4. Hedge Funds

Dr. Denis Schweizer

Associate Professor of Finance

John Molson School of Business, Concordia University

Mailing address: 1455 de Maisonneuve Boulevard West, Montreal, Quebec H3G 1M8

Office: MB 11.305

Phone: +1(514)-848-2424, ext. 2926

Fax: +1(514)-848-4500

E-mail: [email protected]

4. Hedge Funds

Investment Analysis

Investment Analysis

Denis Schweizer

Learning Outcome Statement

Get the Big Picture

Placement of Hedge Funds in the universe of alternative investments and their

differentiation from traditional investment vehicles

Getting to know the essential properties of single hedge funds and funds of hedge funds

Consideration of the development of the hedge funds market and elaboration of

specific investment strategies and cost structures of hedge funds

Acquiring knowledge in the problematic field of the usage of hedge fund indices

Consideration of the special return and risk properties of hedge funds and funds of

hedge funds

Investment Analysis

Denis Schweizer

Agenda

I. Definition Hedge Funds

II. History and market development

III. Characteristics of Hedge Funds

IV. Scandals

Investment Analysis

Denis Schweizer

Classical Definition of the Term Hedge Funds

The term Hedge Fund is

... Generic term for a multitude of different investment strategies

... Misleading, as there is no hedging in the sense of risk avoidance

... Related to diverse features regarding legal residence, regulation, fee structures etc.

Hedge funds are private partnerships wherein the manager or general partner

has a significant personal stake in the fund and is free to operate in a variety

of markets and to utilize investments and strategies with variable long / short

exposures and degrees of leverage

(Crerend, 1995)

Investment Analysis

Denis Schweizer

Termination of Hedge Funds

by Key Characteristics (1/2)

Target

Positive and risk-efficient value creation in all market phases and as far as possible

independent from the market situation

Instruments (investment strategies)

Application of different investment instruments and free choice of investment

techniques in order to reach targets:

Derivatives

Short Selling

Usage of leverage effects by debt financing

Positioning in various markets

Investment Analysis

Denis Schweizer

Termination of Hedge Funds

by Key Characteristics (2/2)

Risk

Active risk management (total risk)

Fee and incentive structures

Profit-oriented compensation scheme management fees!

Significant equity stake of the hedge fund manager

Person of the hedge fund manager

Special importance of the hedge fund manager

Often not interested in normal economic developments

Investment Analysis

Denis Schweizer

Excurse: The Special Importance of the Hedge Fund

Manager Stems from the Combination of His Roles as

... Opportunist is almost unlimited in his possibilities to apply different investment instruments

Why is this so important?

... Entrepreneur goes into business for oneself after a successful career e.g. in investment banking, trader, quant

What about reputation?

... Capitalist has invested a large fraction of his private wealth in the fund and benefits from positive value developments and from performance fees

Is this a good feature?

Hedge fund managers can be tough to like, but it is difficult not to admire the great

confidence and faith that they have in themselves, demonstrated by the willingness to risk

their future on their skills.

William Crerend (1998)

Investment Analysis

Denis Schweizer

Typology of Styles and Strategies

Strategy Indices

Sub-

indices Fixed Income

Arbitrage

Hedge Funds

Style Indices

Relative-Value-

Strategies

Event-Driven-

Strategies

Opportunistic

Strategies

Managed

Futures

Convertible

Arbitrage

Equity Market

Neutral

Merger

Arbitrage

Distressed

Securities

Long/Short

Equity

Short

Sellers

Emerging

Markets

Global

Macro

Corporate

Governance

Investment Analysis

Denis Schweizer

Hedge Fund Strategies

Non-Directional

Strategies

Directional

Strategies

Convertible

Arbitrage

Fixed Income

Arbitrage

Equity Market

Neutral

Event Driven

Distressed

Securities

Long/Short

Equity

Emerging

Markets

Global

Macro

Typology of Styles and Strategies

Corporate

Governance

Investment Analysis

Denis Schweizer

Risk-and-Return Profile of Hedge Fund

Strategies

Dedicated Short Bias

Long/Short Equity 4. Directional

Global Macro

Managed Futures 3. Tactical Trading

Distressed Securities

Merger Arbitrage 2. Event Driven

Equity Market Neutral

Convertible Arbitrage

Fixed Income Arbitrage

1. Relative Value

Ris

k a

nd

Retu

rn

Investment Analysis

Denis Schweizer

Performance of Hedge Fund Sub-Strategies

Last data point: 9/30/2013; Source: Credit Suisse

*compound annual growth rate

**annualized volatility

Merger arbitrage, Distressed securities

Convertible arbitrage, Market neutral,

Fixed income arbitrage

Equity long/short, Emerging markets

Global macro, Managed futures

Compound

Annual

Growth Rate

Risk

(Annualized

Volatility)

8.49% 4.72%

6.09% 5.77%

8.53% 11.06%

8.28% 8.57%

Investment Analysis

Denis Schweizer

Hedge Fund Strategies in Detail:

Merger Arbitrage (1/2)

14.11.99: Vodafone AirTouch (VOD) offers the shareholders of Mannesmann (MMN) 53.7 VOD shares per 1.0 MMN share

04.02.00: VOD raises the former offer to 58.96 VOD shares per MMN share

17.02.00: Expiry date of the offer

Net return of the transaction (without transaction costs or interest):

Buy 1 MMN at 15.11.99 - 203.00

Sell 53.70 VOD shares at 15.11.99 + 246.48 (53.70 x 4.59 per share)

Sell 58.96 - 53.7 = 5.26 VOD shares at 4.2.00 + 31.24 (5.26 x 5.94 per share)

Sell 1 MMN at 17.02.00 + 302.00

Buy 58.96 VOD at 17.02.00 - 302.00

Profit at 17. Feb. 2000 + 74.72

Annualized

Merger Arbitrage: Example VOD/MMN

142.92% 74.72 365 days

203 94 days

Investment Analysis

Denis Schweizer

0%

5%

10%

15%

20%

25%

30%

35%

15.1

1.9

9

22.1

1.9

9

29.1

1.9

9

06.1

2.9

9

13.1

2.9

9

20.1

2.9

9

27.1

2.9

9

03.0

1.0

0

10.0

1.0

0

17.0

1.0

0

24.0

1.0

0

31.0

1.0

0

07.0

2.0

0

14.0

2.0

0

Bid

Pre

miu

m in

%

14.11.99

Vodafone places

an offer to take

over Germanys

Mannesmann:

53.7 VOD for 1

MMN 4.02.00

Vodafone raises the offer to

58.96:1

17.02.00

Expiry of the

offer Difference

Source: Bloomberg L.P.

What is an economical interpretation of the spread?


Merger Arbitrage (2/2)

Merger Arbitrage: Example VOD/MMN

Investment Analysis

Denis Schweizer

3

3.5

4

4.5

5

5.5

6

0 5 10 15 20 25 30

yie

ld

years

4.8

4.9

5

5.1

5.2

6 7 8 9 10

yie

ld

years

long $50 7Y Bond

short $100 8Y Bond

long $50 9Y Bond


Fixed-Income Arbitrage (1/2)

Fixed-Income Arbitrage: Sophisticated interest curve arbitrage (Butterfly)

Investment Analysis

Denis Schweizer


Fixed-Income Arbitrage (2/2)

The hedge fund manager buys low quality (BBB maturity return: 7.95%) and short sells high quality (AAA maturity return: 6.65%) and implements a leverage of 10x.

Fixed Income Arbitrage: Credit-Spreads

0

2

4

6

8

10

12

14

16

18

Jan-1

9

Jan-2

3

Jan-2

7

Jan-3

1

Jan-3

5

Jan-3

9

Jan-4

3

Jan-4

7

Jan-5

1

Jan-5

5

Jan-5

9

Jan-6

3

Jan-6

7

Jan-7

1

Jan-7

5

Jan-7

9

Jan-8

3

Jan-8

7

Jan-9

1

Jan-9

5

Jan-9

9

AAA BBB Spread

Source: http://www.federalreserve.gov/releases/h15/data/m/aaa.txt

Where is the risk?

Investment Analysis

Denis Schweizer


Global Macro

Who: Victor Niederhoffer Return: 32% p.a. 1982-1996 Approach: Applied science (?) Hypothesis: Daily returns are < -5%;

but in Oct 87: -20%?

Strategy: Short out-of-the-money Put Options on Index futures

Date: 27. October 1997 Result: Asian crises: depreciation

Thai Baht, stock market: S&P 7%

Triggered 1: USD 50 Million Margin-Call Triggered 2: Niederhoffer = Dead Legend

Global Macro: Example

Investment Analysis

Denis Schweizer


Convertible Arbitrage (1/2)

Convertible bonds

= straight bond + warrent (long-term equity call)

can be converted into equity at a fixed number of shares

are senior to equity but usually junior to other debt

Have been issued since 1800s to finance railroads in U.S.

A Convertible Arbitrage Manager

benefits from

Price inefficiencies in convertibles

Price volatility in underlying stocks (Gamma Trading)

Interest income from bond coupon

Interest on the proceeds from short sale

Investment Analysis

Denis Schweizer


Convertible Arbitrage (2/2)

Convertible Arbitrage: Description

Transaction: Purchase of underpriced convertible bonds and hedging of the

stock price risk by selling underlying short (or by derivatives)

Important: Consistent hedging of all relevant risks (e.g. stock price, interest rate,

credit risk, currency, leverage)

Opportunities: Complex instruments lead to mispricing, esp. in volatile markets

(characteristics of convertibles can change over time, from bond to

stock)

Attention: Markets for convertibles is dominated by Hedge Funds

Investment Analysis

Denis Schweizer

Why Do Hedge Fund Managers Earn Money?

The real advantages of Hedge Funds

Equity risk

Small Firm risk

Term Structure risk

Corporate Event risk

Hedging demand risk

Short Volatility/Option risk

Complexity or Efficiency

risk

Credit risk

FX Carry risk

Convergence risk

Liquidity risk

Traditional investors only benefit from few risk premia and leave out many alternative risk premia. Hedge Funds offer these new sources for return.

Investment Analysis

Denis Schweizer

Hedge Funds Mutual Funds

Hedge

Leverage Proclaimed

Alpha

Alpha

Market Risk

Premium

True Alpha

(Security, Selection.

Timing, Execution)

Event Risk Premium

Short Vega Risk Premium

Liquidity Risk Premium

Small Cap Risk Premium

Term Curve Risk Premium

Credit Risk Premium

EmMa Risk Premium

Equity Risk Premium

Complexity Risk Premium

Commodity Risk Premium

Convergence Risk Premium

Value Stocks Risk Premium

Currency Risk Premium

Leve

rag

ed

pro

cla

imed

Alp

ha


Investment Analysis

Denis Schweizer Source: Partners Group


Hedge funds have a positive exposure to traditional risk factors. More than 85% of the

variability of hedge fund returns can be explained by systematic risk factors!

Investment Analysis

Denis Schweizer

Case Study: Multivariate Regression-Analysis

Following returns have been observed on the market:

Y Hedgefonds- returns Emerging Markets (EMM)

X1 US Stocks

X2 US Bonds

X3 Corporate Bonds

X4 Commodities

X5 Asset Backed Securities (ABS)

Identify the return factors on an emerging markets based hedge fund!

-0,25

-0,20

-0,15

-0,10

-0,05

0,00

0,05

0,10

0,15

0,20

-0,30 -0,20 -0,10 0,00 0,10 0,20 0,30

retu

rn E

MM

Returns single asset classes

Stocks US

Bonds US

Exercise 2

Investment Analysis

Denis Schweizer


A Risk Premium A return based on market inefficiencies

Is an excess returns that compensates investors for systematic risk

Is the result of non-homogenous risk aversion (non-diversifiable risk)

Is a permanent price effect

Does not disappear when recognized by other investors

Is relatively easy to test

Managers systematically earn risk premia (60-80% of Hedge Fund-Returns)

Is a temporary effect

Disappears quickly when realized by others

Requires intense research, computer capacity and special manager skills

(edges)

Is hard to test

Managers benefit from market inefficiencies (20-40% of Hedge Fund-Returns)

Investment Analysis

Denis Schweizer

Important: Exposure to Hedge Fund Betas requires special investment-

techniques like short sales, leverage and the usage of derivatives


Traditional Betas Hedge Fund Betas

Exposure to

broad stock market

interest rates

credit risk

emerging markets

Exposure to

Style factors like small cap vs.

large cap, value vs. growth (Long/

Short Equity, Equity Market Neutral)

Event risk (Merger Arbitrage)

Volatility (Convertible Arbitrage,

Volatility Arbitrage)

Risk of commercial hedgers in future

markets (Managed Futures)

Liquidity risk (Distressed Securities,

Fixed Income Arbitrage, Reg D)

Spread risk, e.g. Carry trades (Global

Macro)

Investment Analysis

Denis Schweizer


Stock risk premium

Purchase of stocks

Interest duration premium

Purchase of government bonds with long

duration

Credit risk premium

Purchase of corporate bonds

Event risk premium

Purchase of stocks of acquisition targets

Liquidity risk premium

Purchase of illiquid instruments

Small firm risk premium

Purchase of low cap stocks or private equity

Convergence risk premium

Engaging in spread positions

Commodity hedging demand risk premium

trend follower strategy in future markets

Complexity risk premium

Purchase of complex instruments, CDOs etc.

FX risk premium

Carry trade

Short volatility/short option premium

Short sale of options

Emerging Markets risk premium

Investment in stocks / bonds of emerging

markets

Some Well-known Risk Premia and How to Earn Them

Investment Analysis

Denis Schweizer


1. Exploitation of information inefficiencies (violation of the semi-strong version of

Efficient Market Hypothesis - EMH)

Better research and analysis skills (proprietary valuation models, star analyst)

Faster and better access to relevant information (personal contacts, industry network,

recognition of future hedging and product / consumption demand, market making etc.)

Better understanding of macroeconomic information

2. Exploitation of statistical inefficiencies (violation of the weak version of EMH)

Understanding / prediction of market behavior through statistical methods (e.g.

trends, seasonality like the January effect, autocorrelation through certain behavioral

patterns of investors, mean reversions)

Underpricing/overpricing of volatilities (implicit volatilities in regime shifts,

prepayment model in mortgage backed securities)

Technical analysis (e.g. triangle or head-shoulder-head formations etc.)

Two types of manager skills in the exploitation of inefficiencies

Investment Analysis

Denis Schweizer


0%

2%

4%

6%

8%

10%

12%

14%

1995-1

999

2000 -

2004

2005-2

010

exp

ecte

d r

eturn

Average hedge fund return componenents

over time

(35%)

(65%)

(20%)

(80%)

(48%)

(52%)

Investment Analysis

Denis Schweizer


-0.2%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

Jan-

00

Apr-00

Jul-00

Oct-0

0

Jan-

01

Apr-01

Jul-01

Oct-0

1

Jan-

02

Apr-02

Jul-02

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3

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04

Apr-04

Jul-04

Oct-0

4

Jan-

05

Apr-05

Jul-05

Oct-0

5

Jan-

06

Apr-06

Jul-06

Equity Hedge

Event Driven

Merger Arbitrage


The development of alphas for different strategies based on a rolling regression over

a time window of 60 months alpha decreases

Source: HFR, Bloomberg. Calculation: Partners Group

Mo

nth

ly A

lph

a i

n p

erc

en

t

Investment Analysis

Denis Schweizer

So

urc

e: C

red

it S

uis

se /

ID

C

Alpha* of small funds (AuM is less than $10 million) is 6.47% per year

Alpha* of large funds (AuM larger than $1 billion) is 1.67%

*Based on Fung and Hsieh (2004) 7 Factor model

Reduced Competition for Market Inefficiencies

Should Translate into Attractive Alphas

Investment Analysis

Denis Schweizer

Agenda




IV. Scandals

Investment Analysis

Denis Schweizer

The History of Hedge Funds

An Overview

17. century: first hedging of future harvests via credit notes by Japanese rice farmers

1870 1880: ongoing globalization and industrialization leads to expansion of hedging on interest rate and currency risks

1949: Foundation of the first hedge fund by Alfred Winslow Jones

1968: already 140 SEC-registered Hedge Funds

1969: Foundation of the Quantum Fund by George Soros

1969 1970: difficult years at the exchanges (also 1973-1974) Lacking protection led to liquidation of many hedge funds

Assets under Management of the 28 largest hedge funds go down by 70%

1986: Demand wave following an article of Julian Robertson in the Institutional Investor

Translation of Hedge: Absicherung, Hecke, Einfriedung, Schutzumrandung

Investment Analysis

Denis Schweizer


The Jones Nobody Keeps Up With

The Jones Model:

Alfred Winslow Jones was the first to define absolute return targets

He broadened the classical investment instruments with leverage and short sales

The basis of Jones trading strategy was the purchase of stock positions and the short sale for the same amount and the same duration (pair trades)

Hedging is an integral component of hedge funds in the framework of the Jones model

The market risk can be strongly reduced through this investment approach

The performance depends on the right selection of stocks and a volatile market environment

Investment Analysis

Denis Schweizer

Origin of the term Hedge Fund:

Hedging of market risks in Jones investment strategy


Article in the Fortune magazine firstly uses the term hedge fund

The Jones Nobody Keeps Up With 17 years after the foundation of the fund

Target of the fund: Profitability in both, bull and bear markets

Avoidance of market risks in stock positions through short sales of other stocks

Additional leverage

Incentive Fees (however, without High-Watermark)

In 1952: Employment of several independently working fund managers = first Multi-Managers-Hedge Fund

Investment Analysis

Denis Schweizer

Estimated Assets Managed by Hedge Funds

(incl. FoF) (Worldwide)

Last data point: 28.06.2014; Source: HFR, Credit Suisse, IDC

Investment Analysis

Denis Schweizer

Evolution of the Hedge Fund Strategies Over

Time

Source: Credit Suisse Hedge Fund Index

Investment Analysis

Denis Schweizer

Average Assets under Management per Hedge

Fund

0

20

40

60

80

100

120

140

160

199

0

199

1

199

2

199

3

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200

0

200

1

200

2

200

3

200

4

200

5

200

6

Assets under Management per fund in million USD

(Single- and funds of funds)

Investment Analysis

Denis Schweizer

Percentage Assets Under Management

With the Top 100 Hedge Funds

Top 100 hedge funds manage about 61

percent of the hedge

fund industrys total

capital.

Hedge funds currently have about

$2.3 trillion of AuM,

of that $1.4 trillion is

managed by the top

100 hedge funds (Source: Preqin May 2013 Hedge

Fund Spotlight)

Source: Institutional Investors Top 100 Hedge Funds, HFR

Investment Analysis

Denis Schweizer

Size of the Hedge Fund Market

0

500

1.000

1.500

2.000

2.500

3 Biggest US Companies Hedge Fund Market

Mark

et

Cap

/ A

uM

in

bil

lio

n U

SD

Microsoft Exxon Mobile Apple

Hedge funds industry in comparison to the market capitalization of the three biggest

U.S. companies in mid 2012

Investment Analysis

Denis Schweizer

Hedge Fund Performance in 2008

Investment Analysis

Denis Schweizer

Historically Hedge Funds Performed Strongly

after Hedge Fund Crises

Periods of more than 5% loss of Credit Suisse/Tremont Hedge Fund Index since 1994

In the past the Credit Suisse/Tremont Hedge Fund Index has performed better than the MSCI World Index after hedge fund crises

Investment Analysis

Denis Schweizer

DJ CS Hedge Fund Index Drawdowns vs.

Equities

Last data point: 28.09.2012; Source: Datastream, Credit Suisse / IDC

Investment Analysis

Denis Schweizer

Agenda




IV. Scandals

Investment Analysis

Denis Schweizer

Short-Selling

Short Sale = Sale of assets which are not part of the portfolio at the time of the

transaction:

Borrowing of securities, usually by involvement of a prime broker for a lending fee

(see lecture on trading instruments)

Short sales are not applied in every investment strategy

Short sale of overvalued stocks buyback at lower prices

Short sales allow for profits also in falling markets

Theoretical loss potential: unlimited

Application purpose: hedging or Speculation

Investment Analysis

Denis Schweizer

Short-Selling (contd)

Short sales allow for the exploitation of inefficiencies to a great extent

Hypothesis:

There are inefficiencies on the short side

Reason:

Restrictions on short selling do not allow to some investors to trade their pessimism

towards a security

Consequence:

Overvalued securities = inefficient pricing

Investment Analysis

Denis Schweizer

Stock market or other capital market

Return from short selling: 100 Euro (sale price) 80 Euro (purchase price) lending fee

today

Lender

(e.g. depositary bank or

strategic investor)

Hedge Fund

Hedge Fund

borrows stock X

Hedge Fund collateralizes

security lending with fund

wealth

Hedge Fund

sells stock X

short

Hedge Fund receives

the current market price

(e.g. 100 EUR)

in 6 months

Lender

(e.g. depositary bank or

strategic investor)

Hedge Fund

Hedge Fund pays the

current market price

(e.g. 80 EUR)

Hedge Fund

buys stock X

Hedge Fund pays the

lending fee

Short-Selling (contd)

Hedge gives back

stock X

Investment Analysis

Denis Schweizer

Hedge Fund Cash is at a Historical Record

Level in 2008

-160

-120

-80

-40

0

40

80

120

160

200

240Jan 9

2

Jan 9

3

Jan 9

4

Jan 9

5

Jan 9

6

Jan 9

7

Jan 9

8

Jan 9

9

Jan 0

0

Jan 0

1

Jan 0

2

Jan 0

3

Jan 0

4

Jan 0

5

Jan 0

6

Jan 0

7

Jan 0

8

in U

SD

Mrd

.

Record Level

Cash + Cash at Margin Accounts

Investment Analysis

Denis Schweizer

Cost Structures

Typical fee structure of a Hedge Fund:

Fix management compensation: 1-2% p.a. (up to 5% p.a.)

Median: 1% p.a.

(Funds of Funds: 1,5%)

Performance (incentive) Fee: 10%-30% p.a. of the positive return

Median: 20% p.a. (Funds of Funds: 10% p.a.)

Characteristic features of the Performance Fee:

Hurdle Rate:

positive return above a specific performance benchmark (e.g. fixe: 0-30%,

stochastic: LIBOR, S&P 500, etc.)

High-Watermark:

profit-based compensation only after netting of possible losses in the previous periods

Investment Analysis

Denis Schweizer

Jan 14 Jan 12 Jan 10 Jan 08

160

150

140

130

120

110

100

90

HW 4

HW 3

HW 2

HW 1

Cost Structures

Illustration of the High Watermark

Investment Analysis

Denis Schweizer

Cost Structures

Sample Calculation

2011 A - 2012 B - 2012 C - 2012

Investment at beginning of year $1.000.000 $750.000 $750.000 $750.000

Change in value before fees -25% 66.67% 66.67% 66.67%

Investment at end of year $750.000 $1.250.000 $1.250.000 $1.250.000

Hurdle rate 10% 10% 0% 0%

Incenfive fee $0 $30.000 $50.000 $100.000

Change in value after fees -25% XXX% XXX% XXX%

Example A:

High-Watermark does apply

Hurdle Rate: 10%

Incentive Fee (20%)

Example C:

High-Watermark does not apply

Hurdle Rate: 0%

Incentive Fee (20%)

Example B:

High-Watermark does apply

Hurdle Rate: 0%

Incentive Fee (20%)

Exercise 3

Investment Analysis

Denis Schweizer

Cost Structures of Funds of Funds (contd.)

Example:

Fund of Funds invests EUR 1 million each in three hedge funds

Every hedge fund charges an incentive fee of 20%

No hurdle rate (Zero-Benchmark)

Neglect of management fee for simplicity

Hedge

Fund 1

Hedge

Fund 2

Hedge

Fund 3

Fund of Fund

Investment at beginning of year

(million ) 1 1 1 3

Performance (before fees) 20% 40% -75% -5%

Investment at end of year (million ) 1.2 1.4 0.25 2.85

Incentive Fee (million ) 0.04 0.08 0.00 0.12

Performance (after fees) 16% 32% -75% -9%

Source: Brown, Goetzmann and Liang (2002)

Investment Analysis

Denis Schweizer

Will this remain after the financial market crisis?

Frequency of Reporting, Liquidity and Liquidation

Investment Analysis

Denis Schweizer

Annual Mortality Rate of Funds (%)

Is there a problem for the benchmarks?

Source: Rouah (2005), p. 15

Investment Analysis

Denis Schweizer

Agenda




IV. Scandals

Investment Analysis

Denis Schweizer

The problem of the white swans

No finite number of observations of white swans is sufficient to conclude that all swans

are white. But a single observation of a black swan is sufficient to rebut the first

hypothesis. (Karl Popper/ David Hume)

Which Strategies Bear a High Risk?

Investment Analysis

Denis Schweizer

Return development LTCM


LTCM... or the existence of the black swan!

0

50

100

150

200

250

300

350

400

450

Feb 9

4

Apr

94

Jun 9

4

Aug 9

4

Okt

94

Dez

94

Feb 9

5

Apr

95

Jun 9

5

Aug 9

5

Okt

95

Dez

95

Feb 9

6

Apr

96

Jun 9

6

Aug 9

6

Okt

96

Dez

96

Feb 9

7

Apr

97

Jun 9

7

Aug 9

7

Okt

97

Dez

97

Feb 9

8

Apr

98

Jun 9

8

Aug 9

8

Okt

98

The frequency or probability of a loss within an investment strategy is not the most important question

The more important question is the magnitude of the worst case!

Investment Analysis

Denis Schweizer

*) Nobel Prize winner Milton Friedmans comment of the Mexican Peso crisis in the early 70ies


Carry Trades / FX Arbitrage (The PESO Problem*)

Debt position in US$ and investment in emerging market currencies (Bath)

Investment Analysis

Denis Schweizer

Long-Term Capital Management

Founded 1993 by John W. Meriwether (and former colleagues from Salomon Brothers) and Robert Merton, Myron Scholes and David Mullins

minimum investment: 10 million USD

minimum duration of investment: 3 years

Performance Fee: 25%

Management Fee: 2%

Annual return of 40% between 1992 and 1996 at moderate volatility

17% p.a. in 1997 (Asia crisis)

Global Macro Relative Value Hedge Fund

Repayment of 2.7 bn USD to investors in order to increase leverage from 18:1 to 28:1 (end of 1997) to 100:1

LTCM had 'too much risk to be sustainable' says Myron Scholes

Investment Analysis

Denis Schweizer

*Fung/Hsieh, The Risk in Hedge Fund Strategies: Theory and Evidence from Fixed Income Traders, October 2001

Long-Term Capital Management (contd)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

1919

1923

1927

1931

1935

1939

1943

1947

1951

1955

1959

1963

1967

1971

1975

1979

1983

1987

1991

1995

1999

Spread (US BBB minus AAA)

The case of LTCM a unique one? Fixed Income

Arbitrage

Regression

-Analysis*:

An increase of the

credit spread of

+1% triggers a negative

return of - 8%!

Historical returns

FI Arbitrage:

1931: - 24%

1970: - 10%

1974: - 14%

1979: - 7%

1980: - 9%

?

Investment Analysis

Denis Schweizer

Long-Term Capital Management (contd)

In 1998 the fund loses more than 90% of its value due to turbulences in the international financial markets that followed the Russia crisis

In order to serve margin calls, positions had to be sold at a loss to generate liquidity in a difficult market environment

A syndicate of creditor banks under the leadership of Bill McDonough (New York Fed) invested 3.5 bn USD, and the fund got the opportunity to hold and to manage its positions

for 1 year

In December 1999, the money was paid back and LTCM was liquidated

In the meantime, John Meriwether had founded a new fund (JWM Associates)

Investment Analysis

Denis Schweizer

Julian Roberson & Tiger Management

In March 2000, Julian Robertson closed down Tiger Management LLC and the 6 Tiger Funds

Julian Robertson sticks to his investment strategy to buy the best stocks and to sell the worst

During the unexampled rally of the NASDAQ, the fund suffered heavy losses

There is no point in subjecting our investors to risk in a market which I frankly do not understand.

Annual return (1980-2000): 25% p.a.

Investment Analysis

Denis Schweizer

Manhattan Capital Management

Fund manager: Michael Berger

Long/Short-Equity-Fund with industry focus (Short-Positions in Internet-stocks)

Residence: British Virgin Islands

280 investors, 350 million USD Assets under Management

Berger suffered a loss of about 300 million USD in 2000

Instead of reporting the losses to his investors, Berger announced that the fund generates between 12% and 27% annual return

in August 1999 he announced that the fund volume was over USD 426 million (in fact it was only USD 28 million)

in November 2001, Berger was found guilty and is on escape since then

Investment Analysis

Denis Schweizer

Eifuku Investment Management

Strategy: Long/Short Equity Japan

AuM: 200 million USD

Period: January 2003

Return: 2002: +76%

2003: total loss within 7 trading days [January 15, 2003]

Bets on a few Japanese banks and technology companies

Founder: John Koonman former trader of Lehman Brothers (proprietary trading)

Eifuku = eternal luck

Investment Analysis

Denis Schweizer

Amaranth Advisors LLC

Amaranth (located in Greenwich, Connecticut, USA), a multi-strategy fund specialized in energy trading, lost more than 5 billion USD in bets on the natural gas price after the fall

of natural gas futures at the beginning of September 2006

The two most important funds lost 65%, a loss of 35% year-to-date

It is the largest hedge fund (since LTCM in 1998) that has been destroyed through bad bets. As one of the largest US hedge funds with a wealth of 9.2 billion USD at the end of

August, Amaranth made the largest weight in many funds of hedge funds

The losses at Amaranth Advisors LLC have hit funds of funds like those of Morgan Stanley, Credit Suisse, UBP, Deutsche Bank and Goldman Sachs Group hard

Investment Analysis

Denis Schweizer

Too good to be true!

. . . the results were suspiciously smooth. Mr. Madoff barely ever suffered a down month, even in choppy

markets . . ., The Economist, 18 December 2008, The Madoff affair: the con of the century.

Investment Analysis

Denis Schweizer

Agenda


Back-Up Summary of Hedge Fund Strategies



IV. Hedge Fund Indices

V. Performance of Hedge Funds

VI. Scandals

Investment Analysis

Denis Schweizer

Typology of Styles and Strategies:

Market Neutral or Relative Value

Fixed Income Arbitrage

Managers of such arbitrage funds work

with mutual long and short positions

in similar interest rate securities (i.e.

bonds) and their derivatives


Strategy uses inefficiencies in relative

pricing of different securities, i.e.

manager buys convertible bond of a

company and sells short the underlying

stock at the same time

Equity Market Neutral

Manager holds long and short

positions in stocks and is therefore

protected against market risk

Source: Joenvare et al (2012

Investment Analysis

Denis Schweizer


Event Driven

Risk (Merger) Arbitrage

Strategy benefits from mergers

or restructurings of companies

Distressed Securities

Strategy specializes on companies that are in economic distress and in the middle of

restructuring processes. The hedge fund buys for example the bonds (low risk) or

stocks (higher risk) of the company that significantly gain value in the case of a

successful restructuring

Regulation D

Strategy invests in companies with a very low capitalization (small and micro caps) that

raise their funds on private capital markets. Investment instruments in this strategy are

mostly stocks, convertible bonds or other derivatives

Increasing Importance of PIPE (Public Investments in Private Equity) investments

Source: Joenvare et al. (2012)

Investment Analysis

Denis Schweizer


Directional (1/4)

Long/Short Equity Hedge

In a long-strategy the manager buys stocks in the hope of increasing stock prices, in a

short-strategy he sells borrowed stocks that he considers over-valued to buy them back

later at a lower price. Long/short equity is a directional trading strategy. The manager

has to estimate the direction of stock prices or their volatility.


Investment Analysis

Denis Schweizer


Directional (2/4)

Dedicated Short Bias (Short Sellers)

Manager focuses (almost) entirely on short-selling of securities and screens the market

for stocks that are overvalued. He borrows these securities and sells them immediately.

As the stocks are expected to be overvalued the manager speculates on a down-

movement of the stock price and expects to buy back the shares for a lower price.


Investment Analysis

Denis Schweizer


Directional (3/4)

Global Macro

Fund managers estimate the direction of the market by global trends and events.

The goal is to foresee price oscillations triggered by changes in economic forecasts or

political changes. For example, if a fund manager anticipates falling oil prices, he sells

short oil contracts. Global macro funds often use debt financing to increase their

returns.


Investment Analysis

Denis Schweizer


Directional (4/4)

Emerging Markets

Common strategies from tra-

ditional markets are applied in

emerging markets: trading bets

on fundamental changes of

market directions in threshold

countries.

Blue Capital Chinese Hedge Fund is seeking for government arbitrage

Managed Futures

Managed-Futures-Funds buy

futures and forwards (OTC-

counterparts of futures) and

acquire positions in the global

markets for financial products,

currencies, energy, metals,

agricultural products etc. The fund can engage in long and short positions.



Investment Analysis

Denis Schweizer

Special Types of Strategies

Multi-Strategy

Funds usually apply two or

three specific and pre-

determined strategies for

diversification reasons.

Funds of Funds

Funds of funds invest deposits

they receive from their

investors in other hedge funds,

sometimes in leveraged

transactions. In this way, also

smaller private investors can

invest their money in large

hedge funds or can diversify

their exposure in hedge funds.



Investment Analysis

Denis Schweizer

Hedge Fund Strategies AuM versus Number of

Funds

Investment Analysis

Denis Schweizer

References

Ackermann, C., R. Mc.Enally und D. Ravenscraft (1999), The Performance of Hedge Funds: Risk, Return and Incentives, Journal of Finance 54 , 833-874.

Amenc, N., S.E. Bied und L. Martellini (2003), Predictability in Hedge Fund Returns, Financial Analysts Journal 59, 32-46.

Anson, Mark J.P. (2006), Handbook of Alternative Assets, John Wiley & Sons: New Jersey.

Bailey, J.V. (1992), Are manager universes acceptable performance benchmarks?, Journal of Portfolio Management 18, 9-13.

Brown, S.J., R.G. Goetzmann und B. Liang (2002), Fees on Fees in Funds of Funds, Working Paper 9464, National Bureau of Economic Research, January, Cambridge.

Lhabitant, F.-S. (2006), Hedge fund indices and passive alpha: A buy-side perspective, in G.N. Gregoriou und D.G. Kaiser, ed.: Handbook for the Institutional Investor, Risk Books: London.

Fung, William, and David A. Hsieh, 1997, Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds, The Review of Financial Studies 10, 275-302.

Liang, B. (1999), On the Performance of Hedge Funds, Financial Analysts Journal 55, 72-85.

Liang, B. (2003), On the Performance of Alternative Investments: CTAs, Hedge Funds, and Funds-of-Funds, Isenberg School of Management.

Sharpe, W.F. (1992), Asset Allocation: Management Style and Performance Measurement, Journal of Portfolio Management 18, 7-19.

Documents

4. Hedge Funds