BSFS Handouts – Hedge Fund Strategies By Samuele Mazzoli 1 Outline 1. What are HFs and what are their characteristics? • Definition and distinctive features • Structure • Fee structure 2. Hedge Fund 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 investment strategies (e.g. directional, market neutral, 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 (‘Alternative Investment 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 short 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: distressed securities, event- driven and macro funds → these funds seek very high expected return but also increase overall portfolio volatility § “Risk reducer” strategies: convertible arbitrage, 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 § Convertible arbitrage § Dedicated Short Bias § M&A Risk Arbitrage 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 fundamental analysis) 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. security 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