Book 5. Risk and Investment Management

FRM Part 2

IM 9. Hedge Funds

Presented by: Sudhanshu

Module 1. Hedge Fund Industry, Alpha-Beta Separation and Hedge Fund Strategies

Module 2. Hedge Fund Performance, Risk Factors and Risk Sharing

Module 1. Hedge Fund Industry, Alpha-Beta Separation and Hedge Fund Strategies

Topic 1. Characteristics of Hedge Funds

Topic 2. Evolution of the Hedge Fund Industry

Topic 3. Impact of Institutional Investors

Topic 4. Alpha-Beta Separation

Topic 5. Hedge Fund Strategies

Topic 1. Characteristics of Hedge Funds

• Hedge funds are private, less regulated investment vehicles unavailable to the general public, while mutual funds are more structured and heavily regulated.
• Hedge funds employ high leverage and generate profits from both long and short positions, with managers taking large bets based on perceived relative price discrepancies.
• Privacy is a hallmark of hedge funds, with minimal transparency in the industry as managers protect their proprietary methods from being copied.
• Hedge funds charge a fixed management fee plus a substantial performance fee on new profits, typically ranging from 10% to 20% of gains.

Topic 2. Evolution of the Hedge Fund Industry

• Historical hedge fund performance data was difficult to obtain prior to the early 1990s until dramatic losses in early 1994, triggered by Federal Reserve interest rate policy changes, prompted the development of hedge fund databases for better performance analysis.
• Assets under management increased 10 times from 1997 to 2010 while the number of funds quadrupled, though selection bias (self-reporting bias) exists as some hedge funds do not participate in commercial databases.
• Evidence suggests selection bias in large hedge fund databases is small, as the average return of funds-of-hedge funds (FoFs), which invest across all hedge funds, is highly correlated to average returns in commercial databases.
• Concerns remain about measurement errors and biases in reported hedge fund returns, though the consensus is that hedge fund index returns became increasingly reliable beginning in 1996.
• From 1987 to 1996, 27 large hedge funds substantially outperformed the S&P 500 index by margins large enough to account for any measurement biases.
• The 1998 collapse of Long-Term Capital Management (LTCM) was a watershed event reminding investors that higher returns accompany higher risk, with the collapse affecting hedge fund performance more severely than equity performance.
• During the 2000-2001 dot-com bubble collapse, the hedge fund industry experienced 20% net asset inflows and a major structural shift as hedge funds outperformed the S&P 500 with half its standard deviation, attracting substantial institutional investor capital.

Practice Questions: Q1

Q1. What critical shift occurred in the hedge fund industry following the collapse of Long-Term Capital Management (LTCM) in 1998 and the dot-com bubble burst in 2001?
A. There was a significant drop in assets under management in the hedge fund industry.
B. There was a large influx of institutional investors investing in hedge funds.
C. Reporting within the hedge fund industry became more regulated than mutual funds.
D. There was a significant increase in hedge fund failures.

Practice Questions: Q1 Answer

Explanation: B is correct.

During the time period following the dot-com collapse, hedge funds outperformed the S&P 500 with a lower standard deviation, which attracted institutional investment.

Topic 3. Impact of Institutional Investors

• Beginning in 1999, institutional investors (foundations, endowments, pension funds, and insurance companies) shifted capital into hedge funds, growing assets under management from $197 billion in 1999 to $1.39 trillion by 2007.
• Institutional investors were rewarded for higher fee structures, as three hedge fund databases (DJCSI, HFRI, and HFRFOFI) reported cumulative returns of 72.64%, 69.82%, and 38.18% respectively from 2002 to 2010, compared to the S&P 500's 13.5% return.
• Hedge funds demonstrated lower volatility with annualized standard deviations of 5.84%, 6.47%, and 5.51% respectively, compared to the S&P 500's 16% standard deviation during the same period.
• The influx of institutional investment created greater demands on hedge fund management for operational integrity and governance.
• Institutional investors sought either absolute performance or alternative return sources beyond equities, while concerns emerged about the absence of identifiable alpha in hedge fund investing, making manager differentiation increasingly critical.

Topic 4. Alpha-Beta Separation

• Alpha is a risk-adjusted return measure used to assess active manager performance, representing returns in excess of compensation for risk taken.
• Distinguishing alpha and beta involves identifying how much of a strategy's return results from systematic risk (beta) versus active management skill (alpha) using statistical techniques, quantitative tools, and benchmarking.
• Separating alpha and beta means independently managing a portfolio's alpha and beta exposure, allowing managers to pursue alpha while maintaining a target beta level.
• Managers typically seek to limit beta exposure while optimizing alpha, often using derivatives to minimize or eliminate undesired systematic risks.
• For example, a manager benchmarked to the S&P 500 can use futures contracts to hedge non-S&P 500 systematic risks, maintaining a portfolio beta of 1.0 relative to the benchmark while simultaneously pursuing an alpha-optimizing strategy to independently manage alpha and beta.

Topic 5. Hedge Fund Strategies

• Managed Futures Funds
  • Focus: Investments in bond, equity, commodity futures, and currency markets globally.
  • Methodology: Utilize systematic trading programs based on historical pricing data and market trends.
  • High leverage: Employ a high degree of leverage due to the use of futures contracts.
  • No bias: No net long or net short bias due to managed futures.
  • Market timing: Many are market timing funds, switching between stocks and Treasuries.
  • Payoff Function: Similar to a lookback straddle (combination of lookback call and put options).
• Global Macro Funds

  • Focus: Large directional bets on movements in interest rates, exchange rates, commodities, and stock indices.

  • Performance: Tend to perform better during extreme moves in currency markets.

  • Dynamic Allocation: Act as dynamic asset allocators, betting on various risk factors over time.

• Both managed futures and global macro funds:
  • have trend following behaviour.
  • are essentially asset allocation strategies, since the managers take opportunistic bets in different markets.
  • have low return correlation to equities.

• Merger (Risk) Arbitrage

  • Strategy: Capture spreads in merger/acquisition transactions involving public companies after public announcement.

  • Primary Risk: Deal risk – the risk that the transaction will fail to close.

  • Return Characteristics: Largest negative monthly returns occur after large negative S&P 500 index returns, indicating a "long deal risk" exposure. This is because market declines increase the tendency for mergers to be called off.

• Distressed Securities

  • Strategy: Invest across the capital structure of firms facing financial or operational distress, or in bankruptcy.

  • Bias: Tends to have a long bias.

  • Objective: Profit from an issuer's ability to improve operations or successfully emerge from bankruptcy.

  • Key Feature: Long exposure to credit risk of corporations with low credit ratings.

  • Proxy: Publicly traded high-yield bonds (correlation with DJCS Distressed index is 0.55).

• Nonlinear Return Characteristics (Both Strategies)

  • Tail Risk: Both event-driven strategies exhibit nonlinear returns, with tail risk appearing under extreme market conditions.

    • Merger Arbitrage: Large drop in equity investments.

    • Distressed Hedge Funds: Big move in short-term rates.

• Vulnerability: Unlike trend-following strategies, both these event-driven funds are hurt by extreme market movements.

Topic 5. Hedge Fund Strategies

• Fixed-Income Arbitrage Funds

  • Strategy: Exploit inefficiencies and price anomalies between related fixed-income securities.

  • Objective: Limit volatility by hedging exposure to interest rate risk.

  • Example: Leveraging long/short positions in mathematically/economically related fixed-income securities.

  • Traded Sectors:

    • Credit yield curve relative value trading (swaps, government securities, futures).

    • Volatility trading using options.

    • Mortgage-backed securities arbitrage.

  • Examples: 

    • Swap spread trades: A bet that the fixed side of the spread will stay higher than the floating side of the spread, and stay in a reasonable range according to historical trends.

    • Yield-curve spread trades: The hope is that bond prices will deviate from the overall yield curve only in the short term, and will revert to normal spreads over time.

    • Mortgage spread trades (bets on prepayment rates): Bets on prepayment rates

    • Fixed-income volatility trades: Bets that the implied volatility of interest rate caps have a tendency to be higher than the realized volatility of, for example, a Eurodollar futures contract

    • Capital structure/credit arbitrage trades: These trades try to capitalize on mispricing among different types of securities (e.g., equity and debt).

Topic 5. Hedge Fund Strategies

• Convertible Arbitrage Funds

  • Strategy: Profit from purchasing convertible securities and shorting corresponding stock.

  • Objective: Take advantage of perceived pricing errors in the security's conversion factor.

  • Positioning: Number of shares shorted is based on a delta-neutral or market-neutral ratio to make the combined position insensitive to underlying stock price fluctuations under normal conditions.

  • Return: The return to convertible arbitrage hedge funds comes from the liquidity premium paid by issuers of convertible bonds to hedge fundmanagers, for holding convertible bonds and managing the inherent risk by hedging the equity part of the bonds.

Topic 5. Hedge Fund Strategies

• Long/Short Equity Funds

  • Strategy: Take both long and short positions in equity markets, diversifying or hedging across sectors, regions, or market capitalizations

  • Example: Value to growth, small- to mid-cap stocks, and net long to net short.

  • Trading: Can also use equity futures and options.

  • Prevalence: 30-40% of hedge funds employ this strategy.

  • Performance: Highly idiosyncratic due to managers being stock pickers with varying opinions and abilities.

  • Bias: On the long side, underpriced/under-researched stocks and small stocks are favored. On the short side, low liquidity makes small and foreign stocks less attractive.

  • Exposure: Directional exposure to the overall market; exposure to long small-cap/short large-cap positions.

• Dedicated Short Bias Funds

  • Strategy: Tend to take net short positions in equities.

  • Implementation: Sometimes the short position strategy is implemented by selling forward.

  • Risk Management: Managers take offsetting long positions and stop-loss positions.

  • Correlation: Returns are negatively correlated with equities.

Topic 5. Hedge Fund Strategies

• Emerging Market Funds

  • Strategy: Invest in currencies, debt, equities, and other instruments in countries with emerging or developing markets.

  • Identification: Markets identified by GNP per capita (e.g., China, India, Latin America, Southeast Asia, Eastern Europe, Africa).

  • Bias: Tend to have a long bias due to difficulties in shorting securities in these markets.

• Equity Market Neutral Funds

  • Strategy: Aim to achieve zero beta(s) against a broad set of equity indices.

  • Risk Factors: Research shows no single common component or risk factor in their returns.

  • Methodology: Different funds utilize diverse trading strategies, all working towards the goal of market neutrality.

Topic 5. Hedge Fund Strategies

Practice Questions: Q2

Q2. Which of the following hedge fund strategies would be characterized as an “asset allocation” strategy that performs best during extreme moves in the currency markets?
A. Global macro.
B. Risk arbitrage.
C. Dedicated short bias.
D. Long/short equity.

Practice Questions: Q2 Answer

Explanation: A is correct.

A global macro fund does better if there are extreme moves in the currency markets. Along with managed futures, global macro is an asset allocation strategy.
Managers take opportunistic bets in different markets. The strategy has a low correlation to equities.

Practice Questions: Q3

Q3. Jamie Chen, FRM, is considering investing a client into distressed hedge funds. Which of the following investments would serve as the best proxy for the types of returns to expect?
A. Convertible bonds.
B. Small-cap equities.
C. Managed futures.

D. High-yield bonds.

Practice Questions: Q3 Answer

Explanation: D is correct.

Distressed hedge funds have long exposure to credit risk of corporations with low credit ratings. Publicly traded high-yield bonds are a good proxy for the returns to expect.

Module 2. Hedge Fund Performance, Risk Factors and Risk Sharing

Topic 1. Hedge Fund Performance

Topic 2. Convergences of Risk Factors

Topic 3. Risk Sharing Asymmetry

Topic 1. Hedge Fund Performance

• Historical Portfolio Construction & Performance Trends

  • Early Research (27 Large Funds, 2000):

    • Regressed against an 8-factor model.

    • Findings: No significant exposure to stocks and bonds.

    • Significant Alpha: Equally weighted portfolio had a large alpha of 1.48% per month.

    • Persistent Exposure: Consistent exposure to emerging markets, but other factor betas varied.

    • Alpha Decline: Alpha declined over time, and no persistent directional exposure to the U.S. equity market.

    • Note: Measurement bias may have slightly affected these results.

• Performance of Top Funds (2002-2010)

  • Two Test Portfolios (Top 50 Large Hedge Funds):

    1. Mimicking Strategy: Equal dollar investment, rebalanced yearly, selected based on AUM at year-end 2001.

    2. "Foresight-Assisted": Similar portfolio, but selected based on year-end 2010 (used for comparison, not a real-world strategy).

• Results:

  • Mimicking portfolio: No significant alpha.

  • Foresight-assisted portfolio: Monthly alpha of 0.53% (statistically significant).

  • Alpha Decline: Consistent with increased competition in the hedge fund industry. No significant negative alpha observed.

• Top 50 vs. All Hedge Funds: Top 50 portfolios (both versions) showed statistically significant alpha relative to DJCSI and HFRI hedge fund indices.

• Outperformance: During 2002-2010, top 50 hedge fund portfolios and broad hedge fund indices (DJCSI, HFRI) outperformed the S&P 500.

• Conclusion: Large hedge fund managers continue to deliver alpha relative to peers and maintain low exposure to the U.S. equity market, attracting institutional investors.

Topic 1. Hedge Fund Performance

Practice Questions: Q1

Q1. Comparing hedge fund performance during the time period 2002–2010 to earlier time periods, how would monthly alpha compare, if looking at large hedge funds?
A. Alpha was higher in the 2002–2010 time period.
B. Alpha remained constant over both time periods.
C. A “foresight-assisted” portfolio did not have a statistically significant alpha during the 2002–2010 time period.
D. There was a decline in alpha in the 2002–2010 time period.

Practice Questions: Q1 Answer

Explanation: D is correct.

Comparing the two different time periods, there was a decline in alpha due to more competition in the hedge fund industry.

Topic 2. Convergences of Risk Factors

• Diversification Implosion During Stress: During periods of market stress, seemingly diverse hedge fund portfolios converge in terms of risk factors, and diversification benefits implode. All strategies (or most) undergo stress simultaneously.

• Major Market Events & Convergences

  • March-April 1994 (Fed Interest Rate Changes):

    • Caused losses for 7 of 10 DJCS style sub-indices.

    • Exceptions: Short sellers and managed futures funds.

    • Merger arbitrage and equity market neutral funds had positive returns in specific months.

  • August 1998 (Pre-LTCM Collapse):

    • 8 of 10 niche DJCS style sub-indices experienced large losses.

    • Short sellers and managed futures funds avoided losses.

    • Losses primarily due to market-wide liquidation of risky assets and high leverage of LTCM.

  • ​​August 2007 (Pre-Financial Crisis):

    • For the first time, all 9 specialist style sub-indices lost money (excluding short sellers).

    • Illustrated how market-wide funding crises impair leveraged positions.

• July-October 2008 (Peak Financial Crisis):

  • July to September saw losses for all hedge fund styles (excluding short sellers).

  • Forced liquidation of leveraged positions led to high losses.

• Implications for Risk Mitigation

  • Difficulty in Mitigation: During market-wide funding crises, it's difficult to mitigate risk by simply spreading capital among different hedge fund strategies.

  • Credit-Driven Tail Risk: Significant credit-driven tail risk exists in hedge fund portfolios.

  • Partial Solution: Managed futures may offer a partial solution due to their convex performance profile relative to other strategies.

  • Investor Consideration: Hedge fund investors must consider portfolio risks associated with dramatic market events.

Topic 2. Convergences of Risk Factors

Topic 3. Risk Sharing Asymmetry

• The Principal-Agent Problem: In the hedge fund industry, risk sharing asymmetry between the principal (investor) and the agent (fund manager) is a concern due to variable compensation schemes

• Incentives for Excessive Risk-Taking: Incentive fees of 15–20% on new profits above a high water mark (HWM) can encourage hedge fund managers to take excessive risks.

• Future Loss-Carried-Forward: This tends to increase the future loss-carried-forward if and when these bets fail.

  • Re-establishment: If a fund fails, the same manager can potentially start a new hedge fund.

• Mitigating Factors & Persistent Conflict

  • Opportunity Cost: Closing a fund is costly for managers, harming their track record and reputation.

  • Incomplete Mitigation: This cost does not fully mitigate the basic principal-agent conflict.

• Investor Best Practice: Investors may be best served by investing in funds where managers invest a significant portion of their own wealth.

• Unchanged Structure: Despite discussions, the basic compensation structure for fund managers has largely remained unchanged.

Practice Questions: Q2

Q2. What would be an ideal approach for a hedge fund investor who is concerned about the problem of risk sharing asymmetry between principals and agents within the hedge fund industry?
A. Focus on investing in funds for which the fund managers have a good portion of their own wealth invested.
B. Focus on diversifying among the various niche hedge fund strategies.
C. Focus on funds with improved operational efficiency and transparent corporate governance.
D. Focus on large funds from the “foresight-assisted” group.

Practice Questions: Q2 Answer

Explanation: A is correct.

The incentive fee structure within the hedge fund industry has not really changed over the years, and there is incentive for managers to take undue risks in order to earn fees. Thus, there should be a focus on investing in funds for which the fund managers have a good portion of their own wealth invested.