Copyright © 2018 T Leitch & J Liew

Agenda

• Course Info
• Group Projects

Topics

• Hedge Fund Building Blocks
• Performance Measures/Back-Testing
• Standard Statistics
• Beta-in-the-Tails
• Building a FOF
• Mistakes/Limitations

Course Info

Logistics

• Class Time: 8:30am-11:30am or 1:30pm-4:30pm
• Location: TBD
• Office hours 1:30-3 Thu

TAs :

Grades are based on:

• Projects 30%
• Investment Presentation 60%
• Class Participation 10%

Etiquette

• Class starts on time, attendance taken
• Respect your fellow students’ desire to learn
• No cell phones, side conversations, etc.
• Questions are always welcomed and encouraged
• Be polite, respectful, responsible, and prepared

Group Project

• Create an alternative strategy and pitch it
• Assigned groups of 5-6
• Due at the beginning of the last class
  • power-point presentation & 10 page write-up
  • each group will give ~15-minute presentation
  • Each stduent will have a role in the company and a CV to support it
  • You will be quizzed on the company’s strategy and your CV
• We will build an end to end fund with hedge fund and fund of fund capability for yoo to leverage at the end

Follow your own interests/passions!

Group Project

Presentations need to include:

1. Your investment thesis/idea
2. Back-tested results/empirical support/motivation
3. Survey of investment opportunity
4. A summary of prior works (if available)
5. Starting portfolio of securities/positions
6. R code!

Class Schedule

1st Class – Intro to HFs and FOFs
2nd Class – Performance Measures for Alternatives — HWK1 assigned
3rd Class – Rule Based Strategies — HWK1 due
4th Class – Factor Investing — HWK2 Assigned
5th Class – Equity Strategies/Quant — HWK2 due, HWK3 assigned
6th Class – Equity/Long-Short — HWK3 due
7th Class – Social Media and HFs
8th Class – Final Presentations — Final Write-up/Presentations

Some useful links to market info

seeking alpha

value investor

hedge fund news

risk.net hedge fund news

fed data sources

Useful links for R

hadley wickhams book

cran R package repository

datacamp beginer R course

Why Code in R?

• Leverage your skills with a vector based language
• Leverage technology from others: stand on shoulders of giants!
• Think about how to use the tools, not how to build them!

Why Alpha?

Recall that if we have a porfolio of two risky securities, their combined return is

\[E(P)=w_1*E(R_1)+w_2*E(R_2)\] Where \(w_1\) & \(w_2\) are the weighted portion of assets 1&2 in portolio P

The standard deviation of P is in terms of the risk of asset 1 & 2, ie \(\sigma_1\) & \(\sigma_2\) is

\[\sigma(P)=\sqrt{w_1^2 \cdot \sigma_1^2+w_2 \cdot ^2\sigma_2^2+2\rho w_1w_2\sigma_1 \sigma_2}\] Obviuosly, \(\rho <=0\) is optimal as it lead to lower risk in P.

Also recall, from regression analysis, that the intercept term in the fit equation \(y=\beta x+\alpha\) has zero correlation with X by construction. So, if we regress on asset combinations versus our benchmark and find assets with statistically significant intercept terms, or \(\alpha\), to add to the portfolio, we derease the risk of the portfolio.

Why Alpha?

Why Alpha?

• Equal weighted portfolio of 2 assets

w1=w2=1/2
r1=r2=.06
sig1=sig2=.2
rho=.7
sharpe1=(w1*r1+w2*r2)/(sqrt((w1*sig1)^2)+(w2*sig2)^2+2*rho*w1*w2*sig1*sig2)   #typical equity correlation
sharpe1

## [1] 0.483871

rho=.0
sharpe2=(w1*r1+w2*r2)/(sqrt((w1*sig1)^2)+(w2*sig2)^2+2*rho*w1*w2*sig1*sig2)   #zero correlation
sharpe2

## [1] 0.5454545

sharpe2/sharpe1-1    # increase in Sharpe Ratio due to choice of uncorrelated asset

## [1] 0.1272727

Why Alpha?

Say you have a portfolio of $9B that is \(\beta=1\) with the S&P 500.A prudent strategy would be to add assets that are uncorrelated with the S&P 500 for the next $1B.

w1=9;w2=1
r1=r2=.06
sig1=sig2=.2
rho=.7
sharpe1=(w1*r1+w2*r2)/(sqrt((w1*sig1)^2)+(w2*sig2)^2+2*rho*w1*w2*sig1*sig2)   #typical equity correlation
sharpe1

## [1] 0.2559727

rho=.0
sharpe2=(w1*r1+w2*r2)/(sqrt((w1*sig1)^2)+(w2*sig2)^2+2*rho*w1*w2*sig1*sig2)   #zero correlation
sharpe2

## [1] 0.326087

sharpe2/sharpe1-1    # increase in Sharpe Ratio due to choice of uncorrelated asset

## [1] 0.273913

Choosing that next $1B’s allocation will be your final project

Why Alpha?

What is a Hedge Fund?

“I don’t know what a hedge fund is…”
Ray Dalio, Founder and Chief Investment Officer at Bridgewater ($100B)

dalio principles
dalio economic principles

What is a Hedge Fund?

“The term ‘hedge fund’ is undefined, including in the federal securities laws. Indeed, there is no commonly accepted universal meaning.”

William H. Donaldson, ex-Chairman, SEC, testimony concerning investor protection

What is a Hedge Fund?

“A fund that charges greater than or equal to 1 and 20, won’t tell you what they’re doing, and often does not hedge.”

Cliff Asness, Partner AQR ($160B)

Regulator definition

Wiki

A hedge fundis a pooled investment vehicle administered by a professional management firm, and often structured as a limited partnership,limited liability company, or similar vehicle. Hedge funds are generally distinct from mutual funds as their use of leverage is not capped by regulators and from private equity funds as the majority of hedge funds invest in relatively liquid assets. Hedge funds invest in a diverse range of markets and use a wide variety of investment styles and financial instruments.

Hedge funds have existed for many decades, but have become increasingly popular in recent years, growing to be one of the world’s major investment vehicles and sources of capital.

Professional Definition

“A hedge fund is a business that attempts to raise and manage client capital successfully. Typically, hedge funds buy/sell liquid securities/derivatives (e.g. not private market securities), employ leverage, and (may) sell short securities.

Hedge fund investment strategies vary substantially and managers are often poor in disclosing their “edge,” this leads to much confusion.”

“Hedge funds attempt to provide “alpha” for their clients’ investments.”

Hedge Fund Issues

• Are hedge funds easy to find for the average investor?
  
• What are differences from, say, mutual funds?
  
• Are hedge funds easy to understand? Why/Why not?
  
• Can you master hedge fund investing? How?
  
• Do hedge funds have “alpha”?
  
• What percentage of hedge fund managers are providing “alpha”?

Some Large Hedge Funds

Top 10 Hedge Funds

Top 10 Then and Now…..

Why has the composition of the top hedge funds changed so much over the years?

Background on Hedge Industry

Currently, industry has over +$3.5T AUM, total global assets over $150T

Background on Hedge Fund Industry

• Generally, lower market exposure, so good diversifier to traditional portfolio of stocks and bonds
  
• Good past returns, but since data is riddled with biases. Difficult to arrive at strong conclusions (voluntary performance disclosure)
  
• Backfill bias – bring prior returns to fill database
  
• Survivorship bias – “living” funds report on database, what about “defunct” funds?
  
• Pre-selection bias – “open-attractive” funds report, what about the “ugly” funds?
  and risks
  
• Negative skew: short-put strategy by Decimation Partners, short-vol, liquidity providing strategies
  
• Excess kurtosis: tails fatter then what is expected from Normality
  
• Low persistence, i.e. winners do not remain winners, look at largest fund listings
  
• High attrition: 10-25% of hedge funds go belly-up each year
  
• Liquidity risk: stuck in investments, lock-ups, gates
  
• Hedge fund charge 1-2% of AUM (management fees) and 20% of up-side (incentive fees). Are fees coming down?
  
• Some strategies are murky, managers typically are not open with their investment process, unless you are a large investor

Hedge Fund Strategies

Classification best viewed by Asset Class and Strategy

Asset Classes - Equity
- Fixed Income
- FX/Futures
- Multi Strate (cominations of above)

Let’s go through strategies by asset class

Equity Strategies

• Pick stocks using fundamental investing techniques – Long/Short
• Short stocks that are considered fundamentally “bad” – Short-Biased
• Chose stocks using quant tools – Equity Market Neutral
• Bet on specific corporate events* – Event Driven
• Pick stocks in emerging markets – Emerging Markets

Fixed Income Strategies

• Trade the yield curve, or credit curve – Fixed Income Arbitrage
  
• Trade convertible bonds – Convertible Arbitrage

FX & Futures Strategies

• Global Macro
• Managed Futures
• Carry

Multi Strat - Combination of all of the above

• Pick stocks using fundamental investing techniques – Long/Short
• Short stocks that are considered fundamentally “bad” – Short-Biased
• Chose stocks using quant tools – Equity Market Neutral
• Bet on specific corporate events* – Event Driven
• Pick stocks in emerging markets – Emerging Markets
• Trade the yield curve, or credit curve – Fixed Income Arbitrage
  
• Trade convertible bonds – Convertible Arbitrage
  
• Global Macro
• Managed Futures
• Carry

More details on strategies

• Long/Short: Typically value-investors or GARP by nature holding concentrated portfolios. Attempts to gain “better” information advantage about portfolio companies. With deep-dives into company’s earnings quality/management quality/business prospects. Many times long/short managers will focus on specific sectors. eg. Tiger and Tiger clubs, Buffett-clones, Activists, T2, Ichan, Einhorn,

• Dedicated short bias: Managers attempt to profit by shorting weak companies. These hedge fund managers attempt to identify corporate frauds, to examine forensic accounting issues and flaws with business model e.g. Island Drive, Kingsford, Jim Chanos of Kynikos

• Equity market neutral: “Quants” incorporate, value, B/M, P/E; size; momentum; reversals; convergence trades, pairs trading; statistical arb; high frequency trading; index arbitrage, eg. Bogle, BGI32, Symphony, O’Connor, Univ of Chicago PhDs, Fama’s students

• Event Driven: “Special situations” investors attempting to capitalize on corporate events such as a merger, corporate restructuring, liquidation, bankruptcy, etc. Mergers: cash deals, stock-for-stock, stock and/or cash, collars; spin-offs; stubs; distressed securities, bankruptcy, when-issued; IPOs; SPACs, eg. Paulson, Donatello, Farallon

• Emerging Markets: Long/Short/Fixed Income with local market expertise, typically stock selection and hedge with liquid instruments, country selection, currencies, eg. Boyer Allan, Everest, LIM, SPARX, (BRIC, Mark Mobias)

More details on strategies

• Fixed Income Arb: Managers attempt to gain edge by trading predominantly fixed income securities such as interest rate swap arbitrage, US/non-US gov’t bond arbitrage, forward yield curve arbitrage, yield curve behaviors, butterfly; mortgage backed securities arbitrage; CDS-bond basis; on-the-run/off-the-run, eg. Long-Term Capital, Oakhill, Ellington, III, MKP, PIMCO

• Convertible Bond Arbitrage: Typical trade includes long converts, hedge equity and/or credit, fixed income; flip newly issued convert, gamma, busted, high-money, e.g. Citadel, Canyon, CQS, Nisswa, Quattro, Wolverine, Zazove

• Global Macro: Discretionary trading, trade in anticipation of global macro shifts, carry-trade (uncovered interest rate parity); devaluation; thematic; global yield curves; monetary/fiscal policies, macro economics, real rates across countries; tactical asset allocation, eg. Soros, Brevan-Howard, Pantera

• Managed Futures/CTAs: Trend-followers, countertrends, overextended trends, as well as concentrated fundamentals, eg. Aspect, BlueTrend, Campbell, Crabel, Graham, AHL Man, Sunrise, AHL, Winton, Millburn, MLM, Quadriga, Rotella, Roy G. Niderhoffer, RQSI, Sunrise, Transtrend

• Statistical Arb: “Quants”, High turnover/speed, electronic market making, sophisticated statistical analysis, PCA, OU, eg. GETCO, JUMP, Tower

• Multi-Strategy: Combines several hedge fund strategies and attempts to rotate across strategies, eg. GLG, Concordia, Highbridge, DE Shaw, TPG, OZ

• Fund of funds: Invests in a portfolio of hedge funds, eg. Rock Creek, PAAMCO, UBP, Glenwood

Hedge Funds Over Time - Performance

• Over period from Jan. 1994 to May 2015: S&P500 vs Hedge Funds
• Annual Returns (+10% vs +6.8%), Annual Std (14.9% vs 7.5%), and Sharpe(Rf=0) (0.68 vs 0.91)

Hedge Funds Over Time _ Stratgey Allocation

• 1990s Golden Global Macro era
• Long/Short emerged with help of buoyed equity markets
• Recently Event Driven has emerged as largest sector
• Note that sector allocation varies substantially over time

mean return, std dev, & sharpe broken down over time

## [1] "All Data"

## [1] "2008/Today"

## [1] "1993/2007"

Some stats broken down over time

## [1] "All Data"

## [1] "2008/Today"

## [1] "1993/2007"

Performance Measure - Sharpe Ratio

\[\frac{\overline{r} - r_f}{\sigma}\] For monthly return data

• Compound monthly returns to annualized return:
  
• Monthly standard deviation multiplied by square root of 12 equals annualized standard deviation:

Note the distinctions between raw price differences, simple returns, compounded returns, and continuously compounded returns. Must keep track of what time periods you are using

kable(SharpeRatio.annualized(hfrets[,1:6]))