(1) Project (Group, Written, 50 points): Build a long short portfolio and measure its performance

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1 FIN 580 Hedge Funds Instructor: Professor Malay K. Dey, Ph. D Office and Contact: 109 Wohlers Hall, Phone: , mdey@illinois.edu Office Hours: TTH 9:45 to 10:45 a.m. or by appointments Lectures: TTH 11:00-12:20 pm; Meets at WH 240 A. Course Overview The course will provide an in-depth study of the hedge funds industry and performance measurement. We will start with an overview of the hedge fund industry. Next, we will introduce two key instruments used by hedge fund managers: leverage and short selling. The rest of the course will provide detailed coverage on formulation and performance metrics of some commonplace equity investment strategies: long/short equity hedge strategies based on quantitative models and fundamental analyses, event-driven strategies including merger and statistical arbitrage. Finally, we will discuss hedge fund regulation. B. Pre-requisite Fin 511: Investments or equivalent Proficiency in MS Excel Data Analysis utility C. Required Materials Textbook: Investment Strategies of Hedge Funds by Filippo Stefanini, Wiley, Course packet containing readings list is available at ; additional materials, if any will be posted on compass. D. Grading The course grade is based on 1 group project ( =45 points) broken into 3 distinct successive learning components, an individual case study (20 points), a final exam (20 points), 1 individual Tell us about a HF presentation (5 points), and 2 individual readings list summaries (10 points). (1) Project (Group, Written, 50 points): Build a long short portfolio and measure its performance Report 1: Form a long only portfolio with 3 stocks (20 points) Step 1: Use portfolio theory/ multi-factor model for stock selection Step 2: Construct 3 long portfolios with the 3 stocks varying their respective weights Step 3: Write (< 750 words) a report summarizing the risk/return characteristics of the 3 constructed portfolios. Report 2: Identify 2 publicly traded stocks for short selling and write (< 500 words) a report summarizing the risk/return characteristics of the 2 stocks (10 points) Report 3: Form long short portfolios (20 points) Step 1: Reconfigure the 3 long only portfolios by adding one or more shorts to the mix (you will have many alternative ways for the reconfiguration)

2 Step 2: Write about your methodology and main results (generous use of graphs/charts recommended) to an investor group e.g., pension and endowment funds managers. Include a comparison of the performance, risk/return characteristics of the new long short portfolios with those of the long only portfolios. For each Report (1, 2, and 3), you will write and submit for grading how you constructed the model, collected data, and analyzed results. A template for reports follows. 1. Executive summary in 10 lines or less 2. Purpose (Begin with The purpose of this report OR In this report, we intend. ). 3. Model identification (We choose a 3 months trailing P/E multiplier model to identify over/undervalued stocks for our portfolio OR For security selection, we use a 3 months trailing P/E multiplier approach) 4. Data and results ( We choose 10 blue chip stocks from the Dow 30 and download daily closing prices for those stocks for the period 1/1/2014 to 4/30/2014 from the Bloomberg terminals at MIL. We compute return as The descriptive statistics for the 10 stocks are in Table 1 We tabulate our model output in Table 2, which shows based on a 3 months trailing P/E model, 7 out of those 10 stocks are overpriced. This section will contain approximately 500 words.) 5. Recommendation in 3 lines or less. (2) Summary of readings (Individual, written, 10 points): Write a summary of any TWO readings list materials, each less than 200 words in length. You MUST submit the summary on/before the day when the readings list item is scheduled to be discussed in the class. Be prepared to lead the class discussion (for approximately 10 minutes) on the topic on which you submit your readings list summary. The following are content wise templates of reading summaries. a) Summary of Eling and Schumacher Analyze and compare 13 different performance measures Sharpe s, Treynor s, and Jensen s measures, as well as Omega, the Sortino ratio, Kappa 3, the upside potential ratio, the Calmar ratio, the Sterling ratio, the Burke ratio, the excess return on value at risk, the conditional Sharpe ratio, and the modified Sharpe ratio. Using these measures, analyze 2763 hedge funds to find an answer to the question of whether the ranking of the funds depends in a critical way on the choice of the performance measure. Tables 1, 2, and 5 contain relevant results Conclude despite significant deviations of hedge fund returns from a normal distribution, comparison of the Sharpe ratio to other measures results in virtually identical rank ordering across the hedge funds. Choice of performance measure does not have a crucial influence on the relative evaluation of hedge funds. (138 words)

3 b) Summary of Ibbotson et al. HF industry is largely unregulated- usually due to their incorporation status as either LPs or off-shore corporations. Accurate measurement of performance difficult- hfs are not required to report their returns, mostly volunteered to data vendors. 2 main biases- Survivorship and Backfill with huge impact (Fung and Hsieh, FAJ, 2009) Attempt to measure historical hedge fund returns accurately and without bias; decompose returns into fees, alpha, and beta. The equally weighted sample of funds that existed at the end of the sample period had a compounded return of 14.88% net of fees. Including dead funds reduced this return to 11.72%. Excluding the backfilled data further reduced the return to 7.70% net of fees. Pre fee return from the equally weighted index of hedge funds estimated to be 11.13%, which consisted of fees of 3.43%, an alpha of 3.00%, and returns from the betas of 4.70%. (144 words) (3) Case Study (Individual, written, 20 points) Write a report outlining a) the central and peripheral problems b) alternative approaches/solutions along with the pros and cons of each approach c) recommendation The following additional templates for your written assignments are included in the course packet. a) Institutional ownership reaches all-time high: Good or bad for alpha seekers? b) Do life insurance stocks provide higher returns? c) An examination of alternative portfolio rebalancing strategies applied to sector funds (4) Final (Individual, written, 20 points)- Tuesday, 12/9/14 E. Group Assignments Each group should ideally consist of THREE students. All groups should be formed by the end of the 2 nd week of class. F. Lecture Notes and Grades Lecture notes and grades will be posted on G. Guest Speakers (Fall 2014) Although I make no promises at this point, I expect having a couple of guest lecturers from the hedge funds industry during the semester. You will be notified of any such event in advance. Mark Vonnahme CPA, UIUC Monday, April 14, 2:10-3:30 p.m. Topic: Case study

4 Professor Summer Kim J.D., UIUC Law School Monday, April 21, 3:30-4:50 p.m Topic: Hedge Fund Regulation David Richter CPA, Grosvenor Capital Management, Wednesday, April 23, 3:30-4:50 p.m Topic: Hedge Funds: Strategies, Industry Trends, and Current Market Opportunities E. Tentative Schedule 1. Introduction to Hedge Funds (8/26-9/4) Evolution of the Hedge Fund Industry Overview of Hedge Fund Strategies Myths about hedge funds The role of hedge funds in asset allocations a. Text, Chapter 1 b. Fung and Hsieh, 2006, Hedge funds: An industry in its adolescence, FRB Atlanta Review c. Stulz, R., 2007, Hedge funds: Past, present, and future, Journal of Economic Perspectives d. Kat, H., 2008, Ten things.about hedge funds, Journal of Wealth Management e. Lo, Hedge Funds, Tables 2.1, 2.5 (a, b), 2.7, 2.9, 2.10 (a, b), 2.11, 8.1, Appendix A **DUE: Student Presentations: Tell us about a hedge fund 2. Performance measurement (9/9-9/16) Portfolio risk and return Statistical properties Alternative measures of performance a. Malkiel and Saha, 2005, Hedge funds: Risk and return, Financial Analyst Journal b. Eling and Schuhmacher, 2007, Does the choice of performance measure influence the evaluation of hedge funds? Journal of Banking and Finance c. Fung, W. and D. Hsieh, 2009, Measurement biases in hedge fund performance data: An update, Financial Analyst Journal d. Ibbotson, R. and N. Chen, 2011, The ABCs of hedge funds: Alphas, betas, and costs, Financial Analyst Journal e. Brown et al., 2009, The ω-score, Financial Analyst Journal 3. Sources of return/performance: Quantitative stock selection via factor models (9/18-9/25) a. Text, Ch. 4

5 **DUE: Written report on long only portfolio performance 4. Do Hedge Funds need to be regulated? (9/25-10/2 lectures) Overview of hedge fund regulation: A Historical Perspective What are the lessons learned? Excess Risk Taking, High Leverage, Lack of Regulation? Which are the current legislative proposals on the table? a. Lo, Hedge Funds: Chapter 9.4 b. Shadab, H., 2008, An artifact of law: US prohibition of retail hedge funds c. Danielsson, J, A. Pierre, and J. Zigrand, 2005, Highwaymen or heroes: Should US hedge funds be regulated? A survey, Journal of Financial Stability d. Cumming, D. and Na Dai, 2010, A law and finance analysis of hedge funds, Financial Management e. PriceWaterhouseCoopers, 2007, The regulation, tax and distribution of hedge funds around the world f. PBS Frontline program on SAC Capital 5. Building hedge fund portfolio I (10/7-10/9) A. The Mechanics of Short Selling and Leverage B. Use of derivatives a. Text, Ch. 3 b. Lo, Hedge Funds: Chapter , , 11.3 c. Barnard and P. Boyle, 2009, Mr. Madoff s amazing returns: An analysis of the splitstrike conversion strategy, Journal of Derivatives d. Chen, Yong, 2011, Derivatives use in hedge fund industry, Journal of Financial and Quantitative Analysis **DUE: Written report on short stocks 6. Case study: Guest Lecture (10/14) 7. Long/Short Equity Portfolio: Quantitative Stock Selection (10/16-10/28) Steps for setting up market-neutral alpha portfolios a. Text, Ch. 4 b. Lo, Hedge Funds: Chapter , , 11.3 c. Jacobs, B. and K. Levy, Long/Short equity investing, Financial Analyst Journal

6 d. Lo, A., Where do alphas come from? 2008, A new measure of the value of active investment management, JOIM (companion publication- Can hedge fund returns be replicated? The linear case, JOIM, 2007) e. Barnard and P. Boyle, 2009, Mr. Madoff s amazing returns: An analysis of the splitstrike conversion strategy, Journal of Derivatives f. Fung, W. and D. Hsieh, 2011, Risk in hedge fund strategies: Evidence from long short equity funds, Journal of Empirical Finance **DUE: Report on long short portfolio 8. Specialized hedge funds (10/16-10/28) a. Text, Ch. 4 b. Brav et al. 2009, Hedge fund activism, Financial Analyst Journal c. Ibbotson et al. 2011, Liquidity as investment style, Financial Analyst Journal Biographical Sketch: Malay K. Dey Malay K. Dey is currently a visiting Assistant Professor of Finance at the University of Illinois at Urbana Champaign and a senior partner of FINQ LLC, a diversified financial technology startup. He held faculty positions in multiple US universities including Cornell University, NYIT, Morgan State University, and the University of Minnesota, Twin Cities. He was a Research Fellow at the Networks Financial Institute at Indiana State University ( ) and served as a Vice president, Quantitative trading strategy at ITG, the leading crossing network in the world ( ). Professor Dey received his Ph.D. (Finance) degree from the University of Massachusetts Amherst in His primary research interests are market microstructure, international financial markets, and financial econometrics with a secondary interest in financial technology. Professor Dey s research focuses on theoretical and empirical issues related to institutional trading and liquidity in equity markets. Professor Dey has several publications in reputable finance journals and has presented his research at many national and international finance conferences/workshops including, NBER, INQUIRE Europe, Bocconi University, IGIDR and academic institutions in the US and abroad. Professor Dey received the second competitive paper award in Turnaround Management Association s Global Conference in 2006 for his paper Bank and stock market liquidity. Dr. Dey has been a consultant for projects related to cost of capital of business segments of multi-line insurance companies, determination of VaR risk for insurance operations, training programs on quantitative trading, and quantitative trading strategies for hedge/money management funds.

7 The Department of Homeland Security and the University of Illinois at Urbana-Champaign Office of Campus Emergency Planning recommend the following three responses to any emergency on campus: RUN > HIDE > FIGHT ONLY FOLLOW THESE ACTIONS IF SAFE TO DO SO. When in doubt, follow your instincts you are your own best advocate! RUN Action taken to leave an area for personal safety. Take the time now to learn the different ways to leave your building BEFORE there is an emergency. Evacuations are mandatory for fire alarms and when directed by authorities. No exceptions! Evacuate immediately. Pull manual fire alarm to prompt a response for others to evacuate. Take critical personal items only (keys, purse, and outerwear) and close doors behind you. Assist those who need help, but carefully consider whether you may put yourself at risk. Look for EXIT signs indicating potential egress/escape routes. If you are not able to evacuate, go to an Area of Rescue Assistance. Evacuate to Evacuation Assembly Area and remain until additional instructions are given. Alert authorities to those who may need assistance. Do not re-enter building until informed by emergency response personnel that it is safe to return. ACTIVE THREAT: If it is safe to do so run out of the building. Get as far away as possible. Do not go to the Evacuation Assembly Area. HIDE Action taken to seek immediate shelter indoors when emergency conditions do not warrant or allow evacuation, such as for severe weather. Take the time now to learn the different ways to seek shelter within your building BEFORE there is an emergency. If you are outside, proceed to the nearest protective building. If sheltering-in-place due to severe weather, proceed to the identified Storm Refuge Area or to the lowest, most interior area of the building away from windows or hazardous equipment or materials. ACTIVE THREAT: Lock or barricade your area. Get to a place where the threat cannot see you. Place cell phones on silent. Do not make any noise. Do not come out until you receive an Illini-Alert advising you it is safe. FIGHT Action taken as a last resort to increase your odds for survival. ACTIVE THREAT: If you cannot run away safely or cannot hide, be prepared to fight with anything available to increase your odds for survival.