Lecture 6 - Hedge Funds Flashcards by Amar Sangar

Private Management (Private Wealth)

Clients contract directly with firm
Private management and personal relationships

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Investment Companies (Mutual Funds)

Pooling of investment capital of several clients in an investment company
New shares/units issued representing proportional ownership of the fund

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Mutual Fund MER

0.25 - 1.00%

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Mutual Fund Load Fees

1% to 5%+

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Alternative Investing

Hedge Funds
Private Equity
Real Assets

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Hedge Fund Portfolio Description

Combines both a long/short position
Able to produce superior alpha
Management fee + performance fee is paid to the manager
Low liquidity
Little or no regulation

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Two types of Hedge Fund Strategies

1) Non-directional
2) Directional

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Non-directional strategy

Buy one type of security and sell the another (e.g. Buy TD and short Scotia)

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Directional strategy

One sector or another will outperform other sectors

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Categories of Hedge Fund Strategies

1) Relative Value
2) Event Driven
3) Opportunistic
4) Global Macro

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Relative Value Strategies

1) Convertible Arbitrage
2) Equity Market Neutral
3) Fixed Income Arbitrage
4) Statistical Arbitrage & HFT

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Event Driven Strategies

1) Merger Arbitrage
2) Capital Structure Arbitrage
3) Distress Securities

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Opportunistic

1) Long/Short Equity
2) Emerging Markets
3) Managed Futures

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Convertible Arbitrage

Buying convertible bond and shorting the underlying stock

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Equity-Market Neutral

Involve taking both long and short positions in stocks, with the goal of minimizing exposure to the market’s systemic risk

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Fixed-income Arbitrage

Returns are generated by taking advantages of bond pricing disparities

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Statistical Arbitrage

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Seek out many temporary and modest misalignments in prices

High Frequency Trading

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Using powerful computer programs to transact a large number of orders in fractions of a second

Merger Arbitrage

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Returns are dependent upon magnitude of spread on merger transactions

Distressed Securities

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When HFs invest in risky (high yield) bonds or other securities of distressed firms

BCE attempted takeover 2008
Details:
Takeover price: $42.75
Planned Closing date: January 1, 2008
Quarterly dividend/share = $0.20 (assume 2 dividends will be paid before closing)
Margin required: 30%
Margin borrow rate: 7%
Market price July 1, 2007 = $28.00
Market Price as at July 4, 2007 (after deal was announced): $39.00

Q1: What is annualized return (with and without margin) to deal closing date?

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HPR = [$42.75 + (2 x $0.20)]/$39.00 = 1.1064

Annualized HPY = (1.1064)^2 - 1 = 22.40%

Annualized return with margin:
Cash required for trade = 30% x $39 = $11.70
Borrowing amount = 70% x $39 = $27.30
Borrowing expense = $27.30 x 7% x 0.5yr = $0.96

HPR = [($42.75 - $27.30) + (2 x $0.20) - $0.96]/$11.70
= 1.2735

Annualized HPY = (1.2735)^2-1 = 62.2%

Q2: What is the leveraged return if the deal does not close?

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Cash required for trade = 30% x $39 = $11.70
Borrowing amount = 70% x $39 = $27.30
Borrowing expense = $27.30 x 7% x 0.5yr = $0.96

HPR = [($28 - $27.30) + (2 x $0.20) - $0.95]/$11.70
= 0.0128

HPY = 0.0128 - 1 = -99% for 6 months!

Two Risks that could cause the deal not to close

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i) Shareholders or bond holders vote against it
ii) Does not get regulatory approval

Long-short equity

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Managers attempt to identify misvalued stocks and take long positions in undervalued ones and short positions in the overvalued ones

Emerging markets

Broad class seeks to profit from improvement in developing countries

Managed futures

Using long and short positions in futures

Special situations

Events like bankruptcies, spinoffs.

Global Macro Strategies

Involve long or short positions in capital or derivative markets across the world

Portable Alpha Strategies

1. Select target market index 2. Replicate index with market-linked instruments 3. Invest cash into alpha source and cash reserve

Hedge Fund Fee Structure

Management Fee: 1-2% Performance Fee: 10-20% over a bench return High Water Mark: If fund has losses in a year, future performance fees will not be paid until losses have been recovered

$100 million HF with 1/20 fee structure; Benchmark = 5%; HPR = 12% (net profit after fee = $12 million)

Mgmt. Fee: 1% x 100million = $1 million to HF Manager Performance Alpha= 12% - 5% = 7% or $7 million Performance Fee (paid to HF manager) = 20% x 7% = $1,400,000 (recalculate if HPR = 22%)

Hedge Fund vs. Mutual Funds

Transparency: Hedge funds have minimal disclosure Investors: Hedge Funds have no more 100 investors Investment Strategies: Hedge funds are very flexible Liquidity: Hedge Funds have lock up periods

Would a market-neutral hedge fund be a good candidate for an investor’s entire retirement portfolio?

No, a market-neutral hedge fund would not be a good candidate for an investor’s entire retirement portfolio because such a fund is not a diversified portfolio.

How might the incentive fee of a hedge fund affect the manager’s proclivity to take on high-risk assets in the portfolio?

The incentive fee of a hedge fund is part of the hedge fund compensation structure; the incentive fee is typically equal to 20% of the hedge fund’s profits beyond a particular benchmark rate of return. Therefore, the incentive fee resembles the payoff to a call option, which is more valuable when volatility is higher.

Why is it harder to assess the performance of a hedge fund portfolio manager than that of a typical mutual fund manager?

Hedge funds invest in assets that are hard to sell, so their profits might just reflect this risk. Hedge fund valuations for these assets can be unreliable. Databases often show only successful hedge funds, giving a biased view. Hedge fund risks change over time, making performance hard to measure. Rare events can skew returns, so short-term results might not show the full picture.

Which of the following would be the most appropriate benchmark to use for hedge fund evaluation?

A multifactor model

With respect to hedge fund investing, the net return to an investor in a fund of funds would be lower than that earned from an individual hedge fund because of:

Both the extra layer of fees and the higher liquidity offered

Which of the following hedge fund types is most likely to have a return that is closest to risk-free?

A market-neutral hedge fund

Is statistical arbitrage true arbitrage?

Statistical arbitrage isn’t true arbitrage because it involves risk instead of risk-free trades. It works by making many small bets on temporary market inefficiencies, hoping the combined returns will be positive.

A hedge fund with $1 billion of assets charges a management fee of 2% and an incentive fee of 20% of returns over a money market rate, which currently is 5%. Calculate total fees, both in dollars and as a percent of assets under management, for portfolio returns of -5% & 10%

Portfolio RoR|Incentive Fee|Incentive Fee ($)|Total Fee|Total Fee (%) -5 0 0m 20m 2 10 20 10m 30m 3

Lecture 6 - Hedge Funds Flashcards

(40 cards)