5.1 Structure Of HF Industry Flashcards
First HF was found in and by?
by Alfred Winslow Jones in 1949. The A.W. Jones & Co. hedge fund took long and short positions in U.S. stocks with the intention of limiting market risk while focusing on stock selection.
Growth of HF over the years?
1968, the number of hedge funds in the U.S. had increased to 140.
The bear market in the early 1970s witnessed the demise of many hedge funds and interest in the industry was not renewed until late 1980s.
The number of hedge funds grew considerably during the 1990s
2021, there were about 9,300 hedge funds with more than $4 trillion in total assets. In contrast, mutual funds and exchanged-traded funds had $30 trillion in total assets in 2021.
3 primary elements of HF?
1) privately organized
2) manager performance based fees
3) investment flexibility
Safe harbor
Exemption from certain disclosure regulations under US law
6 differences of HFs?
i. Invest in nonpublic, unlisted securities. ii. Use significant leverage.
iii. Use derivative securities more often. iv. Short public securities.
v. Trade in riskier investments.
vi. More actively managed, with more complex strategies & dynamic risk
exposures.
Reasons for HF growth? Latest growth figures?
• Reasons for growth -
1. Potential diversifiers (due to low correlations with traditional assets)
2. Investment flexibility (going long and short)
3. Potentially high, double-digit returns
Growth pre-2007; after financial crisis, consolidation (decline in AUM and
# of funds); 2009-2014: # of funds grew; 2015-2017 net attrition.
Typical HF fees? Each fee detailed
Typically 1.6% management, 17.5% incentive
Management fee: 2% of AUM, charged periodically
Incentive fee: 20% of profits after management fee is deducted, charged annually
High water mark (HWM) provision
A NAV above which the HF manager is compensated.
Every time the NAV expands, the new NAV is set as the benchmark
Value of standard call option (HFs incentive fees) depend on 5 variables
- Current value of underlying assets (the fund’s NAV)
- Strike price (higher of the beginning-of-period NAV or HWM)
•If there is a hurdle rate, the strike price is the future value of the NAV using the hurdle
rate. - Time to maturity of the option (in this discussion, one year)
- Risk-free rate (one-year risk-free bond yield)
- Volatility of the underlying asset’s returns (standard deviation of the returns of the fund’s
NAV)
What is Option view of incentive fees?
Increasing fund’s volatility can increase PV of incentive fees.
Entitles manager to long European call on part of fund’s profits.
Incentive fee has option-like payout: manager shares upside of fund’s NAV; losses are limited
If profit generated, manager exercises in-the-$ call at year’s end and collects incentive fee; otherwise, out-of-the-S call expires worthless
> Incentive fee has maturity of one year
Manager pays no premium for option (just time and effort).
At maturity - Payout on incentive fee = Max [i (ENAV - BNAV), 0]
BNAV/HWM is strike price
Incentive fee example:
HF with 20% incentive fee has $100m NAV and 9% annual return volatility.
What is the value of a one-year at-the-money incentive fee call option at start of year?
Why are December returns for HFs higher? By how much?
(agardaw, daniel, naik)
Because of massaging or managing returns
By 1.5%
Which funds are less likely to manage volatility?
Smaller & younger funds
Single VS Multi manager HF?
Single: invests in securities / derivative instruments
Multi: different strategies / different sub managers
HF classification
HF Program
Process for construction, monitoring and maintaining portfolio of HFs
HF Strategies by risk exposures
Short bias funds
1) negative correlation (beta with equities = good risk reducers
2) lowest return of all HF strategies (zero average return)
3) positive alfa
Event driven & relative value HF strategies key characteristics?
Consistently earn small profits, sometimes incur large losses
Lowest SD, large negative skew & excess kurtosis
Returns on this strategy are like selling insurance or puts
Convergent strategies definition?
When prices of 2 securities converge and a return is made
Short volatility exposures
Any risk exposures that result in losses if volatilities increase
Absolute return strategies
Aim for consistently positive returns in any market conditions.
HF are absolute return products
Relative return products (mutual funds)
Driven by broad market returns and evaluated relative to benchmark index
Diversified funds returns?
High returns, reasonable risk, low drawdowns
Global & macro HF - generated returns close to normally distributed
In 2008, managed funds generated a profit and macro funds maintained their values
What to consider in HF invest program
target leverage, return, risk
HF Performance findings?
- Shocks felt by one segment of industry reverberate to other strategies.
- Historical HF returns may consistently overestimate future results, since growth in industry and effects on returns are not factored in.
- Empirical data suffers from biases (e.g., selection or survivorship bias, which can inflate returns by 70bp to 450bp).
4) HF returns are not normally distributed
Long only managers constraint
1) tracking error
2) long only - can short a stock up to its weight in the benchmark, thus underweighting a stock is constrained if it is only a small fraction of the index.
Opportunistic HF Investing?
Good returns with aggressive positions in investments that offer short term superior ex ante alpha
Headline risk
Change in economic value from unexpected news
Reasons HF indices are useful benchmarks
- Proxy for HF asset class (needed for asset allocation) - compare
- Benchmarks of performance - among different managers
How can fees affect reported returns?
1) frequency (paid annually, returns monthly)
2) fee bias (when hedge fund managers raise the fees they charge new investors, resulting in lower returns for the investors. Therefore, a hedge fund index’s historical returns will be overstated/higher relative to returns that new investors can earn.)
Why is Size of HF universe is unknown?
1) little regulation
2) little overlap between index providers
3) high attrition rate (average life of manager 2.5-3yrs, mortality rate expected to increase)
Database biases?
1) survivorship bias (2.6-5% per year)
2) selection bias
- managers voluntarily provide information
- high drop out rate after 14months
3) instant history / backfill bias (more of a problem for databases than published indices)
- 1-5% inflation of returns
4) liquidation bias (increases 0.7%)
Reasons strategy definition can be problematic for an index
- No standard for defining HFs strategies
- No standard for classifying HFs
• Classification by managers are often vague (what style or market is used?) - Style drift
• Managers often stray from stated investment styles.
> Other issues: industry seen transition from single- to multi-strategy HFs, and synthetic hedge funds (which aim to replicate HF returns at lower fees) may become available.
Investability of HF indices?
Investability of an index refers to whether market participants can hold a portfolio equivalent to the portfolio implied by the index and achieve the same returns. If an index contains closed funds, market participants cannot achieve the returns of the index.
Which HF indices outperform?
Non investable indices outperform investable
Hazard rate
% of funds that drop out of database at a given age (close)
Which risk is off balance sheet?
Event risk
Goal of HF investment program?
Risk management
Incentive fee in terms of hedge funds?
Short position on European call option
Main goal of opportunistic HF investment? How is it achieved?
Enhance returns of existing investment, can by accomplished by using best managers
Short volatility strategy is similar to?
Selling a put option
Participation bias?
Participation bias refers to the bias that arises when successful fund managers stop reporting their returns because they no longer need to advertise and attract new capital.
Average returns are likely to be understated by a hedge fund database if successful funds are omitted.
The CAIA curriculum classifies market-neutral hedge funds as which strategy type?
Market-neutral hedge funds are equity funds (along with long/short and short selling funds).
Is there a difference in cap weighted index and equally weighted?
No, cap-weighted and equally-weighted indices have similar correlations to equity and bond indices, which counters the argument that hedge fund indices should be cap-weighted because most asset lasses are benchmarked against cap-weighted indices (e.g., S&P 500).
Annuity view of HF fees?
Manager earns large fees by consistently generating positive returns, attracting new investors, and staying in business as long as possible to continue earning fees on compounded returns and new capital.
Increasing volatility of the fund’s assets jeopardizes the longevity of the and may scare off potential new investors.
Caveats with respect to using hedge fund performance data -
- Different segments of the industry can be affected by the same market shocks.
- Historical hedge fund returns may overstate future returns, since the growth in the industry has not been incorporated into the data; and this growth may result in lower returns due to increased competition, etc.
- Biases (e.g., survivorship and selection) exist in hedge fund data, and these can inflate returns.
The return generated by absolute return products is most likely attributable to?
Manager skill
AUM of hedge fund industry in 2018 in the US
3.2+ trillion USD
Some officials have accused hedge funds of playing a significant role in two major crises in currency markets in the 1990s.
Which most accurately identifies the crises and the evidence concerning the role of hedge funds?
1992 sterling devaluation and 1997 Asian contagion
