Chapter 20
Hedge Funds
20-1
Hedge Funds vs Mutual Funds
Transparency
Mutual Funds
Hedge Funds
• Public info on
portfolio
composition
• Info provided only to
investors
• Unlimited
• < 100, high dollar
minimums
Investors
Strategies
• Must adhere to
prospectus, limited
short selling &
leverage, limited
derivatives usage
• No limitations
20-2
Hedge Funds vs Mutual Funds
Mutual Funds
Liquidity
Fees
Hedge Funds
• Multiple year lock
• Redeem
up periods typical
shares on
demand
• Fixed percentage
• Fixed
of assets; typically
percentage of
1% to 2% plus
assets;
incentive fee =
typically 0.5%
20% of gains
to 2%
above threshold
return
20-3
Directional & Non-Directional
Strategies
• Directional strategies
– A position that benefits if one sector of the
market outperforms another, an unhedged bet
on a price movement
– For example, buy bonds in anticipation of an
interest rate decline
20-4
Directional & Non-Directional
Strategies
• Non-Directional strategies
– Attempt to arbitrage a perceived mispricing
• Typically a risky arbitrage
• For example, spread between corporates and
Treasuries is believed to be too large so you buy
the corporates and short the Treasuries.
• Market neutral with respect to overall interest
rates.
• Which type of strategy is riskier,
Directional or Non-Directional?
20-5
Hedge Fund Styles
Insert Table 20.1 here or
http://www.hedgeworld.com/education/ind
ex.cgi?page=hedge_fund_styles or
http://www.magnum.com/About.aspx?Row
ID=15
20-6
Statistical Arbitrage
• Statistical arbitrage
– Uses quantitative math models and often automated trading
strategies that attempt to identify small mispricings in multiple
securities.
– Involves placing small bets in hundreds of different securities for
short holding periods (minutes).
– Require fast trading and low transactions costs.
– “Pairs Trading”
• Find two ‘twin’ stocks; short the high priced one and buy the
low priced one.
• Do this for many pairs, rely on law of large numbers.
20-7
Fundamental risk and mispriced
securities
• Problem:
– A fund finds a positive alpha stock but expects
the overall market to fall.
• Solution:
– Buy the stock and sell stock index futures to
drive effective stock beta to zero,
– This is a ‘market neutral’ pure play,
– When combined with a passive strategy this is
called alpha transfer.
20-8
Pure Play Example
β  1.20; α  0.02; rf  0.01;S & P500 Index  800, futuresmultiplier  250
Starting Dollar Value  $1,000,000
Hedged End Value  $1,030,000  $1,000,000e
$1,030,000  $1,000,000
Re turn 
 .03
$1,000,000
.03  rf  
.01  rf   (.02  )
We have captured the alpha and hedged out the
market risk. (Unsystematic risk remains.)
20-9
Style and Factor Loadings
• Many fund strategies are directional bets and
may be evaluated with style analysis (see
Chapter 18),
• Directional investments will have nonzero betas,
called “factor loadings,”
• Typical factors may include exposure to stock
markets, interest rates, credit conditions and
foreign exchange.
20-10
20.5 Performance Measurement for
Hedge Funds
20-11
Fund Alphas and Sharpe Ratios
• Hasanhodzic and Lo (2007) find that style adjusted
alphas and Sharpe ratios are significantly greater than
the measures for the S&P500 for a large sample of
hedge funds. Changing nowadays!
• This implies:
– Hedge fund managers are highly skilled OR
– Aragon (2007) controls for illiquidity of hedge funds
with lockup periods and other redemption restrictions
and finds the alphas become insignificant.
– Related work by Sadka (2008) shows that hedge
funds must generate significantly larger returns to
offset liquidity risk.
20-12
Fund Performance and Survivorship
Bias
• Survivorship bias is a problem in performance
measurement of risky hedge funds
– Those that don’t survive don’t report results that are
used in estimating average performance.
• Backfill bias
– Hedge funds report returns to publishers only if they
choose to.
20-13
Tail Events and Performance
• Many hedge funds employ mathematical models that
rely on near term historical price data.
• Their strategies’ performance takes the form of a written
put option.
– Writing a put option is a way to capture the put
premium and is appropriate in low volatility markets.
– In high volatility markets they face large losses, out of
pocket if markets fall and large opportunity costs if
markets rise.
• When the more rare large market moves (tail events) do
occur hedge fund performance is not likely to appear as
strong and they may suffer large losses.
20-14
Evaluating Hedge Fund Fees
which is very high but coming down recently
• Typical hedge fund fees includes a fixed
management fee between 1% and 2% of assets
plus an incentive fee usually equal to 20% or
more of investment profits above a benchmark
performance return.
• Incentive fees are analogous to call options on
the portfolio with a strike price equal to the
current portfolio value x (1+ benchmark return).
20-15
Black-Scholes Value of Incentive
Fee
•
•
•
•
•
•
•
Suppose a hedge fund’s returns have an annual  =30%
The annual incentive fee is 20% of the return over the risk free money
market rate.
The fund has a net asset value of $100 per share and the annual risk free
rate is 5%.
The implicit exercise price of the incentive fee is $100 x 1.05 = $105
The Black-Scholes value of a call option with S0 = $100,
X = $105,  =30% ,T = 1 year, & rf = LN 1.05 = 4.88% is $11.92. (See
Chapter 16 for details on option prices)
Incentive fee is equal to only 20% of the value over $105 so the current
value of the incentive fee = 20% x $11.92 = $2.38 per share or 2.38% of
net asset value.
Coupled with 2% management fee yields total fees of 4.38%, much larger
than mutual funds.
20-16
Fees and the High Water Mark
• High Water Mark
– Funds that experience losses in one period
may not be able to charge any incentive fee
until the prior period losses are regained.
– This complicates estimating the value of the
incentive.
– Gives managers an incentive to close the
fund and start over when large losses occur.
20-17
Funds of funds
• Funds of funds invest in one or more other hedge funds.
– Serve as ‘feeder funds’ to ultimate hedge fund
– Allows investors to easily diversify across hedge
funds.
– May be a bad deal because of extra layer of fees.
– Earned a bad reputation when it became apparent
that many large fund of funds were major investors in
Bernard Madoff’s $50 billion Ponzi scheme.
20-18