Alternative Investments Portfolio Management

1. Alternative Investments Portfolio Management Part II

2. The Hedge Fund Industry • First hedge fund started by Alfred Jones in 1949 • “Hedge”: Long-short strategy to hedge/neutralize market exposure • Hedge fund management hot spots (Global and Mail, Nov. 6, 2010) • Pfaffikon, Switzerland $92 billion (pop.7,200) • Greenwich, Connecticut $150 billion • London $290 billion • New York $647 billion • Compared to Canada $6.3 billion

3. Market Neutral • A type of long/short strategy • Similar beta exposure on both sides; the two betas cancel each other out

4. Sample long-short fund Pyramis Global – Global market neutral September 2012

5. Sample long-short fund * Once the fund size reaches $250m, MER will go up for new investors

6. Return comparisons

7. The Hedge Fund Industry • Structure • Single funds • Multi-strategy funds • Opportunistic choice of strategy depending on outlook • Fund of (hedge) funds • Fund allocates its cash to several other hedge funds to be managed

8. Support Services • Prime brokerage • Support services for funds offered by investment banks, such as fund accounting and reporting, financing, trade execution, securities lending, start-up advice • Legal counsel • Auditor • Custodian/administrator

9. Characteristics of Hedge Funds Hedge funds today no longer defined by “hedging”, but by their organizational and structural characteristics: • Transparency • Hedge funds are set up as private partnerships (e.g., LLP), and hence not governed by many SEC regulations. Registration is typically overseas, e.g., Cayman Islands, Bermuda • Policy debate because of transparency and fraud risks • Unlike mutual funds, disclosure and reporting is voluntary • Clientele • Traditionally to institutional investors and high net worth clients only • Now, minimum can be as low as $25,000 for some funds

10. Characteristics of Hedge Funds • Investment strategies • Mutual fund strategies are well-defined and narrower, e.g., U.S. small-cap, EAFE value • Hedge funds invest in a wider range of assets, and strategies are less predictable and more opportunistic • Liquidity • Lock-up periods and redemption notices • Ranges from 0 month to 3 years (the more illiquid the assets, the longer the period) • Use of leverage • Ranging from moderate (100-200%) to high (300%+)

11. Characteristics of Hedge Funds • Compensation structure • 2&20 common, 1&10 additional fees for fund-of-funds • Asymmetric compensation potentially problematic • High-water mark: If a manager loses money over a period, the manager must get the fund above the high-water mark (previous peak) before receiving a performance fee again • High fee structure • Not justified if a fund provides mostly beta exposure • Maybe justified as an insurance premium if a fund adds significant diversification benefit

12. Characteristics of Hedge Funds • Target return • Absolute return strategy – not benchmark driven (benchmark agnostic) • Target is “cash plus”: Ranges from LIBOR + 3% to LIBOR + 8%, depending on the strategy

13. Style of Hedge Fund Strategies • Broad categories • Directional: Making active bets about the performance of a market/sector versus another • Non-directional: Exploit temporary mispricing in securities. Not betting on broad market/sector movements, but rather on relative valuation • Price anomalies may be small, so funds are often highly leveraged to magnify gains • In a financial crisis, values may continue to diverge (e.g., because of flight to quality, U.S. Treasuries continue to be overvalued)  heavy losses (e.g., LTCM)

14. DJ Credit Suisse 10 Classifications • Convertible arbitrage • Hedged investing in convertible securities: Long convertible bonds, and short stock if bond is undervalued • Dedicated short bias • Net short position, usually in equities • Emerging markets • Exploit market inefficiencies in emerging markets. Typically long-only, because short-selling is not feasible in many of these markets • Equity market neutral • Long/short positions. Balances sector, market cap and other exposure to neutralize market (or beta) exposure

15. DJ Credit Suisse 10 Classifications • Event drive • Attempts to profit from corporate events such as mergers and acquisitions, restructuring, bankruptcy, or reorganization • Long/short equity • Long and short depending on outlook, not meant to be market neutral. May establish a concentrated regional or sector focus • Managed futures • Financial (e.g., stock), currency, or commodity futures. May make use of technical rules or less judgemental approach

16. DJ Credit Suisse 10 Classifications • Fixed income arbitrage • Attempts to profit from price anomalies in related fixed income securities. Examples: “On-the-run” vs. “off-the run” Treasuries. The former is more liquid and more expensive than the latter. Long Term Capital Management: Long off-the-run and short on-the-run • Global macro • Long and short positions in capital or derivative markets across the world. Portfolio positions reflect views on broad market conditions and major economic trends

17. DJ Credit Suisse 10 Classifications • Multi-strategy • Used to also include: Fund of funds (FOF) • Typically holds 10 – 30 hedge funds • Performs due diligence on investors’ behalf (BUT did not catch Madoff) • DJ and Credit Suisse joined forces in 2010. Prior to that, the index was called the CS/Tremont Hedge Fund index

18. Strategy performance not stable • Annual returns • Managed Futures and Dedicated Short Bias only two strategies with positive returns in 2008 • Only two strategies with negative returns in 2009 Source: CS/Tremont Least positive return Least negative return

19. Hedge Fund Benchmarks • DJ Credit Suisse, CISDM, HFR, MSCI Barra • Only a few have daily data (DJ, HFR, MSCI Barra), most are monthly • Not all are investable (i.e., can one buy a fund that tracks the hedge fund index?) • Only some list actual funds used in the index • Selection criteria (track record, AUM) • Weighting scheme (equal or asset-based)

20. Problems with Hedge Fund Indices • Survivorship bias • Managers with poor track record exit the database • ~ 11% of hedge funds become defunct per year • Results in upward bias when historical returns are based on only survivors. This bias has been estimated to be 1.5% to 3% per annum • Stale prices bias • Problem with assets that do not trade often. Correlation with other assets may appear lower than otherwise • Backfill bias • A hedge fund joins an index. Will supply past data (backfill) only if track record is good

21. Hedge Fund Performance

22. Hedge Fund Performance

23. Liquidity and Hedge Fund Performance Hasanhodzic and Lo (2007)

24. A Positive Relationship Using data from the previous table:

25. Is It Just A Liquidity Premium? • Serial correlation in returns: An indicator of less liquid markets • If an asset is not actively traded, the hedge fund manager must estimate its value to calculate returns. Tendency to smooth out value estimates or only gradually mark prices to true market values • Aragon (JFE,2007) shows that once lock-up periods and redemption notice periods are controlled for, the alpha turns insignificant • Excess returns of funds with lockup restrictions are 4 to 7% per year higher than those of non-lockup funds

26. Hedge Fund Due Diligence • Due diligence includes • Structure (legal entity, manager, domicile, registration, personnel, support providers) • Strategy (style, instruments, benchmark, niche, holdings) • Performance data (all funds, since inception) • Risk (measurement, controls, use of leverage) • Research (changes due to past findings, efforts, budget and personnel) • Administration (lawsuits, turnover, disaster recovery) • Legal (fee structure, lock-up, subscription maximum and minimum, drawback) • References (professional, other investors)

27. Performance Evaluation Concerns • Measuring volatility • Annualized standard deviation - monthly standard deviation  12 • Underestimate volatility if monthly returns are serially correlated • Hedge fund returns have more skewness and kurtosis than other investments • For example, strategies that take on default risk, liquidity risk, or other forms of catastrophe risk (negative skewness)  higher Sharpe ratio until the risk is realized • Harvey and Siddique (JF 2000) show that stocks with negative skewness generate higher average returns

28. Hedge Funds and the Sharpe Ratio • Not appropriate when investment returns are asymmetrical • Biased upward by illiquid holdings, when returns are serially correlated • Has not been found to predict future returns • Can be gamed by lengthening measurement interval, compounding monthly returns but calculating standard deviations without compounding, writing out-of-money calls and puts (and collecting the premiums), and smoothing returns