hedge fund presentation

How to build a hedge fund

Louis Plowden-Wardlaw23rd March 2011

How to build a hedge fund

Why are there hedge funds?

● Investors are always looking for higher returns

● Hedge funds have promised them in exchange for higher fees

● Traditional asset managers offered relative returns, benchmarking their return typically against a bond or equity index

● Hedge fund managers think they developed the concept of absolute returns ie positive whatever the market does; for marketing purposes this has been called alpha to distinguish it from market return (beta from CAPM theory)

● Arguably this is a bit naive; wealth owners have generally expected their money managers to avoid the downs and ride the ups

● Hedge fund managers have used instruments first developed for hedging for speculating, and have helped fuel the buyside of the late 80's to present day wave of globalisation and the financial innovations developed with increased computing power

● The trading floor in the wild outside its natural home in investment banks

Characteristics

What are the characteristics of a hedge fund?

● Remuneration structure (2 and 20)

● Use of leverage

● Use of derivatives

● High level of management discretion

● Opacity/mystique

● High returns

● Promise of uncorrelated returns

● Cash substitute

● Large minimum investment

● Hurdle rate

● High water marks

● Cannot advertise

23rd March 2011 Hedge Fund Presentation "How to build a hedge fund" © Louis Plowden-Wardlaw 2011

Evolution (1)

Number of hedge funds and assets under management in sector

● Hard to get precise numbers as by definition private investment vehicles

● People who track these numbers use different groups of funds

● But figures from Hedge Fund Research suggest that between 1990 and 2007 the number of funds grew from 610 to 9767, and assets under management from $39billion to $1,700 billion.

● US based at first, Europe proportion of sector moved from 12% in 2002 to 24% in 2006, Asian from 5-8% over the same period

● Fees estimated according to The Economist at $65 billion in 2005

● Whilst there was a pulling back from the industry after the credit crisis, characterised by heavy redemptions, FSA as of February 2011 estimates $1,900 billion managed by the industry

● In 2005, when it was a mere $1,000 billion, the FSA estimated this comprised 5% of total assets under management


Evolution (2)

Increasing importance

● Nonetheless, in 2005 again, the FSA estimated that hedge funds accounted between 1/3 and ½ NYSE and LSE turnover

● Servicing hedge funds generated 1/8 of investment banking revenues in broking commissions and fees ($19bn) and prime brokerage revenues ($6bn) (again 2004)

● Major liquidity providers (see point 1)

● Largely an investment banking diaspora

● Investment banks themselves engage in proprietary trading to a major extent – in 2010 for the first three quarters Goldman Sachs was obliged to reveal that 18% of its revenue was proprietary trading derived, as compared to the figure generally disseminated by them of 10%

● Doing the investment and lending functions the banks won't do


Relative versus absolute returns

The elusive alpha ● Hedge funds like to say they can achieve positive returns on their investments whether the markets go up or down

● Opinion is divided on whether this works

● One of the major selling points for hedge funds as an asset class is that they are said to be uncorrelated to other asset classes

● As we have learnt, it is one of the features of an inter-connected financial system that nearly all asset classes have come to be correlated when there are major changes in sentiment

● However it is easy to be too negative; there are reasons why the asset class is flourishing

● The core of the question is whether higher returns achieved are higher returns adjusting for the risk assumed


The sceptical perspective

Sceptics say ● Hedge funds are usually geared; markets of assets usually go up most of the time slowly, then correct in a short period. If your investment manager has multiplied exposure to the upwards evolution of prices by borrowing, then returns will be high. Of course when prices correct – usually a much quicker process, a geared investment will exacerbate the losses too, and equity that would be hit on an ungeared strategy could well be wiped out on a geared strategy. If this isn't obvious, see cartoon on next page (Washington Post March 14 2008, Laura Stanton)

● During up periods, superior investment returns are a function of superior investment insight; during down periods – well, hey, that's the market!

● Andrew Lo, an MIT econometrician, in 2001 wrote an article in which he detailed a hypothetical hedge fund called Capital Decimation Partners. (Risk Management For Hedge Funds: Introduction and Overview", Financial Analysts Journal 57, 16-33.)


The sceptical perspective (2)

CDP and other issues● Lo postulated a fund that sold out of the money

put options – insurance if you will on declining stock prices – on the S&P 500 from 1992-99.

● The strategy made a return of 2721.3% when the S&P made a return of 367.1%

● But would lose all those accumulated returns in one major market downturn.

● Lots of other ways to benefit from assuming tail risk for a steady premium where the adverse event would have a catastrophic effect on capital

● LTCM and 1998 Russian contagion

● Survivorship bias

● Persistence of returns

● Backfilling in indices of performance


A less jaundiced view

There are plenty of buyers of hedge funds and academic research that supports hedge fund out-performance

● As already demonstrated, the sector is growing

● More discretion leads to more outperformance than can be explained by luck ( Role of managerial incentives and discretion in hedge fund performance, V Agarwal, N. Daniel and N. Naik, 2007)

● Others conclude that there is more than luck involved (Do hedge funds deliver alpha? A Bayesian and bootstrap analysis Robert Kosowskia, Narayan Y. Naik, Melvyn Teo)

● So maybe the jury is out, but there is supporting evidence for superior returns


Taxonomy

No agreed taxonomy, but shared characteristics of flexible instruments to implement strategies involving gearing

● Event driven

● Macro

● Convertible arbitrage

● Pair trading

● Black box quantitative model

● Fixed income

● Market neutral

● Statistical arbitrage

● Foreign exchange etc

● (per Agarwal Naik and Daniel) Can be boiled down to

– Directional– Relative value– Security selection– Multiprocess


The building blocks

Hedge funds are multi-entity and usually multi-jurisdiction constructs with key functions outsourced

● Master fund

● Feeder fund(s)

● Investment manager

● Administrator

● Prime broker

● Counterparties

● Lawyers

● Auditors

● Investors

● Regulators

● Depository


JurisdictionsWhere are funds incorporated and managed?

● Typically the funds are incorporated offshore, and managed onshore

● Fund jurisdictions include Cayman Islands, BVI

● UK, Switzerland and US are typical manager jurisdictions


UK investment managers

An important UK industry

● Usual “permanent establishment” rules trumped by Investment Manager Exemption

● The cornerstone of the UK hedge fund management industry – leads to standard structures compliant with these rules

● Ensures funds not taxed under UK tax regime if the fund is trading (different rules apply to funds making long term investments)


Institutionalisation

Funds of funds ● Hedge funds associated with higher risk

● Diversification – number of investments required 12? 25?

● But extra fee layer eats at returns – another 1 and 10 layer


The model is catching on

Everyone wants to be a hedge fund

● A striking examplePorsche v Volkswagen

●


In 2008 Porsche (a smallish company) revealed it owned nearly 75% of VW (a biggish one) with direct ownership and CFD's

● VW shares up to €1000 from €250

● Hedge funds short VW lose €30bn


In 2009 Porsche fail to get 75% they require and are crippled by debt taken on in their audacious attempt

● VW buy controlling stake in Porsche; Porsche management resign


Lessons

Leverage ● Maybe it does need some professional management

● Or maybe Porsche just unlucky to be caught in the credit crisis...


What do the building blocks do?

Master and feeder funds

● Master – transacts with counterparties

● Feeders – invest in master fund

● Independent board overseeing service providers including investment manager

● Feeder – tailored for different investor consituencies eg US/Europe

● Features of funds

● Fees

● Lock ups

● Redemption periods

● Frequency of valuation

● Hurdle rate

● Share classes

● Risk statements

● Key document: Prospectus


What do the building blocks do? (2)

Administrator ● Shareholders register – take in subscription monies and pay out redemption monies

● Valuation

● Correspond with investors

● Independence key

● European hedge funds generally better at having independent valuation structurally built in; in house valuation sometimes practiced but not a great idea cf Madoff

● Usually offshore

● Key document: Administration agreement



Prime broker ● Who? Investment bank

● Capital introduction

● Systems

● Trading

● Lending allowing trading on margin

● Faces executing brokers

● Liquidity

● Pre credit crunch – single main PB the norm; post credit crunch hedge funds diversify risk

● Key document: Prime brokerage agreement and relevant counterparty documentation; give up agreements with executing brokers



Counterparties ● Who? Banks and brokers

● Give up trades to PB

● Trading

● Access to multiple markets/prices where PB not strong

● Key document: ISDA's; Credit Support Annexes; repo and security lending documentation



Lawyers and auditors ● Reputable law firms and accountants

● Add seal of approval● Deal with ongoing issues and

verify returns● Key document: retainer

documentation



Investment manager ● Invest subscribed monies by entering trades with PB and counterparts

● Risk manage within stated parameters

● Manage liquidity● Court investors and answer

their questions: marketing● Key document: investment

management agreement



Investors ● Invest● Conduct due diligence on

their own account or as fiduciary for others

● Asset allocate● Key document: prospectus

and side letter in certain cases



Depository ● Look after assets● Links with prime broker● Issues surrounding

rehypothecation of securities; are assets held by custodian on title transfer or charge basis

● Complexities of sub-custodial arrangements – extent of liability

● Client money or not?● LBIE?



Regulator ● Provides investor confidence

● Fund and manager have different regulators

● Eg typical Cayman Fund regulated by light touch Cayman Island Monetary Authority regime, UK investment manager authorised by FSA

● FSA historically prided itself on light touch and concentrating on retail protection so left hedge fund sector alone save for attempts to monitor systemic risk after LTCM

● Key regulator issue – divided regulation of financial firms creates risks

● Key document: licence/authorisation and reports


Hedge funds and systemic risk

Post LTCM, there was a lurking fear that the growth of the hedge fund sector embedded systemic risk

● LTCM – highly geared, multi trade, Nobel laureate assured glamour fund broken by market turbulence in 1998

● LTCM privately rescued – no government monies

● In fact rather than banks being exposed to hedge funds, hedge funds were exposed to banks – cf Lehman as prime broker

● Well known hedge fund failures (Madoff, Amaranth) more than capable of being absorbed by market. The investors could afford to lose the money

● In credit crisis it was the unrisky banks with their embedded leverage that failed


Nonetheless – EU regulation

UCITS IV and AIFMD ● UCITS – retail● AIFMD – professional● Debate 2009-late 2010 – perceived

by London as a rear guard battle to save the London financial services industry from a jealous Paris and Frankfurt

● Final text took on board some of these concerns, but remains to be implemented in national legislation, and is riddled with inconsistencies, problems and “devil in detail” points

● At stake are eg the returns made by European pension funds


AIFMD

What are the contentious issues?

● Who is caught?● Marketing● Protectionism● Capital requirement● Remuneration reporting● Leverage use● Reporting generally● Failure to understand markets● Applying > retail protections to

professional investors● Migration of industry


The future of the fund management industry

Are all asset managers destined to need to use leverage to meet return requirements?

● Is this where hedge fund managers are going? Convergence with the asset management industry as a whole?

● Does it stack up● Can the incentive

structure stand?

hedge fund presentation

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