Asset Management

1. Asset Management Lecture 18

2. Outline for today • Hedge funds • General introduction • Styles • Statistical arbitrage • alpha transfer • Historical performance • Alphas and betas

3. 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

4. Industry Size

5. Styles

7. 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

8. 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.

9. 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.

10. 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.

11. 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

12. 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

13. Pure Play Example • Manage a $1.5 million portfolio • Believe alpha is >0 and that the market is about to fall • Capture the alpha of 2% per month • β = 1.20 S&P 500 Index is S0 = 1,440 • α = .02 • rf = .01 • Hedge by selling S&P 500 futures contracts • S&P 500 futures contracts: $250 each

14. Pure Play Example The dollar value of your portfolio after 1 month: The dollar proceeds from your futures position: 3% return Non-systembatic risk

15. Historical Performance

16. Historical Performance

17. Hedge Fund Alpha Hedge Funds Spring 2008 17

18. Alfas and betas Measure fund performance using regression: Beta measures how fund goes up and down with the market i rmtmeasures 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)

19. 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, it’s 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

20. 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

21. 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)