The Hedge fund environment
This introductory chapter serves to introduce the reader to hedge funds and the market that they act in. We will introduce the market itself and compare it to the more traditional market of mutual funds. Following that, the most common hedge fund strategies are briefly described. Hedge fund indices are then introduced and discussed as a way of dealing with the various strategies. Lastly the concept of fund of hedge funds is introduced together with our client company, Optimized Portfolio Management Stockholm AB.
The fund market
Investors are faced with a huge number of different investment opportunities. He or she can basically either invests in the fundamental financial instruments (i.e. stocks, bonds, commodities, and various derivatives of these) or in managed products, which in turn invest in the basic financial instruments. In this thesis we are only concerned with a sub set of the managed products market, namely hedge funds. We will nevertheless also introduce the other most common product – mutual funds.
Investing in securities is for most people done through mutual funds. A mutual fund is simply capital pooled from many investors that can be invested in stocks, bonds or other securities. The supply of mutual funds is enormous and the funds are offered in a great variety, e.g. small / big cap, value / growth, sector funds, geographically focused funds, bond funds, etc. In the US alone, total mutual fund wealth exceeded $ 7.4 trillion (Investment Company Institute, 2004). Among many advantages are low cost diversification and professional management. Mutual funds allow investors to cut down on risk by diversifying and also give access to a huge number of investment opportunities, usually otherwise not reachable due to limited amounts of capital.
Mutual funds strive for relative return and usually compare their returns to a certain benchmark or index. Many mutual funds attempt to follow this index or benchmark, and therefore purchase every stock or bond represented in the index (alternatively in a quantitative manner select and purchase a subset of the index that will behave just as it). Their goal is to achieve a return that exceeds the benchmark in all types of market conditions. A manager is successful if he or she exceeds the index, even though the index has dropped 30 %. The mutual funds also measure risk by comparing the return against a certain benchmark or index, for example S&P 500. A deviation from the benchmark gives the mutual fund an opportunity to make a better return than the index, but it also creates the risk that the fund will perform worse than the benchmark. Because of legal limitations, mutual funds are not allowed to sell a stock short, which usually leads to losses if the market declines.
All mutual funds carry some form of cost. Most common is a fixed management fee of around 1 – 2 % annually. Many funds also carry purchase and / or sell costs charged on the total amount invested, typically 1 – 5 %. Important is that the costs are not in any way associated with the funds returns.
Alternative investments / Hedge funds
A hedge fund can be described as a fund with a high level of flexibility, available to act in several financial markets, using many different strategies. Hedge funds can take long and short positions, for instance in the equity market, use leverage to increase the return, and use different types of derivates such as puts, calls, swaps, futures, etc. Hedge fund investors are usually high net worth individuals or institutions. The minimum investment usually ranges from $ 100.000 to $ 5 million. The aim for all hedge funds is to perform well independent of the market condition, and hence to produce absolute returns. Their main investment goal is to achieve an annualized return of approximately 10-15% (Anderlind et al, 2003).
The hedge fund industry has over the past decades grown exponentially, see figure 1 below. Every year so far has seen record inflows of capital to the industry and the trend does not seem to be slowing down. The expected long-term growth of the market is estimated to be around 20 – 25 % annually (10 % gross performance and 10 – 15 % new capital inflows)1. Ever since Albert W. Jones started the first hedge fund back in 1949, much of the industry has been associated with secrecy and non-transparency. The industry has mainly been aimed at wealthy individuals who were looking for absolute performance, even in market down turns. However, this has over the past few years started to change. The reason is that institutional investors, such as insurance companies and pension funds, are starting to invest in hedge funds. In fact, the institutional investors’ share of the hedge fund market has increased from 19 % in 1992 to over 55 % at the end of 2003.2 This radical change in the hedge fund’s client base has brought about changes to the way business is done in the industry. The institutions have demanded a higher level of transparency and in many ways shifted the hedge fund industry from being an investment activity in the periphery to becoming a mainstream asset class.
Figure 1 Number of hedge funds and assets under management (AUM).
Because of the unregulated nature of the industry, it is very hard to know the exact market size. Estimates by industry practitioners indicate that the assets under management is somewhere between $ 7503 and $ 1.0004 billion US. These assets are managed in around 9,000 hedge funds by approximately 3,500 managers. 4 To put the hedge fund industry in perspective to the financial markets as a whole, the hedge funds account for approximately 1.3 % of the total market (3.5 % leveraged). Estimates also indicate that around 10 % of the global trading volumes can be derived to hedge fund trading.4
A great misunderstanding about hedge funds is that they are associated with a high level of risk (volatility) and that they use the same type of strategy, namely the Global Macro5. In fact, this is not always true; many hedge funds try to reduce the risk and protect themselves against losses by hedging their positions (normally with derivates) against unexpected market turns. The most important target for almost every hedge fund manager is to reduce the volatility and make money irrespective of market condition. Investing in hedge funds is usually associated with a limited liquidity. Transactions to and from the fund are usually not conducted more often than monthly, often quarterly. Many hedge funds also have a lock-up period of one to several years. Both the poor liquidity and the lock-up periods are required because the investments are often illiquid in nature (e.g. corporate debt). These limitations in liquidating the portfolio positions are by investors generally referred to as liquidity risk. Another risk that is, or has earlier been associated with hedge funds is fraud risk. This type of risk stems from the unregulated nature of hedge funds and is becoming less and less of a problem due to the entrance of institutional investors to the hedge fund arena (as described above).
Hedge funds also carry a fee structure. As opposed to mutual funds, hedge funds charge an incentive fee dependent of the performance of the fund. If the hedge fund makes a loss, no incentive fee is charged. The incentive fee is based on a percentage of the profit, generally 20 %. Hedge funds typically also carry a small fixed management fee around 0.5 – 1 %.
It is most common that the hedge fund manager acts both as an investor and as a manager. In most cases, the manager invests a great deal of his / her own capital in the hedge fund. This gives the manager a greater challenge to perform well as well as a proof of the manager’s dedication to the funds performance.
Differences between hedge funds and mutual funds
Hedge funds separate in a number of ways relative to the traditional mutual funds.
The most evident difference is the legal structure of the two investment vehicles. The unregulated hedge funds call for an extremely flexible investment approach in relation to mutual funds. The differences in investment approaches in turn call for the second obvious difference; the return targets. Hedge funds do not compare their returns against a special benchmark. Instead, they try to make money independent of market conditions. Hedge funds and mutual funds also differ in their approach to face risk. The risk, associated with hedge funds is the risk of losing money. With mutual funds, the risk is the actual deviation from the funds selected benchmark.
In terms of fees, hedge funds and mutual funds have some similarities but also differences. Both types charge a fixed management fee, however, a smaller fee is charged for hedge funds. The major difference is the incentive based fee charged by hedge funds. This fee may at times be larger but is only paid on positively generated returns.
Due to the lack of transparency in hedge funds, they differ in valuation compared to mutual funds. Information on mutual funds is more open, and performance is reported on a daily basis as a net asset value (NAV). Hedge funds report only once a month. However, hedge funds have no obligation to publish financial information. Even investors have limited access to the information. This lack of information to investors is changing, because of the hedge fund’s need to attract new groups of investors, especially institutions.
In the world of mutual funds, an investment by the manager in charge is very uncommon. The mutual fund manager, as opposed to the hedge fund manager, incurs no personal financial gains / losses from a good / bad performing fund.
Hedge fund strategies
In this section we will briefly describe the most common strategies in the hedge fund universe. Each strategy will later be analyzed in terms of a sub index. Figure 2 below gives the reader an indication of the relative sizes of each strategy.
Although historical returns are shown in conjunction with each strategy, more detailed information can be found in Appendix 1.
The Convertible Arbitrage strategy involves taking offsetting positions in mispriced (undervalued) convertible bonds. The convertible bond is a hybrid between a bond and a stock, the valuation is therefore dependent on these two instruments. The core strategy for the hedge fund manager is to identify undervalued convertible bonds (i.e. mispriced relative to the underlying stock) that he or she believes will have a favorable return. If the manager finds a mispriced convertible bond, he or she purchases it and sells the underlying stock short. If the market declines, the price of the convertible bond tends to fall less rapidly than the underlying stock. If the opposite occurs (rising equity market), the bond tends to mirror the price of the underlying stock. The amount of shares that are sold short is dependent on how much market exposure the manager wants. The Convertible Arbitrage manager’s ability to realize a profit in any type of market condition is dependent on his or her skill to identify undervalued convertible bonds. If the market is bearish, the amounts of shares sold short is a greater number than the conversion factor. In a bull market, the amount of shares sold short is smaller than in the bearish market approach. If the price of the stock falls, the manager will make a profit from the shares that have been sold short, but a loss on the convertibles. If prices rise, the manager will realize a loss on the stocks that are sold short, but a gain on the convertibles. Over all, the right amount of shorting will always make it possible to achieve a positive return, which of course requires a correct market prediction.
The Convertible Arbitrage strategy has performed a consistently low risk return, with lower standard deviation than traditional investments. One explanation to the steady performance can be assigned to the manager’s adaptability for different market conditions.
Commodity Trading Advisers, commonly referred to as CTA Global funds or managed futures, invest in world wide financial markets, including the commodity and currency markets. Most CTA funds take bets on market momentum (i.e. they follow market trends). There are several different sub-strategies under the CTA strategy, for example long-term, short-term and non-trend followers, which among them tend to have very low correlation. The majority of the CTAs are systematic (i.e. they use sophisticated models to find investment opportunities).
Managers of this strategy usually take all bets their models suggest, even though they seem to contradict each other, such as taking both a long commodity as well as a long fixed income position (unlike Global Macro, see section 2.2.8). This might not always be the best strategy, but it tends to lead to that CTA managers are unlikely to miss any major market movements. Because the CTAs rely so heavily on their models to find investment opportunities, their timing is usually different than the Global Macro strategies. Macro managers rely on fundamentals, which allows them to be very early in the trends. CTA managers on the other hand need a persistent shift for their models to notice it, which means that they tend to be both later in catching a trend as well as later to get out. Even though CTA and Global Macro have access to the same markets, the CTAs tend to be more diversified in that they trade in more individual markets increasing their exposure to trends.
Figure 4 Historical return characteristics of the CTA Global strategy compared to the S&P 500 and Lehman Brothers US Aggregate Bond Index
The Distressed Securities strategy attempts to generate profits by investing in companies in financial distress (i.e. under reconstruction, bankruptcy, liquidation, etc.). A manager typically purchases a company’s securities (stocks, convertibles or (un)secured debt) and holds it throughout the restructuring period. The strategy is to capitalize on the knowledge, flexibility, and patience that a distressed securities fund manager has that the creditors of a company often do not have. Many institutional investors, such as pension funds, are banned by regulators from buying or holding onto below investment-grade bonds (BBB or lower) – even if the company is a feasible one. Often they may therefore sell at sharply discounted prices, which often has the effect of lowering prices further. Banks, on the other hand, often prefer to sell their bad loans (which are no longer paying interest) in order to remove them from their books and to use the freed-up cash to make other investments. Sometimes sufficiently large proportions of company debt are purchased for the hedge fund manager to take a position on the board of creditors, giving him yet further opportunities to influence the outcome probabilities.
Profits hence depend on the manager’s ability to assess success probabilities of the different investment options. The strategy is generally characterized by high returns and some degree of correlation with the stock and bond markets and can hence be thought of as a “return enhancer”. Figure 5 Historical return characteristics of the Distressed Securities strategy compared to the S&P 500 and Lehman Brothers US Aggregate Bond Index
This strategy aims to take advantage of emerging financial markets’ inefficiencies. Many emerging markets show a great lack of financial information transparency, which leads to inefficient markets with lots of mispriced assets. The Emerging Market specialist searches these markets to identify undervalued assets. To find these assets, they use their special talent, in combination with on the ground presence. The core strategy is to identify the undervalued assets before the market corrects itself. Emerging markets are associated with different risk factors such as; illiquidity, limited market infrastructure, very few investment options, lack of information and political turmoil. An investment in such a market is associated with greater risk than the developed markets. On the other hand, these risk factors can provide great investment opportunities.
Because of the limited market infrastructure, the managers primarily take long positions (shorting is typically not allowed and derivatives not available), which limits the possibility to hedge against falling prices. The Emerging Market specialist identifies undervalued stocks by fundamental bottom up research. They make investments (purchase stocks and / or bonds) in securities that they believe the market has mispriced. To keep the losses on a controllable level, they usually sell a stock when it falls to a specific stop-loss level.
Emerging Markets has performed relatively poorly during the late 1990’s, with a low average annualized return at volatility comparable to the S&P 500 index. Emerging Markets strategies have however the later years produced higher returns. This leads to a strategy that exhibits large short-term volatility.
Table of contents :
1.5 READING INSTRUCTIONS
2 THE HEDGE FUND ENVIRONMENT
2.1 THE FUND MARKET
2.1.1 MUTUAL FUNDS
2.1.2 ALTERNATIVE INVESTMENTS / HEDGE FUNDS
2.1.3 DIFFERENCES BETWEEN HEDGE FUNDS AND MUTUAL FUNDS
2.2 HEDGE FUND STRATEGIES
2.2.1 CONVERTIBLE ARBITRAGE
2.2.2 CTA GLOBAL
2.2.3 DISTRESSED SECURITIES
2.2.4 EMERGING MARKETS
2.2.5 EQUITY MARKET NEUTRAL
2.2.6 EVENT DRIVEN
2.2.7 FIXED INCOME ARBITRAGE
2.2.8 GLOBAL MACRO
2.2.9 LONG/SHORT EQUITY
2.2.10 MERGER ARBITRAGE
2.2.11 RELATIVE VALUE
2.2.12 SHORT SELLING
2.3 HEDGE FUND INDICES
2.4 FUND OF HEDGE FUNDS
2.5 OPTIMIZED PORTFOLIO MANAGEMENT STOCKHOLM AB
3 INTRODUCTION TO PORTFOLIO THEORY
3.1 MEAN-VARIANCE APPROACH
3.2 SHARPE RATIO
4 PROBLEM DESCRIPTION
5 THEORETICAL FRAMEWORK
5.1 RISK ADJUSTED RETURN
5.1.1 MODIFIED SHARPE RATIO
5.1.2 CONDITIONAL VAR
5.2 VARIABLES EXPLAINING RISK AND RETURN
5.2.1 PLAUSIBLE VARIABLES
5.2.2 FAMA FRENCH VARIABLES
5.2.3 PCA AND FACTOR ANALYSIS
5.3 FINANCIAL TIME SERIES
5.3.1 CORRELATION AND COVARIANCE
5.4 PREDICTABILITY MODELS
5.4.1 REGRESSION MODELS
5.4.2 IMPLICIT FACTOR MODELS
5.4.3 VOLATILITY PREDICTION MODELS
5.5 PORTFOLIO OPTIMIZATION
5.5.1 MINIMUM-VARIANCE OPTIMIZATION
5.5.2 STYLE TIMING
5.5.3 MEAN-CVAR OPTIMIZATION
6 PROBLEM ANALYSIS
6.1 RISK ADJUSTED RETURNS IN A HISTORIC PERSPECTIVE
6.2 CORRELATION WITH TRADITIONAL FINANCIAL MARKETS
6.3 INTERNAL CORRELATION AND COVARIANCE
6.4 RISK AND RETURN PREDICTION
6.5 PORTFOLIO EVALUATION
7.1 RISK ADJUSTED RETURNS IN A HISTORICAL PERSPECTIVE
7.2 CORRELATION WITH TRADITIONAL FINANCIAL MARKETS
7.3 INTERNAL CORRELATION AND COVARIANCE
7.4 RISK AND RETURN PREDICTION
7.4.1 PREDICTING RETURN
7.4.2 PREDICTING RISK
7.5 PORTFOLIO EVALUATION
7.5.1 MINIMUM-VARIANCE PORTFOLIOS
7.5.2 MEAN-VARIANCE SHARPE-OPTIMIZED PORTFOLIOS
7.5.3 OTHER PORTFOLIOS
7.5.4 PORTFOLIO COMPARISONS
8 DISCUSSIONS AND CONCLUSIONS
8.1 RISK ADJUSTED RETURNS IN A HISTORIC PERSPECTIVE
8.2 CORRELATION WITH TRADITIONAL FINANCIAL MARKETS
8.3 INTERNAL CORRELATION AND COVARIANCE
8.4 RISK AND RETURN PREDICTION
8.5 PORTFOLIO EVALUATION
8.5.1 MINIMUM-VARIANCE PORTFOLIOS
8.5.2 MEAN-VARIANCE PORTFOLIOS
8.5.3 FURTHER DISCUSSION