978-0077502249 Chapter 20 Lecture Notes

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Chapter 20 – Hedge Funds

CHAPTER TWENTY

HEDGE FUNDS

CHAPTER OVERVIEW

While mutual funds are still the dominant type of investment fund, hedge funds enjoyed much

faster growth until the financial crisis of 2008. In 1997 assets under management were about

$200 billion; this number peaked at about $2 trillion before the downturn in 2008 reduced the

number to $1.6 trillion. Hedge funds are organized as private partnerships and are not subject to

SEC disclosure requirements. Hence many people have only a limited understanding of what

these funds do and particularly have little idea about their risk adjusted performance. The chapter

provides an overview of different hedge fund strategies before turning to evaluating hedge fund

performance. Hedge fund alphas and Sharpe ratios are presented and problems with interpreting

these measures are presented. The chapter covers hedge fund fees and their effect on

performance, particularly for funds of funds. The chapter concludes with a brief discussion of the

Madoff scandal.

LEARNING OBJECTIVES

After studying this chapter students should be able to differentiate between directional and non-

directional strategies and state several of each. Students should understand a pure play strategy

such as alpha capture while hedging out fundamental risk. Readers should have knowledge about

some of the problems involved in evaluating hedge fund performance and should understand the

value and effects of incentive fees. After completing the chapter students will be far more familiar

with this industry and will be able to sort out the myths and the facts about hedge funds.

CHAPTER OUTLINE

1. Hedge Funds versus Mutual Funds

PPT 20-2 through PPT 20-3

Mutual funds are regulated under the SEC Act 1933 and the Investment Company Act of 1940

and they must invest according to the stated goals in the prospectus. They are adjured to avoid

‘style drift.’

Characteristic Mutual Funds Hedge Funds

Transparency Public info on portfolio

composition

Info provided only to

investors

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Strategies

limited short selling &

leverage, limited

derivatives usage

No limitations

Liquidity Redeem shares on demand Multiple year lock up

typically 0.5% to 2%

gains above threshold

return

Notes to the table:

Some mutual funds can engage in short selling, but not to the extent that hedge funds can. The

lock up period employed by some hedge funds allows the funds to invest in less liquid assets and

2. Hedge Fund Strategies

PPT 20-4 through PPT 20-7

Text Table 20.1 provides a comprehensive list of hedge fund strategies. Hedge funds employ both

directional strategies and non-directional strategies. A directional strategy is a position that

benefits if one sector of the market outperforms another, an unhedged bet on a price movement.

capture the increase in price of the corporate bonds as their yield falls when the spread narrows

and you capture the price drop on the Treasuries that occurs when their yield rise. The offsetting

long and short positions limit risk from interest rate moves. This position is said to be market

neutral with respect to overall interest rates. Directional strategies are riskier, but neither is

riskless. The strategy described above is termed an intermarket spread strategy or a convergence

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Chapter 20 – Hedge Funds

Convertible bond arbitrage is a type of risky arbitrage strategy. If the fund thinks the convertible

is underpriced it would buy the convertible and short the stock and then wait for the mispricing to

strategy requires fast trading and low transactions costs. An example of this is so called “Pairs

Trading” where the fund attempts to find two ‘twin’ stocks and then shorts the high priced one

and buys the low priced one. The fund places small bets on large numbers of pairs hoping to rely

on the law of large numbers.

3. Portable Alpha

PPT 20-8 through PPT 20-12

Suppose a fund finds a positive alpha stock but the fund expects the overall market to fall. This is

called fundamental risk. The solution is to buy the stock and sell stock index futures to drive the

The example assumes the hedge termination date is the futures contract expiration date. That is

why we get convergence. The two terms with rM cancel out and we effectively have a zero beta

position.

Step 3: Verify that the return captures the alpha of 2% (plus the risk free return of 1%).

4. Style Analysis for Hedge Funds

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Chapter 20 – Hedge Funds

5. Performance Measurement for Hedge Funds

PPT 20-14 through PPT 20-26

Hasanhodzic and Lo (2007) find that style adjusted alphas and Sharpe ratios are significantly

greater than these measures for the S&P500 for a large sample of hedge funds. Does this mean

that hedge funds are earning abnormal returns? The answer is maybe, but probably not. On the

of hedge fund shares.

Prices in illiquid markets tend to exhibit serial correlation. This is because in illiquid markets the

funds themselves estimate values for their investments to calculate the fund’s share values and

rates of return to quote to investors. This brings up the possibility that funds estimate prices

optimistically and/or mark to market slowly instead of all at once if the positions are generating

additional evidence of manipulation of position values by hedge fund managers.

\ Other Problems in Hedge Fund Performance Evaluation

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Chapter 20 – Hedge Funds

Most performance measures assume constant risk levels and many hedge funds have variable risk

levels. This implies that the positive alphas may simply be due to measurement error. Moreover,

many funds hold options or perform like options. Option positions make performance

measurement more challenging because options result in nonlinear performance, but most

performance measures assume or fit a straight line to return data. Text Figures 20.4,

market betas, although not all hedge funds exhibited this pattern.

Figure 20.6 Panel B Returns on Income Arb Funds vs S&P500

Figure 20.6 Panel C Returns on Event Driven Funds vs S&P500

Hedge fund performance lines in Panel B and Panel C are roughly analogous to writing a put

option. This may well be an explanation of the supposed positive alphas. Many hedge funds

likely to appear as strong and they may suffer large losses.

6. Fee Structure in Hedge Funds

PPT 20-27 through PPT 20-28

Typical hedge fund fees includes a fixed management fee between 1% and 2% of assets plus an

incentive fee usually equal to 20% or more of investment profits above a benchmark performance

return. Incentive fees are analogous to call options on the portfolio with a strike price equal to the

The fund has a net asset value of $100 per share and the annual risk free rate is 5%.

The implicit exercise price of the incentive fee is $100 x 1.05 = $105

The Black-Scholes value of a call option with S0 = $100,

X = $105,  =30%, T = 1 year, & rf = LN 1.05 = 4.88% is $11.92. The Black-Scholes

inputs are as follows:

20–6

incentive fee = 20% x $11.92 = $2.38 per share or 2.38% of the $100 net asset value.

Combining this with the 2% management fee yields total fees of 4.38%. This is much

larger than most mutual funds.

Mutual funds as a group suffered large losses during the subprime fallout and the related financial

crisis. However according to the Economist Magazine in 2009, hedge fund customers were

so called “High Water Mark.” This complicates estimating the value of the incentive and it gives

managers an incentive to close the fund and start over when large losses occur. This is probably

one of the reasons for the large amount of turnover in the industry.

Funds of Funds

Funds of funds invest in one or more other hedge funds and serve as ‘feeder funds’ to the ultimate

investors in Bernard Madoff’s $50 billion Ponzi scheme (see below for more on the scandal).

Suppose a fund of funds has $1 million invested in each of three hedge funds. For simplicity

assume the hurdle rate to earn incentive fees is a zero rate of return (no losses) and the normal

fixed asset management fee is zero. The following text table illustrates the effect of the fees on

this fund of funds:

Chapter 20 – Hedge Funds

End of year (M$) $1.20 $1.40 $0.25 $2.85

Gross rate of return 20% 40% -75% -5%

Incentive fee (M$) $0.04 $0.08 $0 $0.12

End of year value, net of fee $1.16 $1.32 $0.25 $2.73

Bernard Madoff pleaded guilty to operating a $50 billion Ponzi scheme. In a Ponzi scheme the

con artist (Madoff) promises and initially pays high returns to investors. The large returns are

generated by paying out to old clients some of the money paid in by new clients. The con artist

also skims some of the money for his or her own use. The scheme can work for some time until

the fund stops growing. When growth stops the fraud will become apparent. Madoff apparently

Partners and Access International Advisors. Their due diligence must have been poorly done.

In 2008 redemptions began as more clients needed money and the scheme unwound. The lack of

reporting requirements in this industry made the fraud possible but there were several warning

signs including:

Returns were too stable for too long. His firm was Bernard L. Madoff Investment

The fund fee structure was too generous by far in comparison to competing funds. There

were no incentive fees and apparently no management fees. Madoff claimed the

commissions on trades provided sufficient income for his firm.

All assets were kept in house rather than with a custodian. This made the fraud possible

since no one could check on the actual fund assets.

apparently ignored the letter.

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