investing in hedge funds: risks and rewards

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Investing In Hedge Funds: Risks and Rewards

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Page 1: Investing In Hedge Funds: Risks and Rewards

Investing In Hedge Funds: Risks and Rewards

Page 2: Investing In Hedge Funds: Risks and Rewards

Contents

I. History, Definition and Overview

II. Types of Hedge Funds

III. Historical Performance

IV. Benefits of Investing in Hedge Funds

V. Risk Measurement and Risk Management

VI. Strategies for Investment

Page 3: Investing In Hedge Funds: Risks and Rewards

History, Definition and Overview

• First Hedge Fund: Alfred W. Jones

• In 1949 he raised $100,000 (40K his own) and added short positions to his stock portfolio to hedge overall market risk.

• He also levered by borrowing and later required a performance fee from his investors

• As of 1984 there were around 20 hedge funds in existence

Page 4: Investing In Hedge Funds: Risks and Rewards

History, Definition and Overview• DEFINITION: A HEDGE FUND IS A PRIVATE INVESTMENT

PARTNERSHIP

• MANY ARE NOT HEDGED

• THEY ARE NOT REGULATED BY THE SEC

• INVESTORS MUST BE “QUALIFIED” REGARDING NET WORTH AND INCOME

• ARE NOT ALLOWED TO ADVERTISE

• LONG, SHORT, LEVERAGED AND DERIVATIVES POSITIONS MAY BE TAKEN

• USUALLY A HIGH MINIMUM INVESTMENT

Page 5: Investing In Hedge Funds: Risks and Rewards

History, Definition and Overview

• FEES:• MANAGEMENT: 1% TO 2% OF ASSETS

• INCENTIVE: 10% TO 40% ON RETURNS IN EXCESS OF A HURDLE RATE (T-BILLS)

• HIGH WATERMARK: RETURNS BELOW HIGH WATERMARK MUST BE MADE BACK BEFORE INCENTIVE FEE APPLIES

• THESE INCENTIVES MAY RESULT IN TAKING ON EXCESSIVE RISK

Page 6: Investing In Hedge Funds: Risks and Rewards

History, Definition and Overview

• ARE CURRENTLY 8000 FUNDS. -rivaling mutual funds and listed US stocks

• $1.3 TRILLION UNDER MANAGEMENT

• BECOMING PART OF TRADITIONAL INVESTMENT PORTFOLIOS

• BENCHMARKS (Indexes) HAVE BEEN CREATED,IN ADDITION TO RETURN AND RISK TARGETS

• INCREASING EMPHASIS ON RISK/RETURN MEASURES AND RISK BUDGETING

Page 7: Investing In Hedge Funds: Risks and Rewards

History, Definition and Overview• Over half have <$50mm assets

• 80% of Hedge Funds have <$200mm in assets

• Out of the 8000 hedge funds, 116 account for half of the industries assets

• Half do not survive the first 5 years

• Less then 2% of all hedge funds are 10 years or older

• There is a wide dispersion in returns.

Page 8: Investing In Hedge Funds: Risks and Rewards

History, Definition and Overview

• INVESTMENT OBJECTIVES ARE MOST OFTEN ABSOLUTE RETURN AND RISK TARGETS, NOT BENCHMARKS

• ABSOLUTE RETURN IS “PORTABLE ALPHA”

• INDEXES HAVE BEEN CREATED, SOME INVESTIBLE

• THERE CAN BE PROBLEMS WITH SURVIVAL BIAS, BACKFILLING AND CEASATION OF REPORTING

Page 9: Investing In Hedge Funds: Risks and Rewards

TYPES OF HEDGE FUNDS(STRATEGIES)

• ARE AROUND 20 DIFFERENT STRATEGIES

• SOME OVERLAP AND CAN CHANGE THROUGH TIME

• SOME ARE NOT EASILY DEFINED

• WE WILL COVER THE MOST POPULAR STRATEGIES

Page 10: Investing In Hedge Funds: Risks and Rewards

TYPES OF HEDGE FUNDS

• Capital Structure ArbitrageRelative value approach, attempts to capture pricing inefficiencies among various tranches of debt or equity of the same or related companies.

• Convertible ArbitragePurchase different securities of the same issuer such as the common stock and convertible bonds, one position being long, the other short.

• CTA’s / Managed FuturesCommodity Trading Advisors. Trade commodity futures, options and foreign exchange; often highly leveraged; trend following .

Page 11: Investing In Hedge Funds: Risks and Rewards

TYPES OF HEDGE FUNDS

• Distressed Securities Buy the equity or debt of companies that are in or facing bankruptcy, hoping that company will come out of bankruptcy.

• Emerging Markets Invest in the securities of companies from "emerging" or developing countries.

• Event Driven Take positions in companies with "special situations": depressed stock; event offers significant potential market interest such as company merging with or acquired by another company; reorganizations; bad news which temporarily depress stock, which is shorted

Page 12: Investing In Hedge Funds: Risks and Rewards

TYPES OF HEDGE FUNDS• Fixed Income Arbitrage

Plays the spread between similar fixed income securities. Often highly leveraged

• Fund of funds Invests in a basket of different hedge funds. Benefit is to have experts choose the funds and also get into funds closed to new investors. There is a second layer of fees.

• Long/Short Equity Buy securities expected to perform well and sell short securities expected to perform poorly. Often either net long or net short depending on market view

• Global Macro Investment is based on shifts in global economies. Derivatives are often used to speculate on currency and interest rate moves

Page 13: Investing In Hedge Funds: Risks and Rewards

TYPES OF HEDGE FUNDS

• Market Neutral Any strategy that attempts to eliminate market risk and be profitable in any market condition; equity or fixed income.Example: beta=0 for “double alpha”

• Market Timing Attempts to time the market by allocating assets among different investments such as between mutual funds and money markets.

• Multi-Strategy A single hedge fund that runs several different strategies in-house. Different from a fund of funds in that the money is kept in-house as opposed to being farmed out. Thus more nimble

Page 14: Investing In Hedge Funds: Risks and Rewards

TYPES OF HEDGE FUNDS

• Regulation D Private investments made in public companies in need of financing.

• Merger Arbitrage Also known as “Risk Arbitrage". Invest in event-driven situations, such as leveraged buy-outs, mergers, and hostile takeovers. Example: purchase stock in the firm expected to be taken over and sell short stock of the acquiring company.

• Short Bias Any manager who consistently has a "net short" exposure to the market. Includes short only funds.

Page 15: Investing In Hedge Funds: Risks and Rewards

TYPES OF HEDGE FUNDS

• Special Situations Consists of some type of event driven strategy. Opportunistically trade in any type of security that deemed to be a "special situation."

• Statistical Arbitrage Invest in equities believed to behave in a way that is mathematically describable.

• VC / Private Equity Invest in venture capital or private equity

• Sector Funds

Page 16: Investing In Hedge Funds: Risks and Rewards

TYPES OF HEDGE FUNDS• AN EXAMPLE IN DETAIL: CONVERTIBLE ARBITRAGE

• A Convertible Bond is a Hybrid: It pays a coupon and PAR at Maturity

• It gives the holder the right but not obligation to convert to a fixed number of shares of the issuer at a fixed price and date (s)

• Convertible arbitrage: Purchase the bond and hedge by shorting the shares

• If the shares fall in price the bond “convertible shares” price fall is offset by the short position. Thus the principle risk is hedged. What is left is a stream of income. (This is the theory)

Page 17: Investing In Hedge Funds: Risks and Rewards

TYPES OF HEDGE FUNDS• AN EXAMPLE IN DETAIL: CONVERTIBLE ARBITRAGE

• Being bonds, convertibles are subject to interest rate risk: rising rates may severely reduce their value. This risk is often hedged too by shorting Treasuries

• Many Convertibles are callable. If rates drop the bonds may be called and shares issued or cash paid. This could mean a substantial loss to the fund.

• Interest rate and equity volatility can effect the value of the call option and thus the bond

• Finally, there is credit risk (default, spread risks)

• In summary managing these risks and earning a good return require in-depth expertise.

Page 18: Investing In Hedge Funds: Risks and Rewards

TYPES OF HEDGE FUNDS• Another Example: Market Neutral Equity

• Goal: Long attractive stocks, Short stocks expected to under-perform

• Create a portfolio with a beta of zero

• The attractive stocks hopefully result in a long position with positive alpha

• The un-attractive stocks have negative alphas so shorting them results in another position with positive alpha

• Hence the name “double alpha”

Page 19: Investing In Hedge Funds: Risks and Rewards

TYPES OF HEDGE FUNDS• Market Neutral Equity

• In order to create a beta neutral portfolio an ex-ante risk model such as BARRA or Northfield is required

• Need a predicted alpha for each stock and an optimizer to construct the portfolio: to be beta neutral as well as neutral on other risk factors (size, industry, growth, value etc.)

• This cannot be accomplished in one’s head: weight alone does not measure risk

Page 20: Investing In Hedge Funds: Risks and Rewards

TYPES OF HEDGE FUNDS• FINAL EXAMPLE: MERGER ARBITRAGE

• COMPANY ‘B’ WILL BE, OR MAY BE, TAKEN OVER BY COMPANY ‘A’

• WHEN THE MERGER IS ANNOUNCED B’s SHARE PRICE RISES AND A’s DROPS

• SEVERAL WAYS IN WHICH TO PROFIT: SHORT A’s SHARES AND GO LONG B’S SHARES OR GO LONG B’S SHARES WHEN THE MERGER IS ANNOUNCED AND SELL THEM WHEN (IF) THE MERGER OCCURS

• THIS IS ALSO CALLED RISK ARBITRAGE

Page 21: Investing In Hedge Funds: Risks and Rewards

TYPES OF HEDGE FUNDS• SUPPOSE B WILL BE TAKEN OVER BY A FOR 40$ PER SHARE.

CURRENT PRICE IS 25$ PER SHARE

• ON THE DAY OF ANNOUNCEMENT B’s PRICE GAPS TO 39.25$

• THE HEDGE FUND POTENTIAL PROFIT IS 75 CENTS PER SHARE(THEY COULD PREDICT AND PURCHASE AT 23$, MAYBE)

• THE RETURN IS THUS 1.9%

• IF THE DEAL FAILS THE SHARE PRICE WILL FALL BACK TO 25$ FOR A LOSS TO THE HEDGE FUND OF 14.25$, MANY TIMES THE POSSIBLE PROFIT

• THERE ARE FAMOUS EXAMPLES OF DEALS FALLING THROUGH: GE TAKEOVER OF HONEYWELL, BRITISH TELECOME TAKEOVER OF MCI

• THESE COST HEDGE FUNDS HUGELY

Page 22: Investing In Hedge Funds: Risks and Rewards

HISTORICAL PERFORMANCE

HFRX GLOBAL AND STRATEGY INDICES

Hedge Fund Research with permission

  Feb 2005 2004 2003

HFRX Index ROR TOTAL TOTAL TOTAL

HFRX Global Hedge Fund Index 0.17 2.72 2.69 13.39

HFRX Absolute Return Index -0.11 -0.02 3.2 11.95

S&P 500 0.00 3.00 9.00 26.00

  HFRX Convertible Arbitrage Index 0.57 -5.69 -0.14 8.85

  HFRX Distressed Securities Index -0.68 1.21 8.95 20.9

  HFRX Equity Hedge Index 0.35 4.19 2.19 14.47

  HFRX Equity Market Neutral Index 0.15 0.21 0.33 -2.38

  HFRX Event Driven Index -0.54 2.81 6.93 18.74

  HFRX Macro Index 0.22 6.67 -0.32 14.61

  HFRX Merger Arbitrage Index 0.89 3.72 2.8 4.26

  HFRX Relative Value Arbitrage Index 0.5 -0.97 1.98 9.15

Page 23: Investing In Hedge Funds: Risks and Rewards

Net Performance

Hedge Fund Index S&P 500

FTSE All World Index

1 Month 3.23% 2.65% 5.00%

1 Year 11.45% 10.38% 19.77%

2 Year Cumulative 19.75% 17.26% 33.75%

3 Year Cumulative 38.83% 57.79% 88.64%

3 Year Avg Annual 11.56% 16.42% 23.56%

5 Year Cumulative 49.86% 1.86% 21.89%

5 Year Avg Annual 8.43% 0.37% 4.04%

Since Inception Avg 10.91% 10.69% 8.97%

CS/TREMONT INDEXES

Page 24: Investing In Hedge Funds: Risks and Rewards

CS/TREMONT

Index / Sub Strategies YTD 1 Year Avg Ann Std Dev Sharpe

CS/TREMONT Index 3.23% 11.45% 10.91% 7.88% 0.98

   Convertible Arbitrage 2.75% 0.94% 8.80% 4.78% 1.18

   Dedicated Short Bias -2.98% 6.13% -2.26% 17.29% -0.31

   Emerging Markets 5.76% 22.77% 8.81% 16.44% 0.34

   Equity Market Neutral 1.40% 7.24% 9.97% 2.94% 2.31

   Event Driven 2.92% 11.91% 11.63% 5.70% 1.48

      Distressed 2.52% 13.93% 13.57% 6.45% 1.61

      Multi-Strategy 3.32% 10.85% 10.57% 6.12% 1.21

      Risk Arbitrage 1.63% 4.85% 7.80% 4.21% 1.1

   Fixed Income Arbitrage 1.42% 1.97% 6.36% 3.75% 0.85

   Global Macro 3.37% 12.15% 13.74% 11.11% 0.95

   Long/Short Equity 4.18% 15.23% 12.19% 10.30% 0.88

   Managed Futures 2.71% 8.44% 6.55% 12.03% 0.28

Page 25: Investing In Hedge Funds: Risks and Rewards
Page 26: Investing In Hedge Funds: Risks and Rewards

DRAWDOWN GRAPH

Page 27: Investing In Hedge Funds: Risks and Rewards

Benefits of Investing in Hedge Funds

• Hedge Funds are an alternative to traditional investment strategies designed to offer investors the potential for:

Sophisticated, less restricted portfolio management-Absolute return driven-few restrictions on security types,

constraints-novel investment approaches-hedged positions in many cases

Attractive risk adjusted returns

Often positive returns in negative markets

Page 28: Investing In Hedge Funds: Risks and Rewards

Benefits of Investing in Hedge Funds

Diversification & Reduced volatility

-shifts portfolio to the NW quadrant.

-lower standard deviation

Reduced correlation to traditional investment vehicles

-i.e. HFR index has a .49 correlation to the S&P 500

Page 29: Investing In Hedge Funds: Risks and Rewards

Risk Measurement and Management

Qualitative Risk Issues:

Illiquidity -Long lock-up periods that range from 6 months to 10 years

-60 to 90 day notice required to withdraw money after the lock-up

Lack of Transparency -Not required to provide prospectuses.

-Manager is not required to divulge all holdings or trades.

May employ leverage

-Leverage can magnify losses as well as profits

Page 30: Investing In Hedge Funds: Risks and Rewards

Risk Measurement and Management

Relatively high fees -Typically 1% annual management fee

-Manager is entitled to 10% to 20% of profits above a high watermark. -Avg. mutual fund fee is 80bps to 2.50%

Tax Inefficiencies -Most are limited partnerships with K-1s

Rapid Growth -Has made it difficult for investors to carefully identify, select, and monitor single manager hedge fund

Page 31: Investing In Hedge Funds: Risks and Rewards

Risk Measurement and Management

• FAMOUS EXAMPLE: LONG TERM CAPITAL

• FOUNDED IN 1994• CORE STRATEGY:RELATIVE VALUE ARBITRAGE (PLAYING

SPREADS)• SMALL PROFITS SO LEVERAGE WAS USED (25 TO 1 AT FIRST)• 1997: CAPITAL GREW TO $7 BILLION• BALANCE SHEET $125 BILLION• OFF-BALANCE SHEET POSITIONS HAD NOTIONAL AMOUNT OF

$1.25 TRILLION• 1995,1996 NET RETURNS WERE 40%• 1997 CONVERGENCE TRADES HAD LESS “JUICE” SO RETURN

WAS 17%• TO MAINTAIN LEVERAGE $2.7 BILLON RETURNED TO

INVESTORS• ASSETS KEPT AT $130 BILLION, LEVERAGE WAS 28 TO 1

Page 32: Investing In Hedge Funds: Risks and Rewards

Risk Measurement and Management

• IN JUNE 1998 MORTGAGE BACKS TURNED NEGATIVE AND LTCM LOST 16%

• THEN AUGUST 17 RUSSIA DEFAULTED ON DEBT• CREDIT AND LIQUIDITY SPREADS ACROSS ALL MARKETS

WIDENED• TCM LOST $550 MILLION ON AUGUST 21• BY THE END OF AUGUST THEY WERE DOWN 52%• ASSETS WERE KEPT AT $126 BILLION FOR LEVERAGE OF 55 TO

1• ON SEPT 21 LOST ANOTHER $550 MILLION• EVENTUALLY BY END OF SEPTEMBER THE LOSS TO INVESTORS

WAS 92%• THE MAIN LOSSES CAME FROM INTEREST RATE SWAPS AND

EQUITY DERIVATIVES• THE NEW YORK FED HAD TO ORGANIZE A BAILOUT TO

PROTECT THE FINANCIAL MARKETS

Page 33: Investing In Hedge Funds: Risks and Rewards

Risk Measurement and Management

• LESSONS?• EVEN GENIUS FAILS • RISK MANAGEMENT WAS UTILIZED

BUT NO SYSTEM IS PERFECT• HUMANS, NOT MARKETS, ARE THE

MAIN SOUCES OF RISK

Page 34: Investing In Hedge Funds: Risks and Rewards

Risk Measurement and Management

• Statistical Properties of Hedge Fund Returns:

• Low correlations to broad markets

• Lower volatility then equities

• Diverse security types, investment approaches and hedging strategies

• Not (log) Normally distributed

• Often suffer from significant Skewness and Kurtosis.

• Standard deviation may be an inadequate measure of risk

Page 35: Investing In Hedge Funds: Risks and Rewards

x 420-2-4

0.4

0.3

0.2

0.1

0

II. The Statistical Properties of Hedge Fund Returns

• A Normal distribution is characterized only by its first two moments:

mean () and variance (2)

Page 36: Investing In Hedge Funds: Risks and Rewards

x 420-2-4

0.25

0.2

0.15

0.1

0.05

0

II. The Statistical Properties of Hedge Fund Returns

• Hedge funds returns are not Normally distributed and possess non-zero Skewness, i.e. the distribution is asymmetric

Page 37: Investing In Hedge Funds: Risks and Rewards

x 420-2-4

0.5

0.4

0.3

0.2

0.1

0

II. The Statistical Properties of Hedge Fund Returns

• Hedge funds returns also have non-zero Kurtosis, i.e. their distribution is more peaked than Gaussian

Page 38: Investing In Hedge Funds: Risks and Rewards

ACTUAL MONTHLY RETURN SERIES

Frequency

02468

1012141618

-6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7

Mor

e

Frequency

Page 39: Investing In Hedge Funds: Risks and Rewards

III. Traditional and Alternative Risk/Return Measures

• Sharpe Ratio (Ann Ret-Rf) / Stdev(Ret)• Maximum Drawdown• Calmar Ratio (Ann Ret-Rf)/Max Draw-Down)• Sterling Ratio (Ann Ret-Rf)/(Max DD-10%))• Sortino Ratio (Ann Ret-Rf)/(Downside Dev)• Value at Risk, Conditional VaR• Treynor Ratio (Ann Ret-Rf)/beta)• Stutzer Ratio• Omega and Sharpe Omega• Kappa

Page 40: Investing In Hedge Funds: Risks and Rewards

• The traditional ranking scheme for portfolios is the Sharpe ratio

• The Sharpe ratio is motivated by Modern Portfolio Theory, it assumes:

• Return of portfolios is Normal• Investor is free to distribute funds over

the portfolio and a risk free asset

Risk Free Rate

III. Traditional and Alternative Risk/Return Measures

Page 41: Investing In Hedge Funds: Risks and Rewards

• The Sharpe ratio is the slope of the tangent in Markowitz

III. Traditional and Alternative Risk/Return Measures

Page 42: Investing In Hedge Funds: Risks and Rewards

III. Traditional and Alternative Risk/Return Measures

• Downside risk can go undetected if conventional measures (TE, Sharpe, or Std Dev) are used

• This applies to traditional investments too

• Over long investment periods maximizing Sharpe may reduce returns

Page 43: Investing In Hedge Funds: Risks and Rewards

• A different ranking scheme is due to Sortino

• Sortino measures the probability "width" of returns below the benchmark “r”

• r=minimum acceptable return

III. Traditional and Alternative Risk/Return Measures

Page 44: Investing In Hedge Funds: Risks and Rewards

• Another ranking scheme is called Omega

• F(x) is the cumulative distribution function

• Omega measures the entire distribution and does not assume a type of distribution

• r is the minimum acceptable return.

III. Traditional and Alternative Risk/Return Measures

Page 45: Investing In Hedge Funds: Risks and Rewards

III. Traditional and Alternative Risk/Return Measures

Kazemi, Schneeweiss and Gupta have shown that Omega equals the ratio of the price of a call option to a put option (not risk neutral world):

They further define the Sharpe-Omega ratio which is similar to the Sharpe ratio vs the threshold r:

Page 46: Investing In Hedge Funds: Risks and Rewards

• A generalized ranking scheme called Kappa has been proposed by Kaplan and Knowles

• For n=1 Kappa is Omega-1• For n=2 Kappa is Sortino

III. Traditional and Alternative Risk/Return Measures

Page 47: Investing In Hedge Funds: Risks and Rewards

• Stutzer proposed a different ranking scheme

• The Stutzer index measures how fast the probability of a return below the benchmark r goes to zero.

III. Traditional and Alternative Risk/Return Measures

Page 48: Investing In Hedge Funds: Risks and Rewards

TWO EXAMPLES

0

10

20

30

40

50

1 3 5 7 9 11

Series1

0

10

20

30

40

50

1 2 3 4 5 6 7 8 9 10 11 12

Series1

R= 0.005

OMEGA 2.85

SHARPE 1.638

SKEWNESS -1.749

KURTOSIS 4.470

OMEGA 1.36

SHARPE 1.690

SKEWNESS 1.191

KURTOSIS 0.290

Page 49: Investing In Hedge Funds: Risks and Rewards

Di Pierro and Mosevich proved that

for Normally distributed returns

Sharpe, Sortino, Kappa, Omega and Stutzer

imply the same ranking and therefore they are all

Equivalent, meaning that they result in the same rankings.

III. Traditional and Alternative Risk/Return Measures

Page 50: Investing In Hedge Funds: Risks and Rewards

IV. Ranking using various Measures

• For non-Normal distributions the implied rankings are different

• Which is better?

• No explicit answer but by examining stability for various schemes and thresholds we have an idea of the confidence of the rankings

• If returns exhibit long term auto-correlation rankings may be suspect

Page 51: Investing In Hedge Funds: Risks and Rewards

Risk Measurement and Management

Adding hedge funds to traditional portfolio may lower skewness and increase kurtosis

• State dependent correlation; correlations change

• Risk is persistent (high Hurst exponent)

• Risk may be understated because of reporting practices, stale prices or auto-correlation

Page 52: Investing In Hedge Funds: Risks and Rewards

FUND OF FUND RISK MANAGEMENT

• Risk management is cited by many funds of funds as second in importance only to the integrity and abilities of fund managers

• Despite this, reported use of quantitative techniques for monitoring risk exposure to factors such as liquidity, volatility, leverage, credit, traditional markets and extreme events is not very widespread.

• Techniques from traditional investments such as linear multi-factor models are not applicable to most strategies due to the non-linear exposures of hedge funds to these risk factors (the option-like nature of returns).

Page 53: Investing In Hedge Funds: Risks and Rewards

FUND OF FUND RISK MANAGEMENT

• Ex-ante factor and style analysis models at both the fund and strategy level can aid in estimating contributions to risk

• Properly computed correlations of individual managers to each other, to strategies and between strategies is critical in assessing exposures and diversification

• Peer group and hedge fund index correlation, tracking error and information ratio analysis, will in all likely-hood be more and more demanded by institutional clients.

• Risk budgeting is a good framework for construction of the fund of funds portfolio

Page 54: Investing In Hedge Funds: Risks and Rewards

A risk budget specifies how each component of an asset management process contributes to the risk or tracking error of a portfolio.

Example: A global equity portfolio.

6% tracking error target will typically have a risk budget as follows4% security selection4% sector / industry allocation2% currency allocation

Note that assuming no correlation among components we have:

V. Risk Budgeting for Funds of Funds

Page 55: Investing In Hedge Funds: Risks and Rewards

Risk Budgeting for Funds of Funds

• Note that tracking error does not measure downside risk

• Other risk budget approaches for pension funds include contributions to risk from individual external managers, liabilities etc.

Page 56: Investing In Hedge Funds: Risks and Rewards

V. Risk Budgeting for Funds of Funds

Information Ratio: IR = (RP – RB) / TE

Also as fundamental law of active management :

IR = TC * IC * √B

• IC, the Information Coefficient is the correlation between actual security returns and the manager’s prediction of returns.

• TC, the Transfer Coefficient is the reduction in possible returns due to constraints. TC is often larger for hedge funds than for long only.

• B, the Breadth, is the number of independent bets taken on forecasts of excess return.

Page 57: Investing In Hedge Funds: Risks and Rewards

V. Risk Budgeting for Funds of Funds

• An information ratio budget can also be created:

• Excess Return Target: 4.2%Tracking Error Target: 6.0%Information Ratio Target: 0.7

Information Ratio Budget:Security Selection

0.50Sector Selection 0.35Currency Management 0.35

Page 58: Investing In Hedge Funds: Risks and Rewards

V. Risk Budgeting for Funds of Funds

• The application of risk budgeting to funds of funds:• Allocate risk across strategies or• Allocate risk across managers (specific funds)

• The use of index comparisons will undoubtedly be required by consultants and institutional clients which will lead to risk budgeting of tracking error and information ratios

• The non Gaussian nature of hedge funds will require the use of more advanced techniques

Page 59: Investing In Hedge Funds: Risks and Rewards

V. Risk Budgeting for Funds of Funds

• Fund of Funds: An ExamplePortfolio Risk Target: 10.0%

Strategies : Risks

Distressed: 4.8%Merger Arbitrage: 3.3%Convertible Arbitrage 3.5%Equity Long / Short

7.5%

Page 60: Investing In Hedge Funds: Risks and Rewards

V. Risk Budgeting for Funds of Funds

• A risk budget can start with a neutral budget, such as equal contributions to risk from each strategy or manager.

• The components of the budget can then be changed on a regular basis to reflect views.

• It is important to realize that exposures based on weights alone are not adequate.

• Can assume zero covariance among strategies / funds or specifically utilize covariance in a weighted portfolio

Page 61: Investing In Hedge Funds: Risks and Rewards

V. Risk Budgeting for Funds of Funds

Extensions:

In the case of no benchmark: create a “Kappa” budget such that management components contribute to a Kappa target.

In the case of a benchmark: compute the Kappa of the active portfolio (portfolio-benchmark) and use this as the target.

Page 62: Investing In Hedge Funds: Risks and Rewards

Strategies for Investment

• Hedge funds are often thought of as a separate asset class

• They can also be thought of as a group of different strategies

• For asset allocation we might be better off thinking of traditional asset classes as sources of beta and hedge funds as sources of alpha

Page 63: Investing In Hedge Funds: Risks and Rewards

Strategies for Investment

• So the question is: should one include hedge funds in a portfolio and if so which strategies and what quantities?

• First note a possible ambiguity: a 20% allocation to an un-leveraged hedge fund is essentially the same as a 10% allocation to a 2-1 leveraged fund. Thus a blanket % must be treated carefully

Page 64: Investing In Hedge Funds: Risks and Rewards

Strategies for Investment

• One way to answer this is to view hedge funds as sources of portable alphas and to allocate according to the desired alpha given ones policy, which needs to explicitly state a range of allocation to hedge funds

• The expected alpha and risk will be a function of the leverage employed in the funds

Page 65: Investing In Hedge Funds: Risks and Rewards

Strategies for Investment

• THE FUTURE OF HEDGE FUNDS:

• RETAIL OFFERINGS WILL BE APPEARING FOR SMALLER INVESTORS

• IS A MATURING MARKET

• MORE TRANSPARENCY WILL BE OFFERED

• MUTUAL FUNDS ARE ADOPTING SOME HEDGE FUND STRATEGIES

• REGISTRATION AND REGULATION IS COMING

Page 66: Investing In Hedge Funds: Risks and Rewards

Strategies for Investment• Another issue is the choice of hedge funds in which to

invest

• This is actually not easy since so many strategies are very specialized and there are so many funds

• Due diligence questionnaires need to be filled out and meetings held with prospective manages before an investment is made

• Funds of funds are perhaps the best way to quickly invest

• For small investments ($50,000) studying the offering documents and prospectus may be adequate

Page 67: Investing In Hedge Funds: Risks and Rewards

Due Diligence• A very important part of investing in hedge funds is due

diligence

• This is also performed for traditional investments but requires more expertise in the case of hedge funds

• Two broad areas requiring investigation are the investment process and accounting/operations

• Normally a due diligence questionnaire is filled out by the hedge fund manager and one or more site visits are made

Page 68: Investing In Hedge Funds: Risks and Rewards

Due Diligence

• The due diligence questionnaire is very comprehensive and covers the following:

• Fund information• Background of professionals• Markets in which invested• Instruments utilized• Strategies utilized• Sources of return • The “edge” offered by the investment

team• Risk Management

Page 69: Investing In Hedge Funds: Risks and Rewards

Due Diligence

• Fund information:Contact InformationAttorney/Legal AdvisorPrime Broker/CustodianAuditor/AccountingCompliance functionMinimum InvestmentFees

ManagementIncentiveHurdleHigh Water Mark

Liquidity

Page 70: Investing In Hedge Funds: Risks and Rewards

04/10/23 http://www.metacryption.com 70

Due Diligence

• Fund InformationCurrent AssetsCapacityHistory of liquidationsPerformanceDrawdown HistoryHistorical Track RecordInvestments of partners

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Due Diligence

• Background of professionalsTitle and areas of responsibilityYears at fundYears experience in the fieldPrevious positionsReferences

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Due Diligence

• Markets in which investedDomesticInternationalFixed IncomeEquityCommodities

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Due Diligence

• Instruments utilizedListed equitiesDerivative SecuritiesSwaps/CDS’s

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Due Diligence

• Strategies utilizedStatistical ArbitrageQuantitativeInvestment Professional (s)Portfolio construction:

OptimizerHeuristic

HedgingExposure (beta, duration)

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Due Diligence

• Sources of returnPortfolio concentration/exposure

limitsSecurity SelectionAsset allocationCurrency exposureLong/Short biasesAverage turnoverMarket conditions where the fund

performs best/worst

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Due Diligence

• The “edge” offered by the investment team

Unique skillsUnique strategiesWhat separates the fund from peers

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Due Diligence

• Risk ManagementHow much leverage is

employed/limitsHow is hedging employed/what is

hedgedIs there diversificationHow are risks calculated (e.g.

contribution to risk)Is a risk model employedHow is operational risk managedIs there a risk manager