seco. Not to be distributed without permission.
Sample HF report – part 2
© Luis Seco. Not to be distributed without permission.
Hedge Fund Indices
© Luis Seco. Not to be distributed without permission.
Hedge Fund indices !
!
!
They offer fund-of-fund investments that try to track the performance of the hedge fund sector (global and style specific) investing in liquid funds with high capacity. The result is often a fund that tracks nothing and lags performance. In contrast with equity indices, investors in a fund don’t like it when their fund is included in an index. © Luis Seco. Not to be distributed without permission.
Hedge Fund Indices ! !
Investable Non-investable
© Luis Seco. Not to be distributed without permission.
Historical comparative analysis
Pro-Forma
© Luis Seco. Not to be distributed without permission.
Correlation analysis
© Luis Seco. Not to be distributed without permission.
Style correlations
© Luis Seco. Not to be distributed without permission.
X/I correlations
© Luis Seco. Not to be distributed without permission.
alpha and beta
alpha
beta © Luis Seco. Not to be distributed without permission.
Linear regression Dependent variable
Independent variable
Regression coefficients © Luis Seco. Not to be distributed without permission.
Independent error
Linear regression
© Luis Seco. Not to be distributed without permission.
Return attribution: HFRX vs HFRI
© Luis Seco. Not to be distributed without permission.
Fund of Funds
© Luis Seco. Not to be distributed without permission.
Fund of Funds !
!
A Fund whose assets are invested in a collection of hedge funds. The fund manager usually seeks: – style diversification – manager -business risk- diversification.
© Luis Seco. Not to be distributed without permission.
The investment structure: fund of funds Investor 1
Investor 2
Investor 3
Investor 4
The Fund legal structure
Investor n
HF1 HF2 HFn
The Administrator The Management company “the hedge fund”
© Luis Seco. Not to be distributed without permission.
Types of fund-of-funds !
Multi-strategy fund-of-funds. – Un-leveraged: lowest risk, lowest return, highest Sharpe ratio. Institutional investors tend to prefer these. For others, their tame performance often pales in comparison with more aggressive investments
– Leveraged: higher risk, higher return, higher Sharpe ratio. Popular for Unsophisticated investors !
Single strategy fund-of-funds. – To follow fashionable trends. – To fit a risk profile (liquidity, capacity, transparency, etc.). Most popular with managed futures.
!
Indices. – Popular with option writers and other structurers.
© Luis Seco. Not to be distributed without permission.
Types of fund of funds !
Number of hedge funds they invest in: – 10 – 100
!
Management style – Qualitative – Quantitative
!
Business proposition – They manage the portfolio – They market the portfolio
© Luis Seco. Not to be distributed without permission.
Pros and cons ! !
!
!
!
Pros Market risk diversification Business risk diversification Outsourcing of monitoring and duediligence process, which most smaller investors cannot afford Access: minimum investments, lockups, etc.
! ! ! !
Cons Fees Transparency Increased business risk
© Luis Seco. Not to be distributed without permission.
Investing in Hedge funds Portfolio construction Hedge Fund products
© Luis Seco. Not to be distributed without permission.
The Investment Process: two steps Forensic accounting (DD):
Portfolio Theory: ! Markowitz with individual hedge fund returns as underlying assets. ! Efficient frontiers for optimal performance. ! Limits for concentration issues.
© Luis Seco. Not to be distributed without permission.
Structured products Options (CPPI). Guaranteed products. Debt products: CFO.
© Luis Seco. Not to be distributed without permission.
Leveraged products: loans Example: !
Investor provides $25M.
!
Lender provides $75M.
!
$100M is invested in a hedge fund portfolio.
!
The investment pays interest to the lender, and returns the principal at maturity.
!
The investor keeps the rest.
© Luis Seco. Not to be distributed without permission.
Leveraged products: options/warrants. Investors purchase a call option, with a reference hedge fund portfolio as underlying ! They offer non-path dependent returns ! Assets actually invested in hedge funds vary with the delta of the option ! Hedge fund shares are unlisted. ! Illiquidity of the hedge fund portfolio gives rise to higher implied volatilities, which are hard to value. Hedging becomes very difficult. © Luis Seco. Not to be distributed without permission.
Guaranteed notes !
There are two main reasons for a guarantee: – Regulatory environments – Risk perceptions (not to confuse with risk appetite)
!
!
Some guarantees are provided by well-rated banks. Others are not (Portus). Guarantees are obtainable by setting aside an interest-earning portion of the assets, and investing the remainder at higher levels of leverage, through a variety of different instruments. © Luis Seco. Not to be distributed without permission.
Anatomy of a guarantee Guarantees principal in the future:
Obtains exposure to the Hedge Funds
How much is needed is determined by • Interest rates • Maturity date of the note
© Luis Seco. Not to be distributed without permission.
CFO’s
SPV/Trust
Bond Investor (1) Bond Investor (2)
Guarantees principal
Fund Pool
© Luis Seco. Not to be distributed without permission.
Bond Investor (3)
Anatomy of a CFO
© Luis Seco. Not to be distributed without permission.
Bond defaults
© Luis Seco. Not to be distributed without permission.
