Berkeley-NUS CFE Program Topic 1 13 Dec 2006, Wednesday

By David Lee (email:dlee@ferrell.com.sg) And Wong Choon Yuan (email:wongchoonyuan@gmail.com)

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Objectives

Hedge Funds in the news Hedge Funds & Credit Derivatives Delta, Gamma & Vega Hedging with examples What is a Hedge Fund? Characteristics of Hedge Funds Some trends & fallacies regarding Hedge Funds Case questions

Hedge Funds in the news (1)

George Soros The Man who broke the Bank of England

On Black Wednesday (September 16, 1992), Soros Quantum Fund sold short more than $10bn worth of pounds and bought German marks, profiting from the Bank of England's (BOE) reluctance to either raise its interest rates to levels comparable to those of other European Exchange Rate Mechanism (ERM) countries or to float its currency. Finally, the BOE was forced to withdraw the pound out of the ERM and to devalue the pound, and Soros earned an estimated US$ 1.1 billion in the process. Soros Quantum Fund and other currency speculators were also blamed for the crash of the Thai baht on July 2, 1997, generally considered the trigger of the Asia's financial crisis. Soros denied personal responsibility for the crash and maintained he was actually buying, not selling, the Thai baht while it was falling.

ERM Crisis Sep 16, 1992 Black Wednesday USDGBP dropped 15% from 2 to 1.7

Asian Crisis 1997 THBUSD depreciated > 100%

Hedge Funds in the news (2)

Long-Term Capital Management (LTCM)

LTCM, founded in Feb 1994 by John Meriwether, made use of complex mathematical models for fixed income arbitrage and was initially immensely successful, delivering annual returns of almost 40%. The basic idea behind LTCMs convergence trades is to buy the cheaper 'off-the-run' bond and short the more expensive, but more liquid, 'on-the-run' bond, it would be possible to make a profit as the difference in the value of the bonds narrowed or converged when a new bond came on the run. Because these differences in value were minute, LTCM needed to take highly-leveraged positions in order to make a significant profit. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion. It had off-balance sheet derivative positions amounting to $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps. The downfall of LTCM started in May 1998 and was aggravated by the exit of Salomon Brothers from the arbitrage business in July 1998. The scheme finally unraveled in August and September 1998 when the Russian government defaulted on their government bonds. Panicked investors sold Japanese and European bonds to buy U.S. treasury bonds. The profits that were supposed to occur as the value of these bonds converged became huge losses as the value of the bonds diverged. This flight-to-liquidity phenomenon resulted in total losses of $4.6 billion and prompted a bail-out of $3.625 bn by the banks, organized by the Federal Reserve Bank of New York, to avoid a wider collapse in the financial markets.

John Meriwether

Myron Scholes

Robert C. Merton

Hedge Funds in the news (2)

LTCM: When Genius Failed

Hedge Funds in the news (2)

LTCM & Beyond

John Meriwether now runs JWM Partners, a Greenwich, Connecticut, hedge fund he started with about 250 million dollars under management in 1999, and with approximately $2 billion under management in 2006 according to Meriwether's SEC registration. Myron Scholes is currently Chairman of Oak Hill Platinum Partners. Robert C. Merton is a professor at the Harvard Business School. Robert Merton shut down his firm's latest fund after three months because it did not raise enough money. Merton's Integrated Finance closed the IFL Continuum Fund in June 2006. The fund, which concentrated on credit securities, had collected $30 million since its start in March 2006.

John Meriwether

Myron Scholes

Robert C. Merton

Hedge Funds in the news (3)

Hedge Fund Blowout: GM/Ford Credit Shocks

The downgrades of GM and Ford debt in 5 May 2005 sparked speculation about big losses at some hedge funds and even dented equity markets amid concern that the troubles could spread to investment banks that provide trading and other services to the industry. The credit fund of GLG Partners, one of the largest hedge funds in Europe, lost more than 14% in May because the firm's trading model failed to accurately predict how the automakers' bonds, and derivatives linked to that debt, would react to a downgrade.The debt downgrades knocked two types of credit-derivatives trades popular with hedge funds.One was a bet that GM bonds would perform better than the automakers' shares if the company filed for bankruptcy. To try to make money on this expectation, hedge funds sold GM shares short and either bought GM bonds or sold GM credit-default swaps. When S&P cut its rating on the automaker's debt, GM bonds fell and credit-default swap spreads widened sharply by 24% from 875bps to 1086bps. But the company's shares also rose by >20% when Kirk Kerkorian announced he would bid for a stake in the firm. That handed hedge funds losses on both sides of the trade. The other popular hedge-fund trade was correlation trade involving collateralized debt obligations (CDO), which are pools of different corporate credits that are repackaged and sold off in different slices, or tranches. Each CDO tranche has a different level of risk and offers a different return, with the most risky portions paying the most. Credit hedge funds often buy the riskiest "equity" tranches (long correlation) and sell short the sturdier, "mezzanine" slices (long correlation). The intention is to tap into the higher return offered by the equity tranche, while hedging against broad market moves by shorting the mezzanine tranche. These trades assume that the different tranches are correlated and will move in sync, allowing hedge funds to make money from the difference between the higher return offered by the equity tranches and the lower return paid by the mezzanine portion of the CDO. The idea was that one position would hedge the other pretty well as long as the environment for credit changed in unison. After GM and Ford's bonds were cut to junk, the correlations broke down and some CDO tranches moved in different directions. These were disastrous trades for hedge funds that were in it.

Kirk Kerkorian 9

GM share price spiked by > 20% from $27 to $33 in May 2005

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GM 5Y CDS spread jumped 24% from 875bps to high of 1086bps in May 2005

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Hedge Funds & Credit Derivatives

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So how do Hedge Funds speculate on credit? (1)

Contingent Payment Investors CDS Market Increased Fee required by CDS market for new default swaps on XYZ

Corporate XYZ (poor outlook)

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So how do Hedge Funds speculate on credit? (2) Example 1

For example, an investor could have sold protection on Ford in October 2002 at around 650bps and closed out the deal in January 2003 at 400bps, making 250bps (hindsight is a wonderful thing see figure on the right). This is effectively the same as buying Ford bonds (but without the duration risk). Alternatively, an investor could have bought protection on Ford around June 2002 at 200 bps and closed it out later in October 2002 at 650bps, a gain of 450bps. Buying protection is effectively the same as shorting the credit, but with much less hassle.
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So how do Hedge Funds speculate on credit? (3) Example 2: Relative value trades

Here, for example, is an intra-sector trade idea : Ford/GM basis. When the Ford/GM spreads diverge too much, sell Ford protection and buy GM protection in the expectation that spreads will come back together. Alternatively, when the spreads are too close to each other, buy Ford protection and sell GM protection.
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What are CDOs?

In CDOs, portfolio of bonds or CDS is placed into a SPV, which issues several tranches of notes of different ratings / credit risk. Defaults in underlying will affect coupon and principal payment of equity tranche (unrated) first, followed by mezannine (BBB) and senior tranches (AAA). The CDO seller buys credit protection (short credit) on the reference pool and the investors in the CDO tranches are sellers of credit protection (long credit).
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Concept of correlation in CDOs (1)

Chart 1 Chart 2

Chart 3

Chart 4

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Concept of correlation in CDOs (2)

Chart 1: With low correlation the Chart 2: For medium correlation the assets are more or less independent assets are more likely to default and there is a low probability of large together and the distribution of the losses, low probability of zero losses tail is longer more risk in senior spread on senior tranche is small, tranche, larger senior spread than spread on equity tranche is large. before; probability of zero losses has increased, equity less risky and equity spread smaller than before. Chart 3: For high correlation the Chart 4 portfolio behaves like one asset with Equity: Decreasing spread with increasing zero diversification, the names either correlation. You long correlation when you buy equity tranche (you profit as correlation goes all default or all survive. The up but you still collect higher equity tranche probability of a large number of premium & likewise you short correlation when losses is significant, the spread for you sell equity tranche) Mezzanine: Rising spread with increasing senior tranches is relatively large; probability of zero losses is very high correlation. 18 Senior: Flat to rising spread with increasing so equity spread is small.
correlation.

Delta, Gamma & Vega Hedging with Examples

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The Greeks: Delta,

Delta, , is the change in the price of an option for a 1-point move in the price of underlying. Another interpretation of (or N(d1) for call) is the number of units of stock you must hold in a continuously rebalanced portfolio that replicates the payoff of a call.
Far from expiration, eg. 1 yr call

Near expiration, eg. 1mth call

Call 0<<1 ITM ATM OTM +1 +0.5 0

Put -1 < < 0 -1 -0.5 0

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Delta Hedging, portfolio = 0

For a European option with no dividend: (call) = N(d1) (put) = N(d1)-1 where
ln(S0 /K) + (r + ( 2 / 2))T d1 = T

Delta of a call > 0, to delta hedge, long [N(d1)x100] shares, short call on 100 shares Delta of a put < 0, to delta hedge, long [(N(d1)-1)x100] shares, long put on 100 shares

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Delta Hedging, portfolio = 0

For a European FX option with foreign risk-free rf: (call) = e -rfT N(d1) (put) = e -rfT [N(d1)-1] where
ln(S0 /K) + (r - rf + ( 2 / 2))T d1 = T
Example: Calculate delta of a 3 mth put on EUR (or call on USD) with strike = 1.20, EUR risk free = 3.3%, USD risk free = 4.8%, spot EURUSD = 1.27, vols = 15%

ln(1.27/1. 20) + (0.033 - 0.048 + (0.15 2 / 2))0.25 d1 = 0.15 0.25

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Delta Hedging, portfolio = 0

Similarly, for a European stock index option with dividend rate, q: (call) = e -qT N(d1) (put) = e -qT [N(d1)-1] where
ln(S0 /K) + (r - q + ( 2 / 2))T d1 = T

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Costs of Dynamic Delta Hedging, portfolio = 0

But delta is time-variant! Delta floats with the spot. Eg. In the case of a call, as it gets more ITM with a rise in spot, +1 , you need to rebalance the portfolio by buying more shares. This incurs significant transaction costs, especially if the rebalancing is done frequently! (ie. Daily) In addition, delta fluctuates the most near ATM, so that means more frequent rebalancing!
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Example on Delta Hedging, portfolio = 0

You have a portfolio valued at $34,553,799 and your portolios beta (wrt NASDAQ-100 index) is 1.65. You want to hedge your portfolio by buying 3 month put on NASDAQ-100 with strike of 95 and spot NASDAQ-100 at 95.63 with risk free at 5.97% and vols at 36.12% with 47 days to expiration. Calculate the number of put contracts required for the hedge and the resulting cost of this put hedge and draw the payoff diagram.
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Example on Delta Hedging, portfolio = 0, payoff diagram

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Example on Delta Hedging, portfolio = 0

Using Black Scholes, put premium = $4.26 No. of equivalent NASDAQ-100 shares representing your underlying portfolio: = x Portfolio Value
= 600,145

ATM Put Strike Price 1.65 x34,553,799 = 95

We also derived put delta to be 0.4365 No. of put contracts required =(600145 / 0.4365) / 100= 13749 since one put contract is for 100 shares. Hedging cost = 1374903 x 4.26 = $5843338 or 17% of your 27 portfolio value which is a high price to pay for a hedge!

Example on Delta Hedging, portfolio = 0

Market Impact Buying 13749 put contracts will artificially drive up put premiums, as put volume ~30k!

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The Greeks: Gamma,

Gamma, is the change in an options delta for a 1-point change in the price of the underlying. Gamma is also called curvature or convexity. Gamma is nonnegative for standard calls & puts (ie their deltas rise with increasing S). From put-call parity, gamma of call is same as gamma of put.
Far from expiration, eg. 1 year call Near expiration, eg. 1mth call

Long: > 0 For a European call or put with no dividend, gamma is:
N ' (d1 ) S 0 T

Short: < 0
1 e 2
d12 2

where N ' (d1 ) =

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Delta-Gamma Hedging, portfolio = portfolio = 0

You have sold 1000 shares of a stock short. The stock is currently at $100. How many call options at $10.5193/call with strike of $100 would be bought/sold to hedge this position if the delta of the call option is 0.5695? Now assuming that the stock price moves to $120. What is your net position? With the stock price at $120, how would you create a delta-gamma neutral position?

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Delta-Gamma Hedging, portfolio = portfolio = 0

The number of call contracts required to delta hedge is 1/ * (No. of shares to hedge) / (Contract size) = -1 / 0.5695 * (-1000) / 100 = 18 You would buy 18 calls at total cost of 10.5193*18 *100 = 18935. Now if the stock price jumped to $120, the change in value of call should be equal to call delta times change in underlying = 0.5695*20 = 11.39. You have 18 call contracts, so they went up by 11.39 * 18 * 100 = $20502 But your stock portfolio went down by 1000 * 20 = 20000 so you are a bit over-hedged. Is this correct? Think again!

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Delta-Gamma Hedging, portfolio = portfolio = 0

Note that when the stock price spiked to $120, the actual call delta will also change to 0.8171 and not static at 0.5695! And the new call premium will be $24.6194 as the call gets deep ITM! So the actual call will appreciate by (24.6194-10.5193) * 18 * 100 = 25380. You need to watch your deltas closely as underlying spot changes! To gamma hedge, we need to add a new position in another call option with a different strike. Because a position in the underlying share or even a forward position will have zero gamma and does nothing to change gamma of entire portfolio.

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Delta-Gamma Hedging, portfolio = portfolio = 0

To create a delta-gamma neutral portfolio, we have to satisfy 2 equations at strike price, S1 and S2.
Delta neutral Gamma neutral position : N S + S 1 N S 1 + S 2 N S 2 = 0 position : S 1 N S 1 + S 2 N S 2 = 0

N represents no. of shares held or no. of number of call contracts, we choose strike S1=100, S2 = 120, and 100 = 0.0088, 120 = 0.0131. Solving the two equations, we need to short 16 contracts of 120-strike call and long 23 contracts of 100-strike call to create delta-gamma neutral portfolio.

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The Greeks: Vega,

Vega, is the change in the price of an option for a 1- point increase in volatility of underlying.
Near expiration, eg. 1mth call Far from expiration, eg. 1 year call

Long: > 0

Short: < 0
d12 2

For a European call or put with no = S T N ' (d ) where N ' (d ) = 1 e 0 1 1 dividend, vega is: 2

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Delta-Gamma-Vega Hedging, portfolio = portfolio = portfolio = 0

Consider a portfolio that is delta neutral, with gamma of 5000 and vega of 8000. Next we select 2 options with the following characteristics. The first option has gamma of 0.5, vega of 2 and delta of 0.6. The second option has gamma of 0.8, vega of 1.2 and delta of 0.5. To make the portfolio gamma & vega neutral, we solve the following equations. Gamma neutral: -5000 + 0.5(w1) + 0.8(w2) =0 ....Equation 1 Vega neutral: -8000 + 2(w1) + 1.2(w2) = 0...Equation 2 Solving the 2 equations gives w1=400 and w2=6000 Delta of these 2 options combined = 400x0.6+6000x0.5=3240 Hence, 3240 units of underlying asset need to be sold to maintain portfolio delta at zero.
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Realities of Hedging (1)

In the real world, it is not possible to maintain delta-gamma-vega neutral all the time because it will be prohibitively expensive to do so and it is also difficult to find options or other nonlinear derivatives that can be traded in the volume required at competitive prices. Nonetheless, there are larger economies of scale if we try to maintain delta neutrality for an entire portfolio instead of a single trade because the cost of rebalancing can be offset by profits on other trades. Typically limits are defined for each Greek letter and permission is required if a trader wants to exceed a limit at the end of a trading day. Breaching limits can cost your job! As a matter of course, options traders make themselves delta neutral or close to delta neutral at the end of each day. Gamma and vega are monitored but are not usually managed on a 36 daily basis.

Realities of Hedging (2)

Banks often find that their business with clients involves writing options, as a result they accumulate negative gamma and vega. Thus banks are always looking out for opportunities to manage their gamma& vega risks by buying options at competitive prices. Recall the gamma & vega graphs in previous pages, gamma & vega tend to be at their peak when ATM. Options are typically close to money when banks first wrote them, so at the initial stage, these options tend to have high gamma & vega. However, after sometime, the underlying spot has often changed enough for the options to be either OTM or ITM, rendering the gamma & vega to be small and of little consequence. Of course, the nightmare scenario for an options trader is when written options remain very close to the money as the maturity date is 37 approaching!

Listamania!
1. Options, Futures & Other Derivatives (6th edition) by John C. Hull 2. The Complete Guide to Option Pricing Formulas by Espen Gaarder Haug 3. Implementing Derivatives Models by Les Clewlow and Chris Strickland 4. Exotic Options: A Guide to 2nd Generation Options by Peter Zhang 5. Heard on the Street: Quantitative Questions from Wall Street Job Interviews by Timothy Falcon Crack 6. VAULT GUIDE to Advanced Finance and Quantitative Interviews by Jennifer Voitle 7. My Life As a Quant by Emanuel Derman 8. Advanced modelling in finance using Excel and VBA by Mary Jackson and Mike Staunton
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Lets break now for 15 minutes & return me your group name list by end of break, thank you.
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What is a Hedge Fund? Characteristics of Hedge Funds

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History of Hedge Funds (1)

From Alfred W. Jones to 2000s

US based Australian, Alfred W. Jones, is attributed as setting up the first hedge fund in 1949 - The fund used short-selling, leverage and had a performance fee Long/Short hedge fund managers still refer to the Classic Jones model to describe their strategy.

Although the Jones fund closed in the 1950s, there was significant growth of hedge funds during the 1960s. The first fund of hedge funds, Leveraged Capital Holdings, was launched in 1969. Growth slowed in the 1970s following the oil crisis but picked up in the 1980s, with an explosion in the number of hedge funds in the 1990s and through into the 2000s.
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The Jones Nobody keeps up with

History of Hedge Funds (2)

Jones started his first equity hedge fund after raising $100,000 (including all of his $40,000 personal wealth). Jones relied on 2 assumptions when setting up his fund: - Jones was convinced that he had superior stock-picking skills - Jones believed he had no market timing skills, he cant predict market directions Therefore, Jones focused on going long on undervalued stocks and shorting overvalued stocks but profits were small and Jones leveraged up to magnify his profits by using the proceeds from the short position to finance purchase of his additional long positions. Jones fund has no management fee but charged a 20% performance fee. On investments left with Jones during the five years ending 31 May 1965, Jones made 325 percent. Fidelity Trend Fund, which had the best record of any mutual fund during those years, made only 225 percent. For the tenyear period ended in May 1965, Jones made 670 percent; Dreyfuss Fund, the leader among mutual funds that were in business all during that decade, had only 358 percent gain. Jones success sparked the interest & growth of hedge funds in 1960s. 42

Hedge Fund Jargon! (1)

Short selling - Sale of borrowed securities (overvalued) in a cost-efficient Hedging - Not restricted to perfect hedge, eg. short IBM + long IBM - Can be done more cost efficiently by shorting S&P futures +
manner, and subsequent repurchase at lower price. Watch out for regulatory restrictions, short squeezes

long 2500 IBM shares, focus on minimizing cost but beware of the shift in correlation between IBM & S&P!

Arbitrage - Exploiting temporary price discrepancies between markets - Underlying assumption is historical relationships hold true for
the future but what if you are wrong?
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Hedge Fund Jargon! (2)

Leveraging - Amplifier of profits or losses! - Achieved via borrowing money or placing collaterals (margin) to enlarge your effective exposures. Due ever-increasing efficiency of the market, returns on arbitrage trades are too small, hence, HF leverage up to enhance return.

Absolute return - Beat the cash rate, not a benchmark (mutual fund) Alpha - Return generated above that of market by the HF manager Liquidity - Exit without difficulty and without much price impact, no problem
finding counterparties.
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What is a Hedge Fund? (1)

There is no standard legal definition, too much diversity in HF Hedge Fund describes an investment structure for managing a private unregistered investment pool This structure charges an incentive-based fee that compensates the fund manager through a percentage of profits the fund earns Absolute return focus Exemption from securities registration limits the number of participants who must be accredited investors or institutional investors Limited regulation & high barriers to entry for investors All hedge funds are not alike, managers usually specialize in one of a diverse number of alternative investment strategies operated through the hedge fund 45 structure

What is a Hedge Fund? (2)

In the past, hedge fund described both an investment structure - a commingled investment fund - and a strategy - a leveraged long portfolio hedge by stock short sales Today, it only describes the investment structure - like the term mutual fund - not what it invests in. In summary, it can be identified by the presence of the following: - Invests both long & short - Use leverage & derivatives - Managers own money is invested in the fund - Fee structure emphasizes performance and aligns interest of HF managers and investors, absolute return focus - Flexible investment mandate (focus on making money & not restricted to just beating a particular benchmark!) - Limited regulation
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Hedge Fund Vs Mutual Fund (1)

A hedge fund goal is to turn market opportunities into investment return - no different from mutual fund Hedge Fund differs from Mutual Fund - in the range of allowable investment approaches - the goals of the strategies that they use - the breadth of tools and techniques available to investment managers to achieve those goals

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Hedge Fund Vs Mutual Fund (2)

Hedge Funds Risk Return Potential loss of invested capital Unit trusts Deviation/tracking error from a benchmark

Aim to deliver absolute returns, depends Aim to deliver relative on skill of hedge fund managers, returns, depends on mandate to beat the cash rate performance of asset class, regardless of how well/bad the market, relative return targets, highly low correlation with market, non-linear correlated to returns of returns-(optionality) standard asset classes. Flexible, uses long & short, leveraged, dynamic trading strategies, choose among various asset classes Pegged to performance, watermark feature, make up for previous losses before getting paid. Limited, long only, restricted use of leverage, buy-andhold Pegged to AUM ie management fees
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Investment Strategies Fees

Hedge Fund Vs Mutual Fund (3)

Hedge Funds Unit trusts Life span & Averaging about 3.5 years, very Comparatively longer life span. size few survive > 10 years, more than 50% HF AUM < 25 million, restrict fund size because of diseconomies of scale Liquidity Investment Size Regulation Liquidity restrictions and initial lock-up periods (eg. 2 Years) Usually large minimum initial investment of US$1 million Good liquidity Small minimum initial investment size of US$1000

Less regulated, less mandated Highly regulated, restricted use disclosure, limited risk exposure of short selling and leverage, transparency, restrictions in high disclosure and marketing funds publicly transparency, can market fund publicly. 49

Why are Hedge Funds so mysterious? (1)

Exemption from Investment Act 1940 and subsequent rulings In return for this, HF: - Can go short - Can use leverage - Can use derivatives - Do not have to report their positions

But: - They are not allowed to advertise publicly - They can only deal with qualified investors
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Why are Hedge Funds so mysterious? (2)

Because hedge funds do not want to report their positions, they are regarded as: - Mysterious - Speculative - Secretive So why dont they want to report? - Their positions are their primary added-value. - If others knew those positions they could take
advantage by copying them or front-running them at the exit or blocking them from trade they want to do

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Recent performance of Hedge Funds Really?

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Positive Absolute Returns but what about beating the market? Its all a matter of data!
Underperformed t the Marke Underperformed t the Marke

2000-2002 Watershed Period for HFs

2.1% Return vs. 43.8% Losses

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Size of the industry

With AUM at 1.5 trillion dollar (reported by FT July 2006) and average hedge funds leveraging their positions up 15 to 20 times, the actual positions taken up by the entire hedge fund industry is larger than the GDP of USA! (~US$12.5 trillion) 54

2004 Hedge Funds Ranking by AUM Top 10

Fund Name Caxton Associates (New York, NY) GLG Partners (London, U.K.) Citigroup Alternative Investments (New York, NY) Farallon Capital Mgmt (San Francisco, CA) Citadel Investment Group* (Chicago, IL) Angelo, Gordon & Co.* (New York, NY) Vega Asset Mgmt (Dublin, Ireland) Andor Capital Mgmt* (New York, NY) Soros Fund Mgmt (New York, NY) Bridgewater Associates (Westport, CT)
Source: University of Pennsylvania

AUM (US$ million) 11,500 11,017 9,900 9,856 9,500 9,000 8,500 8,300 8,300 8,061
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Asian Hedge Funds see explosive growth FT 24-Jul-06

Fund Name Sparx Asset Management (Tokyo) PMA Capital (Hong Kong) Applebys ADM (Hong Kong) Ward Ferry (Hong Kong) Penta (Hong Kong)

AUM (US$ million) 5,200 2,100 1,440 1,400 925

AUM of top 25 Asian-based HF: US$23bn Size of Asian HF pales against US HF (eg. Goldman Sachs Asset Mgmt Hedge Fund Strategies Group & Bridgewater Associates: AUM US$20bn each.) # of Asian HF quadrupled to > 700 since 2002, AUM soared 10-fold to US$120bn (souce: Eurekahedge, GFIA) Reason behind Asias growth due to investors enthusiasm for EM (eg. In 2005, MSCI Far East Index (22.5% return!) vs S&P500 (4.9% return) and MSCI Europe Index (6.5% return)
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The Asian Hedge Fund Dilemma

Source: Eurekahedge

Only 5% of Asian HFs are invested by Asians and 40% of Asian HFs are invested by the Swiss.

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Number of Asian HFs vs AUM

Average AUM for Asia-based HFs : US$75 million est

Source: Eurekahedge

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Location of Asian Hedge Fund Managers Singapore ranks

fifth in highest number of Asian HF managers, ahead of Japan.

Source: Eurekahedge

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Average Asset Size of Funds by Location (USD M)

Singapore has a lot of catching up to do in terms of average AUM!

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Hedge Fund Strategies

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Relative Value Arbitrage

Not all Market neutral HF have absolute zero correlation with market, even though it has 50% long and 50% short positions. Research shown than market neutral HF has correlation of 0.3 with market.
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Event Driven

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Equity Hedge

Difference between EQ long/short vs Market Neutral: EQ L/S example: long LCD company, short disk drive company in a different sector, still directional. Market neutral example: long undervalue company , short overvalue company in the same 64 sector, low correlation with market. Even if market slumps, in the long run, profit still positive.

Global Macro

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Asia Hedge Funds by Strategy

Dominance of Long/Short Equities tied to ability to short equities & liquidity in Asian markets. We will talk more about HF strategies later on!
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Why invest in Hedge Funds?

Superior returns (Caution: no guarantee!) - A lot depends on strategies used, skills of HF

managers

Low correlation with traditional asset class - Regarded as low risk profile, risk diversifier for the
portfolio

Positive absolute returns even in bear market, & even in volatile market - Not just beating market indexes (Caution: it depends
again!)

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Low average correlation of Hedge Funds

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Problems for HF investors

Key to investing in HF: Research, Research, and Research! But good research is not guarantee to selecting best HF managers. You cannot be passive investor in HF. And there are so many HFs that are mushrooming fast everywhere and many of them closing or closing quickly as well. (eg.Mertons IFL Continuum Fund closed in June 2006 just after 3 months!) Its hard to get info on the fund itself, its managers, its strategies etc. For traditional funds, if you pick a mid-cap growth fund and if this is a good year, your return will be some positive number. But for hedge funds, if you pick a relative value hedge fund, you may lose even when other relative value funds are profitable because it depends on the individual HF managers skill. 69

But there are a lot potential for HF managers!

Wake-up call for pension funds came with decision of the California Public Employees Retirement System (Calpers) to commit $11bn in alternative investments, including $1bn to HF. Demand for HF are rising for institutional clients. 60% of US foundations & endowments invest in HFs 20% of US Pension funds invest in HFs, but that amounts to only 1% of their 5 trillion wealth, so imagine the potential! Non-US pension funds have 3.9 trillion of wealth and their allocations to hedge funds are rising.
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HF characteristics revisited (1)

HF are securitized trading floors - Many HF managers have a trading or investment

banker background. HFs gave them the opportunities to start doing for their own account what they had been doing for many years in large I-banks. Following 1998 Asian crisis, a lot of I-banks became nervous of proprietary trading and farmed out a lot of their prop trading activities to HFs, shrinkage in prop trading desks in I-banks translated to growth of HFs.
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HF characteristics revisited (2)

HF managers are partners not employees - HF managers have a personal stake in the fund and

combined with performance fee, their interests are supposedly aligned with that of the investors. But personal wealth commitment can have side effects so beware! When the fund first started out, HF managers have little to lose, they may be tempted to take on excessive risk! A successful fund manager at the end of his career will have so large a personal stake in the fund that he will refrain from taking risks, even though he is well remunerated! 72

HF characteristics revisited (3)

HF strategies are not scalable - Unlike mutual funds which thrive on large AUM for

high management fees, HF relies on manager skills & available investment opportunities that are not scalable. Smaller may be better! Some HF managers prefer to close their funds to new subscriptions once they reached their target AUM. Eg. Julian Robertsons Tiger Management fund which went from a peak of $22bn to $6.5bn AUM when it closed in early 2000.
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HF characteristics revisited (4)

HF target specific investors - Legal limits on max # of investors per HF implies large

minimum capital investment ($100k to $1million) per investor to ensure fund has sufficient capital to operate efficiently & properly. Small retail investors typically do not understand complex HF strategies Regulation limits that only sophisticated investors are allowed to invest in HF. HFs are risky investment pools and regulators have duty to protect the small time retail investors.
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Trends and Fallacies of Hedge Funds

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Some common fallacies regarding HFs (1)

HFs generate strong returns in all market conditions - In reality, it depends on HF strategies used - eg. Between Jan 94 Dec 98, market neutral / event driven / equity long short funds all generated annual returns > 10% but Emerging market HF only generated 2.3% due to emerging market events in late 98 (Asian crisis cum Russian default)

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Some common fallacies regarding HFs (2)

HFs reduce exposure to U.S. stock market / S&P 500 index - It ignores S&Ps tidal effect on all financial markets - This claim is based upon limited history, at no point

since late 1980s have we seen a period of sustained bear market to test majority of HF managers. Over 18 years between Nov80 to Dec 98, 43% HF returns were within +/- 1% of S&P and over 60% HF returns were within +/- 2% of S&P, though this is nonconclusive but we should question HFs claim low exposure to S&P.
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Some common fallacies regarding HFs (3)

HFs are safer than traditional assets - Impt to distinguish between correlation & exposure - Low correlation to the market and no exposure to the

market are not the same thing When you long S&P, correlation +1 When you short S&P, correlation 1 When you alternate between long & short each month, regression coefficient will be ~zero as long marketshort market correlation averages out but you are still subjected to risk of S&P!
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Case Questions

Note the following questions only serve as an indicative guide in approaching the various case studies & readings. There are bound to be other issues that are not covered by the following questions, so feel free to explore them! Remember assessment of your group presentation depends on your delivery, content, research into related areas not covered by the case, your independent recommendations and critique and your ability to answer questions during the presentation.
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Case 1: Pine Street Capital

Analyse the case from the position of Harold Yoon, Managing Partner of Pine Street Capital as at 26 July 2000. Some issues to discuss:

- What risks does PSC want to hedge and what risks is PSC willing to

bear? Why? How would you hedge these risks on July 26 using a short-selling strategy? What problems arise with the short-sale strategy? (Hint: PSC hedge by short-selling the NASDAQ index. What happens to this hedge when volatility increased?)

PSC is considering using options for its hedging program.

- Can options-based hedging of market risk help with problems that may arise with the use of short-selling hedging strategy? How? How would one hedge PSCs portfolio on July 26 using options? (Hint: use the concepts of delta and gamma)

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Reading 4: An Evaluation of Hedge Funds: Return, Risks & Pitfalls

What are hedge funds? Describe the size of the hedge fund industry and its recent performance in terms of AUM and returns vs typical equity benchmarks. Describe the various hedge fund strategies Why invest in hedge funds? Discuss the challenges and sampling bias in hedge funds data Discuss the nature of hedge fund returns in terms of mean, variance, skewness, kurtosis and correlation What are the ways to measure risk and return of hedge funds? What are some of the practical challenges in hedge fund performance measurement?
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Case 2: Common Fund HF Portfolio

Analyse the case from the position of David Storrs, President of The Common Fund as at January 1994. Some issues to discuss:

Risk and return profiles of Hedge Funds Recent boom in hedge funds Can good returns continue? Structural issues: high fees and lack of transparency?

How should David Storrs structure the new Common Fund Hedge Fund?

- How to meet the divergent needs of consortium members? - Portfolio management considerations: economics, asset allocation, -

etc? Fund of funds or style-dominant fund? Selection of Hedge Fund Mangers? What is the implicit and explicit risk exposure of The Common Hedge Fund?

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Case 3: LTCM

Read all 4 cases LTCM (A), (B), (C), and (D) but focus on (C). The other cases are provided to you as background. Also read Jorion Risk Management Lessons from Long-Term Capital Management (http://www.gsm.uci.edu/~jorion/papers/ltcm.pdf) Describe in detail one of the typical transactions undertaken by LTCM listed in Exhibit 1. Make sure you describe the financing of the positions, and when one would undertake them. Make sure you describe also the way in which the positions would be unwound and when one would unwind them. Which are the players involved in the transaction and in its outcome? Analyse exhaustively the gamut of unfavourable events that can affect the profitability of this trade from the point of view of LTCM. Generalising from this one example, can you speculate about what went wrong at LTCM? Did they have too much leverage. What is a liquidity crisis? What should LTCM have done differently? Did they make any mistakes? Do you agree with their risk management principles? Are there dimensions of risk that are priced by the market but were overlooked by them? Was LTCM too large?
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Reading 3: CTA Strategies for Returns-Enhancing Diversification

What are CTAs, what are their return characteristics in terms of mean, standard deviation, downside deviation, skewness, kurtosis, Sharpe ratio & Sortino ratios? Describe the data and methodology used for researching CTAs in the paper and what are the findings and observations? What are the benefits of adding CTAs to stocks & bonds portfolio? Why do CTAs have negative correlation? What about adding CTAs to hedge funds portfolio? What are the factors to consider before investing in CTAs?
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Reading 2: Equitable Performance Fees for Hedge Funds

Discuss

the various problems that can arise in an incentive fee contracts for hedge funds What is the structure that is equitable to both managers and investors, as well as fair across investors?
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Case 4: Massachusetts Financial Services

Highlight differences in performance evaluation of MFSs managers & that of a hedge fund. What are the pros & cons with the existing reward system? What are the arguments for & against starting a HF in MFS? Do you think MFS portfolio should continue to have allocation to HF? Why or why not? State your basis and justify.
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Reading 1: The Omega Measure: Hedge Fund Portfolio Optimization

Discuss the statistical properties of hedge fund returns Discuss the conventional frameworks for the investment decision problem Discuss the new framework of the omega measure. Discuss the portfolio optimisation in the omega framework.

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Points on midterm quiz and final exam

Midterm close-book quiz (7 Oct morning) will consist of 20 MCQ, coverage is lecture 14, including the Pine Street Capital case study & reading P4 (Return, Risks & Pitfalls of HF) Final exam (mid-Nov) covers all lectures, all case studies (C1-4) and all readings (P1-4).

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Next lecture...

The case for Hedge Fund investment in Asia Main Risks in HF investment Minimizing Regret and Avoiding Misfortune Regulatory & Legal environment for Hedge Funds Organizational structure of Hedge Funds Funds of Hedge Funds

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Thank you, goodnight and see you on Saturday

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