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CHAPTER 26. Hedge Funds. Hedge Funds Characteristics . Investment pooling Transparency Limited liability partnerships Provide minimal information Investors No more than 100 “sophisticated” investors Investment strategies Wide range of investments. Hedge Funds Characteristics Continued.

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chapter 26


Hedge Funds

hedge funds characteristics
Hedge Funds Characteristics

Investment pooling


Limited liability partnerships

Provide minimal information


No more than 100 “sophisticated” investors

Investment strategies

Wide range of investments

hedge funds characteristics continued
Hedge Funds Characteristics Continued


Lock-up periods

Compensation structure

Charge a management fee plus a substantial incentive fee

hedge fund strategies
Hedge Fund Strategies


Bets that one sector or another will outperform other sectors

Non directional

Exploit temporary misalignments in security valuations

Buys one type of security and sells another

Strives to be market neutral

statistical arbitrage
Statistical Arbitrage

Uses quantitative systems that seek out many temporary misalignments in prices

Involves trading in hundreds of securities a day with short holding periods

Pairs trading

Pair up similar companies whose returns are highly correlated but one is priced more aggressively

Create a market-neutral position

Data mining

alpha transfer
Alpha Transfer

Separate asset allocation from security selection

Invest where you find alpha

Hedge the systematic risk to isolate its alpha

Establish exposure to desired market sectors by using passive indexes

pure play example from the text
Pure Play Example From the Text

Manage a $1.5 million portfolio

Believe alpha is >0 and that the market is about to fall

Capture the alpha of 2% per month

β = 1.20 S&P 500 Index is S0 = 1,440

α = .02

rf = .01

Hedge by selling S&P 500 futures contracts

pure play example continued
Pure Play Example Continued

The dollar value of your portfolio after 1 month:

The dollar proceeds from your futures position:

style analysis
Style Analysis

Hasanhodzic and Lo factors:

Equity market conditions

Foreign exchange

Interest rates

Credit conditions

Commodity markets


liability and hedge fund performance
Liability and Hedge Fund Performance

Hedge funds tend to hold more illiquid assets than other institutional investors


Typical alpha may be interpreted as an equilibrium liquidity premium than a sign of stock-picking ability

Santa Effect

Higher returns reported in December

Stronger for lower-liquidity funds

Figure 26.2 Hedge Funds with Higher Serial Correlation in Returns, an Indicator of Illiquid Portfolio Holdings, Exhibit Higher Sharpe Ratios
hedge fund performance and survivorship bias
Hedge Fund Performance and Survivorship Bias

Backfill bias

Hedge funds report returns to database publishers only if they choose to

Survivorship bias

Unsuccessful funds that cease operation stop reporting returns and leave a database

Only successful funds remain

hedge fund performance and changing factor loadings
Hedge Fund Performance and Changing Factor Loadings

Hedge funds are designed to be opportunistic and have considerable flexibility to change profiles

If risk is not constant

Alphas will be biased if a standard, linear index model is used

table 26 4 index model results for hedge funds allowing for different up and down market betas
Table 26.4 Index Model Results for Hedge Funds, Allowing for Different Up- and Down-Market Betas
black swans and hedge fund performance
Black Swans and Hedge Fund Performance

Nassim Taleb:

Many hedge funds rack up fame through strategies that make money most of the time, but expose investors to rare but extreme losses


The October 1987 crash

Long Term Capital Management

fee structure in hedge funds
Fee Structure in Hedge Funds

Typical hedge fund fee structure

Management fee of 1% to 2% of assets

Incentive fee equal to 20% of investment profits beyond a stipulated benchmark performance

Effectively call options on the portfolio with a strike price equal to current portfolio value

High water mark

The fee structure can give incentives to shut down a poorly performing fund

funds of funds
Funds of Funds

Invest in several other hedge funds

Optionality can have a big impact on expected fees

Fund of funds pays an incentive fee to each underlying fund that outperforms its benchmark even if the aggregate performance is poor

Diversification can actually hurt the investor in this case

funds of funds continued
Funds of Funds Continued

Spread risk across several different funds

Investors need to be aware that these funds of funds operate with considerable leverage

If the various hedge funds in which these funds of funds invest have similar investment styles, diversification may illusory

example 26 6 incentive fees in funds of funds
Example 26.6 Incentive Fees in Funds of Funds

A fund of funds is established with $1 million invested in each of three hedge funds

Hurdle rate for the incentive fee is a zero return

Each fund charges an incentive fee of 20%

The aggregate portfolio of the fund of funds is -5%

Still pays incentive fees of $.12 for every $3 invested