Hedge Fund Investment Strategies

Derivative Based Investment
Strategies
Case: Pine Street Capital
Alternative Assets
Hedge Venture Private
Funds Capital Equity
Managed Commodity
Real Estate
Futures Funds
Natural Distressed
Mortgages Resources Investments
Many alternative investment strategies have ability to profit when stock and bond
prices are declining
Hedge Fund and Mutual Fund Performance During Quarters with
Negative Returns for the S&P 500 (1988-1999)
Cumulative
1Q-90 3Q-90 2Q-91 1Q-92 1Q-94 4Q-94 3Q-98 3Q-99
Return
S&P 500 -3.0% -13.7% -0.2% -2.5% -3.8% -0.02% -9.9% -6.2% -33.8%
VAN US Hedge fund index 2.2% -3.7% 2.3% 5.0% -0.8% -1.2% -6.1% 2.1% -0.7%
Morningstar average equity mutual fund -2.8% -15.4% -0.9% -0.7% -3.2% -2.6% -15.0% -3.2% -37.2%
Morningstar average taxable bond fund -0.9% 0.6% 1.5% -1.1% -2.4% -0.2% 2.0% 0.3% -0.3%
9
Leverage
Generates high HFs seek arbitrage

Increases risk of
return on opportunities in
an investment
portfolio’s equity different markets
HF Searches Typical Loans

Payoffs with Little Used: Marginal
to no Risk Loans
10
Expected PSC portfolio return = a + b*(market return)
Established relationship between performance of
market and PSC’s portfolio
Amount of return in excess of that

due to market risk
a Expected return if market risk

were eliminated from the
portfolio
Example of Hedging by Short-Selling
Today Initial Value Tomorrow's Value
NASDAQ + 10% NASDAQ - 10%
Long portfolio $100 $116 $86.0
Short NASDAQ $150 $135 $165.0
Total $250 $251 $251
Return on hedged portfolio 1% 1%
Assumed alpha: 1%
Assumed beta: 1.5
May use ETFs for short selling market

17
Options and Derivatives
HFs ability to use

Used by HFs for
options gives it
Speculation and
another advantage
Hedging (mostly)
over traditional MFs
Option-based hedging
program is needed to
hedge gamma risk in a
stock portfolio during
negative periods
18
Put Option
Value of put is Put options are held
negatively correlated to insure the
with the value of portfolio against
stock in the portfolio market fluctuation
Ratio of put options

to stocks needed to
perfectly hedge a
portfolio = f {deltas}
Balance Sheet Effects of Hedging with Put Options
Un-Hedged Portfolio
Today Tomorrow (S&P 500 +5%) Tomorrow (S&P 500 -5%)
Asssets (Stock) 100 Asssets (Stock) 107.5 Asssets (Stock) 92.5
Equity 100 Equity 107.5 Equity 92.5
ROE = 7.50% ROE =- 7.50%
Hedged Portfolio
Today Tomorrow (S&P 500 +5%) Tomorrow (S&P 500 -5%)
Asssets (Stock) 89.09 Asssets (Stock) 95.77 Asssets (Stock) 82.41
S&P puts 10.91 Equity 100 S&P puts 5.6 Equity 101.37 S&P puts 19.07 Equity 101.48
ROE = 1.37% ROE = 1.48%
S&P 500: 100 S&P options: 2 month at the money puts
S&P Volatility: 25%
Portfolio beta: 1.5
Risk free rate: 5% 43
Hedging Market Risk by Short Selling
Finding positive alpha

Short-selling removes
1% of return is the alpha stocks in the technology
market return
of long positions in the sector was exactly what
component and market
portfolio PSC felt to be its
risk, leaving alpha return
comparative advantage
Immunizing portfolio
Maintained a debt ratio
against market
of 50% in the fund’s
fluctuations left much
capital structure
less risk in the portfolio
46
Over the past years, over past 4 months, NASDAQ
technology sector had been more volatile
During 1999 and 1Q 2000
Internet based technology firms delivered huge
During the returns
Past NASDAQ appreciated 115%
Mach 2000 – June 2000
NASDAQ declined 40%
Was unprecedented in the recent history of US equity
market
Short-sale hedging strategy was only partially effective during previous two months
Large dips in NASDAQ in March and April
Portfolio showed under-hedged position?
PSC was careful in using models to accurately measure beta of portfolio in order to
immunize the fund against market fluctuations
Options-Based Hedging
Using put options
Put options is more
on NASDAQ
sensitive to market
instead shorting
movements
NASDAQ
Could better
immunize the
portfolio to market
movements
49
Decision
Market could see more volatile
Using less leverage – may not Don’t want the fund to be
times ahead like the past few
maximize equity value liquidated
months
PSC has experienced large

NASDAQ has experienced a
losses on many days
historically unprecedented Problem magnified because of
(sometimes on several
amount of volatility over the usage of leverage
consecutive days) in the last few
last several months
months
Some of the losses that the

fund had experienced had been
large enough that the fund had
come dangerously close to
having its prime broker, a
prominent Wall Street firm,
liquidate the fund
51
Pine Street Capital's Portfolio Allocation on July 26, 2000
NASDAQ S&P 500
Company Shares Share Price Allocation Beta Alpha R-Squared Beta Alpha R-Squared
AMCC 24000 162.875 11.31% 2.15 6.42 0.58 3.06 6.91 0.29
AHAA 45000 36.1875 4.71% 1.63 2.14 0.39 2.39 2.16 0.2
ANAD 70000 26.8125 5.43% 1.65 1.22 0.45 2.36 1.24 0.22
CNXT 42500 35.75 4.40% 1.42 -0.08 0.39 2.24 -0.08 0.24
CY 15000 43 1.87% 1.07 1.44 0.39 1.64 1.44 0.22
HLIT 20000 28.0625 1.62% 1.63 -0.81 0.36 2.29 -0.8 0.17
JDSU 22000 135.9375 8.65% 1.56 1.08 0.57 2.4 1.13 0.33
LSI 12500 32.625 1.18% 1.32 2.44 0.48 2.14 2.42 0.31
PWAV 40500 36.875 4.32% 1.39 6.23 0.3 1.69 6.38 0.11
QLGC 30000 77.9375 6.77% 1.87 1.05 0.48 2.19 1.12 0.16
RFMD 21000 39.75 2.42% 1.62 1.66 0.46 2.45 1.67 0.25
TQNT 25000 48.625 3.52% 1.74 4.22 0.57 2.34 4.31 0.25
TXCC 30000 41.6562 3.62% 1.64 4.21 0.47 2.35 4.25 0.23
VTSS 20000 65.625 3.80% 1.65 3.35 0.42 2.42 3.3 0.22
EMLX 30000 55.81 4.85% 1.86 -0.12 0.4 2.54 -0.1 0.18
PMCS 16000 197 9.12% 1.79 9.99 0.54 2.6 10.07 0.28
SDLI 20000 387.25 22.41% 1.52 13.53 0.45 2.37 13.52 0.27
Portfolio 100.00% 1.65 3.35 0.8 2.41 3.38 0.41
54
Portfolio Statistics for Days of Positive and Negative Market Returns (Half year 1/3/2000 - 7/11/2000)
NASDAQ Up NASDAQ Down S&P 500 Up S&P 500 Down
Company Allocation Beta Alpha R-Squared Beta Alpha R-Squared Beta Alpha R-Squared Beta Alpha R-Squared
AMCC 11.31% 2.53 -0.77 0.32 2.45 208.34 0.50 3.62 -0.55 0.15 3.44 67.61 0.23
AHAA 4.71% 2.05 -0.60 0.20 0.92 -0.99 0.10 3.14 -0.74 0.12 1.74 -0.51 0.08
ANAD 5.43% 1.81 -0.63 0.23 1.97 50.07 0.31 2.75 -0.77 0.14 2.86 25.64 0.15
CNXT 4.40% 1.70 -0.83 0.22 1.08 -0.93 0.13 2.15 0.09 0.09 2.42 0.76 0.15
CY 1.87% 1.50 -0.90 0.30 0.97 1.03 0.16 1.93 0.08 0.13 1.26 -0.30 0.07
HLIT 1.62% 1.64 -0.72 0.20 1.37 -0.98 0.11 1.93 0.63 0.08 1.78 -0.98 0.04
JDSU 8.65% 1.69 0.47 0.27 1.12 -0.95 0.30 3.52 -0.97 0.27 1.97 0.18 0.15
LSI 1.18% 0.88 87.87 0.11 1.43 3.19 0.32 1.46 23.27 0.07 2.99 51.34 0.30
PWAV 4.32% 1.81 -0.56 0.16 1.06 -0.16 0.11 1.31 46.17 0.02 1.49 1.15 0.05
QLGC 6.77% 1.60 7.50 0.18 2.29 54.63 0.34 2.13 1.08 0.07 2.42 4.28 0.09
RFMD 2.42% 1.78 -0.30 0.25 1.70 6.13 0.25 3.57 -0.95 0.22 1.75 -0.51 0.07
TQNT 3.52% 2.09 -0.70 0.37 1.77 12.77 0.35 3.42 -0.95 0.21 2.42 21.71 0.15
TXCC 3.62% 2.27 -0.97 0.30 1.80 62.88 0.36 3.14 -0.66 0.15 1.77 0.10 0.09
VTSS 3.80% 1.69 1.65 0.15 1.76 11.60 0.34 2.34 3.38 0.08 2.67 10.21 0.15
EMLX 4.85% 0.80 334.48 0.05 3.23 27706.21 0.43 2.23 -0.82 0.07 5.06 18466.43 0.27
PMCS 9.12% 1.95 2.19 0.29 1.78 12.76 0.33 2.54 -0.74 0.19 2.36 10.37 0.16
SDLI 22.41% 1.51 9.17 0.19 1.81 182.00 0.33 2.80 2.63 0.15 2.96 3.27 0.11
Portfolio 100.00% 1.71 0.89 0.57 1.86 31.15 0.66 2.89 -0.49 0.25 2.49 9.07 55 0.29
SD of daily return of NASDAQ composite and S&P 500 during the half year period were 3.07 % and 1.54% respectively
56
57
Risk Faced by PSC
NASDAQ Index as a Measure of
the Market
• Have no ability to predict the directions
and magnitude of the market Risks to be Hedged: Market Risk
• Skilled at managing firm specific risk
• Earn an alpha return on an investment
• Invest in stocks that have positive alphas
Have stock Picking Ability but

Market is Inefficient
58
Hedging Market Risk
Short-selling NASDAQ
index – short selling an Hedge all market risks
exchange-traded-fund that they measure in
with the ticker QQQ the portfolio
that tracks the index
59
Hedge Market Risk from PSC’s Portfolio on July 26
Using a Short-sale Strategy
H = Hedge
P = Portfolio
E = Equity
M = Market
$34.5mm * 1.65 – H * 1 = 0
H = 56.93mm
• PSC needs to short-sell $ 56.93 million of QQQ in order to have a stock

portfolio that is delta-neutral with respect to the market or market-neutral
62
Problem Arising from Short-Sale Hedging
Strategy
PSC’s short-sale hedged Key source of problem
portfolio still seems to be • Still some residual market
highly correlated to the risk left in PSC’s portfolio
• Extremely volatile market
market – exhibit 8 & and realizing negative returns
exhibit 9
Reasons for residual risk

• PSC is mis-measuring beta, But generally its unlikely
delta of stock portfolio for the alpha to be
• Alpha of the portfolio is correlated with the
correlated with the market market
64
65
66
67
Perforamnce of Pine Street Capital's Hedge Startegies During NASDAQ Worst 20 Days
(Over the Peirod 1/04/99 to 7/26/00)
NASDA QQQ Unhedged Short Sale Hedge Put Option Hedge
Date Q Return PSC $ Profit / Loss ROE $ Profit / Loss ROE
14-Apr-00 -9.67% -8.66% -16.84% -1253436.86 -7.18% 935932.36 1.98%
3-Apr-00 -7.64% -5.99% -14.20% -2182183.49 -13.50% -3004361.57 -7.27%
12-Apr-00 -7.06% -5.88% -9.93% -437810.11 -2.51% 1599279.25 3.61%
23-May-00 -5.93% -8.35% -12.39% -27653.10 -15.00% 838441.15 1.64%
10-Apr-00 -5.81% -6.10% -10.53% -615272.36 -3.48% 520987.70 1.21%
10-May-00 -5.59% -7.27% -8.25% 751321.71 3.89% 2009996.12 3.86%
19-Apr-99 -5.57% -4.69% -6.71% 8681.20 0.13% 464170.27 7.09%
4-Jan-00 -5.55% -6.86% -7.45% 746550.20 6.94% 5963416.59 41.56%
28-Jul-00 -4.66% -5.44% -4.72% 1082841.42 6.22% 3663503.42 7.54%
24-Apr-00 -4.43% -2.87% -4.64% -140814.13 -0.71% 91294.87 0.19%
2-May-00 -4.36% -5.75% -7.21% 484191.77 2.28% 4483090.41 9.01%
19-May-00 -4.19% -4.74% -5.53% 444170.87 2.28% 1602169.02 3.16%
14-Mar-00 -4.09% -3.70% -6.05% -287101.52 -1.15% 1417348.53 2.94%
30-Mar-00 -4.02% -2.50% -2.36% 572243.01 3.49% 1972150.27 4.87%
20-Mar-00 -3.92% -2.82% -6.11% -918421.33 -4.22% -1002796.54 -2.22%
29-Mar-00 -3.91% -4.14% -10.03% -1811832.73 -9.95% -2382220.64 -5.56%
9-Feb-99 -3.91% -3.91% -5.23% 26606.64 55.00% 247151.80 4.55%
6-Jan-00 -3.88% -6.87% -7.56% 646208.46 5.46% 1031268.09 5.19%
8-May-00 -3.86% -3.90% -9.09% -1214790.73 -5.68% -1051204.31 -1.96%
23-Sep-99 -3.79% -4.14% -3.82% 347743.29 2.88% 963842.98 13.83%
68
Problem Arising from Short-Sale Hedging Strategy
Check for problem in the beta

Betas are computed with 6- Beta of positive return days and
measurement – individual stocks
month regression of daily returns negative return days of NASDAQ
and the portfolio as a whole
Beta is higher on positive return

days and lower on negative return
days – this occurs with small cap Time-varying beta causes over or
stocks (large cap stocks to smaller under hedging
extent) when markets become
more volatile
69
Options-Based Hedging of Market Risk
Alternative Method
Change in delta requires a
• Using nonlinear financial instruments
rebalancing in hedge portfolio
Stocks that PSC is investing in (eg. Options)
as equivalent to a portfolio • Option Delta changes as the underlying
seems to be nonlinear with the
insurance strategy adjusting the price changes – Option’s Gamma
market
short-sale position of QQQ daily
to reflect the changing delta
Construction: Matching the

option portfolio’s delta with the Gamma of a put option: positive Delta of a put option: negative
delta of the stock option
Utilizing options hedging

creates a substantially different Does a much better job than the
time-series pattern of PSC’s short-sale strategy
returns
71
72
73
Hedging PSC’s Portfolio on July 26 Using Options
Construct hedging
portfolio of options Obtaining delta of a put
that would hedge PSC’s option on QQQ
market risk on July 26
Purchasing sufficient
put options to match
the delta of PSC’s stock
portfolio
75
Hedging PSC’s Portfolio on July 26 Using Options
August 2000 Put Option
QQQ = 95.53
X = 95
Market Value Balance Sheet
s = 46.27% H = Hedge D = Debt
r = 6.14%
T = 17/250
ΔH ΔP
+ =0
ΔM ΔM P = Portfolio E = Equity
P
N(d 1 ) - 1 + β p * =0
M
N(d 1 ) = 0.5561
- N(-d 1 ) = -0.4439 M = Market
34.5M
- 0.4439 * N + 1.785 * =0
95.63
N = 1.45 M put options
• Using 17 day put options on QQQ struck at $95

• Fund needs 1.45 mm put options to delta hedge their stock portfolio
• Stock portfolio is also (at least partially) gamma-hedged as well
http://www.option-price.com/implied-volatility.php 76
Features of HF
Low regulation Heterogeneous Using derivatives

grouping
High leverage Investment structure Small market
exposure
Assets covered Investment strategy Alpha driven
Aggressive Manager skills Low risk

investment
Performance fee Look for mispricing Low correlation
High returns Look for arbitrage
77
Hedge Funds
Covering – equity,
Long and short
Less regulated Leveraged positions bond, derivatives,
positions
physicals
High fee –
Aggressive Can expect high Heterogeneous
performance
investments returns grouping
related
Charges incentive- Is both an

Can leverage Fund managers also
based fee that Investment
informational or invest own money
compensates the structure and an
strategic advantage along with the pool
fund managers Investment strategy
78
Hedge Funds
May use conservative HF managers tends to seek

May use aggressive approach Pure bet on skill of a specific
approach – non-leveraged out Arbitrage opportunities
– macro funds manager
market-neutral funds and Mispricing opportunities
Employ large amount of

Uses of variety of cash and Takes small amount of
leverage to extract the Are alpha-driven
derivatives instruments market exposures
greatest value
Reasons for investors

Investments into hedge HF strategies have higher attaching to HF:
Reward/risk significantly
funds in 2000 educational correlation to stock market Diversification – low
more attractive than most institutions endowments: 7% than to fixed-income correlation between HF
stock market investments
- 11% investments styles and traditional
investments
Hedge Funds
Reasons for investors

Reasons for investors attaching to HF: Managed
Leverage is used by ~74%
attaching to HF: Hedges future funds reduces risk
of HFs
away market risk of equity investment
since correlation in ~-0.25
An extreme level of
Leverage used > 20 times leverage combined with
investment capital small nominal losses have
caused the demise of HFs
Hedge Funds
81
Discussion Question
What is the investment structure of hedge fund?
82
Hedge Fund Organizational Structure
Private limited Limited liability

partnership – Corporation companies –
US US
Trust MFs
Managers Compensation
Incentive fee:
Management
10% to 30% of
fee: 1% p.a.
profit p.a
Two Types of Partners
General • Manage the HF

• Responsible for OH expenses of running the fund
Partners
• Are allocated with pro rata with their share of..,
Limited • Investments
• Expenses
• Have defined set of rights
Partners • Limited partnership interests are not tradable

• Limited partnership interests can be sold back to partnership or
redeemed
85
Key Documents used in HF Investments
• Key documents used in HF investments
– Offering memorandum
• Also called as..,
» Private placement memorandum
» Disclosure document
» Prospectus
• Content..,
» Securities HF is selling
» Summary of partnership agreement
» Fee structures
» Redemption provisions
» Background information on manager and key personnel
» Discussion on conflict of interest and taxation
– Limited partnership agreement
– Specifies rights and limits of both the partners
– Subscription agreement
86
Hedge Fund as Investment Structure
• Incentive fee is only paid when fund profits exceed some threshold
amount..,
• Most typically zero (82% of funds)
• Some higher hurdle rate (18% of funds)
• Risk free interest rate
• Previous water mark
• Aggressive in trading with..,
• Long and short positions in equity and fixed income securities
• Nontradable private placements
• Private equity investments
• Cash commodity markets
• Direct purchase of real estate
87
Discussion Question
How HF is different from MF?
88
Hedge Funds vs. Mutual Funds
• Range of allowable investment approaches • Disclosure of information
• Global markets • Disclose monthly NAV
• Fixed-income securities • Much more flexible
• FOREX • Frequently change..,
• Equities • Investment strategies
• Commodities • Types of assets
• Goals of strategy
• Trade
• Breadth of techniques and tools available
• Different approaches to fee structure • Act like frequent traders
• Liquidity • Hope to profit in all market environments
• Many are LT in nature • HFs often provide highest return in 2nd through 5th
• Lock-up period 1 or more years years
• Asset allocation
89
History of Hedge Funds
• Originated in 1949
• First HF: Jones-style HF
• Largest HFs..,
• George Soros
• Michael Steinhardt
90
Discussion Questions
Who are the hedge fund investors?
91
Hedge Fund Investors
• Should be either of..,
• Institution
» Pension funds
» Endowments
» Banks
» Insurance companies
• Individual classified as accredited or higher – high net
worth individuals
• Limit on no. of investors: 99
92
Discussion Questions
How the hedge fund strategies are classified?
93
Hedge Fund Strategies
• Long-biased
Long/Short Equity • Short-biased
• Market-neutral equity
Relative Value • Convertible bond arbitrage
• Fixed-income arbitrage
Event Driven • Merger arbitrage

• Event arbitrage
Approaches • Distressed debt
• Global macro
Tactical Trading • Commodity trading advisers
• Statistical arbitrage
Miscellaneous • Emerging markets

• Insurance type of investments
Strategies • Cross over investment
94
Hedge Fund Categories
95
Hedge Fund Styles
• Directional trading area: ~25% of HF assets
• Managed futures can be divided into..,
• Discretionary trading
• Systematic trading
• Market timing funds are included in tactical allocation category
• Discretionary trading also includes global macro funds
• Least volatile funds: relative-value funds
• HF assets managed in..,
• Arbitrage + merger arbitrage + statistical arbitrage: ~20%
• Security selection funds: > 45%
– Funds use long + short, but not always hedged
– Can be..,
» Long bias funds
» Short-bias funds
» No-bias funds
• Specialist credit and multipurpose funds: <10%
– Takes directional bets on..,
» Changes in debt or equity structure of firm
» Yield spreads between different types of fixed-income securities
96
Hedge Fund Investment Management Process
97
Hedge Fund Classification
98
Return Enhancers vs. Portfolio Diversifiers
99
Discussion Question
What is short selling?
100
Short Selling
• Short seller must pledge other securities or cash equal to the market price
of the borrowed securities with the lender
• Can provide both..,
• Fixed income
• Trading profits
• In short selling creates..,
• Restricted cash asset: proceeds from sale
• Liability: must return the borrowed shares at some future date
• Requires collateral: cash or liquid treasury instruments
• Costly to sell short securities with high dividend yield – seller need to pay
dividend
• Security sold short cash earns: short interest rebate
101
Short Selling
• Amount of restricted credit is adjusted regularly based on MTM
• Increased on: decrease in stock price
• Decreased on: increase in stock price
• Disadvantages
• Potential losses: infinite
• Potential gain: limited
• Short sellers have entire net worth at stake
• Overvalued stock do not collapse without a catalytic event
• Stock analyst are reluctant to issue sell recommendations
• Advantages
• Provides high liquidity to market
• Produces high investment return in bearish markets
102
Short Selling
• Performance; Jan 1990 – March 1998
• Average annualized return: 1.01%
• Annualized SD: 18.43%
• Correlation with stock price: 0.4603
• Beta: -1.02
103
Short Selling
Example
104
Short Selling
Example
105
Discussion Question
What you mean by relative value strategies?
106
Relative Value Strategies
• Market-neutral strategies
• Combines long + offsetting short position
• Extracts returns from mispriced
• Securities
• Market sectors
• Group of securities
• Limits systematic risk
• Maximizes positive alpha
• Range of return (net of fee): TB + 3% to 5%
• Relatively low volatility
• Types..,
• Long / short equity
• Convertible hedging
• Bond hedging
• Rotational
107
Long / Short Equity
• Long: undervalued equities
• Short: over valued equities
• Balances the portfolio structure by consideration of..,
• Markets
• Sectors
• Industries
• Market capitalization sizes
• Attempts to generate a ‘double-alpha’ strategy
• Balancing between short and long may be based on..,
• Amount
• Estimated volatility of short and long position
• May use..,
• Fundamental analysis
• Technical analysis
• Quantitative techniques
108
Long / Short Equity
• Has become the big share of total capital deployed by investors into HFs
• Are directional - tend to have some correlation to the markets in which they trade
• Degree of directionality = f(net exposure)
• Net exposure = gross long positions – gross short investments
• Long-biased funds: higher net exposure
• More directionality
• Higher correlation to equity markets
• Market-neutral funds: zero net exposure
• Net zero directionality
• Theoretical noncorrelation to equity markets
• Short-biased funds: negative net exposure
109
Long-Biased Funds
• Primary approach to long/short equity
• Logical extension of traditional long -only investment
management
• Is organized portfolio management
• Low volatility in the equity market can be a boon
• Achieves return better than overall equity market but with
less volatility
• Dispersion of returns can be wider than dispersion among
long-only funds
110
Short-Biased
• Reverse directionality
• Short exposures are more pronounced
• Requires proper risk management
• May potentially dampen volatility in a
portfolio of multiple hedge fund investments
• May not provide profit in LT because equity
markets have positive directional bias
111
Relative Value
• One of the least homogeneous groupings of hedge strategies
• Non-directional strategies
• Attempts to capture a pending convergence in valuation between securities
• Tend to have a natural hedge in place
• May use securities with..,
• Different voting rights
• Different seniority
• Also called capital structure arbitrage
• Expected spread in a discrepancy: > risk-free rate of return
• Spread is expected to have as short a duration as possible – but not time bound
112
Market-Neutral Equity
• Natural extension of long only equity investments
• Sub strategy of long/short equity
• Net exposure: 0
• Long exposure = short exposure
• Its also requires neutrality in the form of..,
• Beta
• Industry
• Geography – country, market
• Style – growth, value, small, mid, large
113
• Neutrality on beta, sector or geography may
create misneutrality in amount of investments
• No source of return other than alpha
• Factors driving return..,
• Security selection – fundamental, quantitative,
technical
• Portfolio risk management
• Trade execution
• Expense management
114
• May be vulnerable to certain rallies in equity
market that favor
• Lower quality
• Higher-beta equities at the expense of higher quality
• Lower-beta equities
115
Discussion Question
What is convertible hedging / arbitrage?
116
Convertible Hedging
• Long: convertible bonds
• Short: underlying common stock
• Example..,
117
Convertible Hedging
Example
Transaction Assets Units Price

Buy 7% convertible bond of Coy A 1 1000
Sell Common stock of Coy A 22 35
Hedge r a tio: 77%
For ev er y Rs. 1 th a t th e stock m ov es; bon d is ex pected to m ov e by Rs. 0.7 7
If T-bill r a te 5 %; th e y ield on sh or t sellin g = 5 % *7 0% = 3 .5 %
Tota l r etu r n = 7 % in ter est + 3 .5 % r eba te = 1 0.5 %
Lev er a ge is a ttr a ctiv e beca u se a 7 % bor r ow in g cost w ou ld y ield a n a ddition a l 3 .5 %

for ea ch u n it of lev er a g e
If stock pr ice m ov es u p; r equ ir es la r ge sh or t stock position to h edg e th e lon g bon d position
Th e h edge position does'n t cov er th e r isks su ch a s.., in ter est r a te r isk of bon d, cr edit r isk,
ca ll r isk, m a r ket a n d in su tr y r isk of equ ity
118
Convertible Arbitrage
• Extracting profit from complex pricing
relationships between stock and bond
• Price of convertible bond will decline rapidly
than stock price declining in equity market
• Convertible bond price will mirror stock more
closely in a rising market
• They look for mispriced convertible bond
• Convertible bond’s price declining less rapidly than the
underlying stock in a falling equity market
119
• Investment value = value of the bond component
• Latent warrant = conversion component of the convertible
bond
• Price of CB will not below investment value even in a declining
stock price
• Degree to which change in value of bond reflected by change
in stock value depends on convertible bonds premium over
conversion value
120
Example…
• Bond’s trading price: Rs. 1000 (par value)
• Can be converted to 50 shares of Rs. 14 each
• Conversion value: Rs. 700
• Premium = Rs. 1000 – Rs. 700 = Rs. 300
• Conversion premium = 300/700 = 42.9%
• Higher the conversion premium; lesser will be the correlation
of bond’s price with the stock price
• Factors affecting conversion premium
• Higher the bond yields; higher the conversion premium
• Interest rate changes
121
• Factors considered in selecting a convertible bond..,
• Undervalued bonds – bonds mispriced relative to underlying stock
• Premium-to-conversion ratio
• Call provisions on the bond
• Creditworthiness of the issuer
• Probability of default
• Yield advantage
• Company’s earnings momentum
• Short sold stock generates short interest rebate
122
• Amount of stock sold short = < full conversion amount
• Allows the position to retain profit potential on the upside
• No. of shares sold short depends on how much market exposure required
• Hedge ratio = no. of shares sold short out of total number possible
• Neutral hedge = hedge ratio that will not add exposure to up or down
market
• Hedge is determined based on..,
• Stock prices
• Yield curve shifts
• Dividend yield
• Volatility of the stock
123
Example…
124
• Factors disrupting pricing relationship between convertible bond and
stock..,
• Market factors
• Shifts in stock market volatility
• Interest rate changes
• Foreign exchange relationships
• Political events
• Factors specific to the company
• Improving or weakening credit quality
• Short stock buy-ins
• Call features
• Dividend increases that reduce the cash flow component
• Takeovers and recapitalization
125
• Disadvantage
• On expected price relationship not holding can make the investment to
loose on both bond and equity component of bond
• Not all stocks are available to short
• Performance
• Produced very steady low-risk return in 1990’s
• Jan 1990 – Mar 1998
» Average annualized return: 11.86%
» Annualized SD: 3.24%
» Correlation with stock market: 0.1287
126
Discussion Question
What is bond hedging?
127
Bond Hedging
• Also called..,
• Yield curve arbitrage
• Long/Short debt positions
• Long: higher yielding fixed income instrument…,
• Short: lower-yielding fixed income instrument
• Can be..,
• Treasury vs. treasury (on maturity differences)
• Mortgages vs. treasury
• Corporate vs, treasury
128
Rotational
• Moving across relative value strategies
opportunistically..,
• Hedging spread between commodities
• Hedging spread between spot and future
• Long position in closed end funds and short in
constituent stocks
129
Discussion Question
What is sector funds?
130
Sector Funds
• Investing into..,
• Specific industry
• Segment of economy
• Other groupings that shares a common..,
» Product
» Market
» Theme
• Can invest long and short in various instruments
• Their generally pursued strategies include..,
• Equity hedge
• Event-driven approaches
131
Sector Funds
• Invest in industries having..,
• LT growth rates superior to economy
• Holding long position in those companies offering best value in the industry
• Can enjoy money in their down market by..,
• Specialized knowledge
• Experience
• Flexibility to sell stocks of the worst companies
• Successful sector funds have concentrated on..,
• Biomedical
• Health care
• Energy
• IT
• Media
• Financial services
132
Sector Funds
• Factors looked in a sector..,
• High growth rates relative to general market
• Industry in which specialist holding a distinct informational advantage
• Size and breadth to offer plentiful opportunities that are independently affected by variety of factors
• Investment process..,
• Identify growth stock with..,
• Good earnings and cash flows
• Price < intrinsic value of stock
• Look for catalytic event to heighten investor interest in the company
• New product launch
• Regulatory approval
• Corporate restructuring
• Understanding business model
• Taking positions
• Core positions: LT positions
• Trading and hedging positions: ST positions in overvalued companies
• Hedge positions: may use index derivatives
133
Sector Funds
• Risk control..,
• Maintaining balance between..,
• Diversification
• Concentration in meaningful positions
• Disadvantages..,
• Limited focus – less opportunities
• Highly correlated investment returns
• Fortune depends on..,
» Technology life cycles
» Caprices of product development
• Has to accept ST volatility
134
Sector Funds
• Performance; Jan 1990 – Mar 1998
• Annual SD: 9.17%
135
Discussion Question
What is event driven strategies?
136
Event Driven Strategies
• Long-biased strategies
• Focus: specific corporate transactions
• M&A
• Tender offers
• Bankruptcies
• Liquidations
• Financial reorganizations
• Reasonably well defined..,
• Increase in value of security
• Time horizon
• Returns are independent of broad market movements
137
• Investors expectations..,
• Return: >15%
• Lack of correlation with broad market moves
• Most complicated strategies
• Deeply rooted in..,
• Good research
• Strong convictions
138
Example..,
Stock
Trading
Name Price
Acquiring company ABC
Acquired company XYZ 50
Willing to pay price Premium of 30% to the pre-deal price 65
On anouncement of 65 bid the market price may not hit 65
Risk arbitrageur's questions
What is the probability that the deal will go through?
If the deal happens, what will be the final price for XYZ?
If the deal happens, when will it happen?
139
Event Driven Investing
• Investing in corporate events..,
• Mergers
• Bankruptcies
• Spinoffs
• Warrant arbitrage
• Largest returns to event driven investments
come in average to strong equity markets
140
141
142
Equity Hedge Strategies
• Invest in equity securities both long and short
143
Discussion Question
What is distressed investing?
144
Distressed Investing
• Trading debt and equity securities of companies in financial distress
• Currently in default on some debt obligations
• Close to default and negotiating with creditors to restructure obligations
• Firm declared bankruptcy
• Firms may have below investment grade rating
• Also called ‘ultimate-value investing’
• Correlation between default rates and stock prices: ~-43.8%
• Must have special skills to understand bankruptcy process
145
• Bankruptcy court has broad powers to restructure the
obligations of the firm..,
• Canceling debt
• Negotiating partial settlements
• Canceling leases
• Changing the terms of labor contracts
• Declaring the previous equity of the firm to be worthless
• Low risk investments: senior bonds, collateralized bank debt
• High risk securities: junior bonds, equity
146
• Hedging debt from distressed investing
• Hedging interest rate risk: shorting treasury bonds
• Hedging the risk of business conditions: shorting the stock of other firms in the industry to
hedge against the decline in the liquidation values of the assets of the firm
• Capital structure arbitrage
– Strategy 1
– Purchase: debt securities
– Short sell: equity shares
– Strategy 2
– Purchase: junk bonds to earn high yields
– Purchase: equity put options to insure against a continued decline in the stock price
» Can buy large no. of deep out-of-the-money puts ensuring that options will have relatively small
price, yet still have significant payoff if the company declares bankruptcy before expiration of
option
» Requires high correlation between high yield debt and equity
147
• Return is based on..,
• Value at which securities are bought
• Value receivable on bankruptcy
• Time to be spent on bankruptcy process
• Probability of stock value moving to zero
• Price paid by financial buyers < price paid by strategic buyers
• Less popular strategy; 2.6% of total strategy in 2001
• Correlation between distressed investing and S&P 500: 0.55
• Significant risks: event risk and liquidity risk
148
• Largest returns to distressed investments
come in average to strong equity markets
149
150
151
Distress Investing vs. Stock Market
152
Discussion Question
Hedge fund vs. stock market?
153
Hedge Funds vs. Stock Market
154
155
156
Hedge Funds vs. Debt Market
157
Discussion Question
What hedge fund can do in a portfolio?
158
Portfolio Effects of Hedge Fund Investments
• HF in portfolio is..,
• Extremely diversifying – improving efficient frontier
• Improves portfolios Sharpe ratio
• Largest and smallest monthly returns fall in magnitude
• Five separate classes of hedge funds..,
• Distressed securities
• Long-only funds
• Global/macro style
• Trend following in major currencies
• Trend following on diversified markets
• These classes of HFs have less correlation to each other
159
Portfolio Effects of Hedge Fund Investments
160
Discussion Question
What is fixed income arbitrage?
161
Fixed Income Arbitrage
• Principles..,
• Yields between all fixed-income securities are related
• Spreads between yields on related securities are mean reverting
• Betting on convergence of spread
• Capturing small pricing anomalies
• Most quantitatively sophisticated and data intensive strategy
• Requires understanding of..,
• Tracking of thousands of bonds worldwide
• Credit risks
• Embedded options
• Liquidity
• Issuance schedules
• Strategies of govt. and corporate debt issuers
162
• Market neutral funds

• Fund having zero duration
• Returns are uncorrelated with direction of interest rates
• Requires balance of currency exposure in portfolio – matching duration of
bonds in each currency
• Requires hedging for rotational duration to hedge against yield curve
twists
• Involves significant amounts of leverage
• Requires continues access to lowest cost funds available
• Also requires good credit rating
163
Discussion Question
What is macro investing?
164
Macro Investing
• Uses top-down global approach
• Required to know how global macro macro economic and political events
affect valuation of financial instruments
• Uses any investment approach
• Warranted method: directional bets
• A general approach
• Invest leveraged base across..,
• Sectors
• Markets
• Instruments
• Trading styles
165
Macro Investing
• They invest on forecasted changes in..,
• Interest rates
• Currency markets
• Equity markets
• Global political policy
• Economical policy
• Invest in anticipated SD more than 1
• Such events with SD>1 occurs once in two to three decades
• Some macro events occurred in the past are..,
• Junk bond and emerging market debt in 1990s
• Eurodollar in 1994
• Japanese yen during late 1980s
• Eg: in Mid 1980s Soros took long on US stock and short on Japanese stock
anticating devaluation in yen
166
Macro Investing
• Not confined by a market niche
• Required to move from opportunity to
opportunity
• Risky directional betting or speculating
• Correlation with general market: 0.2511
• Jan 1990-Mar 1998
• Annualized SD: 9.39%
167
Discussion Question
How to measure the performance of HFs?
168
Measuring Hedge Fund Performance
• Annualized monthly return = [(1+monthly return) ^ 12] – 1

• Risk = downside semi variance = [Smin (rj-r*,0)2] / (n-1)
• Sharpe ratio = [return – risk free return] / SD
• Sortino ratio = [return – risk free return] / downside deviation
• Treynor ratio = [return – risk free return] / Beta
• Skewness
• Kurtosis
• Drawdown = [recent high-water mark – lowest subsequent monthly
close] / recent high-water mark
• Percent winning month = no. of months with positive returns / total no. of
months invested
169
170
171
172
173
174
175
176
Performance Analysis of Hedge Funds
• Performance of traditional investments are

measured by..,
• Mean-variance
• Sharpe ratios
• Issues in using performance analysis of HF
investments..,
• Nonlinear payoffs
• Exposed to significant event risk
• Cannot be fully captured by mean and variance
177
• HFs can be a valuable addition to a diversified portfolio
• Demonstrates low correlation with traditional investments
• In hedge fund returns higher moments of distribution are present
• HF returns..,
• Cannot be described by first two moment of distribution (normal distribution)
» Mean or average return
» Variance or SD
• Can be described by third and fourth moment of distribution (downside return
distribution)
– Kurtosis
– Skewness
178
• Normal distribution
• Bell-shaped
• Has no skew
• Negative skew: indicates downside exposure
• Positive skew: indicates upward bias
179
• Kurtosis
• Describes general condition
• Probability mass associated with tails of a distribution or outlier events
• Negative value for kurtosis would indicate that there is less probability mass in the tails than
normal distribution
• Leptokurtosis
» Condition of large tails in the distribution
» Describes a distribution of returns that has significant mass concentrated in outlier events
» Fit well for credit risky investments – having event risk
• Platykurtosis
» Condition of tails of a distribution are thinner that that expected by normal distribution
» Has less probability mass concentrated in outlier events
» Are less risky than leptokurtosis distributions because they have less exposure to extreme
events
180
Discussion Question
What is existing investment vehicles?
181
Existing Investment Vehicles
• Fund manager – general partner

• May be an individual or corporate entity
• Invests large portion of fund
• Liability: unlimited
• Compensation: fee linked to fund’s performance
• Offshore fund
• Organized out of a country
• Organized in tax havens
• Minimum required contribution is higher
• Has limit on contributors
• Fund’s gain or losses are realized through increase or
decrease in stock price
182
Existing Investment Vehicles
• Contents of portfolio: not disclosed to investors

• Manager reports performance on limited basis..,
• Monthly / quarterly
• May have lock up period
• Generally uses single investment strategies
• Smaller investors participate through..,
• Feeder fund structure
• Wrap fee program
183
Discussion Question
What is separate managed accounts?
184
Separate Managed Accounts
• Not a HF as such
• Helps in accessing HF managers good talents
• HF manager acts as an advisor
• Administrative burdens..,
• Individual reports
• Transparency requirements
• Specialized liquidity demands
• Trade allocation issues
• Individualized investment strategies
• Increased likelihood of requirement to register as an investment adviser
• Is an active investment vehicle
185
Separate Managed Accounts
• May use multiple investment strategies
• Agreement between investor and HF manager includes..,
• Types of investments
• May be discretionary or non discretionary
• May be pre clearance or non pre clearance
• Cap on investment in sector or strategies
• Type of instrument
• Investor theoretically has unlimited liability
• Quite liquid
• Uses..,
• Custodian
• Independent brokers
• Investor has full knowledge of all transactions
• Offers..,
• More flexibility
• Ability to negotiate manager’s fee
• Customized risk management
• More transparency
186
Separate Managed Account
187
Existing Fund vs. Managed Account
188
Discussion Question
What is fund of funds?
189
Fund of Funds
• Organized as: limited partnership firm
• General partner receive fee from limited partners
• Invest in two or more HF manager’s funds
• Advantage: investors obtain access to no. of different HFs in which, because of high
minimum investment required by each, they could not invest individually
• Can diversify across..,
• Instruments
• Strategies
• Markets
• Exposes to high diversified investment with very low..,
• Administrative costs
• Research costs
190
Fund of Funds
191
Discussion Question
How an offshore fund is structured?
192
Offshore Fund
193
Discussion Question
How an domestic fund is structured?
194
Domestic Fund
195
Discussion Question
How an hedge fund is regulated?
196
Regulation of Hedge Funds
• Securities offered to investors are not

registered
• Fee
• Two fees – management fee + incentive fee
• Higher water mark – manager to attain performance
above highest previous level before earning additional
fees
• Liquidity
• Before redemption need to follow notice period – 30 to
90 days
• On redemption may make payment on securities
197
• Performance and reporting

• No standard reporting format
• Requires annual auditing
• Need to provide investors with..,
» Auditors report
» Tax reporting document
• Tax issues
• Tax expenses pass through to investors
• Tax consequence varies across investment strategies
198
• For hedge funds to exempt from regulations and disclosures

should meet following requirements..,
• Limited to 99 accredited investors
• Not allowed to actively market its investment products
• Allowed to accept investments from qualified purchasers
» Families: assets > $5 million
» Institutions: assets > $25 million
• Accredited investors include..,
» Minimum liquid assets > $1 million
» An individual’s income > $200,000
» An individual’s family income > $300,000
199
Hedge Fund Characters
200
Discussion Question
What is managed futures funds?
201
Managed Futures Funds
• Highly regulated exposure to alternative investments
• Invest in…,
• Physical commodities
• Futures
• Futures options
• Registered as..,
• Commodity pool operators (CPOs)
» Place all investor funds in a commingled account
• Commodity trading advisers (CTAs)
» Single manager funds
» Managed in separate personal accounts
» Invest in no. of CTAs
202
Managed Futures Funds
• Trade in variety of liquid world wide future
markets..,
• Energy
• Metal
• Agricultural commodities
• Currencies
• Financial futures
• Interest rate indices
• Stock market indices
• Charge extremely high fees
203
Alternative Investments vs. Traditional
investment
• Returns not correlated to business cycles
• Lower volatility of returns
204
CSFB/Tremont Hedge Funds Index
• Includes categories of..,
• Convertible arbitrage
• Dedicated short bias
• Emerging markets
• Equity market-neutral
• Event-driven
• Fixed-income arbitrage
• Global macro
• Long-short equity
• Managed futures
205
Discussion Question
How the assets in HF investments are

distributed?
206
Assets Distribution of Hedge Fund Investments
207
Discussion Question
How the hedge industry has changed over a

period of time?
208
Changing Hedge Fund Industry
209
Discussion Question
How HF managers and investors manage each

other?
210
Investors vs. HF Managers
• Conflicting on adding new investments
increasing risk
• Lock-back period arrangement
• Eg: incentive fee will be rebated if fund loses value
within 3 months of a new high-water mark
• Surrender fee
• Financing fee
• Trading commission
211
Discussion Question
What is the popular business structure used in

HFs?
212
Business Structures
Partnership
• Not taxed as business entity

• Also called ‘flow-through entity’
• Investors pay tax only once on money earned by partnership
• Partners are jointly and separately liable for the obligations of business
• Minimum required: two investors
• Income and expenses allocated to partners according to allocation rules
choose (allocation does not be equal)
213
Business Structures
General / Limited Partnership (LP)
• Types of Partners
• General partners
» Simply a partner in a partnership firm
• Limited partners
» Cannot be asked to invest more than the capital
• Income and expenses are allocated to all investors on partnership tax
returns
• Allocation follows complex rules
• Should have at least one general partner and one limited partner
• To avoid registration with SEC should have < 99 investors
• Most common structure for the pool of investment funds that make up a
HF
214
Business Structures
Subchapter S Corporation
• Combines: tax features of partnership firm +

corporation’s limited liability
• Like a LP without general partners
• Files tax return not leading to tax liability for
business
• Investors cannot be more than 35
• Can be only one class of shares
• All owners must be individuals, not businesses
215
Business Structures
Limited Liability Corporation (LLC)
• Closely resembles an S corporation

• Is flow-through tax entity
• Investors liability is limited to their paid-in
investment
• Created to assume general partners
responsibility
• Expected to completely replace both
partnership and S corporation
216
Business Structures
Nested Structure
217
Business Structures
Domestic LP Structure
• Actual investment fund: LP

• Has no employees
• Funded by: LP and GP
• Investment decision by: hired management company
• S corporation ..,
• Can serves as..,
» General partner
» Management company
• Carries all employees in his name
• Pays management fee + incentive fee
• Assets of investment management company are not exposed to the risk of
loss from any of the hedge funds
218
Business Structures
Domestic LP Structure
219
Business Structures
Offshore Hedge Funds
• A corporation
• Located in country with less or not tax
• Minimized penalty of double taxation
• Simple fund administration
• NI does not flow through
220
Business Structures
Offshore Hedge Funds
221
Business Structures
Mirrored Structure
• Two funds run identically..,

• Domestic funds
• Offshore fund
• Requires rebalancing on cash flows
• Transactions down between funds
• Impossible to rebalance on..,
• Derivatives securities
• Private placements
222
Mirrored Funds After Cash Flow
223
Mirrored Funds After Cash Flow (Not Rebalanced)
224
Mirrored Funds After Cash Flow (Rebalanced)
225
Business Structures
Master-Feeder Hedge Fund Structure
• Offshore fund carries all positions

• Domestic funds has a single asset; investment
in offshore hedge fund
226
Business Structures
Master-Feeder Hedge Fund Structure
227
Setting Up Hedge Fund Business
• Questions to be answered..,
• Should the management company be an S corporation
or an LLC or something else?
• Should the management company also be the general
partner?
• Where should each business be domiciled?
• What happens to the founders of the partnership if
things go well? Or poorly?
• What registrations are necessary to comply with state
regulations?
228
Discussion Question
What are steps involved in setting up hedge fund

business?
229
Setting Up Hedge Fund Business
• Stages..,
• Setting up management company
• Creating partnership
• Select professional to deal with documents – lawyer or
an accountant
» Partnership agreement
» Risk disclosure document
» Subscription agreement
• Make fixed up-front expenditures and underwrite both
fixed and variable continuing expenses
230
Discussion Question
What are the administrative functions of HF’s

management firm?
231
Administration Functions of HF’s
Management Firm
• Ticket writing
• Safe keeping of securities
• Making and taking delivery of securities
• Receiving and disbursing money from and to investors
• Paying expenses
• Corresponding with investors
• Marketing
• Accounting
• Governance of business
232
Discussion Question
What are tax issues involved in HF investments?
233
Tax Issues of HFs
• Must pick a tax year
• At the year end banks and broker-dealers
must publish a B/S
• Should distinguish..,
• ST gains and losses
• LT gains and losses
• Gains and losses of future and commodities
234
Discussion Question
How HFs disaster?
235
Hedge Fund Disasters
The Granite Fund
• Invest in: exotic mortgage instruments

• Provides: market-neutral pattern of return
• Deal with..,
• Pass-through bundled by..,
» Fannie Mae
» Freddie Mac
» Federal Home Loan Mortgage Corporation
• Collateralized mortgage obligations (CMOs)
• Real estate mortgage investment conduits (REMICs)
• Cash flow resemblance: ST and LT govt. bond
• Risk resemblance: prepayment risk for loan portfolio
236
The Granite Fund
• Generally used hedging tool: interest rate options

• Leverage: too much (10 times)
• Mistakes: inadequate hedging
• Lenders demanded..,
• Additional collateral
• Reduction in loan balances
• Immediate repayments
• Spiral resemble: run on a bank
237
The Granite Fund
• Lessons learnt..,
• Leverage creates a unique risk independent of assets
• Other hedge funds under threat were..,
• Ellington Capital
• Illinois Institutional Investors
238
Fenchurch Capital Management
• Type: Mirrored fixed-income arbitrage funds

• Fund amounts..,
• 1990: $25 million
• Mid-1995: $850 million
• Performance..,
• High return
• Low risk
• Highest sharpe ratio in industry
• Funds invested in combinations of..,
• Futures
• Options arbitrage
• Yield spread between variety of high-quality fixed income assets
» Treasuries of adjacent vs. non adjacent maturities
» Treasuries vs. Euro dollar futures
» Mortgage pass-through vs. treasuries
• Arbitrage trades
• Non directional relative value trades
239
• New business started in: London

• Was not doing well
• Traded at high volatility (10 times as volatile as US)
• Merged US and Europe businesses
• Consequences
• Faced losses
• Redemption from investors
• Reduced position size of..,
» Cash: 60 times capital
» Futures: 60 times capital
» Options positions: 60 times capital
240
• Reasons for failure

• Merging two business (US and Europe)
• Capacity constraints
• Huge size fund in less liquid markets
241
Long Term Capital Management (LTCM)
• Founded by: senior traders from Salomon

Brothers
• John Meriwether, former vice chairman, Salomon
Brothers
• Performance..,
• Enjoyed good performance
• Strengthened reputation of the firm
• Billions of fund raised with support of: Merril Lynch
• Hired large research team
• Established massive credit lines with trading counter
parties
242
• Leverage: > 250 times the fund capital

• Greatest source of risk reduction: diversification between
strategies employed
• When market were in disarray, correlations reverted to 100%
• Fund experienced huge loss
• Could reduce position since market followed LTCM and caused
liquidity
• Aggregate risks of portfolio: > sum of individual risks
243
Tiger and Bowman Funds
• Found by: Julian Robertson

• Investment idea: buying stocks that are under priced and
selling short issues that are over priced
• Growed to world's largest hedge fund
• Investment growth: 150 times of initial investment
• Aug 1998-April 2000: lost ½ of investment
• Result: closed funds and returned fund to investors
244
• Lessons learnt..,
• Narrowly growing strategies can be vulnerable to
persistent periods of performance beyond the control
of the manager
245
Manhattan Fund
• Established by: Michael Berger

• Type: long-short value hedge fund
• Fund raised: $400 million 300 investors over
several years
• Result: falsified results to claim profitable
• Learning: How much trust and confidence to
place in a fund manager
246
Performance and Diversification Attributes
• Attributes supporting HFs in a portfolio of

assets are..,
• Prospects for performance enhancement
• Diversification
• HFs have some non correlated attributes
• HF indexes are subject to biases
• Survivor bias
• Backfill bias
• Reporting bias
247
Hedge Funds
• Things expected by external investment

managers..,
• Well-defined investment process
• Transparency
• Relative returns
248
Discussion Question
What is HF indexes?
249
Hedge Fund Indexes
• Serves two key purposes..,

• Proxy for hedge fund asset class
• Performance benchmarks to judge the success or failure of HF managers
• Constructed using different no. of HFs
• HFs used range: 60 to >5,000
• May use..,
• Simple averages
• Capital-weighted indexes
• Are many different construction techniques of HF indexes
250
Issues in Hedge Fund Indexes
• Size of total universe of HFs is not known with certainty

• Voluntary disclosure of HF’s performance
• Annual disclosure of performance
• High attrition rate
• Average age life of a HF manager is 2½ to 3 years
• Considerable turnover on a annual basis with respect to HF
index construction
251
• Survivorship bias
• HF survived time period of study and are available for index construction
• Upward bias
• HFs with superior performance will survive in long run
• Selection bias
• Free option for HF managers to report
• Instant history or backfill bias
• Liquidation bias
• HF performing badly will stop reporting before cessation
252
• Distinct lack of consistency in HF index construction

• Indexes provide month-by-month performance while HF
discloses performance annually
• Changing fees structure by HFs
• HF turnover tends to be one-sided
253
Strategy Definition for Index Providers
• Difficult to define strategy

• HF classification system varies from index to index
• Different way of classifying
• Dynamic trading nature of HFs
• Based on disclosure document by HFs
• Lack of specificity by HFs leads to guess work on part of index providers
• No established format for classifying HFs
• Problem of strategy drift
• Mostly unregulated trading practices
• Limit on investment assets by HFs affecting investability
254
Asset Weighted Index vs. Equal Weighted Index
• Asset weighted index

• Susceptible to disproportionate representation from large funds that have
a very large gain or loss in any given time period
• Smaller HF can transact with a smaller impact
• Equal weighted index
• Not favoring large funds HF strategies that attract a lot of capital
255
Strategic Capital Management
256
Consolidated Balance Sheet for Creative Computers, Inc. on September 30, 1998 (Thousands of Dollars)
Assets Liabilities and Stockholder's Equity
Cash and equivalents 15528 Accounts payable 75877
Accounts receivable 40564 Short-term debt 2969
Inventory 44958 Other current liabilities 15336
Other current assets 12428 Capital leases 29
Property, plant and euipments, Net 15040 Notes payable 154
Other long-term assets 14313 Stockholder's equity 48466
Total assets 142831 Total liabilities & stockholder's equity 142831
CC’s outstanding shares as on Dec 9, 1998: 10,238,703
265
Consolidated Balance Sheet for Ubid, Inc. on September 30, 1998 (thousands of Dollars)
Other current assets 10 Advances from the parent 3709
Property, plant and euipments, Net 302 Stockholder's equity -3292
Other long-term assets 739

Ubid’s outstanding shares as on Dec 9, 1998: 9,146,883
266
Ubid’s Market Value
• Using book value values as estimates of market values for net working capital, PP&E, other LT assets, and
debt yield – the market value balance sheet..,
Ubid's Market Value Balance Sheet

Cash and equivalents (cash + AR) 25899 Accounts payable 4760
Other current assets 10 Advances from the parent 3709
Property, plant and euipments, Net 302 Stockholder's equity 326540
Other long-term assets 739
Growth Opportunities (Plug) 304432
• Ubid’s market value was based almost exclusively on anticipated growth opportunities
• Upid’s growth rate fueled the market’s anticipation of future growth
• 326540 = 9146.883*35.69
• 25899 = 499 + ((1817*15) – 1900) 274
Creative Computer’s Market Value
• 9 Dec, 1998
• Stock closed at $22.75
• Market capitalization = $22.75 x 10,238,703 = $233 mm
• Book equity: $48.5 mm
Creative Computer's Market Value Balance Sheet (Thousands of Dollars)

Accounts receivable 40564 Short-term debt 2969
Other current assets 12428 Capital leases 29
Property, plant and equipments, Net 15040 Notes payable 154
Other long-term assets 14313 Stockholder's equity 232930
Ubid stake (9146883 - 1817000) x $35.6875 261585
Stub (plug) -77121
• Cash and current liabilities and assets are assumed book values
• Market places a negative value on the stub assets
• If market value of other assets exceeds the book value (as would be expected give the conservatism principle of
accounting), stub value will be even more negative than the -$77.1 mm
What does it mean in an efficient capital market 275

for assets to have a negative value?
Negative Assets
• Negative assets are viewed as liabilities

• Its difficult to characterize CC’s stub assets as liabilities
• CC’s
• Had achieved record sales in the most recent quarter
• Net income was highest since the 3rd quarter of 1997
• Large off balance sheet liabilities might explain the negative stub value
• Investors fears that CC’s managers will squander the value of Ubid stake
might explain the apparent anomaly
• Valuing one firm relative to another can often be considerably easier
than an absolute valuation done in isolation
276
Investment Decision Options
• Buy CC
• Buy Ubid
• Short sell CC
• Short sell Ubid
278
Buy CC
• For
• Rapid growth
• Profitable
• Ubid stake is valuable – buying CC dominates the buy Ubid strategy
» Buying one share of CC gives the owner 0.7159 shares of Ubid (9146883 –
1817000)/10238,703 = 0.7159)
» Cost of CC share is $22.75
» Value of 0.7159 Ubid shares is $25.55
• Against
• Off-balance-sheet liabilities could explain the negative stub value
» Ex: CC’s management may squander the value of the Ubid stake
• Value of CC depends on value of Ubid – a young company valued solely on
perceived growth opportunities
280
Short Sell Ubid and Buy CC
• Attempts to profit from CC’s negative stub value
• By purchasing one share of CC for $22.75, Elena will effectively own
0.7159 shares of Ubid
• She simultaneously short sell 0.7159 shares of Ubid, producing short
proceeds of $25.55
• If the proposed spin-off occurs, Elena’s short proceeds will be released
generating a minimum unlevered six months return 12.3%
• If CC’s other assets actually have positive value, and if Elena receives
interest on her short proceeds, her return will be greater than 12.3%
281
• For
• Market neutral strategy is consistent with the hedge-
fund’s mandate
» Profit does not depend on overall market moves
» Profit will be made whether CC and Ubid go up or down
• Profit depends on Elena’s ability to calculate relative
values of CC and Ubid, not absolute value
282
• Against
• Proposed spin-off may take longer than six months
• IRS approval of tax status of spinoff may not be granted
• CC’s management may squander the Ubid stake
• Unknown off-balance sheet might explain the apparent
arbitarge opportunity
• Shorting stock subjects investors to unlimited downside
– what if Ubid stock skyrockets?
283
Implementing Arbitrage Strategy
• Long positions in equity can be established on an unlevered
basis
• Short position must use financial leverage
• Underlying short position requires the investors to sell borrowed stock,
which gives rise to a liability
• Margin requirements
• Investors post minimal initial capital of 50% for any long position
» Margin loan from investor’s broker can be used to finance remaining
50%
• 50% initial margin is required for all short positions
284
Implementing Arbitrage Strategy
• Maintenance margin requirements are set by
stock exchanges and self-regulatory
organizations
• 25% for long positions
• 30% for short positions
285
Arbitrageur's Initial Balance Sheet per One Share Long Creative Computers
Assets Liabilities
Cash collateral posted for short position
(50% of 25.22) 12.78 Margin loan (50% of 22.75) 11.38
Short proceeds 25.55 Short 0.7159 Ubid shares 25.55
Long 1 share of CC 22.75 Equity 24.15
Total assets 61.08 Total liabilities and equity 61.08
If CC and Ubid’s stock prices change, both the margin requirements and
the equity capital available to meet the margin requirements change
What if the following happens?
Change in Ubid stock price: from $35.6875 to $53.125 286
Change in stock CC stock price: from $22.75 to $28.875
Arbitrageur's Initial Balance Sheet per One Share Long Creative Computers
Assets Liabilities
Cash collateral posted for short position
(50% of 25.22) 12.78 Margin loan (50% of 22.75) 11.38
Short proceeds 25.55 Short 0.7159 Ubid shares 38.03
Long 1 share of CC 28.88 Equity 17.8
Total assets 67.21 Total liabilities and equity 67.21
Change in Ubid stock price: from $35.6875 to $53.125
Change in stock CC stock price: from $22.75 to $28.875
287
Remember
• HF search for violations of law of one price – giving rise to +alpha with low
risk investment strategies
• Difficult to find 2 securities with such clean link
• No guarantee that prices will converge
• Even if prices converge, arbitrageur may not be able to maintain his position until
convergence
• Path to convergence may be too long or too bumpy
• Requires upfront capital to secure loans – cost is involved in borrowing
• Skills required for a HF
• Specialized to identify arbitrage opportunities
• Requires a diversified approach – not easy
• Arbitrageurs work hard to eliminate mispricings, but-real world frictions
limit their effectiveness
288
• Non-directional strategies
• Return is independent of market directions
• Investing in relative performance between two securities
• Equity market neutral
• Balanced long short position
• Minimizes exposure to market
• Provides risk-free rate if its hedged against all possible market factors
• Performs well in both bear and bull market
296
An investor believes stock ‘A’ will outperform stock ‘B’
Long stock A: $1000, Short stock B: $1000
Scenario 1 Gain Scenario 2 Gain

(Loss) (Loss)
Stock A appreciates by 30% $300 Stock A depreciates by 10% -$100
Stock B appreciates by 10% -$100 Stock B depreciates by 30% $300
$200 $200
(Loss) (Loss)
-$200 -$200
Positive return = al long as the long position outperforms the short

position on a relative basis 297
• Long: bond expected to do better
• Short: bond expected to do bad
• Used to benefits from pricing anomalies
• Neutralizes interest rate and inflation risks
• Yield curve arbitrage
• Kink in yield curve: 20-year T-bond yield is lesser than 10-year T-bond yield
Short: 10-year T-bond

• Long: 20-year T-bond
• Performance depends on relative performance of T-bonds
299
• Yield spread arbitrage
• Treasury / Eurodollar spread (TED spread)
arbitrage – investing in Edr and TBs futures
• Mortgage-back securities arbitrage
• Closed-end fund arbitrage
• ADRs arbitrage
• Statistical arbitrage – using mathematical
models to know mispricing
300
• Trading on stock of companies involved in
special situations or events
• Merger arbitrage
• Also called risk arbitrage
• Long: target stock
• Short: acquirer’s stock
• Distressed securities
• High yields
301
Merger Arbitrage
• Company A: $50
• Company B: $70
• Offer made by ‘A’ to buy ‘B’
• Swap ratio; A:B = 2:1
• B price increases to $90 on announcement, leaving a
gap of $10 between new price and bid price
» Long: 1 share of B
» Short: 2 shares of A
» If deal happens, profit = $10
302
Directional Strategies
• Taking bets on direction of market movement
to make substantial profits
• Leverage is used to enhance return
• Long or short equity
» One side and trying to make money in direction
movements of stocks prices
• Dedicated short
• Global macro
• Emerging markets – possible mispricing
303
Hedge Fund Strategies in Assets Under Management
Strategies $ bn %
Relative value 193.1 22%
Equity market neutral 33 7%
Convertible arbitrage 40.7 8%
Fixed income arbitrage 35.6 7%
Event-driven 83.8 17%

Directional 254.6 52%
Long / short equity 161.8 33%
Dedicated short 0.9 0%
Global macro 51.7 11%
Emerging markets 17 3%
Managed futures 23.2 5%
Others 41.9 9%
304
TASS asset flows report, Termount Capital Management, 4Q 2003
Beta of Selected Investment Strategies vs. S&P 500
Strategy Beta
Fixed-income arbitrage 0.0
Mortgage arbitrage 0.0
Conventional bond arbitrage 0.0
Special situations 0.4
Currency trading 0.1
Managed futures 0.2
Risk / merger arbitrage 0.3
Hedged equities 0.3
Emerging markets 0.8
Global macro 0.5
Corporate restructuring 0.7
Directional equity 0.9
Average Beta 0.4

Source: Merrill Lynch Investment Partners, Inc. 305
Measures in Practice
• Key risk measures
• SD
• Downside risk
• Drawdown
• Key performance measures
• Sharpe ratio
• Sortino
• Calmar
• Other quant analysis (Supplementary)
• Time window analysis
• Benchmark
• Draw Down analysis
• Gain/Loss
• Up capture
• Down capture
• Recovery
• Rundown
367
HF Investment Strategies
454
Hedge Funds
• Private investments vehicles where the manager has a significant stake in the fund
and enjoys high level of flexibility to employ a broad spectrum of strategies
Traditional Hedge fund

Return Target Relative Return Absolute Return
Definition of risk Tracking Error Loss, VaR
Principale font of return Market direction Alfa
Methodology Buy Long, Port. Constr. Long – Short
Definition of succes Outperformance vs bcmk Absolute Return vs Risk
Incentive System Fixed Fees Performance Fees
455
Hedge Fund
An asset manager That is less constrained than a traditional
investment manager
Accessing the same Investing in their choice of Equities, Fixed

markets as others Income, Currencies and Commodities.
But who is un Can use leverage, short selling and

constrained derivatives without a benchmark constraint
And is incentivised Relates compensation directly to

performance
To be a skill based Allowing investors to access some of

investor thebest talent in money management
456
Hedge Fund
Have different return Can give exposure to different sources of
return from those which drive traditional
drivers
asset classes
And pursue many Hedge Funds comprise a large and growing

different strategies set of strategies
In a more lightly Require a higher level of initial due

regulated environment diligence and ongoing monitoring than
traidtional managers
And may perform Offering different return distributions from

differently traditional managers
Offering diversification Generate returns with a low correlation to

benefits traditional strategies
457
Hedge Fund
Portfolio return
Return from
Risk-Free rate Market Active Return
exposure
Beta Dependant Alpha generated
Source:GSAM
458
Hedge Fund
 Not an asset class, closer to a normal business into the AM space
 In order to survive HFs need other agents acting on diverse target

functions (central banks, indexed asset managers, liability managers,
managers subject to regulatory changes)
Source:UBS
459
Using Hedge Funds
 Diversification
Absolute Return
Low Correlation
Low Volatility
Increase Return per units of Risk
460
Benefits of Hedge Funds
Bond S&P 500 Hedge

Annualized Return 8.30% 9.68% 12.83%
Standard deviation 4.25% 15.28% 4.28%
Sharpe Ratio 0.83 0.32 1.88
Correlation 0.15 0.41 1

Worst Montly
-2.45% -14.46% -4.45%
Return
461
Low Risk
Relative Value
Attempt to capitalize on inefficiencies between mispriced related securities. No
correlated with market
Event Driven
They seek to generate positive return capitalizing on inefficiencies create by the dynamics of a particular
corporate event (merger, bankruptcies, liquidation, buy back, etc). No correleted with market.
Long / Short
They seek to generate return limiting market risk (beta) and looking for alpha. LS
managers use fundamental analysis.
Global Macro
They seek to generate return from an extremly wide variety of trading strategies and
asset classes. They can take directional wiews, both long and short, on global interest
rate, currencies, commodities, equity.
High Risk
462
Market Indipendent Directional
Relative Event Equity Tactical

Value Driven Long/Short Trading
Diversified Managed
Fixed Income High Yield/ Futures
Relative Value Didstressed debt Geography
Global Macro
Equity Market Special Situations Industry/Sector
Neutral Quantitative
Risk Arbitrage Concentrated Macro
Convertible Long Only
Hybrid Public ad Macro Relative
Trading
Private Investing Value
Credit
Direct Lending
Relative Value
Mezzanine
Emerging
Financing
Market Debt
Relative Value Capital Structure
Trading
463
Convertible arbitrage
Managers buy convertible bond and generally hedge with short position
in underlying stock.
Fixed income arbitrage

Managers tray to capitalize from temporary distorsions in the
relationships between similar fixed income securities
Statistical arbitrage
Managers analyze statistical tradind pattern of pairs or groups of secuirity
(equities) that tend to follow similar historical pattern. They tray to take
profits when these pattern become disjointed
Capital Structure arbitrage

Profit from inefficiencies found among the various securities within a
single firm’s capital structure.
464
Merger arbitrage
The strategy seeks to generate returns from corporate merger and take over
activity.
Distressed Securities
Distressed fund invest in the dept or equity of companies experiencing
financial or operational difficulty. These secuirities typically trade at
substantial discount compare to fair value
Special Situations
They can refer to a variety of corporate event (liquidations, stock
repurchase, stock splits, spin - off
465
Long/Short Strategies
L/S Equity Market Neutral
Fund are run with low net market exposure
L/S Equity Long Biased

Funds that have high degree of market exposure and high correlation with
markets
L/S Equity Short Biased

Funds that have low degree of market exposure and low correlation with
markets
L/S Equity Sector Fund

Funds that focus on one or a few industry sectors
466
Macro Strategies
Discretionary
Managers analyze macroeconomic factors (GDP, trade Deficit, unemployment,
monetary policiy) to formulate thei positions on fixed income, currency,
equity, commodities, etc).
Systematic (trend followers or CTA)

Managers utilize computerized trading systems designed to capture the
trading tendencies of global markets. Price movements and volatility are
monitored in order to anticipate market’s dynamic.
467
Strategy Comparison
Quantitatvie Analysis: January 1, 1990 to December 31, 2005
Annualized Std. Dev. Best Worst Correlation

Return Month Month S&P 500
Relative 9.96% 3.54% 3.33% -3.19% 0.24

Value
Event 10.10% 4.24% 2.90% -6.14% 0.39

Driven
L/S 17.16% 8.79% 10.88% -7.65% 0.66

Equity
Macro 15.68% 8.49% 7.88 -6.40% 0.5
Leh. Bond 7.36% 3.88% 3.87% -3.36% 0.15
S&P 500 8.21% 14.27% 11.16% -14.58% 1
468
Risks
True Risks False Risks
6000
Exponential Growth Mispricing 5000
of masses 4000
Insitutional investors Leverage: leverage is 3000
are tipically last dimishing contrary to 2000
movers what Mr.Greenspan 1000
Over-Recruiting Media Coverage 0
1990
1992
1982
1984
1986
1988
2000
2004
1994
1996
1998
2002
(negative feeling)
Rare arbitrage
opportunities:
spreads, M&A,
convertibles
Excessive return
Expectaions
469
Leverage
Example
Without Leverage
Capital Available $ 1000 After 1 Month – Market up
Market Exposure $ 1000 Selling Price $ 12
Price per Share $10 Profit in $ $ 200
Number of Share $ 100 Profit in % 20%
With Leverage
Capital Available $ 1000 After 1 Month – Market up
Add leverage by borrw. $100 Leverage Factor 1.1 to 1
Market Exposure $ 1100 Selling Price $ 12
Price per Share $10 Profit in $ $ 220
Number of Share $ 110 Profit in % 22%

470
Long- Short Equity Funds
+100%
Long: 80%
Net Exposure: 40% Gross Exposure: 120%
Short: - 40%
-100%
Beta Long: 0.96 Beta Short: 1.14
Beta Portfolio: 80% * 0.96 - 40% * 1.14 = 0.76 – 0.46 = 0.30
Theoretically, if the overall equity market falls by 10%, the portfolio should only
Lose approximatly 3%, thus protecting against 70% of the dowun side equity
Market movement.
471
Alternative Investments
472
Developments in HF Industry
25% Growth p.a.
473
HFs are a Kind of Progressive MFs
474
Hedge Funds are More Flexible than Mutual
Funds
475
FoFs vs. HFs
476
HF Strategies
477
Long / Short HF Strategies
478
Commonly Used Legal Structure
479
Off Shore Structure of FoF
480
Off Shore Structure of HF
481
Role of Different Parties
482
Hedge Fund Management
483
484
Hedge Fund Risks
485
HF and Leverage
486
Hedge Fund Downside Correlation
487
Core Satellite Investment
Approaches
488
HF Investors
489
Paradigm Shift in Asset
Management Industry
490
HF Returns
491
Return Decomposition
492
Integration of HFs in Tarditional
Portfolios
493
Why HF?
494
Future of HF Industry
495
HF Classification
496
Analysis of HF Returns
497
HF and Performance Luck
498
Features of HFs
499
Benefits of Including HFs
500
Barriers to HFs
501
Hedge Fund - Definition
Hedge funds are investment pools that are relatively unconstrained in what
they do. They are relatively unregulated (for now), charge very high fees,
will not necessarily give you your money back when you want it, and will
generally not tell you what they do. They are supposed to make money all
the time, and when they fail at this, their investors redeem and go to
someone else who has recently been making money. Every three or four
years they deliver a one-in-a-hundred year flood. They are generally run
for rich people in Geneva, Switzerland, by rich people in Greenwich,
Connecticut.”
-Cliff Asness, Journal of Portfolio Management 2004.
502
HF Return Issues
• Survivors / backfill / self-reported
• Everyone seems to have beat the average. All alive have! 20% death rate
• Best guess: average HF returns are overstated by 2-5% per year
• Uncertainty about mean returns = σ/√T. If σ = 15% then uncertainty about 5 year
mean returns is 2 x 15/ √5 = ± 13%. (And 5 years is a lot!)
• Dynamic strategies, options. With small probabilities of large disasters, historical
averages are especially poor measures (more coming)
• Very little persistence. The strategy of buying HF that did well in the past does
not do well going forward
• → Evaluating average returns, alphas from return history (track record) is nearly
hopeless
• Historical data are still useful for measuring risks, betas
503
Alphas and Betas
rti   i  i rt m   ti
 
r   i  i E r
i
• Beta: tendency ofEreturn to rise if the m
 
market rises
• Beta times rm: How much of the return can you get in an
index fund. (“Style”)
• Alpha: average return earned in excess of this. (“Selection”)
• Epsilon: extra risk beyond index fund.
504
Care about Beta
rti   i  i rt m   ti
E r     E r 
• No point to paying fees for beta x rm that you can get in an index fund. Hence, beta x rm is
the right benchmark; only pay feesi for alpha. m
• With beta, you can short beta x rm to remove i marketi risk (or the fund could do it and really
be market-neutral).
• Risk management: To form a portfolio, controlling market (and other) risks, controlling
correlation between HF, you need to know the betas.
• Example: Invest in index futures as an “alternative asset” to get diversification? Beta tells you
no!
• In fact, you want to know betas corresponding to all passive strategies!
rti   i   im rt m   iv (valuet )   ib (bondst )  ...   ti

505
506
Alpha and Betas
• Betas are larger than you might have thought, larger than “market neutral”
“absolute return” claim, and interest rate fee benchmark.
• Alphas are correspondingly smaller than average returns. You’re paying
performance fees for index-fund components.
• Betas are hard to measure, especially for illiquid securities. At least look
longer than 1 month.
• Even if some alpha remains, are HF really about a few percent alpha (plus
big risks?)
• Q: “Sure, average alpha is low, but my alpha is big.”
• A: How to separate luck from skill? Only answer: form a portfolio of good-
looking funds based on ex-ante information, track them later. So far, little
alpha here.
507
Option Like HF Returns
508
509
Example – Merger Arbitrage
Price
•Cash offer. Borrow, buy target.

•Large chance of a small return if successful. (Leverage: a large return)
•Small chance of a large loss if unsuccessful.
•The strategy seems unrelated to the overall market, “beta zero”
•But…offer is more likely to be unsuccessful if the market falls!
•Payoff is like an index put! 510
Merger Arbitrage Morals
• Even though it’s an all-equity strategy (no option positions)

dynamic trading gives an option-like payoff
• Not necessarily a bad thing! Writing index puts earns a
premium. It provides “disaster insurance” to the market
• But no need to pay 2+20 to write index puts!
• “Alpha”, “beta”, benchmark, performance evaluation should
be relative to the strategy of writing index puts!
• (Mitchell and Pulvino are now running a merger-arb hedge
fund, so at least they think such alpha is there.)
511
HF Up / Down Betas
512
Option-like Returns Mean: Beware Averages (Even
More)
• Example. If the return is (1, 1, 1, 1, 1, -10, 1, 1, 1, -10, 1, 1, 1, 1,…) you are very likely to see many years
with only +1, “we consistently outperform the market.’’
• Actual mean return depends on how likely the disaster -10 is. You need a long history to figure that out
based on statistics.
• Like writing earthquake insurance in LA.
• Distribution of profits from writing puts is very far from normal:
513
HF Fees
• Management + performance
• Often 2% + 20% of gains
• Funds of funds charge 2% + 20% too!
• → Massive number of new funds!
• → How do they attract money, and maintain
such high fees?
514
HF Fees, Incentives and Options
Management fee
2% + 20%
2%
Portfolio value
515
HF Fees, Incentives, and Options
• (0), 2%, 20% = a call option.

• Investor view: Incentive for needless volatility.
• Examples. You are given $1000:
– Do nothing : Fee = $20
– Bet $500 50/50: Expected Fee = $70
• ½ x 0.02 x 500 + ½ x (0.02 x $1500+ 0.20 x $500) = $70
– Bet 99% + $1K,1% -$100K: Expected Fee = $238
• Mean : 0.99 x $2000 + 0.01 x (-$99000) = $990 → lose $10!
• Fee: 0.99×(0.02×$2000 +0.20×$1000)+0.01×0 = $237.60
• Negative mean bet gets manager $238 with 99% prob.
516
Real Strategies to Game 2+20
• Write put options.

• Synthesize options with dynamic trades.
– Example: Double or nothing.
• Secret betas.
– Claim “beta zero” yet invest in index.
– Lots of other betas. Example: Value-growth, is
“market neutral” yet a mechanical strategy that
gives a good average return. 517
Solutions to the Incentive Problem
• General partners invest large fractions of their own wealth.

– Huge loss of diversification to GP. Really?
– Cannot apply to HF run by banks, institutions.
• “GP want to preserve their reputations”
– Effective?
• Clearly understood strategy, clear and honest risk management and
reporting.
– Not yet, but I can’t see any other way!
518
Risk and Reward or Magic Alpha?
• Example: Spring 2005: GM downgraded. HF (short treasury, long corporate) have big losses.
• Big losses lead to withdrawals. Funds have to sell illiquid securities at the worst possible time.
• Why should losses lead to withdrawals? If investors understood the risk and strategy they
would double up!
• Answer 1: If investors understood it they wouldn’t pay 2+20!
– Catch-22. Honest: investors won’t pay 2+20. Sell alpha magic: investors pull out at the worst time.
• Answer 2: High-water marks, losses mean the fund will will lose managers. Also, slow marking
to market means early withdrawers get more. It’s rational to pull out, like a bank run
– High water marks can be bad for investors, lock-in can be good for investors!
• General point. The fee and contract structure is important.
• (Future: is there “bounceback” in HF returns, so long term investors should ignore price
drops? Nobody has checked yet. If so, it changes everything.)
519
HF as Part of a Portfolio
• Problem 1: Risk management. Must know betas!
• How much are you overall short volatility?
• What is the chance that all HF investments go down together?
• Problem 2: Cost and fee explosion
• Is HF shorting something you already own?
» Portfolio is (10 A, 10 B). HF is long A short B
» Is (11A, 9 B) really worth short cost, 2+20 fee?
• Are HF offsetting each other?
» Is HF #1 long A, short B, HF #2 short A, long B?
» You pay ½ ( 2 + 20 ) for sure, plus short costs for nothing.
• Cost explosion – portfolio of options ≠ option on portfolio.
» 100 mean zero stocks in one fund: 2% for sure
» 100 stocks in 100 funds: 2% + ½ (20%) for sure!
520
Silliness in HF Investments
• “Hedge funds give us diversification”
• You can’t be more diversified than the market portfolio. If you have A and
B, adding (long A, short B) to the mix does not make you more diversified
– it makes you less diversified
• “We need to add ‘alternative investments,’ ‘new asset classes’ to ‘make
our rate of return targets.’”
• Most HF are not a new asset class. They trade in exactly the same stuff
you already own. And you can’t wish returns
• “We hold a lot of funds to diversify across managers”
• And get back to the market portfolio. Why pay fund 1 to long A short B
and fund 2 to long B short A?
• HF are not taking idiosyncratic risk. (If so, 2+20 is a disaster!)
• Hedge style betas with passive, not multiple active investments!
521
Another View
• Understanding HF: A brilliant marketing
success in a marketing business
• “Absolute Returns,’’ ”Market-Neutral,” “Alternative
asset,” “Near-Arbitrage”… “Alternative beta,”
“Entrepreneur”
• Whatever they mean, they separate rich people, money
• 2% + 20% “We only charge if we win.”
• Makes sense for a single investment. Makes much less
sense in the light of day, thinking about forming a
portfolio that is part passive, part active and spread
over many funds
522
Bottom Line
• Many large betas on a bewildering variety of new styles; Option-like returns with big tails.
• Betas, risks are hard to measure with historical data: style drift, short samples, too many
styles.
• Standard view of investor-manager relation.
– Both sides understand betas
– Clear “style” (no fee) vs. “selection” (fee) separation.
– Investor has already optimized “style” choice in passive investments.
• Our world
– HF sketchy on betas, investors have no clue.
– Most investors have not thought about multiple betas, passive “styles.”
– “style” vs. “selection”, “alpha” vs. “beta” is no longer relevant in the post-CAPM, dynamic, 20-factor
world. HF exist largely to collect large premia for holding risks of unusual styles.
– Alpha based on track record, statistical analysis is close to hopeless.
• Yes, I have asked more questions than I have answered. Large rewards for figuring out how to
answer these questions!
523
MF Regulations
• Custodial requirements
• Liquidity and portfolio diversification
• Restrictions on use of debt leverage
• Short selling restrictions
• Management fee arrangements
• Redemption requirements
• Disclosure and reporting requirements
524
Exemptions to HF Operations
• Trade any security or financial instrument
• Operate in any security market in world
• Unlimited use of derivative securities
• Unrestricted use of short selling
• Unlimited use of debt leverage
• Hold concentrated positions
• Set own investor redemption policies
• No extensive disclosure requirements
525
Regulatory Concerns about HF
Investments
• Investor Protection due to growth of HF
industry, instances of increasing fraud and
broadening exposure of institutional investors
in HF investments
• Systemic risk to other regulated financial
institutions caused by HF failures
• Market Integrity risk caused by HF activities in
the financial markets
526
Taxation of HF
• HF typically structured as a limited partnership, the general partner being the HF
management company
• Partnerships are not taxed directly as an economic entity (i.e. not a legal
corporation)
• Profits earned in partnership are reported to individual partners as income subject
to their Personal Income Tax filings
• General Partner earns “carried profits” from managing funds, as major source of
income for their services
• Carried profits are not taxed as income for services rendered (i.e. wages and
salary), but rather as investment income subject to Long and Short Term Capital
Gains
• Partners do not pay highest personal marginal tax rate (35%) but only 15% rate on
Long Term Capital Gains. (STCG taxed at 35% marginal)
527
HF Investor Protection
• Basic attitude of SEC regarding HF investors is “let them fend for themselves”
• SECrequires most HF advisors to be ‘registered’ under IAA ’40 will allow SEC
oversight regarding
• Conflicts of interest
• Anti-fraud provisions
• More disclosure of financial records
• Limits on advisor fees based on performance (i.e., no “asymmetric” performance fees)
• Only HF with “qualified” clients (net worth over $1.5 mil or min $750,000 invested
with advisor) can maintain the “asymmetric” performance fee structure
• Other HF limits and restrictions not set by SEC, but rather by contractural
relationships with investors and the market discipline of creditors and
counterparties
528
Systemic Risk of Hedge Funds
• Possibility of a series of Hedge Fund failures and defaults that are highly
correlated with resulting defaults inflicted on lenders (banks) and other
securities brokerage firms, that occurs over a short period of time. This
may also be caused by a single major event in the markets or economy
• Causes by be
• Illiquidity of assets held by HF due to being non-market traded, long time to find
opposite trade, and asset being too large to sell to single buyer
• Hedge funds may have high serial correlations with performance in past time
periods. This raises potential that loss in one month may be continued for many
subsequent months.
529
Retailization of the Hedge Funds
• Methods by which retail investors, below the “accredited” standards, can

invest in the Hedge Funds
• More households are meeting “accredited” standards (i.e., in 2002 5.2 million
households qualified, and in 2006, 8.9 million households did)
• Fund of Funds allow lower investments by retail customers because the FOF is the
“qualified” investor in the individual HF. However, the FOF advisers charge their
advisory fees on top of fees paid to the individual HF advisors
• Buy shares in a Hedge Fund Management Advisory company when it goes “public”
in IPO. (see Fortress Investment Group IPO in Feb 9, 2007, at price of $18.50 per
share, ending after first day at $31 per share on NYSE)
• Pension plans (private and public) are investing in HF on behalf of the many retail
customers that are in the pension plan
530
Evaluating HF Performance
• Peer groups are not reliable
• Severe survivor and backfill bias
• Extreme range of returns
• HF are not like one another
• Peer groups are loaded with biases
• Long waiting time for index to determine significance
• Hedge funds are unique
• Peer group – a collection of managers who are
similar in their investment approach, as
evidenced by correlated (>0.80) performance
531
Evaluating HF Performance
532
533
HF Evaluation Example
534
535
Alfred Winslow Jones
536
537
538
539
540
541
542
543
544
545
Relative Value Event-Driven Directional

Equity market neutral Merger / risk Long / short
arbitrage equity
Convertible arbitrage Distressed assets Dedicated short
Fixed income arbitrage High yield Global macro
Regulation D Emerging markets
Managed futures
546
• Non-directional • Minimizes exposure to
market
strategies • Provides risk-free rate if its
• Return is independent of hedged against all possible
market factors
market directions • Performs well in both bear
• Investing in relative and bull market
performance between
two securities
• Equity market neutral
• Balanced long short
position
547
An investor believes stock ‘A’ will outperform stock ‘B’
Long stock A: $1000, Short stock B: $1000

(Loss (Loss)
)
$200 $200
(Loss (Loss)
)
Positive return = as long as the long position outperforms the short
-$200 -$200
position on a relative basis 548
• Long: Convertible securities • Delta = (change in convertible
bond prices / change in share
of a company price) * (No. of share / No. of
• Short: Underlying stocks convertible bonds)
• Profit = coupon payments + • Conversion ratio = number of
interest on short proceeds shares into which each
convertible bond can convert
• Minimized exposure to • If delta = 10%, $1 change in
fluctuating stock prices underlying stock price will
result in a $0.10 increase in
• Ratio of convertible bonds to convertible price
underlying stocks is based • In delta hedged portfolio;
on delta.., gain/loss on long offsets
loss/gain on short
• Delta holds only for small
price changes – since its
linear
549
• Long: bond expected to • Yield curve arbitrage
do better • Kink in yield curve: 20-year
T-bond yield < 10-year T-
• Short: bond expected to bond yield
do bad Long: 10-year T-bond
• Short: 20-year T-bond
• Used to benefits from • Performance depends on
pricing anomalies relative performance of T-
bonds
• Neutralizes interest rate
and inflation risks
550
Treasury / Eurodollar
Yield spread spread (TED spread)
arbitrage – investing in
arbitrage Edr and TBs futures
Mortgage-back
Closed-end
securities
arbitrage fund arbitrage
551
Trading on stock of Merger arbitrage
companies involved in Also called risk arbitrage
special situations or Long: target stock
events Short: acquirer’s stock
Distressed
High yields
securities
552
Merger Arbitrage
Company Company
A: $50 B: $70
Offer made by ‘A’ to buy ‘B’
Swap ratio; A:B = 2:1
B price increases to $90 on announcement,
leaving a gap of $10 between new price and bid
price
Long: 1 share of B
Short: 2 shares of A
If deal happens, profit = $10 + interest on short
sales
553
Directional Strategies
Leverage is used to enhance return
Taking bets on Long or short equity
direction of market One side and trying to make money in
direction movements of stocks prices
movement to make Dedicated short
Global macro
substantial profits Emerging markets – possible mispricing
554
Hedge Fund Strategies in Assets Under
Management
Strategies $ bn %
Relative value 193.1 22%
Equity market neutral 33 7%
Convertible arbitrage 40.7 8%
Fixed income arbitrage 35.6 7%
Event-driven 83.8 17%
Directional 254.6 52%
Long / short equity 161.8 33%
Dedicated short 0.9 0%
Global macro 51.7 11%
Emerging markets 17 3%
Managed futures 23.2 5%
Others 41.9 9%
555
TASS asset flows report, Termount Capital Management, 4Q 2003
Beta of Selected Investment Strategies vs. S&P 500
Strategy Beta
Fixed-income arbitrage 0.0
Mortgage arbitrage 0.0
Conventional bond arbitrage 0.0
Special situations 0.4
Currency trading 0.1
Managed futures 0.2
Risk / merger arbitrage 0.3
Hedged equities 0.3
Emerging markets 0.8
Global macro 0.5
Corporate restructuring 0.7
Directional equity 0.9
Average Beta 0.4
Source: Merrill Lynch Investment Partners, Inc. 556
Remember
If shorting not allowed

– may use derivatives
557
Directional Relative Value Event Driven Tactical Trading Others
Long-biased Equity-market- Merger arbitrage Global macro Emerging markets
neutral
Short-biased Convertible bond Distressed debt Commodity trading Insurance type of
arbitrage advisers investments
Variable-bias Fixed income Event arbitrage Statistical arbitrage Cross over
arbitrage investments
Yield curve arbitrage Tender offer Managed future
Warrants arbitrage Liquidation Venture capital
Rotational Financial Mezzanine debt
reorganization
Spread between Spin-off Private real estate
commodities price
Spread between spot Carve-out REITs
and future price
Long in closed end
fund and short on
stocks
ADRs arbitrage
558
Hedge Fund Styles
• Directional trading area: ~25% of HF assets – Can be..,
» Long bias funds
• Managed futures can be divided into.., » Short-bias funds
• Discretionary trading » No-bias funds
• Systematic trading • Specialist credit and multipurpose funds:
<10%
• Market timing funds are included in tactical – Takes directional bets on..,
allocation category » Changes in debt or equity structure
of firm
• Discretionary trading also includes global » Yield spreads between different
macro funds types of fixed-income securities
• Least volatile funds: relative-value funds

• HF assets managed in..,
• Arbitrage + merger arbitrage + statistical
arbitrage: ~20%
• Security selection funds: > 45%
– Funds use long + short, but not always
hedged
559
Return Enhancers vs. Portfolio Diversifiers
560
Assets Distribution of Hedge Fund
Investments
561
• Market-neutral strategies • Rotational
• Combines long + offsetting short • One of the least homogeneous
position groupings of hedge fund strategies
• Extracts returns from mispriced • Non-directional strategies
• Securities
• Market sectors
• Attempts to capture a pending
• Group of securities convergence in valuation between
• Limits systematic risk securities
• Maximizes positive alpha • Tend to have a natural hedge in
• Range of return (net of fee): TB + 3% place
to 5% • May use securities with..,
• Relatively low volatility • Different voting rights
• Types.., • Different seniority
• Long / short equity • Also called capital structure
• Convertible hedging arbitrage
• Bond hedging
• Expected spread in a discrepancy:
> risk-free rate of return
• Spread is expected to have as
short a duration as possible – but
not time bound
562
• Natural extension of long • Factors driving return..,
only equity investments • Security selection –
• Sub strategy of long/short fundamental, quantitative,
technical
equity • Portfolio risk management
• Net exposure: 0 • Trade execution
• Long exposure = short • Expense management
exposure • May be vulnerable to
• Its also requires neutrality in certain rallies in equity
the form of..,
• Beta market that favor
• Industry • Lower quality
• Geography – country, market • Higher-beta equities at
• Style – growth, value, small, the expense of higher
mid, large
quality
• Neutrality on beta, sector or • Lower-beta equities
geography may create
misneutrality in amount of 563
investments
Long / Short Equity
• Long: undervalued equities • Quantitative techniques
• Short: over valued equities • Has become the big share of total
• Balances the portfolio structure by capital deployed by investors into HFs
consideration of.., • Are directional - tend to have some
• Markets correlation to the markets in which they
• Sectors trade
• Industries • Degree of directionality = f(net
• Market capitalization sizes exposure)
• Attempts to generate a ‘double-alpha’ • Net exposure = gross long positions –
gross short investments
strategy
• Long-biased funds: higher net exposure
• Balancing between short and long may • More directionality
be based on.., • Higher correlation to equity markets
• Amount
• Estimated volatility of short and long • Market-neutral funds: zero net exposure
position • Net zero directionality
• May use.., • Theoretical noncorrelation to equity
markets
• Fundamental analysis
• Technical analysis • Short-biased funds: negative net
exposure
564
Long-Biased Funds
Primary Logical extension of

traditional long -only
approach to investment
long/short equity management
Is organized Low volatility in

portfolio the equity market
management can be a boon
565
Short-Biased
Short exposures
Reverse
are more
directionality pronounced
Requires proper May potentially dampen

volatility in a portfolio
risk of multiple hedge fund
management investments
566
• Long-biased strategies • Largest returns to event driven
• Focus: specific corporate transactions investments come in average to strong
• M&A equity markets
• Tender offers • Investors expectations..,
• Bankruptcies • Return: >15%
• Liquidations • Lack of correlation with broad
• Financial reorganizations market moves
• Spinoffs • Most complicated strategies
• Warrant arbitrage • Deeply rooted in..,
• Reasonably well defined.., • Good research
• Increase in value of security • Strong convictions
• Time horizon
• Returns are independent of broad
market movements
567
Example..,
Stock
Trading
Name Price
Acquiring company ABC
Acquired company XYZ 50
Willing to pay price Premium of 30% to the pre-deal price 65
On anouncement of 65 bid the market price may not hit 65
Risk arbitrageur's questions
What is the probability that the deal will go through?
If the deal happens, what will be the final price for XYZ?
If the deal happens, when will it happen?
568
• Trading debt and equity securities • Canceling debt
of companies in financial distress • Negotiating partial settlements
• Currently in default on some debt • Canceling leases
obligations • Changing the terms of labor
• Close to default and negotiating contracts
with creditors to restructure
obligations • Declaring the previous equity
• Firm declared bankruptcy of the firm to be worthless
• Firms may have below investment • Low risk investments: senior
grade rating bonds, collateralized bank
• Also called ‘ultimate-value debt
investing’ • High risk securities: junior
• Correlation between default rates bonds, equity
and stock prices: ~-43.8% •
• Must have special skills to
understand bankruptcy process
• Bankruptcy court has broad
powers to restructure the
obligations of the firm..,
569
• Hedging debt from distressed investing • Return is based on..,
• Hedging interest rate risk: shorting • Value at which securities are
treasury bonds bought
• Hedging the risk of business conditions:
shorting the stock of other firms in the • Value receivable on bankruptcy
industry to hedge against the decline in • Time to be spent on bankruptcy
the liquidation values of the assets of process
the firm
• Probability of stock value moving
• Capital structure arbitrage to zero
– Strategy 1
– Purchase: debt securities
• Price paid by financial buyers <
– Short sell: equity shares price paid by strategic buyers
– Strategy 2 • Less popular strategy; 2.6% of
– Purchase: junk bonds to earn high
yields total strategy in 2001
– Purchase: equity put options to insure
against a continued decline in the • Correlation between distressed
stock price
» Can buy large no. of deep out-
investing and S&P 500: 0.55
of-the-money puts ensuring
that options will have • Significant risks: event risk and
relatively small price, yet still
have significant payoff if the
liquidity risk
company declares bankruptcy • Largest returns to distressed
before expiration of option investments come in average to strong
» Requires high correlation
between high yield debt and equity markets
equity
570
Bond Hedging
Also called..,
Long: higher yielding
Yield curve arbitrage
fixed income
Long/Short debt
positions instrument…,
Can be..,
Short: lower- Treasury vs. treasury (on
yielding fixed maturity differences)
Mortgages vs. treasury
income instrument Corporate vs, treasury
571
• Principles.., • Issuance schedules
• Yields between all fixed-income • Strategies of govt. and corporate
securities are related debt issuers
• Spreads between yields on • Market neutral funds
related securities are mean • Fund having zero duration
reverting • Returns are uncorrelated with
• Betting on convergence of spread direction of interest rates
• Capturing small pricing anomalies • Requires balance of currency
• Most quantitatively sophisticated and data exposure in portfolio – matching
intensive strategy duration of bonds in each
• Requires understanding of.., currency
• Tracking of thousands of bonds • Requires hedging for rotational
worldwide duration to hedge against yield
• Credit risks curve twists
• Embedded options • Involves significant amounts of leverage
• Liquidity • Requires continues access to lowest cost
funds available
• Also requires good credit rating
572
Rotational
Moving across relative value strategies

opportunistically..,
Hedging spread between commodities
Hedging spread between spot and
future
Long position in closed end funds and
short in constituent stocks
573
Sector Funds
• Investing into.., • Can enjoy money in their down market by..,
• Specific industry • Specialized knowledge
• Segment of economy • Experience
• Other groupings that shares a • Flexibility to sell stocks of the
common.., worst companies
» Product • Successful sector funds have concentrated
» Market on..,
» Theme • Biomedical
• Can invest long and short in various • Health care
instruments • Energy
• Their generally pursued strategies include.., • IT
• Equity hedge • Media
• Event-driven approaches • Financial services
• Invest in industries having..,
• LT growth rates superior to
economy
• Holding long position in those
companies offering best value in
the industry
574
Sector Funds
• Factors looked in a sector.., • Risk control..,
• High growth rates relative to general market • Maintaining balance between..,
• Industry in which specialist holding a distinct » Diversification
informational advantage » Concentration in meaningful
• Size and breadth to offer plentiful opportunities positions
that are independently affected by variety of • Disadvantages..,
factors • Limited focus – less opportunities
• Investment process.., • Highly correlated investment returns
• Identify growth stock with.., • Fortune depends on..,
» Good earnings and cash flows » Technology life cycles
» Price < intrinsic value of stock » Caprices of product development
• Look for catalytic event to heighten investor • Has to accept ST volatility
interest in the company
» New product launch • Performance; Jan 1990 – Mar 1998
» Regulatory approval • Average annualized return: 26.23%
» Corporate restructuring • Annual SD: 9.17%
» Understanding business model
• Taking positions
» Core positions: LT positions
» Trading and hedging positions: ST
positions in overvalued companies
» Hedge positions: may use index
derivatives
575
Convertible Hedging
• Long: convertible bonds
• Short: underlying common stock
• Example..,
576
Convertible Hedging
Example
Transaction Assets Units Price

Buy 7% convertible bond of Coy A 1 1000
Sell Common stock of Coy A 22 35
Hedge r a tio: 77%
For ev er y Rs. 1 th a t th e stock m ov es; bon d is ex pected to m ov e by Rs. 0.7 7
If T-bill r a te 5 %; th e y ield on sh or t sellin g = 5 % *7 0% = 3 .5 %
Tota l r etu r n = 7 % in ter est + 3 .5 % r eba te = 1 0.5 %
Lev er a ge is a ttr a ctiv e beca u se a 7 % bor r ow in g cost w ou ld y ield a n a ddition a l 3 .5 %

for ea ch u n it of lev er a g e
If stock pr ice m ov es u p; r equ ir es la r ge sh or t stock position to h edg e th e lon g bon d position
Th e h edge position does'n t cov er th e r isks su ch a s.., in ter est r a te r isk of bon d, cr edit r isk,
ca ll r isk, m a r ket a n d in su tr y r isk of equ ity
577
Extracting profit from Price of convertible bond
complex pricing will decline rapidly than
relationships between stock price declining in
stock and bond equity market
They look for mispriced

Convertible bond price convertible bond
will mirror stock more Convertible bond’s price
closely in a rising declining less rapidly than the
underlying stock in a falling
market equity market
578
Investment value Latent warrant =
conversion
= value of the component of the
bond component convertible bond
Price of CB will not Degree to which change in

value of bond reflected by
below investment change in stock value depends
value even in a on convertible bonds premium
declining stock price over conversion value
579
Example…
Can be converted to 50 shares of Rs.
Bond’s trading 14 each
Conversion value: Rs. 700
price: Rs. 1000 Premium = Rs. 1000 – Rs. 700 = Rs.
300
(par value) Conversion premium = 300/700 =

42.9%
Higher the conversion Factors affecting conversion

premium
premium; lesser will be
Higher the bond yields; higher
the correlation of bond’s the conversion premium
price with the stock price Interest rate changes
580
Factors considered in selecting a convertible bond..,
Undervalued bonds – bonds mispriced relative to
underlying stock Short sold stock
Premium-to-conversion ratio
Call provisions on the bond
Creditworthiness of the issuer generates short
Probability of default
Yield advantage
Company’s earnings momentum interest rebate
581
Amount of stock sold short No. of shares sold
= < full conversion amount
short depends on how
Allows the position to
retain profit potential on much market
the upside exposure required
Hedge ratio = no. of Neutral hedge = hedge

shares sold short out ratio that will not add
of total number exposure to up or
possible down market
582
Factors disrupting Market factors
Shifts in stock market volatility
pricing relationship Interest rate changes
between convertible Foreign exchange relationships
bond and stock.., Political events
Factors specific to the company

Improving or weakening credit quality
Short stock buy-ins
Call features
Dividend increases that reduce the
cash flow component
Takeovers and recapitalization
583
Disadvantage Performance
On expected price relationship not Produced very steady low-risk return in
1990’s
holding can make the investment
Jan 1990 – Mar 1998
to loose on both bond and equity Average annualized return: 11.86%
component of bond Annualized SD: 3.24%
Not all stocks are available to short Correlation with stock market: 0.1287
584
Macro Investing
• Uses top-down global approach • Invest in anticipated SD more than 1
• Required to know how global macro macro economic and political • Such events with SD>1 occurs once in two to three decades
events affect valuation of financial instruments • Some macro events occurred in the past are..,
• Uses any investment approach • Junk bond and emerging market debt in 1990s
• Warranted method: directional bets • Eurodollar in 1994
• A general approach • Japanese yen during late 1980s
• Invest leveraged base across.., • Eg: in Mid 1980s Soros took long on US stock and short on Japanese
• Sectors stock anticipating devaluation in yen
• Markets • Not confined by a market niche
• Instruments • Required to move from opportunity to opportunity
• Trading styles • Risky directional betting or speculating
• They invest on forecasted changes in.., • Correlation with general market: 0.2511
• Interest rates • Jan 1990-Mar 1998
• Currency markets • Average annualized return: 23.09%
• Equity markets • Annualized SD: 9.39%
• Global political policy
• Economical policy
585
Fund of Funds
• Organized as: limited partnership • Strategies
firm • Markets
• General partner receive fee from • Exposes to high diversified
limited partners investment with very low..,
• Administrative costs
• Invest in two or more HF • Research costs
manager’s funds
• Advantage: investors obtain access
to no. of different HFs in which,
because of high minimum
investment required by each, they
could not invest individually
• Can diversify across..,
• Instruments
586
Fund of Funds
587
• Annualized monthly return = • Skewness
[(1+monthly return) ^ 12] – 1 • Kurtosis
• Risk = downside semi variance = • Drawdown = [recent high-water
[Smin (rj-r*,0)2] / (n-1) mark – lowest subsequent
• Sharpe ratio = [return – risk free monthly close] / recent high-water
return] / SD mark
• Sortino ratio = [return – risk free • Percent winning month = no. of
return] / downside deviation months with positive returns /
total no. of months invested
• Treynor ratio = [return – risk free
return] / Beta
588
• Performance of • Nonlinear payoffs
traditional • Exposed to significant
event risk
investments are • Cannot be fully
measured by.., captured by mean and
• Mean-variance variance
• Sharpe ratios
• Issues in using
performance analysis
of HF investments..,
589
• HFs can be a valuable addition to a » Mean or average return
diversified portfolio » Variance or SD
• Can be described by third and
• Demonstrates low correlation with fourth moment of distribution
traditional investments (downside return distribution)
– Kurtosis
• In hedge fund returns higher – Skewness
moments of distribution are
present
• HF returns..,
• Cannot be described by first two
moment of distribution (normal
distribution)
590
• Normal distribution • Negative skew:
• Bell-shaped indicates downside
• Has no skew exposure
• Positive skew:
indicates upward bias
591
• Kurtosis » Describes a distribution
of returns that has
• Describes general condition significant mass
• Probability mass associated with concentrated in outlier
tails of a distribution or outlier events
events » Fit well for credit risky
investments – having
• Negative value for kurtosis would event risk
indicate that there is less
probability mass in the tails than • Platykurtosis
normal distribution » Condition of tails of a
distribution are thinner
• Leptokurtosis that that expected by
» Condition of large tails in normal distribution
the distribution » Has less probability mass
concentrated in outlier
events
» Are less risky than
leptokurtosis
distributions because
they have less exposure
to extreme events
592
Hedge Fund Indexes
• Serves two key purposes.., • May use..,
• Proxy for hedge fund asset • Simple averages
class • Capital-weighted indexes
• Performance benchmarks to
judge the success or failure of • Are many different
HF managers construction techniques of
• Constructed using different HF indexes
no. of HFs
• HFs used range: 60 to >5,000
593
• Size of total universe of HFs is not known with
certainty
• Voluntary disclosure of HF’s performance
• Annual disclosure of performance
• High attrition rate
• Average age life of a HF manager is 2½ to 3 years
• Considerable turnover on a annual basis with respect
to HF index construction
594
• Survivorship bias
• HF survived time period of study and are available for index
construction
• Upward bias
• HFs with superior performance will survive in long run
• Selection bias
• Free option for HF managers to report
• Instant history or backfill bias
• Liquidation bias
• HF performing badly will stop reporting before cessation
595
• Distinct lack of consistency in HF index construction
• Indexes provide month-by-month performance while
HF discloses performance annually
• Changing fees structure by HFs
• HF turnover tends to be one-sided
596
Strategy Definition for Index Providers
• Difficult to define strategy
• HF classification system varies from index to index
• Different way of classifying
• Dynamic trading nature of HFs
• Based on disclosure document by HFs
• Lack of specificity by HFs leads to guess work on part of index providers
• No established format for classifying HFs
• Problem of strategy drift
• Mostly unregulated trading practices
• Limit on investment assets by HFs affecting investability
597
Asset Weighted Index vs. Equal Weighted
Index
• Asset weighted index
• Susceptible to disproportionate representation from large funds
that have a very large gain or loss in any given time period
• Smaller HF can transact with a smaller impact
• Equal weighted index
• Not favoring large funds HF strategies that attract a lot of capital
598
The Granite Fund
• Invest in: exotic mortgage instruments • Mistakes: inadequate hedging
• Provides: market-neutral pattern of • Lenders demanded..,
return
• Additional collateral
• Deal with.., • Reduction in loan balances
• Pass-through bundled by..,
• Immediate repayments
» Fannie Mae
» Freddie Mac • Spiral resemble: run on a bank
» Federal Home Loan Mortgage
Corporation • Lessons learnt..,
• Collateralized mortgage obligations
(CMOs) • Leverage creates a unique risk
• Real estate mortgage investment conduits independent of assets
(REMICs)
• Cash flow resemblance: ST and LT govt. • Other hedge funds under
bond threat were..,
• Risk resemblance: prepayment risk for • Ellington Capital
loan portfolio • Illinois Institutional Investors
• Generally used hedging tool:
interest rate options
• Leverage: too much (10 times)
599
•
•
Type: Mirrored fixed-income arbitrage funds
Fund amounts..,
• New business started in:
• 1990: $25 million London
• Mid-1995: $850 million • Was not doing well
• Performance.., • Traded at high volatility (10
• High return
• Low risk
times as volatile as US)
•
• Highest sharpe ratio in industry
Funds invested in combinations of..,
• Merged US and Europe
• Futures businesses
•
•
Options arbitrage
Yield spread between variety of high-quality • Consequences
fixed income assets
» Treasuries of adjacent vs. non • Faced losses
»
adjacent maturities
Treasuries vs. Euro dollar futures
• Redemption from investors
» Mortgage pass-through vs.
treasuries
• Reduced position size of..,
• Arbitrage trades » Cash: 60 times capital
• Non directional relative value trades » Futures: 60 times
capital
» Options positions: 60
times capital
• Reasons for failure

• Merging two business (US
and Europe) 600
• Founded by: senior traders • Greatest source of risk
from Salomon Brothers reduction: diversification
• John Meriwether, former between strategies
vice chairman, Salomon employed
Brothers
• Performance.., • When market were in
• Enjoyed good performance disarray, correlations
• Strengthened reputation of reverted to 100%
the firm
• Billions of fund raised with
• Fund experienced huge
support of: Merril Lynch loss
• Hired large research team • Could reduce position
• Established massive credit since market followed
lines with trading counter
parties LTCM and caused liquidity
• Leverage: > 250 times the • Aggregate risks of
fund capital portfolio > sum of
individual risks
601
• Found by: Julian Robertson • Result: closed funds and
• Investment idea: buying returned fund to investors
stocks that are under priced • Lessons learnt..,
and selling short issues that
are over priced • Narrowly growing
• Growed to world's largest strategies can be
hedge fund vulnerable to persistent
• Investment growth: 150 periods of performance
times of initial investment beyond the control of the
• Aug 1998-April 2000: lost ½ manager
of investment
602
Manhattan Fund
• Established by: • Result: falsified
Michael Berger results to claim
• Type: long-short profitable
value hedge fund • Learning: How much
• Fund raised: $400 trust and confidence
million 300 investors to place in a fund
over several years manager
603

Hedge Fund Investment Strategies

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Hedge Fund Investment Strategies

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Derivative Based Investment

Generates high HFs seek arbitrage

HF Searches Typical Loans

Amount of return in excess of that

a Expected return if market risk

May use ETFs for short selling market

HFs ability to use

Ratio of put options

Finding positive alpha

PSC has experienced large

Some of the losses that the

Have stock Picking Ability but

• PSC needs to short-sell $ 56.93 million of QQQ in order to have a stock

Reasons for residual risk

Check for problem in the beta

Beta is higher on positive return

Construction: Matching the

Utilizing options hedging

• Using 17 day put options on QQQ struck at $95

Low regulation Heterogeneous Using derivatives

Aggressive Manager skills Low risk

High returns Look for arbitrage

Charges incentive- Is both an

May use conservative HF managers tends to seek

Employ large amount of

Reasons for investors

Reasons for investors

What is the investment structure of hedge fund?

Private limited Limited liability

General • Manage the HF

Partners • Limited partnership interests are not tradable

How HF is different from MF?

Who are the hedge fund investors?

How the hedge fund strategies are classified?

Event Driven • Merger arbitrage

Miscellaneous • Emerging markets

What is short selling?

What you mean by relative value strategies?

What is convertible hedging / arbitrage?

Transaction Assets Units Price

Lev er a ge is a ttr a ctiv e beca u se a 7 % bor r ow in g cost w ou ld y ield a n a ddition a l 3 .5 %

What is bond hedging?

What is sector funds?

What is event driven strategies?

What is distressed investing?

Hedge fund vs. stock market?

What hedge fund can do in a portfolio?

What is fixed income arbitrage?

• Market neutral funds

What is macro investing?

How to measure the performance of HFs?

• Annualized monthly return = [(1+monthly return) ^ 12] – 1

• Performance of traditional investments are

What is existing investment vehicles?

• Fund manager – general partner

• Contents of portfolio: not disclosed to investors

What is separate managed accounts?

What is fund of funds?

How an offshore fund is structured?

How an domestic fund is structured?