Hedge Funds

Question 1

Herd Mentality

Answer 1

• investors chase the returns of huge HFs, plunging more and more money into a high-performing HF
  
  • no regard for how the performance was obtained and - more important - whether the performance can be repeated in the future

Question 2

Hedge Funds similarities with Mutual Funds

Answer 2

• pooled investment vehicle that makes investments in equities, bonds, options, and a variety of other securities
• separate manager

Question 3

Organizational Structure

Answer 3

• two-tiered organization
• GP and LPs (investors)
• general/limited partnership model is most common structure for the pool of investment that make up a hedge fund

Question 4

Fee Structure

Answer 4

• different from mutual funds in how they charge fees
  
  • fees paid by investors are far higher than in a mutual fund
• Management Fee
  
  • ​​typically 2% of assets managed
• Incentive Fee
  
  • ​​typically 10-20% of fund profits
  • to reward HF managers for good performance

Question 5

High-water Mark

Answer 5

• a hedge fund’s previous high
• a manager only collects an incentive fee for profits exceeding the hedge fund’s previous high

Question 6

Two and Twenty

Answer 6

• a type of compensation structure that is performance-based
• charge a flat 2% of total asset value as a management fee and an additional 20% of any profits earned

Question 7

Jim Simmons

Answer 7

• Renaissance Technologies
  
  • creators of Medallion Fund
• $65 billion in AUM, fund generates $3.2 billion in annual mgmt. fees
  
  • charges 44% profit fee
• has produced $55 billion in profit
• averaged 71.8% between 1994 and 2014
  
  • fund’s worst performance between 2001 and 2013 was a 21% gain

Question 8

No Longer two-and-twenty

Answer 8

• in 2015, average mgmt. fee was 1.5% of assets and 17.7% of profits

Question 9

Long-Term Capital Management Blow Up

Answer 9

• nearly collapsed the global financial system in 1998
  
  • used high-risk arbitrage trading strategies
• financial crisis in Russia (government bonds defaulted)
  
  • too highly leveraged and was about to default on loans
• owned about 5% of global fixed-income market
• bailed out by Federal Reserves

Question 10

Natural Hedge

Answer 10

• a method of reducing financial risk by investing in two different financial instruments whose performance tends to cancel each other out
• for example, bonds are a natural hedge against stocks because bonds perform well when stocks are performing poorly, and vice versa

Question 11

Pair Trading

Answer 11

• buying long and short positions in highly correlated stocks because the performance of one will offset the performance of the other

Question 12

Term Structure

Answer 12

• terms offered by a hedge fund are so unique that each fund can be completely different from another fund

Question 13

Term Structure: Redemptions and Subscriptions

Answer 13

• hedge funds do not have daily liquidity
• some accept monthly, others only quarterly
  
  • should be consistent with HF’s strategy
• more liquidity = more frequent the subscription/redemption terms should be

Question 14

Term Structure: Lock-Ups

Answer 14

• preventing the investor from withdrawing funds
  
  • typically 1 year but can also be 2 years

Question 15

Equity Hedge

Answer 15

1. Long/Short
2. Market Neutral
3. Global Macro
4. Relative Value Arbitrage
5. Convertible Arbitrage
6. Distressed

Question 16

Long/Short Equity Strategy

Answer 16

• Buying long positions that are expected to increase in value, while selling short positions that are expected to decrease in value
• Bullish view = higher net exposure (more long positions)
• Bearish market outlook = lower net exposure, possibly negative (more short positions)
• Managers tend to have a positive net exposure because, over time, equity market beta is generally positive
• If manager goes 80% long and 30% short, then using 10% leverage

Question 17

Hurdle Rate

Answer 17

• some managers have to clear hurdle rate, such as the return on U.S. treasuries, before getting incentive fee

Question 18

Market Neutral

Answer 18

1. long/short equity strategy with 0% net exposure, meaning 50% long and 50% short
2. zero beta exposure
   
   1. intention is to remove any impact of market movements and rely solely on his or her ability to pick stocks

Question 19

Global Macro Strategy

Answer 19

• highest risk/return profiles of any hedge fund strategy
• Global macro funds invest in stocks, bonds, currencies, commodities, options, futures, forwards and other forms of derivative securities
• place directional bets on the prices of underlying assets
  
  • usually highly leveraged
• many of the largest HF “blow-ups” were global macro funds
• Tend to take a top-down view of investing, focusing more on macroeconomic variables
• Discretionary global macro vs. systematic global macro
• Pros:
  
  • Negative correlation with equity markets, mitigating a portfolio’s losses in an economic downturn
  • Tend to perform better when market volatility is higher and less well when market volatility is low

Question 20

Long/Short Equity Strategy: Pros and Cons

Answer 20

• Pros:
  
  • Provides less volatility than long-only strategies
  • Controlling the level of market risk exposure (beta)
  • Greater downside protection
  • In flat or negative markets, where returns are spread across equities, long/short strategy will generally outperform S&P 500
• Cons:
  
  • Although long/short strategy usually performs best in a rising market, the strategy will relatively underperform the S&P 500 in a strong market rally because of its lower net market exposure

Question 21

Merger Arbitrage

Answer 21

• Pros:
  
  • Seek to profit from announced mergers
  • Buy equity in the targeted firm, and short-sell the shares of the acquiring firm, anticipating that the company’s share price converges to the middle (dilution)
• Cons:
  
  • Merger & acquisition deal may fail or not go as planned
• I prefer this strategy because from ’08 to ’15, the merger arbitrage strategy had the best risk-adjusted return compared to the S&P 500, event-driven HFs, and long/short equity HFs

Question 22

Event-Driven Strategy

Answer 22

• Capitalize by speculating on the movement of security prices in anticipation of or after a major catalyst
  
  • Catalysts: M&As, bankruptcies, reorganizations,
• Activist HF
  
  • Buy majority stake in public company and have oversight into management

Question 23

Managed Futures Securities

Answer 23

• Trade mainly markets that have futures on them
• More systematic approach with price based indicators
  
  • Systematic trend following or pattern recognition
    
    • Systematic trend following seek to predict price movements from historical data usually over intermediate to long term
  • Pattern-recognition strategies are used to identify other market effects that can help predict price movements
    
    • In contrast to fundamental analysis, which takes into account economic and financial factors to identify themes and directional influences of market

Question 24

Distressed Debt and Credit Opportunities

Answer 24

• Distressed debt HF managers seek underperforming securities of financially troubled companies that they believe are undervalued
• Many institutional investors have investment policies that require a company to sell their fixed income securities when the securities’ ratings fall below a certain rating
  
  • This creates an opportunity for HF managers to buy securities at a steep discount
• Signs of financial distress lead analysts and rating agencies to downgrade the company which depress the value of the securities
• Distressed debt funds will invest in the debt of these companies in hopes of greater recovery after bankruptcy proceedings
  
  • Prefer investing in senior debt because it is highest in capital structure and has highest likelihood of being repaid if company liquidates
• Cons:
  
  • The strategy can be very risky as many companies do not improve their situation, but at the same time, the securities are trading at such discounted values that the risk-adjusted returns can be very attractive
• Pros:
  
  • Shows significant strength in recover periods: following tech bubble (2001-2007) and global financial crisis (2009-2014)

Question 25

Hedge Funds: Performance Measurement

Answer 25

1. Absolute Returns
2. The Sharpe Ratio
3. Benchmarks
4. Quartile Chart

Question 26

How HFs are different from MFs

Answer 26

• not regulated by the SEC
• manager characteristics
  
  • HF managers were the most talented money managers around
• Hedge Fund Strategies
  
  • Offering memorandums

Question 27

Performance Measurement: Absolute Returns

Answer 27

• should always have positive returns over 12-month periods
• in a perfect world, absolute returns should be positive and consistent

Question 28

Performance Measurement: The Sharpe Ratio

Answer 28

• measures the amount of return adjusted for each level of risk taken
• this metric can be applied across hedge funds to determine whether the HF is generating any alpha (excess return) by taking on additional risk
• Sharpe Ratio > 1 = attractive return
• Sharpe ratio = (Expected portfolio return − Risk-free rate)/Portfolio Standard Deviation

Question 29

Performance Measurement: Benchmarks

Answer 29

• analyze relative returns versus a benchmark
• S&P 500
• see if the manager is doing well relative to other hedge funds using the same or similar strategies
• First, hedge fund must pass “index test” before continuing due diligence
• Second, compare hedge fund manager to other hedge funds using same strategy and place the fund in quartiles to its peers

Question 30

Performance Measurement: Quartiles

Answer 30

• in the peer analysis, we are looking for funds that consistently perform in the top quartile of their peers
• Looking for performance relative to peers during certain market cycles, as well as performance over short and long periods of time

Question 31

Top-Down Investing

Answer 31

• analyzing the “big picture”
  
  1. look at the economy and try to forecast which industry will generate the best returns
  2. then look for individual companies within the chosen industry and add the stock to their portfolios

Question 32

Case: Interest Rates drop (top-down investment)

Answer 32

• macroeconomic variable: interest rates dropping
• industry: housing industry benefits from lower interest rates because they take on large loans
• Buy stocks of the best performing company in the housing industry

Question 33

Bottom-Up Investing

Answer 33

• overlooks the broad sector and economic conditions and instead focuses on selecting a stock based on the individual attributes of a company
• bottom-up strategy simply seeks strong companies with good prospects
  
  • earnings growth, low P/E ratios

Question 34

Portfolio

Answer 34

• Grouping of financial assets such as stocks, bonds, and cash equivalents
  
  • their fund counterparts: mutual funds, ETFs, closed funds
• dependent on risk-tolerance of investor
  
  • should minimize exposure to securities or asset classes whose volatility make investor uncomfortable
• dependent on time horizon
  
  • if for retiring in 5 years, then more conservative investments
  • if just starting career, then more risky investments because of ability to ride out short-term volatility

Question 35

Making a Portfolio for a Conservative Investor

Answer 35

Might favor a portfolio with:

• large-cap value stocks
• broad-based market index funds
• investment-grade bonds
• position in liquid, high-grade cash equivalents

Question 36

Making a Portfolio for a Risk-Tolerant Investor

Answer 36

May favor a portfolio with:

• small-cap growth stocks to an aggressive, large-cap growth stock position
• assume some high-yield bond exposure
• look to real estate, international and alternative investment opportunities for his portfolio

Question 37

3 Main Asset Classes

Answer 37

1. bonds
2. stocks
3. cash and equivalents

Question 38

Cash and Equivalents

Answer 38

• highly liquid
• high credit quality
• low-risk, low-return profile
• Includes:
  
  • U.S. Treasury bills
  • bank certificates of deposit
  • etc.

Question 39

Small Cap

Answer 39

• used to classify companies with a relatively small market capitalization
  
  • market cap = market value of its outstanding shares
• market cap between $300 million to $2 billion
• small-cap companies offer greater potential growth, but also infer greater risk and volatility than large-cap companies
• historically small-cap stocks have outperformed large-cap stocks

Question 40

Mid Cap

Answer 40

• companies with market cap between $2 billion and $10 billion

Question 41

Large Cap

Answer 41

• companies with market cap of more than $10 billion
• most stable stocks, but generate smallest returns

Question 42

Value Stock

Answer 42

• stock that seems undervalued in relation to the underlying fundamentals that indicate a higher value
• stocks that the market sees as underrated or ignored
• undervalued

Question 43

Growth Stocks

Answer 43

• does not pay dividends
• growth investors choose stocks based on the potential for capital gains, not dividend income, so they can be risky
• technology companies are good examples of growth stocks
• stocks that are anticipated to generate substantial capital gains
• growth stocks are often overvalued because the market sees them as the money makers

Question 44

Hedge Fund Risks

Answer 44

1. Investment Risk
   
   1. risk of losing all or some of investment
      
      1. Style Drift: manager strays from fund’s stated goal or strategy
      2. Overall Market Risk
2. Fraud Risk
   
   1. due to lack of regulation, the risk of fraud is more prevalent in the hedge fund industry as compared to mutual funds
   2. risk of unethical behavior
3. Operational Risk​

Question 45

Volatility Measurements: Standard Deviation

Answer 45

• most common risk measure
  
  • measures level of volatility
• Given two funds with the same annual returns, the fund with a lower standard deviation is preferred

Question 46

Volatility Measurements: Value-at-risk

Answer 46

• “Given an investment of a particular return and volatility, what’s the worst that can happen?”
• measures the dollar-loss expectation that can occur with a 5% probability
  
  • tells you with 95% confidence that your losses would not exceed a certain point

Question 47

Volatility Measurements: Downside Capture

Answer 47

• the lower the downside capture, the better the fund preserves wealth during market downturns
• metric is figured by calculating the cumulative return of the fund for each month that the market/benchmark was down, and dividing it by the cumulative return of the market/benchmark in the same time frim

Question 48

Volatility Measurements: Maximum Drawdown

Answer 48

• measures the percentage drop in cumulative return from a previously reached high
• key is to understand the speed and depth of a drawdown with the time it takes to recover these losses

Question 49

Leverage

Answer 49

• Leverage can amplify losses and cause funds to sell assets at a very steep discount

Question 50

Qualitative Measurements of a Fund

Answer 50

1. Management: a fund must have a good, strong management
2. Scale: determine whether a fund’s strategy will be impacted by having too large a fund
3. Soft close and Hard close
   
   1. soft close = no more additional investors
   2. hard close = no more additional investments

Question 51

Why Choose Hedge Funds?: Risk Reduction

Answer 51

*

Question 52

Hedge Fund Due Diligence: Document Request

Answer 52

• Up to this point, pinpointing hedge funds based on performance measurements
• Now, can look at individual pitchbooks of each HF
  
  • strategy
  • investment methodology
  • biographies for firm personnel
  • performance history

Question 53

Hedge Fund Due Diligence: Investment Terms

Answer 53

• Minimum investment
  
  • higher minimum investment may indicate more institutional investors and ultra high net worth individuals
• Share classes
  
  • some share classes will have different terms
• Fee terms
  
  • should include high-water mark
• Redemption Terms and Notice Period
  
  • quarterly, monthly, semi-annually, annually
  • make sure redemption terms fit with fund’s strategies

Question 54

What to ask HF manager?

Answer 54

• Describe past experiences
• How has their strategy evolved and what is their vision for the future?
• Why this current investment process and strategy?
  
  • How will you provide above-average returns in the current and future environment?
• Specific past investments that were a success and those that were failures?
  
  • lessons learned?
• Describe your decision-making process and next steps

Question 55

Performing Due Diligence

Answer 55

• conference call
• office visit

Question 56

Interesting Trend

Answer 56

the commoditization and spread of news, social media, and such have made the markets more efficient, making it harder for funds to generate alpha

• as soon as P/E ratios come out, or a large announcement, the markets adjust to reflect that news very quickly
• reduced the amount of alpha available to hedge funds

Question 57

What makes a hedge fund successful in the long term?

Answer 57

• having deep-specialization, and expertise, in specific industries and sectors

Question 58

Margins

Answer 58

• Buying shares of stock or other securities with a combination of the investor’s own funds and borrowed funds
• If the stock price changes between its purchase and sale, the result for the investor is leverage. This means that that the investor’s percentage gain or loss is magnified compared to the percentage gain or loss had the investor purchased shares without borrowing.