Asset Management

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Asset Management

• Lecture 18

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Outline for today

• Hedge funds
• General introduction
• Styles
• Statistical arbitrage
• alpha transfer
• Historical performance
• Alphas and betas

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Definition

• Investment approach
• Trade any type of security or financial
  instrument
• Operate in any market anywhere in the world
• Unrestricted short-selling and leverage
• Pure management skill
• Fees and liquidity
• Compensation
• Management fee 2 (NAV)
• Performance fee 20
• High water marks
• Limited liquidity (lock-ups)
• Legal
• LLC in US or off-shore open-ended investment
  companies
• Unregulated private investment vehicles for
  wealthy individuals and institutional investors
• Provide minimal information to investors

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Industry Size
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Styles
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(No Transcript)
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Strategies

• Directional
• Bets that one sector or another will outperform
  other sectors
• Non directional
• Exploit temporary misalignments in security
  valuations
• Buys one type of security and sells another
• Strives to be market neutral

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Classification

• Equity Long/Short investing consists of a core
  holding of long/short equities depending on the
  outlook. Commonly employ leverage.
• Equity Market Neutral investing seeks to profit
  by exploiting pricing inefficiencies between
  related equity securities, neutralizing exposure
  to market risk by combining long and short
  positions.
• Convertible Arbitrage involves purchasing a
  portfolio of convertible securities, generally
  convertible bonds, and hedging a portion of the
  equity risk by selling short the underlying
  common stock.
• Distressed Securities strategies invest in, and
  may sell short, the securities of companies where
  the security's price has been, or is expected to
  be, affected by a distressed situation. This may
  involve reorganizations, bankruptcies, distressed
  sales and other corporate restructurings.
• Merger Arbitrage, sometimes called Risk
  Arbitrage, involves investment in event-driven
  situations such as leveraged buy-outs, mergers
  and hostile takeovers.

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Classification

• Emerging Markets funds invest in securities of
  companies or the sovereign debt of developing or
  "emerging" countries. "Emerging Markets" include
  countries in Latin America, Eastern Europe, the
  former Soviet Union, Africa and parts of Asia.
• Event-Driven is also known as "corporate life
  cycle" investing. This involves investing in
  opportunities created by significant
  transactional events, such as spin-offs, mergers
  and acquisitions, bankruptcy reorganizations,
  recapitalizations and share buybacks.
• Fixed Income Arbitrage is a market neutral
  hedging strategy that seeks to profit by
  exploiting pricing inefficiencies between related
  fixed income securities while neutralizing
  exposure to interest rate risk.
• Relative Value Arbitrage attempts to take
  advantage of relative pricing discrepancies
  between instruments including equities, debt,
  options and futures. Managers may use
  mathematical, fundamental, or technical analysis
  to determine mis-valuations.

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Classification

• Macro involves investing by making leveraged bets
  on anticipated price movements of stock markets,
  interest rates, foreign exchange and physical
  commodities. Involves allocating assets among
  investments by switching into investments that
  appear to be beginning an uptrend, and switching
  out of investments that appear to be starting a
  downtrend.
• Fund of Funds invest with multiple managers
  through funds or managed accounts. The strategy
  designs a diversified portfolio of managers with
  the objective of significantly lowering the risk
  (volatility) of investing with an individual
  manager.

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Statistical Arbitrage

• Uses quantitative systems that seek out many
  temporary misalignments in prices
• Involves trading in hundreds of securities a day
  with short holding periods
• Pairs trading
• Pair up highly correlated companies with recent
  pricing discrepancy
• Create a market-neutral position
• Data mining

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Alpha Transfer

• Separate asset allocation from security selection
• Invest where you find alpha
• Hedge the systematic risk to isolate its alpha
• Establish exposure to desired market sectors by
  using passive indexes

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Pure Play Example

• Manage a 1.5 million portfolio
• Believe alpha is gt0 and that the market is about
  to fall
• Capture the alpha of 2 per month
• ß 1.20 SP 500 Index is S0 1,440
• a .02
• rf .01
• Hedge by selling SP 500 futures contracts
• SP 500 futures contracts 250 each

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Pure Play Example

• The dollar value of your portfolio after 1 month
• The dollar proceeds from your futures position

3 return
Non-systembatic risk
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Historical Performance
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Historical Performance
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Hedge Fund Alpha
Hedge Funds
Spring 2008 17
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Alfas and betas

• Measure fund performance using regression
• Beta measures how fund goes up and down with the
  market
• ?i rmt measures the return due to market
  exposure
• ?i measures the excess return, due to manager
  talent (or luck)
• ?(?i) measures the risk specific to the fund
  (presumably diversifiable)

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Alfas and Betas

• You should only pay fees for alpha, the rest you
  can easily (and more cheaply) obtain with an ETF
• To add an hedge fund to a portfolio, we need to
  know how it correlates with the other assets
• Unfortunately, its not so easy to measure alphas
  and betas for hedge funds
• Asset illiquidity biases betas
• Time-varying or non-linear exposure of hedge fund
  strategies

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Hard to spot talent short histories

• Typically hedge funds have histories shorter than
  5 years
• Uncertainty of mean return is
• With 15 volatility, 5 year history, 90
  confidence interval for mean return is
• To evaluate a manager, you need to understand the
  economic story very well
• Risk premia value, illiquidity, Market
  inefficiency why? what capacity?
• Competitive advantage of manager

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Hard to spot talent survivorship bias

• All hedge funds around seem to be exceptional
  And, in fact, all funds alive have had an
  exceptional performance in the past
• Hedge fund indices are based on self-reported
  performance (with backfill)
• Only successful funds report, biasing the
  performance of the index relative to the
  performance of an investor who actually put money
  in a cross section of funds
• Survivorship bias in indices of the order of 3
  per year (Brown and Goetzmann)