BSFS Handouts – Fund Strategies

By Samuele Mazzoli

1 Outline 1. What are HFs and what are their characteristics? • Definition and distinctive features • Structure • Fee structure

2. strategies • Overview of the possible classifications • Classification provided by the Financial Sponsors Group

3. Appendix • Examples of HF strategies

2 Part 1. Hedge Funds Charachteristics & Structure

3 What are HFs and what are their characteristics?

Definition and distinctive features

We can, of course, start by saying that there is no formally accepted definition, so the following is an attempt to capture all the key features:

A HF is a privately offeredinvestment vehicle that..

1. Pools the contribution of investors in order to invest in a variety of asset classes (e.g. securities, derivatives, bonds, currencies…) 2. Uses a variety of active strategies (e.g. directional, , event driven) to achieve positive absolute returns 3. Is unregulated (or lightly regulated) and as such: § They can only be offered to eligible investors (HNWIs & institutional investors) § They can operate with high management and fee structure → After the 2008 crisis, regulators have introduced the AIFMD (‘ Fund Management Directive’) which attempts to impose some regulation from the operational point of view 4. Is designed to exploit superior information held by the HF manager § They can operate with high management and fee structure flexibility: interesting case of FoHF

Source: ‘’Intro to HFs strategies - Connor, Lasarte (2007)’’, Lecture notes 4 What are HFs and what are their characteristics? (cont’d)

Definition and distinctive features… in other words

Hedge fund managers pursue absolute returns rather than returns relative to an index or Absolute benchmark, allowing them to generate gains even when the traditional markets are returns failing or range bound

Returns of hedge funds are derived mostly from the skill of the hedge fund manager in Skill – based executing their chosen strategy rather than exclusively relying on asset appreciation in strategies rising markets

Hedge funds have the ability to trade on the long and side of various financial Flexibility instruments

Hedge fund managers trade across a spectrum of markets and exchanges, investing in a Diversity diverse array of financial instruments including equities, bonds, currencies and derivatives

Hedge fund managers often invest their own money, which aligns their interests with Alignment of those of their investors interest

Source: ‘’Intro to HFs strategies - Connor, Lasarte (2007)’’, Lecture notes 5 What are HFs and what are their characteristics? (cont’d)

Structure

Hedge Fund

Fund Administrator Prime Broker Custodian Hedge Fund Manager

§ Processes the § Executes the § Holds the fund’s § Sets and manages subscriptions and transaction ordered assets (fiduciary the funds redemptions by the fund duties) investment strategy manager § Calculates the value § Monitors and of investors’ controls the capital holdings (NAV or flows to meet partnership shares) margin calls

Source: ‘’Intro to HFs strategies - Connor, Lasarte (2007)’’, Lecture notes 6 What are HFs and what are their characteristics? (cont’d)

Fee structure… and why it matters!

HF usually levy two types of fees: 1. Management fees: calculated as a percentage of the fund’s NAV (Net Asset Value) – typically range between 1 to 4 % per annum 2. Performance (incentive) fees: percentage of the fund’s profits, usually counting both realized and unrealized profits – usually around 20 % of returns (but the range is wide with top managers charging higher fees) § Can be suject to a highwater mark: managers receive perfomance fees only on increases in the NAV of the fund in excess of the highest previously achieved NAV § Can be subject to a hurdle rate: managers will not charge a performance fee until the fund’s performance exceeds a benchmark rate, such as T-bill yield, LIBOR or fixed percentage

ü Incentive to attract very talented managers ☓ The asimmetry of performance fee structure may incentive managers to take excessive risk rather that targeting on long-term return Source: ‘’Intro to HFs strategies - Connor, Lasarte (2007)’’, Lecture notes 7 Part 2. Hedge Funds Strategies

8 Hedge Fund Strategies

Overview of the possible classifications

Any attempt to establish a formal system of classification for hedge fund strategies is limited by the fact that thesestrategies are continually changing (e.g. recentlyseveral hedge funds began taking direct positions in leveraged buyouts, previously the domain of private equity firms) The following are some of the possible classifications of HFs:

1. Fung and Hsieh (1997) classify Hfs strategies according to both ”style” and ”location”: § ”Style” refers to the type of positions the fund manager is taking such as going long and short, betting on a particular type of event, or mantaining market neutrality § ”Location” refers to the asset class the HF is investing in (e.g. fixed income, equity or currencies) 2. Amenc , Martellini and Vaissié (2002) distinguish between: § “Return enhancer ” strategies: , event- driven and macro funds → these funds seek very high expected return but also increase overall portfolio volatility § “Risk reducer” strategies: convertible , fixed income arbitrage, long/short and short selling funds → offering positive excess returns while also decreasing over all portfolio volatility

3. Other binary classifications… § “Systematic“ vs. “Discretionary“ strategies: trading based on complex computer programs vs HF manager judgement § “Multistrategy HFs“ : HF manager changes strategy depending on market conditions

Source: ‘’Intro to HFs strategies - Connor, Lasarte (2007)’’, Lecture notes 9 Hedge Fund Strategies (cont’d)

Classification sugested by Connor, Lasarte (2007) We will discuss some specific hedge fund strategies, grouping them under four broad themes: long/short, event driven, tactical trading, and relative value

1 Long / Short 2 Event Driven 3 Tactical Trading 4 Relative Value

Strategies that exploit the Strategies based on events Strategies that attempt to Strategies designed to take ability of the HF manager to expected to make an impact profit by forecasting the advantage of perceived freely short equities, an over a relatively short period overall direction of the market mispricing among related opportunity not available to of time (e.g. restructurings, or a market component (e.g. financial assets, as such they most portfolio managers; they stock buybakcs, bond geopolitical issues, economic rely on the LR tendency of allow to separate specific from upgrades, earnings surprises, indicators, market trends and market prices to revert to systematic risk spin-offs) liquidity flows) equilibrium relationships, § Equity Market Neutral § Distressed Securities § Macro Strategies (while can deviate in the SR) § Equity Long/Short § High Yield § Long - only Leveraged § § Dedicated Short Bias § M&A Strategies § Capital Arbitrage § Fixed Income Strategies

Source: ‘’Intro to HFs strategies - Connor, Lasarte (2007)’’, Lecture notes 10 Hedge Fund Strategies (cont’d)

1 Long / Short Strategies

Strategy What does it consists in? Pros Cons Equity Market Neutral § Strategy that uses the ü Removes systematic risk ✘ Profit depends on the (e.g. pairs trading) combination of buys and short – ü Profit do not depend on the relative performance of the sales to offset any correlation direction of the market long compared to the short between portfolio return and the position on a relative basis overall market return Equity long/short § Strategy that is the same as ü Increased flexibility for HF ✘ Unclear to the final investor (often bottom-up market neutral except withouth manager to choose net-long how the HF allocation approach, i.e. any explicit promise to maintain or net-short market affects portfolio risk ) market neutrality exposure ü Focus on stock selection opportunities Dedicated Short Bias § It concentrates on the short side ü Most effective when ✘ Since it is focuses on short- (e.g. shortselling of Tyco and thereby sacrifices the market markets are declining selling, unlimited potential shares in 2002 following neutrality feature ü Allows to profit from losses an accounting scandal) § Usually involves shares of large untapped opportunities ✘ Timing and risk management companies, easier to trade and to available to investors that are crucial borrow can not short sell

11 Source: ‘’Intro to HFs strategies - Connor, Lasarte (2007)’’, Lecture notes Hedge Fund Strategies (cont’d)

2 Event Driven

Strategy What does it consists in? Pros Cons Distressed Securities § Strategy that focuses on the ü Can profit from absolute ✘ Prices for these securities purchase of a substantial pricing inefficiencies are volatile and illiquid proportion of the outstanding ✘ High legal risks (e.g. of the distressed company regulators prohibiting the and then attempt to influence the selling of a company stock restructuring process during restructuring) High Yields § Strategy that consists in purchase ü Possibility to capture the ✘ Risk to lose part of the junk bonds / high-yield debt (triple high yield investment BBB or minus), that they can buy at a discounted price M&A Risk Arbitrage § The HF will generally go long on ü An active form of the ✘ Antitrust risk: regulators can (e.g. takeover of the stock of the target and short strategy is to accumulate block the deal Mannesmann by the stock of the bidder large shareholdings in order ✘ Financing risk: acquirer can Vodafone AirTouch – to influence the merger lose the financial backing to 1999) negotiations and outcome carry out the purchase ✘ M&A volume is cyclical Source: ‘’Intro to HFs strategies - Connor, Lasarte (2007)’’, Lecture notes 12 Hedge Fund Strategies (cont’d)

3 Tactical Trading

Strategy What does it consists in? Pros Cons Macro Strategies § Strategy by which the HF manager ü Flexibility for the HF ✘ Return profile is much more (e.g. Yen Carry Trade in makes large bets based on manager in choosing the volatile compared to other the ‘90s, meaning forecasts of major macroeconomic country and/or the asset HF w/t different strategies borrowing at low interest events such as changes in interest class where he sees an ✘ Could suffer from high rates in Japan and invest rates, currency movements and opportunity correlation b/t assets as it is in US debt) performance the case in EM where most § They often rely on the use of of these funds invest leverage and derivatives

Long-only Leveraged § Strategy that is similar to a ü Possibility to benefit from ✘ Usually these funds are Strategy traditional active management lighter regulation associated more similar to traditional strategy but carries more risk as it to HF active funds hence they are involves leverage on top of an not properly hedging aggressive portfolio

Source: ‘’Intro to HFs strategies - Connor, Lasarte (2007)’’, Lecture notes

13 Hedge Fund Strategies (cont’d)

4 Relative Value

Strategy What does it consists in? Pros Cons Convertible Arbitrage § Strategy whereby HF managers ü Allows to profit from the ✘ Subject to interest rate risk (e.g. in 1999, Amazon typically take a long position in the undervaluation of the and credit spread share price was high, convertible bond and short the convertible bond while movements assuming extraordinary company’s equity reducing the exposure to the ✘ Also affected by regulatory growth, while convertibes § Important parameter in the trade underlying stock risk (e.g. in Japan regulators were not reflecting this -> is ‘’delta’’ designed a set of new rules short high priced stocks § The interests on the proceeds to curb short selling and long bonds) from selling short the stock are used to finance the position Capital Arbitrage § Exploits mispricing between a ü Possibility to benefit from ✘ Risk of misinterpreting the (e.g. British Telecom in company’s debt and equity different reactions of equity correlation b/w a company’s 2001, when his debt was § Common case of investment and debt to announcements equity and debt downgraded several times opportunities arises when such as earnings release while its share price was companies are undergoing ü Strategy eased by the slower to react) restructuring processes growth in popularity of CDS Source: ‘’Intro to HFs strategies - Connor, Lasarte (2007)’’, Lecture notes

14 Hedge Fund Strategies (cont’d)

4 Relative Value (cont’d) Among Relative Value strategies, Fixed Income Strategies play an important role. These attempt to exploit mispricing among fixed income securities and rely heavily on mathematical models of the term structure of interest rate to identify mispricing.

Strategy What does it consists in? Pros Cons Yield Curve Arbitrage § Involves taking offsetting positions ü Can be ‘’intra curve’’ (trade ✘ Success of this strategy at various points of the yield involves securities on the depends essentially on the curve, typical those of a T-bill, in same YC) or ‘’inter-curve’’ accuracy with which the HF responde to perceived (trade involves securities manager forecasts macro disequilibrium price relationships issued by different factors affecting the YC → § Often consists in taking positions countries) → many possible high volatility, like for macro in the futures and swaps markets strategies strategies as an alternative to directly buying or selling bonds Besides the Yield Curve Arbitrage, there are many others such as: Corporate Spread, Trasury/Eurodollar, Mortgage, Derivatives, ADR and Stock Index Futures …feel free to learn how they work! Source: ‘’Intro to HFs strategies - Connor, Lasarte (2007)’’, Lecture notes

15 Part 3. Appendix

16 Pairs Trading Example

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Source: ‘’Intro to HFs strategies - Connor, Lasarte (2007)’’, Lecture notes

17 M&A Risk Arbitrage Example

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Source: ‘’Intro to HFs strategies - Connor, Lasarte (2007)’’, Lecture notes

18 Macro Strategies example

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Source: ‘’Intro to HFs strategies - Connor, Lasarte (2007)’’, Lecture notes

19 Convertible Arbitrage Example

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One specific example of convertible arbitrage is Delta Trading, which allows to insulate the strategy from market risk → the idea is to have a ‘’’’ portfolio of CBs and stocks, which in theory, generates positive returns regardless of pricing movements Some definitions and formulas: § Delta = , in other terms it measures the sensitivity of CB price vis-a-vis the stock price

§ N° of shares to short in order to be delta neutral = a ✕ b ✕ c, where: § a = N° of covered bonds I want to long § b = Conversion Ratio § c = Delta We want to long 1 CB, how many Source: ‘’Intro to HFs strategies - Connor, Lasarte (2007)’’, Lecture notes shares to short?

N° shares = 1 (CB) ✕ 50 (conversion ratio) ✕ 0,5 (Delta) = 25 20 Yield Curve Arbitrage Example

1 2

This is a simplified example, infact in reality we distinguish three Source: ‘’Intro to HFs strategies - Connor, Lasarte (2007)’’, ‘’Investment Strategies of HFs, Stefanini (2006)’’ cases: § Steepening YC: short LT securities, long ST securites § Flattening YC: long LT securities, short ST securities § Butterfly YC: depends whether the curve is troughed or humped 21