AI Articles Hedge Funds Flashcards
How are hedge funds organized?
- they are usually limited partnerships (fund has to pay no taxes on investment returns, only the investor)
- investors are limited partners
- managers are general partners
–> similar to PE
commodity trading pools
- regarded as part of the same investment universe as hedge funds
- similar structure to hedge funds but are operated by commodity trading advisors (CTAs) –> they trade futures contracts traditionally, now the lines blurr
How are the returns of hedge funds different from mutual funds?
- more than half of mutual funds have R^2 above 75%
- half of hedge funds have R^2 below 25%
- -> R^2 measured on the returns of 8 standard asset markets
R^2
R-squared is generally interpreted as the percentage of a fund or security’s movements that can be explained by movements in a benchmark index.
What are hedge funds and mutual funds exposed to?
- mutual funds are strongly positively exposed to US stocks and bonds.
- hedge funds have exposures in all asset markets and about 25% are negative exposures through short positions.
How do hedge funds leverage their bets?
By margining their position and short sales
What does margining a position mean?
- it is position financing
- -> if you take a position greater than the amount of cash in your account, interactive brokers may finance part of your position opening up to a certain limit (margin)
Which type of fee do mutual funds get and which do hedge fund managers get
- mutual funds get symmetric payment. Gains lead to a gain for the manager and a loss of the fund leads to a loss for the manager.
- hedge funds managers receive asymmetric fees. They receive positive incentives for gains but are not required to rebate (rückerstatten) fees to investors for losses.
What is the advantage of a Private Limited Partnership?
- there is no double taxation
Why are there offshore funds?
- to min. investors’ tax burden
- min. managers tax burden on incentive fees. Deferred tax payment
- for “non-US persons” and register in tax free jurisdictions
Two approaches to setting investment targets
- relative returns
- absolute returns
Which returns are hedge funds styles usually based on?
On absolute return strategies. they are expected to deliver performance irrespective of market conditions
Two main approaches to achieve absolute return targets
- Market Timing Approach (MT)
long or short attempting to capture the rise and fall of the market - can have seemingly uncorrelated returns to the market over time but significant correlation over a short period of time
- Non-Directional (ND) (low volatility)
extraction of value from a set of diversified arbitrage opportunities - can approach zero correlation to market indices
What part of a traditionally-managed portfolio are hedge funds?
the purely active part
How are the active weights calculated?
h = w-b
h= active weight w= portfolio weights b = benchmark weights
Why is the theoretical h not achievable?
in practice short positions require margin cash. The h has a zero investment and thus no margin cash available.
Why might is be more attractive to hold a passive index plus a hedge fund?
- due to specialization
- the hedge fund is pure information based trading with no capital investment.
Why is the incentive fee crucial for the success of a hedge fund?
- a pay-for-profits compensation causes the manager’s aim to be absolute returns, not merely beating a benchmark
What is a pitfall of the asymmetric incentive fee structure?
there is no corresponding penalty for negative returns
- there is the possibility that managers will be tempted to take excessive risk, in pursuit of asymmetric incentive fees
high water mark
an absolute minimum level of performance over the life of an investment that must be reached before incentive fees are paid
–> ensures that a fund manager does not receive incentive fees for gains that merely recover losses in previous time periods
hurdle rate
another minimum level of performance(typically the return of a risk-free investment) that must be achieved before profits are determined. Only for a single period.
equalization
to treat both earlier and new investors into a hedge fund fairly, the adjustment for profit calculations is an accounting process called equalization
classic long short position
choose two closely related securities, short the perceived overvalued one and long the undervalued one. This eliminates systematic risk in theory. But it is rarely completely market-neutral. Their typically is either a long bias or a short bias.
Relative value strategy
- is a market-neutral strategy
- takes advantage of perceived mispricing between related financial instruments.
Event Driven strategy
- exploit perceived mispricing of security’s by anticipating events such as corporate mergers or bankruptcies, and their effects.
- merger arbitrage is the investment in both companies (the acquirer and the takeover candidate) after a merger has been announced. Long the takeover candidate and short the acquirer.
Tactical Trading
- large variety of directional strategies
- -> e.g. global macro funds
Does the risk in hedge funds come from the benchmark?
No
- a hedge fund hedges away risk not related to its speculative strategy. The riskiness of a hedge fund depends upon its strategy.
- in contrast to mutual funds where most of the risk comes form the benchmark, and a minority from the active portfolio strategy.
What are the sources of risk in a hedge fund?
- equity trading strategies may increase correlation with changes in particular industry sector or global regions
- liquidity risk can occur of hedge funds specializing in emerging markets or distressed assets.
credit risk: - default risk of leverage (repayment of interest)
- default risk of debt securities for hedge funds that specialize in distressed securities
Measuring hedge fund risk
- variance based approach
- value-at-risk approach (VAR)
- -> often both are used
variance of a portfolio return method
- is the expected SD of the return from its mean
- -> becomes less useful if returns differ sharply form a normal distribution. Portfolios that contain derivative securities are notable for their lack of normality
VAR (value-at-risk) approach
- is good to monitor hedge fund risk and guard against extreme events
- defined as the maximum loss to be sustained within a given time period for a given level of probability
Are hedge fund indices good for comparison
No
- there are separate indices for different hedge fund strategies
- the indices from different providers are not always comparable with one another
self-selection bias/ backfill bias/ incubation/ instant history bias
- choosing to report to a database by a hedge fund might be related to the fund’s performance
- history of good performance may be backfilled into the database
survivorship bias
- when a database is created, it cannot reflect funds that are already defunct
- funds that die or otherwise stop reporting are usually removed form an index and its associated database
- some databases providers practice additional selection bias and will not include small or young hedge funds.
-> leads to an upward performance bias on an index
performance shortfall with hedge funds
- hedge funds that are included in aggregate performance data but that are closed to new investors
- if closed hedge funds outperform other hedge funds, then the average measured returns will be higher than the average return available to new investors.
Why might a hedge fund close?
- larger-size funds incurs higher market impact costs in implementing trades, and this detracts from net returns
- a large size makes it difficult for managers to find enough investment opportunities to generate superior returns
Is there alpha in mutual funds
no, it is added value from hedge funds only
Do large funds outperform small funds on average?
Yes
- large funds have more access to leverage or are willing to take extra risk
- managers of large funds may have greater skill than the average fund manager
- managers of large funds have more resources and may be able to focus more on managing the funds instead of managing the business.
Are value weighted indices more likely to be representative?
Yes, large funds are more likely to survive, also less backfilled data because they have been around for longer
traditional long beta?
stocks, bonds and cash
nontraditional beta?
- trend-following exposure (momentum) and derivative based factors.
–> added value of hedge funds
Do hedge funds really produce value?
Yes, they produce alpha. Adds value in bull and bear market.
In the future we don’t know how HF will perform because now money chases deals.
institutionalization of the HF industry
- institutional investors began increasing their allocation to hedge funds, responding to the bad performance in equity markets around 2000.
- -> increased transparency..
Why are HF increasingly multi strategy?
When HF grow they diversity to dampen the impact of economic cycles on their performance.
selection bias
when the HFs in a database are not representative of the universe of HFs.
liquidation bais
- fact that hedge fund managers stop reporting returns to a database before the final liquidation value of a fund
Do HF create systemic risk?
- they can become the transmission mechanism of systemic risk
- -> large losses from one or more HF can cause financial distress to banks and brokers
How to reduce the hedge fund manager to make crazy risk investments?
minimize the call option feature embedded in the inventive contracts
