Alternative Investment Management

Hedge Fund Strategy Report

Executive Summary
With a primary aim to preserve capital, and further yield a positive return, our fund implemented two main strategies after consideration of a wider universe. Through the first strategy, ADR mispricing trading, no opportunities were found over the trading period due to large bid-asks spreads and unclear foreign exchange rates as provided by the trading platform. These elements eroded the potential value of the trades, sometimes halving the premium identified when the trade was placed. Market timing, the fund s second strategy, underperformed expectations due to insufficient macroeconomic knowledge and unexpected volatility due to world events affecting equity markets. Overall, management employed sound strategies. Recommendations for further management of the fund are to take steps to reduce spreads, by utilising a better platform, for ADR mispricing trades, which would significantly increase profits. Moreover the market timing strategy requires further and deeper macroeconomic research, to which time constraints were an impediment. We understand the importance for the management of the fund to confirm all details before entering into a trade, as mistakes were made with dividend dates, and prefer longer dated options longer as in some cases the share prices would have had time to rebound post dividend if the expiry had been longer out. We also find through our trading that when an investment decision has been made and an effective stop-loss in place it is not advisable to reverse the play on market reaction, as you do not give the market time to turn in the direction you initially called.

Structure of Report
Introduction Trading Rules and Limitations Strategy
Options Application Expected Results

Conclusion

Introduction
In January 2011 the Hedge Fund Strategy group was created to formulate investment plans and evaluate performance over a small window period of early 2011. Contained within this report is an evaluation of three trading strategies, reasoning behind the final choice, and evaluation of expected market performance. In undertaking the task three strategies are discussed and evaluated; ADR Arbitrage and derivations, Technical Indicator Trading and Market Timing. Within these strategies an evaluation of the model is made alongside practical considerations given the limitations of the trading platform, outlined below. The primary aim of the fund in these turbulent times is to preserve capital, and as such a smaller profit return is targeted but a strong emphasis placed on preserving the initial investment. Limitations of the Trading Platform The trading platform through Stocktrak was used as the basis of evaluation which leads to significant restrictions. The only stocks with any degree of price series information are US stocks, and as the authors of this report are based in the UK this provides an obstacle as the majority of prior market knowledge is UK based. There are limitations to the trades that can be executed; free access is not granted to foreign exchange trades which excludes any currency hedging. Very limited access to commodity markets is allowed through few futures contracts which limits the ability to tailor commodity holdings to specific requirements. Observances of the platform also note that the bid ask spread on some securities and derivatives is comparatively high which creates significant profit erosion. The platform also performed inconsistently; some trade requests were lost after submission and did not make their way to the market, and there were various points at which the platform either refused admission to the trading site or refused to accept a trade for reasons unknown. Limitations Outside of the Platform Further to the platform limitations there have been other limitations felt over the evaluation period, notably the time restraints in place as a direct result of the author s various other commitments taking precedence over the period. Given the disadvantage this has on the effectiveness of any strategy the models have been looked at in an ideal-world scenario to give an idea of the likely returns should the appropriate time have been allowed for completion of the project.

ADR Arbitrage
Traditional ADR Arbitrage takes advantage of opportunities created when US banks hold foreign assets and issue American Depositary Receipts which are traded on US exchanges. These stocks are essentially a claim on (a multiple of) the foreign stocks, and the ADR Arbitrage process requires the ability to convert them back into the original foreign stocks. From the point of view of an American Investor the process for an ADR Arbitrage is as follows 1. US Investor acquires ADR at the ask price (with USD) 2. ADR is converted into the underlying foreign stock 3. Foreign stock is sold in foreign market at the bid price (in foreign currency) 4. Foreign currency received is then converted into USD at the ask exchange rate The impact of fees, taxes and spreads are present at each stage, along with issues relating to liquidity issues and any restrictions. With regards the last two items, if we discount countries with highly illiquid ADR markets then the volume of trade should provide sufficient illiquidity, and there should not be any restrictions on trade, such as there being no two-way fungibility in the Indian ADR market pre 2001 (Amary & Ottonio, 2005). This limitation to the more liquid markets discounts the choice of ADRs with which to arbitrage. If we consider the average premium by country as in Table 1 then we see the premiums present for the UK are small on average, but with the variance of premiums there should still be some opportunity for profit.
Japan United Kingdom Brazil Hong Kong Australia France Germany Netherlands Mexico South Africa Chile Russia Switzerland China Ireland Argentina India Italy South Korea Israel Other Countries Number of ADRs Average Premium Std Dev 88 0.34 1.1 82 0.06 3.93 51 2.51 23.2 51 -1.32 3.85 37 -0.36 4.92 37 0.55 3.89 29 -3.77 18.22 28 -3.33 16.89 26 0.53 2.96 20 0.27 4.34 18 -0.34 2.41 18 -1.16 6.36 14 0.07 0.36 12 -0.18 1.26 12 -1.41 7.19 11 -7.83 27.34 11 4.63 23.41 11 -0.39 1.45 11 1.7 4.52 10 -0.46 1.64 92 -1.13
Table 1: ADR Premiums by Country

Min -3.05 -29.86 -8.59 -18.37 -13.39 -11.9 -98.34 -89.42 -4.97 -5.7 -9.48 -20.56 -0.73 -3.3 -8.9 -90.18 -62.56 -4.54 -3.54 -2.52 -50.71

Max 3.03 10.95 164.28 3.87 11.5 17.57 1.54 0.9 9.72 11.15 1.63 14.89 0.57 1.35 16.84 1.89 20.62 0.77 12.89 2.51 12.57

ADR Arbitrage
Drawbacks of ADR Arbitrage Using Brazil as an example Alves & Morey (2003) found that there are almost no arbitrage opportunities for the individual investor, though there will be for institutions with lower transaction costs, or financial institutions with no broker fees (if they operate as broker in both markets). Under these conditions, and assuming only opportunities at the larger end of the premium spread are considered, there should still be room to profit from this activity. Practical Considerations ADR Arbitraging requires the ability to transform shares not present in Stocktrak, and absent is the opportunity to convert the foreign currency back into USD at a transparent predetermined rate in order to settle the trade fully. As such, whilst the strategy provides room to profit under the right conditions, a strategy involving direct ADR Arbitrage cannot be considered for this fund. Though we are unable to transact the traditional ADR arbitrage, the possibility remains to extract some value from the relative mispricing of ADRs and their underlying securities, which are explored in the following section.

ADR Relative Mispricing

We could employ a relative pricing strategy when we find ADRs with premiums over the foreign underlying stocks and trade against each other. The process would be as follows (for an arbitrage where US is undervalued against the underlying UK stock): 1. UK security is sold in the UK market for GBP at the bid price 2. FX is sold for the amount of the UK sale and the GBP is converted into USD 3. U.S. investor acquires ADR at the ask price with USD The prices are subsequently expected to align through either natural market movements or by other participants exploiting the ADR arbitrage opportunity present. Either the ADR will increase in line with the UK security or the value of the UK security will fall to that of the ADR. Under both conditions the investor will make money as they will be able to settle the trade in the market on one side; selling their ADRs for a profit, before using the proceeds (after the reverse FX transaction) to buy the UK stocks and settle the short position in the underlying stock. In the example of the UK this should present no practical problems in terms of going short, though there will be some costs incurred in borrowing the stocks (unless it is a naked hedge). This trade should hedge out all market risk as the securities are expected to move together in line with any shocks in the market, and the trade should only be active until the two align and the relative differential narrows. There is however evidence to suggest that the two do not always move in tandem, and in instances where the underlying markets move separately the ADR moves with the US market and not with the underlying security in some cases. In these cases the spread between the two would actually widen, and the ADR premium increase contrary to the theory behind the trade. Though this would not be expected to be a permanent change there have been periods of sustained spreads between ADRs and the underlying assets in times of crisis, such as in Argentina in the 2001 period of social unrest (Amary & Ottonio, 2005). If trades can be found with large premiums (either positive or negative) then this could provide a good source of revenue in the short to medium term, though we recognise that in times of crisis, as there are at present, the trade may take longer than usual to return a profit as spreads may widen or at least remain over the short term. Despite the risks these trades should generate returns with low volatility.

Technical Indicator Trading

Previous work by the authors has explored the area of Technical Analysis, and creating a rules based trading system based on technical indicators. A study was carried out using a large-cap high-volume equity from the US market: Google, over the period of January 2008 to September 2010. Four trading strategies were evaluated, optimized over a test period and then evaluated over a test period. Of the four strategies three were simple one-factor models, and the final was a more advanced two-factor model. Over the test period the models were optimized and three then produced a profit over the evaluation period, the results of which are summarized in Table 2.
Annualised Profit Trade Efficiency 210% 50% 72% 50% Closed Out 0% 804% 100%

Moving Average Crossover +DI -DI Crossover Relative Strength Index ADX and DI Crossover

Table 2: Technical Indicator Trading Rules

Despite the success of the trading rule system the inputs in terms of time were too steep to contemplate on the scale needed for success within the confines of the trading period, with between 15 and 20 hours needed to perform the necessary steps to evaluate just the one equity. Furthermore the intermittency of the trades meant that even if successful strategies could be evaluated over a test period there is no guarantee the trading rules would trigger a clear trading signal over the trading period in early 2011. Table 2 also highlights the issue faced in as such that if the incorrect trading strategy is chosen the full investment may be lost under any technical indicator trading system. As the primary concern of the fund is capital preservation Technical Indicator Trading is discounted as a viable strategy.

Market Timing
Market Timing is either the easiest or most difficult strategy of the three depending on how it is viewed. In essence the fund manager can trade entirely at their discretion, which requires an understanding of the market and an appreciation of drivers and news-flows. Return volatility under this strategy is expected to be very high, and as such steps are necessary to reduce potential losses and provide some downside protection. Instead of investing directly in the underlying assets with protection only afforded by the stop losses in place derivatives are used to provide access to upside with fixed downside protection. As a trade off for the benefit gained the option price is sacrificed, as observed in Figure 1. Investments are made at the discretion of the managers as and when opportunities present themselves. Call Option Put Option

Figure 1: Payoff from Call and Put Options

Stop Loss A stop loss is inbuilt to the trade in the form of the option price itself, however a more sophisticated moving stop loss is desired. To this end a system is put in place where the option stop loss will be moved to breakeven when the option value doubles, as shown in Figure 2. Payoff When Option Value < x2 Payoff When Option Value Doubles

Figure 2: Option Payoff with Moving Stop Loss

Investing Strategy
After consideration of several options a multi-strategy method is employed utilising ADR mispricing and market timing. Where possible ADR arbitrage opportunities are observed a trade will be executed to take advantage of the expected realignment. In addition to this trades will be executed in a discretionary fashion based on market news. So as to preserve capital a maximum value is prescribed for each type of trade; for ADR mispricing, due to the hedged nature of the trades a limit of 10% of the original capital can be traded, meaning each trade can be $200 000 when leverage is taken into account. For the options trades, as the maximum loss is equal to the initial outlay the maximum trade allowed is 3% of the initial capital, or $30 000 per trade.

Alternative Strategies Not Pursued Other strategies which were considered but not chosen due to insufficient knowledge of the market are as follows: Aggressive Growth Distressed Securities Emerging Markets Fund of Funds Income Generating Macro Market Neutral Arbitrage Market Neutral Securities Hedging Opportunistic Short Selling Special Situations Value Deep Discount etc. (Magnum Funds, 2011)

ADR Mispricing Trading

During the course of the trading period several trading opportunities were identified, primarily within the financial sector where UK Banks showed significantly different underlying local security values than the ADR counterparts. At this point the trade was investigated and if significant profit opportunity found the trade would be executed. In practice no opportunities were found over the trading period due to a combination of factors; 1) Non-transparency of foreign exchange rates 2) Large Bid-Ask spreads The expected profit from each trade can be shown as in Figure 3, where the original mispricing is shown as the difference between market values of the underlying price and the ADR price (when converted into a common currency).

Figure 3: ADR Mispricing profit opportunity

The value in the trade is eroded however by the spreads on the securities; in each of the nine opportunities identified the Bid spread on the stock being sold (UK or US depending on the direction of the premium) plus the Ask spread on the stock being bought eroded over half of the premium found. On top of this, though the trading fees are low ($25) the combination of fees contribute in part to an erosion of profit. Given that in every mispricing found over half the premium is eroded in the first round of trading then, even if the prices aligned perfectly, when a similar bid-ask spread is taken into account for the second round of trading to settle the initial trades all opportunity for profit is eroded fully. On top of this the exchange rate is not always clear in the Stocktrak system, so it is not guaranteed the trade would yield the correct amount of one currency or another, as the FX trade is not processed by the manager, but completed automatically by the system. On the next page we take a closer look at one of the possible trades highlighted in which there were potential profit opportunities identified.

Barclays ADR Mispricing

The share price movement of Barclays is shown in Figure 4, where both the UK listed stock (LON:BARC) and the US ADR (NYSE:BCS) are shown. The Implied Market Cap is calculated as the share prices are not direct 1:1 and so would move in tandem but not on the same scale]. So as to present a clear picture the Close price of the UK stock is listed, alongside the open price of the ADR, so the timeframe looked at is consistent. The average exchange rate over the day is applied to transform the prices. As observed there are three opportunities highlighted (as we chose a minimum premium differential of 2.5%) on the 10th Feb and the 10th and 16th March. Unfortunately the combined bid-ask spreads (bid on short and ask on purchase) represented 52%, 55% and 64% of the premium in each case, and as such the trades were not executed as it was almost certain that the second round of spreads would have eroded all of the profit gained. In looking at the range of premiums a viable trade would have been to buy in on the 10th Feb and sell out on the 10th March, which would have resulted in a margin on the trade of 2.6% after fees. This trade is hand-picked from the premiums with the benefit of hindsight though, and not foreseen during the actual trading time. If steps could be taken to reduce spreads (possibly by utilising a better platform) then the ADR mispricing trades could have been executed. Of the three trades identified for Barclays a halving of spread would have led to profitable trades in all three cases.

Barclays (BCS v BARC)

Implied Market Cap ($bn) 70 65 60 55 50 27 Jan 10 Feb 24 Feb ADR OPEN 10 Mar UK CLOSE 24 Mar 07 Apr

% Differential (ADR Premium)

Barclays (BCS v BARC)

3.00% 2.00% 1.00% 0.00% -1.00% -2.00% -3.00% 27 Jan 10 Feb 24 Feb 10 Mar 24 Mar 07 Apr

ADR Premium Figure 4: Barclays Share Price Movements, and ADR Premiums

Market Timing
The decision was made early on to trade in US stocks for two main reasons; 1) Price history and graphing was available only for the US stocks 2) There was little transparency in the FX rates used on the site, and the account was administered in dollars This restriction is particularly costly, as the managers of the fund are both more conversant with the UK market that the US, and so a deal of market knowledge was discounted. Civil Unrest Over the start of the trading period there were fairly benign sideways market conditions, but as the unrest in Tunisia spread across the Arab states the conditions became more volatile. Without in depth macro knowledge the managers decided not to invest in companies affected directly by the unrest, and due to reasons explained further on the decision was made not to invest directly in oil. This decision turned out to be quite costly; oil prices were approximately $100 per barrel (for Brent Crude) and by the end of the trading period had risen to approximately $120. If the investment had been made at the first signs of unrest in Tunisia we could have locked in gains of 20% over the two month period, an annualised gain of nearly 200% when compounded. Despite the signs indicating trading we were unwilling to enter into the trade due to three reasons: 1) There were no options available on oil contracts, which was decided upon as the desired investment strategy due to the downside protection 2) This downside protection was especially important due to the volatility of oil prices over the medium term; oil lost 70% of its value in the crisis of 2008 and we were valuing capital preservation highly 3) News suggested demand was being fuelled by speculators not economic demand, and as the world economy was in a contracting, or at least only slowly-growing phase then we were unsure how long the demand would persist for before possibly declining sharply The volatility expected in oil related companies was due in part to the uncertainty over oil prices and in part the unknown effect the unrest would have on world equity markets. Trades Executed Barclays Throughout February Barclays ADR was trading consistently under the underlying (see Figure 4) and the financial accounts were due to be announced. On the 16th February, with results due on the day the managers felt the results would beat market expectations, and as such bought Barclays short dated call options expiring March, at strikes of 21 and 22, which were the options immediately surrounding the share price. In the short term the share price did move upwards, and the options

Market Timing
gained in value by one third. The managers failed to foresee that the shares at that point were not ex-div, as had been thought, but in fact two days after holding the options the ex-div date passed. Due to this the value of the options fell sharply, and as the options did not reach double their initial value (3% of the portfolio - $30k) the stop loss was not moved from the basic option price and the options continued to fall in value until the expiry date in March. Lessons learned Confirm and reconfirm ex-div dates before entering trades Theta is felt more in short-dated options. The value of the portfolio would not have been impacted by the full $30k if the options had been longer dated as the share price would have had time to rebound post dividend if the expiry had been longer out. Google On the same day; 16th February a mispricing was noticed in far out of the money Google options. The February 2012 call options were higher priced at a strike of 700 than 670 (and the share price at the time was around 620). The managers decided to trade on this anomaly as it was expected to correct and reverse; that is the price of nearer to the money options should cost more. As such a trade was constructed whereby the 700 were sold short in the market and the 670 bought with the proceeds, so the only cost was the initial fee and the stock borrowing costs. The bid-ask spread on the two cancelled out most of the potential gain if we expected the options to equalise, but as we thought the prices would reverse relative to each other there would still be sufficient room for profit. Market orders were placed during London trading hours, to be filled at the start of the US market. Due to the illiquidity of the market for the 670 options that side of the trade could not be filled at US trade start. The trade was sent in good faith and it was not realised until early on the 19th Feb, when the short position was covered and closed out. Lessons learned Acceptance of trade does not constitute a guarantee the trade will go through assume so Markets, and especially open positions need to be checked on a regular basis Apple Whilst researching the release of the upcoming iPhone and iPad 2 (which has since been released) in late February the managers noted concerns there would be delays in the launch date over those already expected, which had not hit the major news outlets. As such apple puts were bought in

it is not safe to

Market Timing
expectation of a fall in Apple share prices when the news hit the market. Added to this was the recent poor performance in the stock price, having fallen from 365 to 340 in roughly a week. Despite beating the news to the market the share prices rallied over the next week or so, picking up most of the losses they had shed, back up to 360 on 3rd March. At this point the managers took the view that the market had reversed and Apple would continue to trend upwards. The put positions were closed out at a loss of approximately 35%, and opposing call positions bought. The market reversed again and fell to 330, further than when the original put options bought. If the original options had been retained this position would have shown a profit over the trading period. Lessons learned It is good to have the willpower to close a losing position and reverse it if the market is heading in a different way, but that doesn t always mean you won t just make a bad decision the second time, and sticking with your original feeling may be the best bet. HSBC The managers took a directional bet on HSBC shares, learning from previous issues with very short option periods, and bought June expiry calls at a strike of 60, when the shares were at 56. Unfortunately the share price subsequently fell to 50 in March before rallying back to 54 in April. These options were the only open positions left at the end of the trading period and lost 80% of their value by the end of the trading period. Trading Performance Over the trading period the S&P gained 0.5% and the portfolio lost 7.31%. Though the managers managed to pick the wrong side in most trades the downside was limited to the option values and as such losses were limited. If large positions were taken in the underlying stocks the losses could have been even greater. If the managers had more time to devote to the active trading without other commitments, which posed the greatest barrier to profit of any of the restrictions, then we have no doubt the errors would have been spotted and rectified prior to causing any problems. If the trading period was extended we feel the loss could have been reversed and the 7.3% loss would not be indicative of annual performance.

Improvements to Strategy
What we would do differently if faced with the same task again? Try to apportion more time to the project; as other deadlines are now complete a repeat project would leave us with more time to devote to this project Utilise different platforms as Stocktrak does not offer the full functionality desired. If needing real time information, and the option to perform quick technical analysis on securities from all countries then utilising Bloomberg alongside the trading platform would be ideal Confirm all details before entering into a trade, specifically from the mistakes made the dividend dates, but any other details. Also confirm a trade has been executed as in low volume markets sometimes trades are accepted as a market order but there is no market to be counterparty for the trade. This can leave hedging strategies un-hedged. Respect the Greeks when option trading take into account the likely movement of share price over the short term if trading very short options, if the term is too small then there is significant erosion of value caused by Theta; the effect of time on option value Once an investment decision has been made and an effective stop-loss in place it is not advisable to reverse the play on market reaction as you do not give the market time to turn in the direction you initially called How would we get around any issues faced? Use a computerised system to keep track of ADR mispricing over all available ADRs, possibly expand to GDRs too, which would highlight opportunities to utilise the desired strategy more often Seek to find a broker with lower bid-ask spreads as this is the primary eroder of value we faced, and with different prices we could have entered into more profitable trades Automate Technical Analysis for stocks under manager s rules, possibly invest in a programme like Metastock or an Excel based tool which can filter share prices for those meeting specific predefined investment criteria Do we need better strategies? The strategies we looked to employ were sound; if we could eliminate some of the bid-ask spread and widen the range of ADRs we look at there is significant potential for profit on the trades Market-timing should only be done when you know a lot more about the market that the common investor, and unfortunately with the time constraints in place we were unable to get a significant edge in the market. If we were to repeat the task we would look to specialise in one or two areas and devote a great deal of time to investigating and understanding the market more fully before entering into any trades

Conclusion
The fund performed poorly over the trading period, losing 7.31%, which is an annualised loss of approximately 37% (as with reduction in capital the 3% rules get progressively smaller) and underperformed the modest 0.5% gain in the S&P500 significantly.

We feel, however that the full year results would not fall into loss as we would take the steps outlined to improve the efficiency of the trading, and being able to devote more time to the task, in terms of technical analysis for example, would improve the performance and turn a profit. As the ultimate aim is capital preservation, we would target a modest 10% gain over the year under these strategies, and would look to increasingly orient our trading on an ADR mispricing strategy rather than market timing, the latter producing volatile results. This exercise has made clear the need for full knowledge about a market before trading in relation to events, as the news is likely to already be encompassed in the price given efficient markets.