Lecture 6 - Hedge Funds Flashcards
Private Management (Private Wealth)
- Clients contract directly with firm
- Private management and personal relationships
Investment Companies (Mutual Funds)
- Pooling of investment capital of several clients in an investment company
- New shares/units issued representing proportional ownership of the fund
Mutual Fund MER
0.25 - 1.00%
Mutual Fund Load Fees
1% to 5%+
Alternative Investing
- Hedge Funds
- Private Equity
- Real Assets
Hedge Fund Portfolio Description
- Combines both a long/short position
- Able to produce superior alpha
- Management fee + performance fee is paid to the manager
- Low liquidity
- Little or no regulation
Two types of Hedge Fund Strategies
1) Non-directional
2) Directional
Non-directional strategy
Buy one type of security and sell the another (e.g. Buy TD and short Scotia)
Directional strategy
One sector or another will outperform other sectors
Categories of Hedge Fund Strategies
1) Relative Value
2) Event Driven
3) Opportunistic
4) Global Macro
Relative Value Strategies
1) Convertible Arbitrage
2) Equity Market Neutral
3) Fixed Income Arbitrage
4) Statistical Arbitrage & HFT
Event Driven Strategies
1) Merger Arbitrage
2) Capital Structure Arbitrage
3) Distress Securities
Opportunistic
1) Long/Short Equity
2) Emerging Markets
3) Managed Futures
Convertible Arbitrage
Buying convertible bond and shorting the underlying stock
Equity-Market Neutral
Involve taking both long and short positions in stocks, with the goal of minimizing exposure to the market’s systemic risk
Fixed-income Arbitrage
Returns are generated by taking advantages of bond pricing disparities
Statistical Arbitrage
Seek out many temporary and modest misalignments in prices
High Frequency Trading
Using powerful computer programs to transact a large number of orders in fractions of a second
Merger Arbitrage
Returns are dependent upon magnitude of spread on merger transactions
Distressed Securities
When HFs invest in risky (high yield) bonds or other securities of distressed firms
BCE attempted takeover 2008
Details:
Takeover price: $42.75
Planned Closing date: January 1, 2008
Quarterly dividend/share = $0.20 (assume 2 dividends will be paid before closing)
Margin required: 30%
Margin borrow rate: 7%
Market price July 1, 2007 = $28.00
Market Price as at July 4, 2007 (after deal was announced): $39.00
Q1: What is annualized return (with and without margin) to deal closing date?
HPR = [$42.75 + (2 x $0.20)]/$39.00 = 1.1064
Annualized HPY = (1.1064)^2 - 1 = 22.40%
Annualized return with margin:
Cash required for trade = 30% x $39 = $11.70
Borrowing amount = 70% x $39 = $27.30
Borrowing expense = $27.30 x 7% x 0.5yr = $0.96
HPR = [($42.75 - $27.30) + (2 x $0.20) - $0.96]/$11.70
= 1.2735
Annualized HPY = (1.2735)^2-1 = 62.2%
BCE attempted takeover 2008
Details:
Takeover price: $42.75
Planned Closing date: January 1, 2008
Quarterly dividend/share = $0.20 (assume 2 dividends will be paid before closing)
Margin required: 30%
Margin borrow rate: 7%
Market price July 1, 2007 = $28.00
Market Price as at July 4, 2007 (after deal was announced): $39.00
Q2: What is the leveraged return if the deal does not close?
Cash required for trade = 30% x $39 = $11.70
Borrowing amount = 70% x $39 = $27.30
Borrowing expense = $27.30 x 7% x 0.5yr = $0.96
HPR = [($28 - $27.30) + (2 x $0.20) - $0.95]/$11.70
= 0.0128
HPY = 0.0128 - 1 = -99% for 6 months!
Two Risks that could cause the deal not to close
i) Shareholders or bond holders vote against it
ii) Does not get regulatory approval
Long-short equity
Managers attempt to identify misvalued stocks and take long positions in undervalued ones and short positions in the overvalued ones
Emerging markets
Broad class seeks to profit from improvement in developing countries
Managed futures
Using long and short positions in futures
Special situations
Events like bankruptcies, spinoffs.
Global Macro Strategies
Involve long or short positions in capital or derivative markets across the world
Portable Alpha Strategies
- Select target market index
- Replicate index with market-linked instruments
- Invest cash into alpha source and cash reserve
Hedge Fund Fee Structure
Management Fee: 1-2%
Performance Fee: 10-20% over a bench return
High Water Mark: If fund has losses in a year, future performance fees will not be paid until losses have been recovered
$100 million HF with 1/20 fee structure; Benchmark = 5%; HPR = 12% (net profit after fee = $12 million)
Mgmt. Fee: 1% x 100million = $1 million to HF Manager
Performance Alpha= 12% - 5% = 7% or $7 million
Performance Fee (paid to HF manager) = 20% x 7% = $1,400,000
(recalculate if HPR = 22%)
Hedge Fund vs. Mutual Funds
Transparency: Hedge funds have minimal disclosure
Investors: Hedge Funds have no more 100 investors
Investment Strategies: Hedge funds are very flexible
Liquidity: Hedge Funds have lock up periods
Would a market-neutral hedge fund be a good candidate for an investor’s entire retirement portfolio?
No, a market-neutral hedge fund would not be a good candidate for an investor’s entire retirement portfolio because such a fund is not a diversified portfolio.
How might the incentive fee of a hedge fund affect the manager’s proclivity to take on high-risk assets in the portfolio?
The incentive fee of a hedge fund is part of the hedge fund compensation structure; the incentive fee is typically equal to 20% of the hedge fund’s profits beyond a particular benchmark rate of return. Therefore, the incentive fee resembles the payoff to a call option, which is more valuable when volatility is higher.
Why is it harder to assess the performance of a hedge fund portfolio manager than that of a typical mutual fund manager?
Hedge funds invest in assets that are hard to sell, so their profits might just reflect this risk.
Hedge fund valuations for these assets can be unreliable.
Databases often show only successful hedge funds, giving a biased view.
Hedge fund risks change over time, making performance hard to measure.
Rare events can skew returns, so short-term results might not show the full picture.
Which of the following would be the most appropriate benchmark to use for hedge fund evaluation?
A multifactor model
With respect to hedge fund investing, the net return to an investor in a fund of funds would be
lower than that earned from an individual hedge fund because of:
Both the extra layer of fees and the higher liquidity offered
Which of the following hedge fund types is most likely to have a return that is closest to risk-free?
A market-neutral hedge fund
Is statistical arbitrage true arbitrage?
Statistical arbitrage isn’t true arbitrage because it involves risk instead of risk-free trades. It works by making many small bets on temporary market inefficiencies, hoping the combined returns will be positive.
A hedge fund with $1 billion of assets charges a management fee of 2% and an incentive fee of 20% of returns over a money market rate, which currently is 5%. Calculate total fees, both in dollars and as a percent of assets under management, for portfolio returns of
-5% & 10%
Portfolio RoR|Incentive Fee|Incentive Fee ($)|Total Fee|Total Fee (%)
-5 0 0m 20m 2
10 20 10m 30m 3
