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
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
CHAPTER OUTLINE
1. Hedge Funds versus Mutual Funds
PPT 20-2
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.’
Hedge funds are not open to the general public. The primary investors are institutional investors
Chapter 20 – Hedge Funds
Characteristic
Mutual Funds
Hedge Funds
Transparency
Public info on portfolio
composition
Info provided only to
investors
Investors
Unlimited
< 100, high dollar
minimums
Liquidity
Redeem shares on demand
Multiple year lock up
periods typical
Notes to the table:
Some mutual funds can engage in short selling, but not to the extent that hedge funds can. The
2. Hedge Fund Strategies
PPT 20-3 through PPT 20-6
Chapter 20 – Hedge Funds
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.
convergence arbitrage and was commonly used by the hedge fund Long Term Capital
Management (LTCM). When global risk premiums increased after the Asian currency crisis and
the Russian foreign debt default, spreads increased beyond their historical norms for an extended
time period. Because LTCM was so highly levered, they could not ride out the crisis and
eventually had to be bailed out by their Wall Street clients. The bailout was arranged by the Fed
3. Portable Alpha
PPT 20-7 through PPT 20-12
Chapter 20 – Hedge Funds
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 effective stock beta to zero. By doing so the fund would engage in a ‘market neutral’ pure
play. When this strategy is combined with a passive investment in an index or sector this is
called alpha transfer, hence the term portable alpha. The following pure play example is also in
the text and can be used to illustrate alpha capture; however the example is somewhat technical
and relies on several topics not developed in this chapter. The example employs a stock hedge
ratio and uses spot futures parity that is covered in Chapter 17.
Step 1: Find the ending dollar value of the portfolio based on the given information.
The hedge ratio must do two things: First, it must adjust for the difference in size in the spot and
futures position. Obviously with a fixed contract size, a bigger spot position (the stock portfolio)
will require a greater number of contracts. Second, the ratio must adjust for relative price
fluctuations of the spot and futures. The portfolio beta is just such a relative price adjustment
measure.
Step 2: Find the profit from the short futures position used to hedge out market risk:
Chapter 20 – Hedge Funds
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%).
The expected value of e is zero but it could turn out to be negative and this could wipe out your
gains. Also, the analyst could be wrong about the alpha. The point is this strategy is not riskless.
Figure 20.1 provides a graphical illustration of the concept that can be used in conjunction with
or as a substitute to the numerical example.
4. Style Analysis for Hedge Funds
PPT 20-13
Many fund strategies are directional bets and may be evaluated with style analysis. Style
analysis is covered in Chapter 18 and you may suggest students review that material. Directional
investments will have nonzero betas, called “factor loadings.” Typical factors may include
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
Chapter 20 – Hedge Funds
Other Problems in Hedge Fund Performance Evaluation
Survivorship bias is a problem in performance measurement of risky hedge funds. Those that
don’t survive don’t report results that are used in estimating average performance. Hedge funds
report returns to publishers only if they choose to. This is another problem in regulation that is
referred to as backfill bias. This problem may be fixed shortly as the industry is coming under
pressure for greater disclosure and transparency.
6. Fee Structure in Hedge Funds
PPT 20-27 through PPT 20-28
Chapter 20 – Hedge Funds
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 current portfolio value x (1+ benchmark return). This is illustrated in Figure
20.7, Incentive Fees as a Call Option. This implies that the value of the incentive fee can be
modeled with option pricing as follows:
• Suppose a hedge fund’s returns have an annual =30%
• The annual incentive fee is 20% of the return over the risk free money market rate.
• The fund has a net asset value of $100 per share and the annual risk free rate is 5%.
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 largely satisfied with their hedge fund investments and planned on continuing to invest in
these funds IF fees were reduced. It is reasonable to expect lower fees in the future.
High Water Mark
Chapter 20 – Hedge Funds
Funds of Funds
Funds of funds invest in one or more other hedge funds and serve as ‘feeder funds’ to the
ultimate hedge fund. This allows investors to easily diversify across hedge funds, as long as the
fund of funds diversifies by investing in funds that employ different strategies. By 2008 about
one half of assets invested in hedge funds were in funds of funds.
Suppose a fund of funds has $1 million invested in each of three hedge funds. For simplicity
assume the hurdle rate to earn incentive fees is a zero rate of return (no losses) and the normal
fixed asset management fee is zero. The following text table illustrates the effect of the fees on
this fund of funds:
FUND 1
FUND 3
FUND OF
FUNDS
Start of year (M$)
$1.00
$1.00
$3.00
End of year (M$)
$1.20
$0.25
$2.85
Gross rate of return
Incentive fee (M$)
$0.04
$0.12
End of year value, net of fee
$1.16
$0.25
$2.73
Net rate of return
The $50 Billion Madoff Scandal
Madoff. For instance, Fairfield Greenwich Advisors had exposure of $7.5 billion. Other funds
with exposure over $ 1 billion included Tremont Group Holdings, Banco Santander, Ascot
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
Securities LLC and the firm reported earnings of between 10% and 12% in both good
markets and bad. Some institutional investors were leery of the Madoff fund because of
the fund’s opacity.