Reading 43 - Investing in Hedge Funds: A Survey

Question 1

What are the main hedge fund strategies?

Answer 1

1. Arbitrage based
2. Convertible Bond Arbitrage
3. Equity market neutral
4. Event driven
5. Risk arbitrage (aka Merger Arbitrage)
6. Fixed Income arbitrage
7. Medium Volatility
8. Global Macro
9. Long Short equity
10. Managed Futures
11. Multistrategy
12. Directional
13. Dedicated short bias
14. Emerging Markets

Question 2

Describe the Arbitrage based hedge fund strategy

Answer 2

• attempts to profit from security mispricings while matching the characteristics of their short position to those of their long positions
• results in a lower standard deviation of net returns and the highest Sharpe ratios of all hedge fund strategies
• are said to be “short volatility”
• They make money slowly (during stable markets) but lose money rapidly (during market turbulence) which results in negative skewness and fat tails in their return distribution

Question 3

Describe the Convertible Bond arbitrage hedge fund strategy

Answer 3

• goes long a convertible bond and short the underlying equity
• Perform well when stock volatility increases (b/c the long call option gains value) and when credit spreads decline (b/c the long fixed income position gains value)

Question 4

Describe the Equity market neutral hedge fund strategy

Answer 4

• Seeks to hedge market exposure in equity investments through long and short positions with equal beta exposure
• The long term goal is zero beta exposure

Question 5

Describe the Event driven hedge fund strategy

Answer 5

• driven by the outcome of specific expected events
• Ex. Distressed Debt investing
• Have the highest liquidity risk among hedge fund strategies

Question 6

Describe the Risk Arbitrage (Merger Arb) hedge fund strategy

Answer 6

• Attempts to profit on the eventual outcome of an announced merger
• Takes a long position in the acquired stock and short position in the acquirer
• The price differences reflect the uncertainty of the completion of the merger

Question 7

Describe the Fixed Income Arbitrage hedge fund strategy

Answer 7

• Goes long lower credit quality bonds and short higher quality bonds. The spread between the two provides income to the fund.
• The spread can shrink or expand based on market conditions

Question 8

Describe the Medium volatilty hedge fund strategy

Answer 8

• Takes both long and and short positions, however the exposures may differ creating a net long position
• This is a partial hedge which results in volatilty below that of the underlying market

Question 9

Describe the Global Macro hedge fund strategy

Answer 9

• Make broad bets on indices, currencies, commodities and other asset classes
• B/c of the large unvierse of investment opportunities, correlations within the fund category tend to be low

Question 10

Describe the Long-short equity hedge fund strategy

Answer 10

• Similar to market neutral but don’t seek zero beta
• a net beta of 0.3 to 0.6 is typical
• Managers have flexibility to adjust need beta based on current market opportunities

Question 11

Describe the Managed futures hedge fund strategy

Answer 11

• employ quantitative models to speculate in futures (commodities, equities, currencies, interest rates , etc.)
• Risk return is poor on its own, but within a portfolio its provides the most diversification and hedging benefit of all the hedge fund strategies
• Typical hedge fund risks like (liquidity, counterparty and valuation

Question 12

Describe the Multistrategy hedge fund strategy

Answer 12

• employ a combination of strategies
• Similar to fund of funds but without the second layer of fees

Question 13

Describe the Directional hedge fund strategy

Answer 13

• makes active bets based on expectations of how security prices are going to move
• B/c no hedging is employed, they experience the full volatility of the underlying markets

Question 14

Describe the Dedicated short bias hedge fund strategy

Answer 14

• Focuses exclusively on shorting equities
• Beta often close to -1

Question 15

Describe the Emerging Markets hedge fund strategy

Answer 15

• Invest in equity securities in emergin markets
• Since short expsores is difficult or expensive in these markets, funds tend to have a long bias

Question 16

What are the 3 biases in reported hedge fund performance?

Answer 16

Backfill Bias - aka incubation bias or instant history bias. When a fund begins reporting performance to an index provider, they will also fill in historical performance. These historical performance return are significantly higher than “live”, current returns

Selection Bias - since reporting performance is voluntary, it is more likely a high-performance fund will report. ** aka self reporting bias. **

Survivorship Bias - funds may chose to stop reporting to an index when they are liquidated or experience poor returns.Adds between 0.6% and 3.6% to reported hedge fund performance.

Question 17

A hedge fund investor would like to see a fund have a high Alpha or high Beta?

Answer 17

Alpaha. Alpha is the value added return while Beta is the market return

Question 18

What is the formula for the hedge fund return factor model?

Answer 18

Question 19

Because hedge fund returns are non-normal, meaning their returns are neither normally distributed or linearly related to traditional market risk exposures, what are the two additional sources of risk to consider?

Answer 19

1. Skewness
2. Kurtosis

Question 20

In additional to larger mean returns and lower standard deviation of returns, investor prefer_____ skewness and _____ kurtosis?

Answer 20

Positive skewness, Lower Kurtosis

***Hedge fund returns distributions often have negative skewness and high kurtosis

Question 21

Which hedge fund strategies can be considered short volatility strategies?

Answer 21

• Short Options
• Merger arbitrage
• Fixed income arbitrage

***These do well during less volatile market conditions

Question 22

Which hedge fund strategies can be considered long volatility strategies?

Answer 22

• Long Options
• Managed futures

Question 23

What happens when you add long volatility hedge funds to a portfolio of short volatility hedge funds?

Answer 23

• The portfolio volatility level will typical increase, but the portfolio returns will become more normally distributed. (less negative skewness and lower kurtosis)
• b/c of this the Sharpe ratio decreases and becomes more desirable for investors because of improved skewness and kurtosis.

Question 24

What a the 3 primary motivations for using a hedge fund replication strategy?

Answer 24

1. Lower Cost - if you can use traditional market securities (etfs, indexes), costs can be reduced.
2. Lack of Alpha - the factor model of hedge fund returns distinguishes return achieved from taking market risk from value added by hedge fund manager. If manager is not delivering high alpha, a replicating strategy may be more attractive
3. Liquidity and transparency - replicating strategies are not subject to lock-ups and require more transparency than hedge funds

Question 25

What are the three difficulties in applying traditional portfolio analysis to hedge funds?

Answer 25

1. _Difficult to develop expected return assumptions _
2. Hedge fund performance can be dynamic - beta exposures, volatility and correlations change over time.
3. Standard deviation is an incomplete measure of risk - it is often the styles with the best standard deviation and Sharpe measures suffer from higher moment risk exposures.

Question 26

Why is a portfolios Skewness important to an investor?

Answer 26

Negatively skewed distributions have what statisticians call a long left tail, which for investors can mean a greater chance of extremely negative outcomes. Positive skew would mean frequent small negative outcomes, and extremely bad scenarios are not as likely.

Question 27

Why is a portfolio’s Kurtosis important to an investor?

Answer 27

Kurtosis measures the “fatness” of the tails of a distribution. Positive excess kurtosis means that distribution has fatter tails than a normal distribution. Fat tails means there is a higher than normal probability of big positive and negative returns realizations

Question 28

The returns of many hedge fund strategies are not normally distributed; rather they are _____kurtotic and ______ skewed.

Answer 28

Highly Kurtotic

Negatively Skewed