BSFS Handouts Hedge Fund Strategies. By Samuele Mazzoli

Transcription

1 BSFS Handouts Hedge Fund Strategies By Samuele Mazzoli 1

2 Outline 1. What are HFs and what are their characteristics? Definition and distinctive features Structure Fee structure 2. HedgeFund strategies Overview of the possible classifications Classification provided by the Financial Sponsors Group 3. Appendix Examples of HF strategies 2

3 Part 1. Hedge Funds Charachteristics & Structure 3

4 What are HFs and what are their characteristics? Definition and distinctive features We can, of course, start by saying that there is no formally accepted definition, so the following is an attempt to capture all the key features: A HF is a privately offered investment vehicle that.. 1. Pools the contribution of investors in order to invest in a variety of asset classes (e.g. securities, derivatives, bonds, currencies ) 2. Uses a variety of active investment strategies (e.g. directional, market neutral, event driven) to achieve positive absolute returns 3. Is unregulated (or lightly regulated) and as such: They can only be offered to eligible investors (HNWIs & institutional investors) They can operate with high management and fee structure After the 2008 crisis, regulatorshave introduced the AIFMD ( Alternative Investment Fund Management Directive ) which attempts to impose some regulation from the operational point of view 4. Is designed to exploit superior information held by the HF manager They can operate with high management and fee structure flexibility: interesting case of FoHF 4

5 What are HFs and what are their characteristics? (cont d) Definition and distinctive features in other words Absolute returns Skill based strategies Hedge fund managers pursue absolute returns rather than returns relative to an index or benchmark, allowing them to generate gains even when the traditional markets are failing or range bound Returns of hedge funds are derived mostly from the skill of the hedge fund manager in executing their chosen strategy rather than exclusively relying on asset appreciation in rising markets Flexibility Hedge funds have the abilityto trade on the long and short side of various financial instruments Diversity Hedge fund managers trade across a spectrum of markets and exchanges, investing in a diverse array of financial instruments including equities, bonds, currencies and derivatives Alignment of interest Hedge fund managers often invest their own money, which aligns their interests with those of their investors 5

6 What are HFs and what are their characteristics? (cont d) Structure Hedge Fund Fund Administrator Prime Broker Custodian Hedge Fund Manager Processes the subscriptions and redemptions Calculates the value of investors holdings (NAV or partnership shares) Executes the transaction ordered by the fund manager Holds the fund s assets (fiduciary duties) Monitors and controls the capital flows to meet margin calls Sets and manages the funds investment strategy 6

7 What are HFs and what are their characteristics? (cont d) Fee structure and why it matters! HF usually levy two types of fees: 1. Management fees: calculated as a percentage of the fund s NAV (Net Asset Value) typically range between 1 to 4 % per annum 2. Performance (incentive) fees: percentage of the fund s profits, usually counting both realized and unrealized profits usually around 20 % of returns (but the range is wide with top managers charging higher fees) Can be suject to a highwater mark: managers receive perfomance fees only on increases in the NAV of the fund in excess of the highest previously achieved NAV Can be subject to a hurdle rate: managers will not charge a performance fee until the fund s performance exceeds a benchmark rate, such as T-bill yield, LIBOR or fixed percentage ü Incentive to attractvery talented managers The asimmetry of performance fee structure may incentive managers to take excessive risk rather that targeting on long-term return 7

8 Part 2. Hedge Funds Strategies 8

9 Hedge Fund Strategies Overview of the possible classifications Any attempt to establish a formal system of classification for hedge fund strategies is limited by the fact that these strategies are continually changing (e.g. recentlyseveral hedge funds began taking direct positions in leveraged buyouts, previously the domain of private equity firms) The following are some of the possible classifications of HFs: 1. Fung and Hsieh (1997) classify Hfs strategies according to both style and location : Style refers to the type of positions the fund manager is taking such as going long and short, betting on a particular type of event, or mantaining market neutrality Location refers to the asset class the HF is investing in (e.g. fixed income, equity or currencies) 2. Amenc, Martellini and Vaissie (2002) distinguish between: Return enhancer strategies: distressed securities, event- driven and macro funds these funds seek very high expected return but also increase overall portfolio volatility Risk reducer strategies: convertible arbitrage, fixed income arbitrage, long/short and short selling funds offering positive excessreturns while also decreasing over all portfolio volatility 3. Other binaryclassifications Systematic vs. Discretionary strategies: trading based on complex computer programs vs HF manager judgement Multistrategy HFs : HF manager changes strategy depending on market conditions 9

10 Hedge Fund Strategies (cont d) Classification sugested by Connor, Lasarte (2007) We will discuss some specific hedge fund strategies, grouping them under four broad themes: long/short, event driven, tactical trading, and relative value 1 Long / Short 2 Event Driven 3 Tactical Trading 4 Relative Value Strategiesthat exploit the Strategies based on events Strategiesthat attempt to Strategiesdesigned to take ability of the HF manager to expected to make an impact profit by forecasting the advantage of perceived freely short equities, an over a relatively short period overall direction of the market mispricing among related opportunity not available to of time (e.g. restructurings, or a market component (e.g. financial assets, as such they most portfolio managers; they stock buybakcs, bond geopolitical issues, economic rely on the LR tendency of allow to separate specific from upgrades, earnings surprises, indicators, market trends and market prices to revert to systematic risk spin-offs) liquidity flows) equilibrium relationships, Equity Market Neutral Distressed Securities Macro Strategies (while can deviate in the SR) Equity Long/Short High Yield Long - only Leveraged Convertible arbitrage Dedicated Short Bias M&A Risk Arbitrage Strategies Capital Arbitrage Fixed Income Strategies 10

11 Hedge Fund Strategies (cont d) 1 Long / Short Strategies Strategy What does it consists in? Pros Cons Equity Market Neutral (e.g. pairs trading) Equity long/short (often bottom-up approach, i.e. fundamental analysis) Dedicated Short Bias (e.g. shortselling of Tyco shares in 2002 following an accounting scandal) Strategy that uses the combination of buys and short sales to offset any correlation between portfolio return and the overall marketreturn Strategy that is the same as market neutral exceptwithouth any explicit promise to maintain market neutrality It concentrates on the short side and thereby sacrifices the market neutrality feature Usually involves shares of large companies, easier to trade and to borrow ü Removes systematic risk ü Profit do not depend on the direction of the market ü Increased flexibility for HF manager to choose net-long or net-short market exposure ü Focus on stock selection opportunities ü Most effective when markets are declining ü Allows to profit from untapped opportunities available to investors that can not short sell Profit depends on the relative performance of the long compared to the short position on a relative basis Unclear to the final investor how the HF allocation affects portfolio risk Since it is focuses on shortselling, unlimited potential losses Timing and risk management are crucial 11

12 Hedge Fund Strategies (cont d) 2 Event Driven Strategy What does it consists in? Pros Cons Distressed Securities Strategy that focuses on the purchase of a substantial proportion of the outstanding security of the distressed company and then attempt to influence the restructuring process High Yields Strategy that consists in purchase junk bonds / high-yield debt (triple BBB or minus), that they can buy at a discounted price M&A Risk Arbitrage (e.g. takeover of Mannesmann by Vodafone AirTouch 1999) The HF will generally go long on the stock of the target and short the stock of the bidder ü Can profit from absolute pricing inefficiencies ü Possibility to capture the high yield ü An active form of the strategy is to accumulate large shareholdings in order to influence the merger negotiations and outcome Prices for these securities are volatile and illiquid High legal risks (e.g. regulators prohibiting the selling of a company stock during restructuring) Risk to lose part of the investment Antitrust risk: regulators can block the deal Financing risk: acquirercan lose the financial backing to carry out the purchase M&A volume is cyclical 12

13 Hedge Fund Strategies (cont d) 3 Tactical Trading Strategy What does it consists in? Pros Cons Macro Strategies (e.g. Yen Carry Trade in the 90s, meaning borrowing at low interest rates in Japan and invest in US debt) Strategy by which the HF manager makes large bets based on forecasts of major macroeconomic events such as changes in interest rates, currency movements and stock marketperformance They often rely on the use of leverage and derivatives ü Flexibility for the HF manager in choosing the country and/or the asset class where he sees an opportunity Return profile is much more volatile comparedto other HF w/t different strategies Could suffer from high correlation b/t assets as it is the case in EM where most of these funds invest Long-only Leveraged Strategy Strategy that is similar to a traditional active management strategy but carries more risk as it involves leverage on top of an aggressive portfolio ü Possibility to benefit from lighter regulation associated to HF Usually these funds are more similar to traditional active funds hence they are not properly hedging 13

14 Hedge Fund Strategies (cont d) 4 Relative Value Strategy What does it consists in? Pros Cons Convertible Arbitrage (e.g. in 1999, Amazon share price was high, assuming extraordinary growth, while convertibes were not reflecting this -> short high priced stocks and long bonds) Capital Arbitrage (e.g. British Telecom in 2001, when his debt was downgraded several times while its share price was slower to react) Strategy whereby HF managers typically take a long position in the convertible bond and short the company s equity Important parameter in the trade is delta The interests on the proceeds from selling short the stock are used to finance the position Exploits mispricing between a company s debt and equity Common case of investment opportunities arises when companies are undergoing restructuring processes ü Allows to profit from the undervaluation of the convertible bond while reducing the exposure to the underlying stock ü Possibility to benefit from different reactions of equity and debt to announcements such as earnings release ü Strategy eased by the growth in popularity of CDS Subject to interest rate risk and credit spread movements Also affected by regulatory risk (e.g. in Japan regulators designed a set of new rules to curb short selling Risk of misinterpreting the correlation b/w a company s equity and debt 14

15 Hedge Fund Strategies (cont d) 4 Relative Value (cont d) Among Relative Value strategies, Fixed Income Strategies play an important role. These attempt to exploit mispricing among fixed income securities and rely heavily on mathematical models of the term structure of interest rate to identify mispricing. Strategy What does it consists in? Pros Cons Yield Curve Arbitrage Involves taking offsetting positions at various points of the yield curve, typical those of a T-bill, in responde to perceived disequilibrium price relationships Often consists in taking positions in the futures and swaps markets as an alternative to directly buying or selling bonds ü Can be intra curve (trade involves securities on the same YC) or inter-curve (trade involves securities issued by different countries) many possible strategies Success of this strategy depends essentially on the accuracy with which the HF manager forecasts macro factors affecting the YC high volatility, like for macro strategies Besides the Yield Curve Arbitrage, there are many others such as: Corporate Spread, Trasury/Eurodollar, Mortgage, Derivatives, ADR and Stock Index Futures Arbitrages feel free to learn how they work! 15

16 Part 3. Appendix 16

17 Pairs Trading Example

18 M&A Risk Arbitrage Example

19 Macro Strategies example

20 Convertible Arbitrage Example 1 2 One specific example of convertible arbitrage is Delta Trading, which allows to insulate the strategy from market risk the idea is to have a delta neutral portfolio of CBs and stocks, which in theory, generates positive returns regardless of pricing movements Some definitions and formulas: Delta =!" #$!" %, in other terms it measures the sensitivity of CB price vis-a-vis the stock price N of shares to short in order to be delta neutral = a b c, where: a = N of covered bonds I want to long b = Conversion Ratio c = Delta We want to long 1 CB, how many shares to short? N shares = 1 (CB) 50 (conversion ratio) 0,5 (Delta) = 25 20

21 Yield Curve Arbitrage Example 1 2 Source: Intro to HFs strategies - Connor, Lasarte (2007), Investment Strategies of HFs, Stefanini (2006) This is a simplified example, infact in reality we distinguish three cases: Steepening YC: short LT securities, long ST securites Flattening YC: long LT securities, short ST securities Butterfly YC: depends whether the curve is troughed or humped 21