Aleksey Matiychenko
for Pace University
INTRODUCTION TO
HEDGE FUNDS
ABOUT RISK-AI
Risk-AI®, LLC was registered in January of 2008 and started operations in July of 2008. The company started as hedge fund
risk management services provider for fund of hedge funds and family offices.
As part of that business we have developed proprietary platform - Transparency Analytics®, which is the online state-of-theart risk management analysis and research platform for Investment Advisors, Fund of Funds, Family Offices and other
Investors managing multi-fund portfolios.
Transparency Analytics® is offered as Software as a Service (SaaS) platform, that eliminates the need for expensive on site
installations and maintenance. Firms without extensive IT departments can quickly get access to our software - ANYTIME &
ANYWHERE.
Transparency Analytics® tools are based on our extensive quantitative analysis and due diligence of hedge fund managers.
Over the years, Risk-AI professionals analyzed hundreds of hedge funds. Lessons learned from such analysis, as well as the
feedback from our consulting clients are incorporated into the tools offered by Transparency Analytics, which range from
basic statistical analysis to more sophisticated tools such as Multi-Variable Style Analysis, Market Regime Analysis, Scenario
Analysis, Monte Carlo Simulations etc. All tools are presented in a simple to use and intuitive web interface. Most analyses
can be accessed with just a few of mouse clicks.
Transparency Analytics® is cloud based, and can be accessed from multiple locations with an Internet access, such as the
office, home, investment conference, client meeting or business trips, and can be viewed online from any modern laptop, or
even without the Internet access using the iPad/iPhone via our native iOS iPad App, which is available for download from the
Apple Store for free.
We offer a competitive pricing model based on a single flat fee license covering the entire investor company. Below is our
quick competitive advantage summary.
1. Affordable pricing model | 1 License covers the entire firm.
2. The only provider with a native iOS iPad/iPhone App for the platform.
3. Intuitive and user-friendly Graphical User Interface for both online and iPad versions.
4. Quick and secure online and offline access to software.
5. Creative visualization of sophisticated tools.
6. Personal attention to clients.
7. Fast new feature/updates implementation time.
WHAT IS A HEDGE FUND
 A mutual fund organized as a limited partnership and using high-risk,
speculative methods to obtain large profits. – Dictionary.com

a largely unregulated speculative fund which offers substantial returns for
high-risk investments-Collins Dictionary
 an investing group usually in the form of a limited partnership that employs
speculative techniques in the hope of obtaining large capital gains –Webster
Dictionary
 A hedge fund is a collective investment scheme, often structured as a limited
partnership, that invests private capital speculatively to maximize capital
appreciation. Hedge funds tend to invest in a diverse range of markets,
investment instruments, and strategies; today the term "hedge fund" refers
more to the structure of the investment vehicle than the investment
techniques. - Wikipedia
 An aggressively managed portfolio of investments that uses advanced
investment strategies such as leveraged, long, short and derivative positions in
both domestic and international markets with the goal of generating high
returns (either in an absolute sense or over a specified market benchmark) InvestoPedia
OUR DEFINITION
Uses Skill
Investment
Manager
To allocate capital among
or trade different asset
classes
With a little bit of luck
Earns a profit
OUR DEFINITION
n
E ( R) =  AssetClass + Leverage + Skill + Luck
1
HEDGE FUND STRATEGIES
Hedge Fund Assets Under Management
by Strategy
Source: www.barclayhedge.com
Equity Market Neutral
Event Driven
Fixed Income
Sector Specific
CTA
Equity Long Bias
Equity Long/Short
Macro
Equity Long/Short
Other **
Multi-Strategy
Distressed
Securities
Emerging Markets
Merger Aritrage
Equity Long Only
Convertile Aritrage
SAMPLE STRATEGIES EQUITY L/S
This directional strategy involves equity-oriented investing on both the long and
short sides of the market. The objective is not to be market neutral. Managers have
the ability to shift from value to growth, from small to medium to large
capitalization stocks, and from a net long position to a net short position. Managers
may use futures and options to hedge. The focus may be regional or sector specific.
– BarclayHedge.com
Example Positions: Pershing Square Capital. Positions as
of 06/30/2013 as disclosed to SEC in 13F Filing
NAME OF ISSUER
AIR PRODS & CHEMS INC
Shares (x1000)
PRN AMT
924,464
10,095,708
1,313,859
20,818,545
748,640
38,372,120
CANADIAN PAC RY LTD
2,932,527
24,159,888
GENERAL GROWTH PPTYS INC NEW
1,346,970
67,789,157
399,939
3,568,017
5,073
202,913
667,414
39,075,771
2,613,051
33,940,133
BEAM INC
BURGER KING WORLDWIDE INC
HOWARD HUGHES CORP
MATSON INC
PENNEY J C INC
PROCTER & GAMBLE CO
SAMPLE STRATEGIES EQUITY L/S
Long side of portfolio is often only half of the picture.
Here is 13F or Pershing Square as of 2007.
NAME OF ISSUER
Shares (x1000) PRN AMT
BARNES AND NOBLE
258,020
6,540,451
BORDERS GROUP
139991
6855580
CADBURY SCHWEPPES PLC
1,818
35,383
CERIDIAN CORP NEW
715360
20532734
MCDONALDS CORP
845818
18757577
The short side is not shown. Pershing Square had a major short
position in MBIA. That was the biggest and most important position of
the fund.
CONVERTABLE ARBITRAGE
This strategy is identified by hedge investing in the convertible
securities of a company. A typical investment is to be long the
convertible bond and short the common stock of the same
company. Positions are designed to generate profits from the fixed
income security as well as the short sale of stock, while protecting
principal from market moves. – BarclayHedge.com
stock
bond
Bond is converted to stock
to cover short position.
Coupon income is generated
until conversion.
stock
bond
Profit from short
position + short interest +
coupon should offset
market loss on the bond
CONVERTABLE ARBITRAGE
• Arbitrage implies risk-free investment.
• In Reality:
2008
2009
27.66%
53.63%
CTA
CTA managers take directional or relative value positions in futures and options
on futures in various markets. CTA’s typically provide higher level of liquidity,
transparency and leverage to investors.
An example strategy may involve a relative value trade between Robusta and
Arabica coffee futures.
CTA
CTAs are often considered a hedge to main portfolios because they perform well
during times of distress:
HEDGE FUND BUSINESS
Simplest Hedge Fund Model – Two guys and a Bloomberg
Start up hedge fund may have 1 or 2 Portfolio Managers / Traders and less than $1,
Million in Assets Under Management (AUM)
HEDGE FUND BUSINESS
WHY INVEST IN HEDGE FUNDS
•
•
•
•
High Risk/High Return
Low Correlation to Other Markets
Better Performance during Crisis
No OPM problem
HIGH RETURNS / HIGH RISK?
On average Hedge Funds Indexes have lower volatility and higher returns.
HIGH RETURNS / HIGH RISK?
On average Hedge Funds Indexes have lower drawdown and higher returns.
REAL FUNDS GLOBAL MACRO
• High Risk / High Return
Manager
• Significant outperformance but
most in the first 3 years
• Typical Investor: High Net
Worth investors
Fund
S&P 500
Annualized Return
36.6%
4.7%
Annualized Volatility
32.9%
18.6%
Max Drawdown
-36.5%
-47.5%
Cumulative Return
403.0%
16.6%
FIXED INCOME ARBITRAGE FUND
• Low Risk/Low Return
manager
• Typical Investor:
Institutional investor (e.g.
Pension Plan) looking for
low volatility uncorrelated
return.
Fund
S&P 500
Annualized Return
6.2%
14.6%
Annualized Volatility
5.2%
15.9%
Max Drawdown
-6.7%
-17.0%
Cumulative Return
17.7%
42.63%
LOW CORRELATION
STRATEGY
CORRELATION
Equity Long Bias Index
85.15%
Hedge Fund Index
77.05%
Event Driven Index
71.52%
Equity Long/Short Index
68.78%
Emerging Markets Index
68.51%
Technology Index
64.45%
Fund of Funds Index
60.20%
Distressed Securities Index
59.06%
Merger Arbitrage Index
54.08%
Multi Strategy Index
52.59%
European Equities Index
50.38%
Healthcare & Biotechnology Index
45.82%
Global Macro Index
45.47%
Convertible Arbitrage Index
43.55%
Pacific Rim Equities Index
42.69%
Fixed Income Arbitrage Index
39.99%
Equity Market Neutral Index
19.03%
Discretionary Traders Index
4.52%
Currency Traders Index
2.36%
Agricultural Traders Index
-0.05%
CTA INDEX
-11.25%
Fin./Met. Traders Index
-15.16%
Systematic Traders Index
-15.30%
Diversified Traders Index
-16.79%
Equity Short Bias Index
-74.98%
PERFORMANCE IN CRISIS
Strategy
Equity Short Bias Index
Diversified Traders Index
Systematic Traders Index
Fin./Met. Traders Index
CTA INDEX
Discretionary Traders Index
Currency Traders Index
Agricultural Traders Index
Equity Market Neutral Index
Global Macro Index
Merger Arbitrage Index
Pacific Rim Equities Index
Equity Long/Short Index
European Equities Index
Technology Index
Event Driven Index
Fund of Funds Index
Multi Strategy Index
Hedge Fund Index
Healthcare & Biotechnology Index
Distressed Securities Index
Fixed Income Arbitrage Index
Equity Long Bias Index
Convertible Arbitrage Index
Emerging Markets Index
Fall 2008
24.75%
11.04%
8.53%
5.77%
5.11%
3.28%
1.98%
-0.25%
-2.08%
-2.92%
-6.77%
-8.53%
-9.44%
-9.76%
-10.26%
-12.55%
-15.30%
-15.96%
-17.19%
-18.14%
-19.64%
-19.87%
-23.88%
-25.08%
-28.13%
S&P
30.14%
NO OPM PROBLEM
Hedge Fund Managers typically invest large portion of
their own wealth into the funds they manage. This makes
sure that investor’s interests are aligned with the
manager’s.
WHY WORK FOR HEDGE FUND?
Compensation
Small business feel
Less formal environment
HEDGE FUND INVESTMENT
 Fees
 Hedge fund typically charge higher fees though traditional model of 2/20 is
changing.
 Liquidity
 Many hedge fund strategies impose limits on how frequent can investors redeem
(e.g. Monthly, Quarterly, Annually).
 Many hedge funds impose Gates and Lockups to prevent investor exodus during
crisis.
 Transparency
 Hedge fund typically provide low level of transparency in their strategy and
holdings.
 Personal touch
 Hedge fund investment requires due diligence and meeting with the hedge fund
manager. In many cases investors talk directly to the portfolio managers of the
fund.
RISK MANAGEMENT
 “It’s not my job to tell people how much risk to take” –
Risk Manager at a large UK hedge fund.
 “If someone believes that a risk manager can have power
in a hedge fund, he is insane” – COO of large US hedge
fund.
RISK MANAGEMENT
 Many small hedge funds don’t have dedicated risk
manager.
 A common risk management tool is “knowing
positions”.
 The most import quality for risk manager at a hedge
fund:
Being able to say no to this guy:
HEDGE FUND LIVE CYCLE
• Average Life Span of Fund: 58 Month (based on funds “dead” as of Jan 1,
2013).
• Among current funds (July 31, 2013) More than half of the funds are less
than 5 years old
HEDGE FUND BLOW-UPS
 Amaranth
 Madoff
 Other 1 (Credit fund in London)
 Other 2 (Credit fund in NY)
 Other 3 (Multi Strategy Fund in NY)
AMARANTH
 Blew up in September of 2006 after suffering losses in
Natural Gas position.
 The trader took crowded positions in long term natural
gas futures.
 There was little control of the manager located in
Calgary while the main fund was in CT.
 Risk Managers misunderstood the attribution of risk.
MADOFF
Why did the fraud came to light?
Crisis of 2008
Hedge Funds impose gates and
lockups to prevent fire sales.
Madoff claims to be liquid.
OTHER MANAGER 1
 Credit focused funds earns very high returns in 2007 by
trading mortgage related securities.
 Early 2008. A large bank decides to liquidate “toxic”
mortgage related assets at steep discount.
 This causes the bank to issue margin calls to the
managers that use it as prime.
 The fund cannot meet margin requirements and is
forced to shutdown.
OTHER MANAGER 2
 Very impressive manager. Friends to Hollywood stars.
 Manager convinced himself and investors in
idiosyncratic nature of returns.
 No effort was made to actually measure/evaluate
idiosyncratic nature of positions.
 August 2007 the fund’s portfolio lost 20% due to
systematic movements in credit markets.
 Manager was forced to liquidate portfolio over time and
shutdown 9 months later.
OTHER MANAGER 3
 Global Macro Fund with focus on Fixed Income.
 Great risk management tools and reports provided to
investors.
 Stress test on the report shows potential loss of 15% if
interest rates move up by 50bps.
 Such stress realizes 3 months later. The fund losses are
on the dot (about 14%).
 Investors redeem because the fund did not pay attention
to risk management report and did not follow its own
risk guidelines.
LEARN ABOUT HEDGE FUNDS
 HF Databases




www.hedgefundresearch.com
www.barclayhedge.com
www.eurekahedge.com
www.hedgefund.net
 Community Website: Albourne Village
village.albourne.com
 News – www.finalternatives.com
 Professional Associations – www.caia.org
 Risk-AI www.risk-ai.com/publcations
CONTACT INFORMATION
 Download this presentation at www.risk-ai.com/publications/
 Contact Aleksey aleksey@risk-ai.com