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Flashcards in week 11 Deck (38)
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1

HEDGE FUND

 Transparency

usually set up as limited Liability Partnerships and provide minimal disclosure of strategy and portfolio composition

2

HEDGE FUND

Investors

No more than 100 “sophisticated” and wealthy investors

3

MUTUAL FUND

Investors

Number is not limited

4

MUTUAL FUND

Transparency

Regulations require public disclosure of strategy and portfolio composition

5

HEDGE FUND

Investment strategies

effectively partake in any investment strategy

can act opportunistically and empowered to invest in a wide range of investments

 Often use shorting, leverage, options

6

MUTUAL FUND

Investment strategies

 

Predictable, stable strategies, stated in prospectus

 Limited use of short selling leverage and use of derivatives is highly restricted

 

7

HEDGE FUND

 Liquidity

Have lock-up periods, require advance redemption notices

8

HEDGE FUND

Compensation structure:

Charge a Management fee between 1-2% of assets and an incentive fee of 20% of profits

9

MUTUAL FUND

Compensation structure:

management Fees are usually a fixed percentage of assets, typically 0.5% to 1.5%

10

MUTUAL FUND

Liquidity

Investments can be moved more easily into and out of a fund

11

Hedge fund strategies

directional

 Bets that one sector or another will outperform

other sectors of the market

12

Hedge fund strategies

non-directional

 Exploit temporary misalignments in in security valuations e.g. corp bonds are higher than treasury bonds, hedge fund would buy corporates and short sell treasury securities

 Buy one type of security and sell another

  Strives to be market neutral

13

Hedge fund strategies

Statistical Arbitrage

Uses quantitative systems that seek out many temporary and modest misalignments in prices  among securities

involves trading in hundreds of securities a day with short holding periods (minutes or less) 

14

Hedge fund strategies

Pairs trading

form of statistical arbitrage 

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

 

15

Hedge fund strategies

statistical arbitrage is associated with Data Mining

sorting through large amounts of historal data to uncover systematic patterns in returns that can be exploited by traders 

16

Possible sources of superior performance of hedge funds

superior managers

Exposure to omitted risk factors with positive risk premiums

 Liquidity
Survivorship bias Changing factor loadings Tail events

17

Liquidity and hedge fund performance

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

Unexpected declines in market liquidity are an important determinant of average hedge fund returns

Hedge funds report average returns in December that are substantially greater than their average returns in other months

 The December spike in returns is stronger for lower-liquidity funds, suggesting that illiquid assets are more generously valued in December

18

Hedge fund performance

Backfill bias:

 Hedge funds report returns only if they choose to, and they may do so only when their prior performance is good

19

Hedge fund performance

Survivorship bias

 unsuccessful funds cease operation and stop reporting returns and drop out of the database, leaving behidn only the successful funds

 Hedge fund attrition rates are more than double those for mutual funds

20

hedge fund performance and changing factor loadings

Hedge funds are designed to be opportunistic and may frequently change their risk profiles (cf important assumption that portfolio manager manatains a stable risk profile over time)

 If risk is not constant, alphas will be biased in the standard linear index model

21

tail events and hedge fund performance

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

 

22

Fee structure in hedge funds

High water mark

High water marks give managers an incentive to shut down poorly performing funds

 If a fund experiences losses, it may not be able to charge an incentive unless it recovers to its previous higher value

With deep losses, this may be too difficult so the fund closes

23

Fee structure in Hedge funds

Funds of funds (feeder funds)

 Hedge funds that invest in one or more other funds, providing an opportunity to diversify across hedge funds

 Supposed to provide investors with ability to diveristy across funds and provide due diligence in screening funds for investment worthiness

24

Fund of funds

hedge funds and fee structure

what do you need to pay?

Pay an incentive fee to each underlying fund that outperforms its benchmark even if the aggregate performance is poor

Diversification can hurt the investor in this case

25

Fund of funds

hedge funds and fee structure

how should you spread risk

 Spread risk across several different funds, but

operate with considerable leverage

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

26

Hedge fund strategies

Pairs trading

how can market neutral positoins be formed

by buying the relatively cheap firm and selling the expensive one. 

27

liquidity and hedge fund performance

typical alpha 

typical alpha exhibited by hedge funds may be interpreted as an equilibrium liquidity premium rather than a sign of stock-picking ability

i.e. fair reward for providing liquidity to other investors

28

liquidity and hedge fund performance

serial correlation

is a symptom of illiquid assets

29

liquidity and hedge fund performance

serial correlation

implications?

thsi suggestion of smoothed prices has 2 important implications

1. hedge funds are holding less liquid assets and their apparent alphas may be in fact liquidity premiums

2. risk-adjusted performance measures are upward bias b/c any smoothing in the estimates of porftofilio value will reduce total volatility (increasing sharpe ratio) as well as covariances and tehrefore betas with systematic factors (increasing risk-adjusted alphas)

30

positive serial correlation

positive returns are followed by positive than by negative returns

this is an indicator of less liquid markets b/c when prices are not available (since asset is not actively traded), the hedge fund estimates its value where firms smooth out their value estimates