Part 1: Review of Hedge Funds

Transcription

1 Part 1: Review of Hedge Funds and structured products Luis A. Seco Sigma Analysis & Management University of Toronto RiskLab

2 A hedge fund example

3 A hedge fund example

4 A hedge fund example

5 A hedge fund example

6 A hedge fund example

7 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.

8 A hedge fund example

9 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%

10 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.

11 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

12 The investment structure Investor 1 Investor 2 Investor 3 Investor 4 Investor n The Fund legal structure The Administrator The Bank Prime Broker The Management company the hedge fund

13 Share value Starting from the Net Asset Value observations (NAV) of the Fund N i on a monthly basis, and the number of outstanding shares n i, we define the share value S i as S i = N i /n i

14 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.

15 The free-ride syndrome Investor A VAMI Investor B

16 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.

17 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

18 Databases

19 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.

20 Data Issues (discussion)

21 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.

22 Hedge Fund Strategies

23 Asset growth

24 Asset growth by strategy

25 Strategy asset composition

26 Assets/firm size

27 Investments w/o hedge funds +10% -6%

28 Hedge fund diversification Hedge funds are uncorrelated to traditional markets, and internally uncorrelated also. Correlation histogram for Dow stocks Correlation histogram for hedge funds

29 Sample Hedge Fund report

30 Sample HF report part 2

31 Hedge Fund Indices

32 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.

33 Hedge Fund Indices Investable Non-investable

34 Historical comparative analysis Pro-Forma

35 Correlation analysis

36 Style correlations

37 X/I correlations

38 alpha and beta alpha beta

39 Linear regression Dependent variable Independent variable Independent error Regression coefficients

40 Linear regression

41 Return attribution: HFRX vs HFRI

42 Fund of Funds

43 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.

44 The investment structure: fund of funds Investor 1 Investor 2 Investor 3 Investor 4 Investor n The Fund legal structure HF1 HF2 HFn The Administrator The Management company the hedge fund

45 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.

46 Types of fund of funds Number of hedge funds they invest in: Management style Qualitative Quantitative Business proposition They manage the portfolio They market the portfolio

47 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

48 Investing in Hedge funds Portfolio construction Hedge Fund products

49 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.

50 Structured products Options (CPPI). Guaranteed products. Debt products: CFO.

51 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.

52 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.

53 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.

54 Anatomy of a guarantee Guarantees principal in the future: How much is needed is determined by Interest rates Maturity date of the note Obtains exposure to the Hedge Funds

55 CFO s SPV/Trust Bond Investor (1) Guarantees principal Fund Pool Bond Investor (2) Bond Investor (3)

56 Anatomy of a CFO

57 Bond defaults