Anoj Half Compiled Hedge Funds

8/14/2019 Anoj Half Compiled Hedge Funds

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The Reality ofThe Reality of

Hedge FundsHedge FundsPresented by:Presented by:

SupermanSupermanSuperwomanSuperwoman

CoolmanCoolman

CoolwomanCoolwoman


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Behavioral

Arguments

EmpiricalArguments

TheoreticalArguments

Case Against Indexing


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Introduction

Active or passive?

Active manager has not outperformed

S&P500 Behavioral analysis & empirical evidence

argument

Passive investing


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The case for indexing The

Theoretical Case

Markets are efficient

Assumes

Investors are perfectly rationaleMarkets are frictionless

Harry Markowitz described how rational

investors should create portfoliosStocks risk should be evaluated in terms of its

contribution to the risk of a diversified portfolio


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The case for indexing The

Theoretical Case


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The case for indexing The Empirical

Evidence

Active managers underperform passive

benchmarks

Median active fund underperformed the

passive index in 12 out of 18 years Majority of mutual fund investors better of

investing in S&P 500 index fund


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Theoretical Arguments Against

Indexing Challenging Assumption: No taxes or Trading

Cost

Different tax systems/trading cost affect

investors An investor who is subjected to high tax/tradingcost may not trade even when new information

creates a reasonable large change in expected

returns

Different investors hold different portfolio,

meaning there is no single market portfolio


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Indexing Challenging Assumption: Homogeneous

Expectations

Investors do not have common expectations

Different school of thoughts (Keynesians

versus Monetarists

Investors calculate risk and return

differentlySome have better technology, analytical

capabilities


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Indexing

Challenging Efficient Markets

In perfectly efficient market prices = fair

value Someone must estimate fair value

else trading will easeMarket collapse

Means active investors are needed to make

market efficient


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Empirical Arguments Against

Indexing

Challenging CAPM

No positive relationship between CAPM and

realized stock returns

Perhaps because market is not efficient

Or because investors dont base their expectations on

CAPM

Failure of CAPM beta to explain returns showthat no single index is optimal for all investors

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Empirical Arguments Against

Indexing

Challenging Volatility

If prices reflects all available information, they

will only response to new information

However, prices are too volatile to be explained

by less volatile changes in i/r and cashflows

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Behavioral Arguments

EMH assume investors are rational

Human make systematic errors in judgment &

probability assessment

Cognitive errors

Selective perception

Illusory correlation

Wishful thinking Hindsight bias

Active managers believe they can generate above

average investment returns

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Overconfidence prediction with limited

information

Overreaction and underreaction to newinformation due to prior beliefs

Overreact to supporting information

Underreact to conflicting information

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No one behaves the way as stated by theory

Investors do not hold some combination of risk-

free securities and the optimal risky portfolio

Investors do not measure a securitys risk in terms

of its contribution to the risk of a diversified

portfolio

Investors do not forgo active management

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Conclusion for Behavioral Argument

If investors do not behave as if the market is

efficient market inefficient

If investors are right

market inefficient Back to catch-22 of efficient markets

If market is efficient passive management

Investor becomes passive market prices nolonger reflect available information

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The Verdict

Active management must exist and do add value Theoretical inconsistencies Empirical evidence Behavioral analysis Catch-22 of efficient markets

Non-existence of pure passive management Selection of benchmark is an active decision

Formation of expectations and how it impact marketprices

Active manager who can minimize behavioral biasesand develop more realistic expectations and

probability assessments can and will add value

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HEDGE FUNDS

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Introduction

Hedge fund is first originated by Alfred Winslow

Jones in 1949

Long and short positioning

To protect the portfolio from market risk

Financial leverage

To enhance the returns of the portfolio

Since then,

Highly performed, increased in the number of hedge funds

Industry does faced several setbacks

Meltdown of Long Term Capital Management (LTCM) in 1998

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What is a Hedge Fund?

A privately organized, pooled investment

vehicle

Investing primarily in securities andderivatives

Also invest in private investments such as

venture capital funds and real estate funds Using long / short positions and leverage

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Characteristics

Limited partnerships or limited liability companies

Often domiciled offshore for tax and regulatory

reasons

Open to a limited number of accredited & super

accredited investors

New developments in 2005: as little as $25,000, such

investors can also invest in hedge funds Not more than 25% of the funds may be contributed

by ERISA plans

Measure by absolute returns

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Characteristics

High management fees 1% or 2% of assets under management 20% cumulative profits (performance fees)

Fund managers are usually partners in their funds Invest huge part of their personal wealth in their own

funds Reduce the effects of unifying the interests of the

managers with the rest of the investors

Advance notice for redemption From one month to three years Limit the impact of fund redemptions on investment

strategy

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Growth trends

From 1987 to 2005: Number of hedge funds had increased by 80 times Amount of funds invested had increased by 46 times

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What are the forces behind the growth?

High net-worth segment has grown rapidly

Customer base of hedge funds increase

Developments of the financial markets

Eg. Derivatives, mergers and acqusitions

Fund managers

Invest huge part of their personal wealth in their own

funds Good reputation

Attractive returns

Low correlation with traditional funds

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Hedge Fund Strategies and

Segmentation

Shorting

Leverage

Concentration Derivatives

Efficient execution

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Hedge Fund Strategies: Shorting

Hedge funds regularly use both long and short position

Offset the systematic market risk common to longpositions

- profit primarily from selection of securities and not frombroad market risk or timing their market exposure

- reduce broad market risk reduce overall risk of theportfolio return from security selection large relative tototal portfolio risk lever portfolio increasing expected

return relative to total capital

Doubles opportunity to profit from security selection

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Hedge Fund Strategies: Leverage

Hedge Funds use leverage to increase return on theircapital

Several ways of leveraging

- Margin loans- Derivative positions

- Unsecured bank loans

Different models of leverage use

- Jones Model- Market Neutral

- Directional Extreme

- Levered Extreme

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Hedge Fund Strategies: Leverage

-500%

0%

500%

1000%

1500%

Models of Leverage Usage

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Hedge Fund Strategies: Concentration

Hedge Funds usually hold portfolios that aresignificantly more concentrated than traditionallymanaged funds

Hedge fund managers typically seek to focus theirbets on a smaller number of investment opportunitiesin which they have a high degree of certainty high risk but also higher expected return (only when

views are accurate)

Traditional managers use diversification as a way toreduce risk.

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Hedge Fund Strategies: Derivatives

Extensive use of derivative instruments- Options

- Futures and forwards- Swaps, convertible bonds etc

Derivatives used as an alternative source of leverageand as an alternative method for taking short

positions Derivative also used to express a view more

precisely

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Hedge Fund Strategies: Efficient

Execution

Hedge Funds managers focus their attention on

trading as efficiently as possible

Often hedge funds trade large gross positionsto capture relatively small profit opportunities

Aware of negative impact of transaction costs

on fund performance

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Hedge Fund Segmentation

Probably as many hedge fund styles as hedge

funds. Yet, some typical segments are as

follows:

Fundamental long/short funds

Quantitative long/short funds

Arbitrage/relative value funds Macro funds

Funds of funds

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Hedge Fund Segmentation:

Fundamental long/short funds

Trade securities that seem mispriced based onthe analysis of business prospects for the firm

Similar to traditional asset management,

except that they extensively use leverage andshort positions

Managers often specialize in some industry or

asset class Leverage position generally between slightly

short to 100% long

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Quantitative long/short fundsApply statistical analysis to historical data to identify

profitable trading opportunities Entails hypothesizing the existence of a particular

type of systematic opportunity for unusual returnsand then backtesting

Once a successful strategy is identified, it isnormally implemented relatively mechanically

Closely related to works published by finance

academics High degree of leverage is used and therefore risk

control is crucial These funds are the most likely to be market neutral

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Arbitrage/relative value funds

Seek to identify expected return differentials(mispricings) between closely relatedsecurities where these mispricings are not

attributable to the business prospects of theissuers of the securities Eg: merger arbitrage, convertible bond

arbitrage

Expected returns are small compared to thevalue of the securities involved

Among the most aggressive users of leverage

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Hedge Fund Segmentation: Macro

fundsTake positions based on their view of global

macroeconomic events Use futures and forwards to bet on currencies, bond

markets or equity markets of whole countries Because of the relatively low degree of correlation

between the currencies and indexes in which theytrade, macro funds are unable to exercise strict riskcontrol. Therefore they typically use less leverage

than other hedge funds Most macro funds are hybrid funds They generally have the largest capital and are most

widely known in the financial community

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Hedge Fund Segmentation: Funds of

funds

They gather investor assets and investthem in other hedge funds

Seek to add value by choosing hedgefunds that will be successful in the future

Diversify by investing in divergent types

of funds Among the lowest risk hedge funds

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PERFORMANCE

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Rapidly growing community

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Hedge Funds success in the 90s

Exhaustive and completely reliable data do notexist.

Private organizations gather and sell data on

hedge fundsTASS Management

Van Hedge Fund Advisors

Financial Risk management Ltd

Imperfect data still concludes hedge funds asuccess in the 90s

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Quality of the Data

Definition of the universe

Distinctions are often blurred

Leverage or short-sellingManaged future funds

Trade futures on commodities,

securities and indexes

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Completeness of the universe

Not all funds can be captured

New funds are added frequently Vendors aware of them only through WOM

Based mainly on estimation

Numbers have to be grossed up (2.7 3) After discussion with other vendors

Quality of the Data

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Participation is purely voluntary

Certain funds choose not to participate

Poor performanceExcellent performance and no need for new

investments

Cause discrepancies in actual figures

Funds are dropped when they go out of

existence (overstate)

Unsure if new bias is upward or downward

Quality of the Data

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Accuracy of report

Not regulated questionable

Hedge funds trade in illiquid securitiesAccurate marks difficult to obtain

Especially so during market stress

Quality of the Data

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Should we trust these data?

Imperfections always exist

Sufficient quality is present

Data confirm our conclusions

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Risk/Return Performance of

hedge funds as a class

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Which hedge funds to choose?

Macro Funds

Highest return

Funds of funds

Lowest risk

Lowest return (Surprising result)

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Risk/Return Performance of

Average hedge funds over time

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Efficient frontier with and without hedge funds

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Why include Hedge Funds

Risk and return slightly lower when using S&P 500 asbenchmark

Lower risk and higher return for all other benchmarksexcept for the bond index

Offers low correlations with all other asset class,including S&P 500

Inclusion of hedge funds increases portfolio return byas much as 200 basis points

Same Return + low correlation = Powerful combination able to lower risk significantly for the same return

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Correlation of hedge funds and major

benchmarks

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Performance of hedge funds during down

quarters of S&P 500

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Tend to outperform market during periods of

poor market performance

However, some funds of suffered severe

financial distress

Too much leverage (risk relative to capital)

Grossly underestimate extreme moves in values

Deviate from core competence

Why include Hedge Funds

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Conclusion

Hedge funds strategies constitute reasonable

approaches to profiting in modern capital

markets

Risks exist, technology to manage the risks

also exist

Historically, hedge funds performance has

been very attractive

Diversification tool

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Future outlook

Expected to grow rapidly

Estimation by Greenwich Alternative

Investment HouseGlobal hedge funds expected to hit US$2 Trillionby 2009 and US$4 Trillion by 2013

Documents

Anoj Half Compiled Hedge Funds