week 1- hedgefunds Flashcards
What are Hedge Funds?
A private investment pool, open to institutional or wealthy
investors, that is largely exempt from SEC regulation and can
pursue more speculative investment policies than mutual funds
- Idea: Sophisticated/wealthier investors need less protection
- Broad term that encompasses funds that follow very different
strategies and have different risk and return profile
- Hedge fund strategies focused on absolute returns
What are the main differences between hedge funds and index funds?
consider: Sharpe ratio, transparency , liquidity, risk exposures, constraints, capacity, trading, fees
Why did hedge fund performance go down recently?
- more competition
- markets more efficient
- more regulations (less flexibility)
- Financial incentives for managers have become less
How do hedge fund fees work?
Management fee plus incentive/performance fee
- management: usually 2% of Asset Under Management + incentive 20% of gains (2/20 scheme)
- Incentive fee can be modeled as call option -> may encourage
excessive risk taking by HF manager (asymmetric payoff). for every dollar above hurdle, manager get 20 cents
What are main investor concerns about Hedge Funds?
Crowding (people following similar strategy, leads to less returns and could lead to fire sale)
style drift
lack of liquidity
What is the high water mark
If fund experiences losses, incentive fee only paid when it makes
up for these losses -> creates incentive to shut down fund after
poor performance and simply start new fund!
“if im underwater, ill just start a new one”
What is a fund of funds
Hedge funds that invest in other hedge funds
* Little diversification if underlying HF follow similar strategies
* Usually 1% management fee and 10% incentive fee
* FoF pays incentive fee to each underlying HF (FoF = fee-on-fee!)
* Number of FoFs has dropped after 2008 due to high fees
What is a an important note about the diversification benefits of hedge funds
There is more correlation during recession, which is when you want to be most diversified.
The diversification benefits have become less due to the grown size funds.
They seem to be correlated to s&p 500 and most strategies correlated to equity but less to the bond market
What are the two main hedge fund strategies
Directional (bets)
* Bets on the direction of financial or economic variables
* Examples: increase in S&P 500, decrease in interest rates, etc.
* Often based on fundamental investment approach
* Typically not market neutral (positive or negative exposure)
Non directional (arbitrage: but no free lunches!)
* Exploit temporary misalignments in security valuations
* Often quantitative investment approach (data mining?)
* Buy one security and sell another (e.g., pairs trading, profit from price variations across markets)
* Strives to be market neutral
* Relative value vs. convergence trades: for latter, convergence period is usually known (e.g., expiration of futures contract)
What is relative value trading
it is a method of determining an asset’s worth that takes into account the value of similar assets
* Pairs trading is a common strategy of relative value funds where a long and short position is initiated for a pair of assets that are highly correlated
What is Convergence trading
It is buying a security with a future delivery date for a low price and selling a similar security, also with a future delivery date, for a higher price
* index arbitrage = taking a position in an index futures contract and one in the underlying stock index
Why do we care about hedge Fund Alphas and Betas
Why do we care about alphas and betas?
1. No point to pay fee for beta exposure that you can get yourself
through index fund or ETF only pay for alpha!
2. Allows to check if HF manager follows proclaimed strategy
3. Investor can short market index (futures/ETF) to remove market risk
What are potential reasons for HF outperformance
- Skill
Best managers have incentive to leave MF and start HF due to higher fees + capture large share of own value creation (money wise) - Investment flexibility (leverage, short selling, derivates)
HF face few restrictions and can follow flexible investment strategies -> use leverage, short selling and derivatives - Fraud (insider trading etc) Ponsi scame -> MADOFF
- Data issues (smoothing, backfilling, survivorship, etc)
What are the main data issues related to hedgefunds
- HF returns self-reported and may be smoothed over a few months. Possible particularity when fund holds illiquid assets that are not market-to-market often
- Santa effect: higher returns reported in December (window dressing) -> 2.5x as large as in other months
o Stronger for lower-liquidity funds close to incentive free hurdle - Backfill bias: hedge funds report returns to data providers only if they choose to (not required to report) -> incentive to start reporting when they have been successful
- Survivorship bias: unsuccessful funds that cease operation stop reporting -> only successful HF remain in database
o Important because of high attrition rate among HF
Why do is sharpe a bad measure for hedge funds?
Sharp ratio based on mean variance theory
* SR assumes that risk can be measured by Standard Deviation
* Only valid when returns follow normal distribution
* Fund may have great SR but extreme downside risk exposure
Why is the performence of market following strategies hard to measure?
The strategy is often dynamic and non linear
Non-linear HF returns due to market timing
* Intercept is alpha, slope is beta biased!
Solution: allow for separate up- and down-market betas
