Hedge Funds

What is a Hedge Fund?

Hedge funds differ substantially from traditional investment funds by being allowed to have a more liberal investment policy and by working with the goal of creating positive returns regardless of market development. The aim to achieve positive returns regardless of market development is different from the normal goals of a traditional mutual fund which normally operate with a goal of relative performance of the market they invest in.

The freer investment policy basically means that hedge fund managers may use financial instruments and investment techniques that are normally not permitted in traditional management. Examples of such financial instruments are options and futures, and an example of such placement methods is the ability to short sell and mortgage assets. Different hedge funds often have very little in common with each other regarding investment techniques and therefore exhibit very different risk profiles. There are hedge funds that exhibit very high risk as well as very low risk.

Below is a table describing the main characteristics of Hedge Funds in comparison with the main characteristics of Traditional Funds (Mutual Funds).

How it all started

Alfred Winslow Jones is usually credited with forming the first modern hedge fund in 1949. He opened an equity fund that was organized as a private partnership (and therefore exempt from SEC regulations) to provide maximum latitude and flexibility in constructing a portfolio. In his original hedge fund model, Jones merged two speculative tools short sales and leverage into a conservative form of investing. Jones’ model was based on the premise that performance depends more on superior stock selection than on market direction. For example, he believed that during a rising market, good stock selection will identify stocks that rise more than the market, while good short stock selection will identify stocks that rise less than the market. Jones’ model outperformed the market. He converted his general partnership to a limited partnership in 1952, used performance-based fee compensation, and operated his fund in complete secrecy for seventeen years.

Hedge funds today

The hedge fund market has evolved significantly over the last 10 years and the assets under management have increased.

The hedge fund managers typically have a background from large investment banks where they used to run similar investment strategies. One way of looking at the growing hedge fund industry is that former investment bank employees have become entrepreneurs. The major driving force behind this development is the dramatic fall in technology costs. A successful trading team can efficiently take their trade private by forming a hedge fund.

In the beginning of the 90:s 70% of the hedge fund assets where run by quantitatively oriented global macro funds such as the Quantum Fund (run by George Soros). Today, global macro funds account for a much smaller portion of the hedge fund assets. The most prevalent strategies today are much less risky and mainly involve relative value trading in traditional assets such as stocks and bonds.

Hedge fund strategies

Below is the Credit Suisse First Boston Tremont Index LLC’s series of sub-indices, which are designed to track the primary categories of investment styles used by hedge fund managers.

Convertible Arbitrage

This strategy is identified by hedged investing in the convertible securities of a company. A typical investment is to be long the convertible bond and short the common stock of the same company. Positions are designed to generate profits from the fixed income security as well as the short sale of stock, while protecting principal from market moves.

Dedicated Short Bias

Dedicated short sellers were once a robust category of hedge funds before the long bull market rendered the strategy difficult to implement. A new category, short biased, has emerged. The strategy is to maintain net short as opposed to pure short exposure. Short bias managers take short positions in mostly equities and derivatives. The short bias of a manager’s portfolio must be constantly greater than zero to be classified in this category.

Emerging Markets

This strategy involves equity or fixed income investing in emerging markets around the world. Because many emerging markets do not allow short selling, nor offer viable futures or other derivative products with which to hedge, emerging market investing often employs a long-only strategy.

Equity Market Neutral

This investment strategy is designed to exploit equity market inefficiencies and usually involves being simultaneously long and short matched equity portfolios of the same size within a country. Market neutral portfolios are designed to be either beta or currency neutral, or both. Well-designed portfolios typically control for industry, sector, market capitalization, and other exposures. Leverage is often applied to enhance returns.

Event-Driven

This strategy is defined as equity-oriented investing designed to capture price movement generated by an anticipated corporate event. There are four popular sub-categories in event-driven strategies: risk arbitrage, distressed securities, Regulation D and high yield investing.

1. Risk Arbitrage:

Specialists invest simultaneously in long and short positions in both companies involved in a merger or acquisition. Risk arbitrageurs are typically long the stock of the company being acquired and short the stock of the acquirer. The principal risk is deal risk, should the deal fail to close.

2. Distressed Securities:

Fund managers invest in the debt, equity or trade claims of companies in financial distress and generally bankruptcy. The securities of companies in need of legal action or restructuring to revive financial stability typically trade at substantial discounts to par value and thereby attract investments when managers perceive a turn-around will materialize.

3. Regulation D, or Reg. D:

This subset refers to investments in micro and small capitalization public companies that are raising money in private capital markets. Investments usually take the form of a convertible security with an exercise price that floats or is subject to a look-back provision that insulates the investor from a decline in the price of the underlying stock.

4. High Yield:

Often called junk bonds, this subset refers to investing in low-graded fixed-income securities of companies that show significant upside potential. Managers generally buy and hold high yield debt.

Fixed Income Arbitrage

The fixed income arbitrageur aims to profit from price anomalies between related interest rate securities. Most managers trade globally with a goal of generating steady returns with low volatility. This category includes interest rate swap arbitrage, US and non-US government bond arbitrage, forward yield curve arbitrage, and mortgage-backed securities arbitrage. The mortgage-backed market is primarily US-based, over-the-counter and particularly complex.

Global Macro

Global macro managers carry long and short positions in any of the world’s major capital or derivative markets. These positions reflect their views on overall market direction as influenced by major economic trends and/or events. The portfolios of these funds can include stocks, bonds, currencies, and commodities in the form of cash or derivatives instruments. Most funds invest globally in both developed and emerging markets.

Long/Short Equity

This directional strategy involves equity-oriented investing on both the long and short sides of the market. The objective is not to be market neutral. Managers have the ability to shift from value to growth, from small to medium to large capitalization stocks, and from a net long position to a net short position. Managers may use futures and options to hedge. The focus may be regional, such as long/short US or European equity, or sector specific, such as long and short technology or healthcare stocks. Long/short equity funds tend to build and hold portfolios that are substantially more concentrated than those of traditional stock funds.

Managed Futures

This strategy invests in listed financial and commodity futures markets and currency markets around the world. The managers are usually referred to as Commodity Trading Advisors, or CTA:s. Trading disciplines are generally systematic or discretionary. Systematic traders tend to use price and market specific information (often technical) to make trading decisions, while discretionary managers use a judgmental approach.

Why hedge funds?

High risk adjusted return

Hedge funds have historically produced a higher risk adjusted return than stocks and bonds and OPM believes that this relationship will hold in the future.

Attractive component to a portfolio

Hedge funds are an attractive complement to a mixed equity and bond portfolio since the general correlation with these assets are low.

Why fund of funds?

Diversification

A portfolio of hedge funds has significantly lower risk than the average risk of individual hedge funds. The reason for this fact is the low correlations between the returns of the individual funds.

Access to an effective portfolio with a limited investment

With a fund of funds investors can access an efficient (diversified) portfolio of hedge funds with a relatively small investment. The minimum investments in international hedge funds are normally 1 MUSD. An efficient portfolio should have a minimum of 10 funds. The absolute minimum size of an efficient portfolio is therefore, 10 MUSD.

Access to a systematic analytical process

With a fund of funds an investor can gain access to a systematic hedge fund investment process that is costly and time consuming. The due diligence process for each fund normally takes 3-6 months.

Investments in hedge funds demand continuous monitoring

Hedge funds must be closely monitored every month and cannot be bought with a buy and hold strategy. The return on an average hedge fund tends to be halved over a time period of 5 years which indicates that hedge funds systematically delivers worse results with time.

Investment process

The OPM investment process for hedge funds is based on proprietary quantitative models in combination with traditional fundamental analysis. OPM continuously analyzes over 10 000 hedge funds and the goal is to select a portfolio of funds with the highest likelihood of good future risk-adjusted returns (both in terms of standard deviation and beta).
 
The process is very detailed and has been continuously evaluated and improved since the firm started in 2003. A substantial part of the work has been focused on identifying different types of key figures with high explanatory values. Many of the added decision criteria are derived from various forms of practical experience.  A substantial part of the operational work with analysis is to really understand all the risk aspects that a hedge fund investment involves.

Step 1. Investment Hypothesis

Initially over 10 000 hedge funds are organized in a database. This database is based on information from several external databases, and supplemented by funds that have been identified through other channels. The database is updated monthly. Several fundamental investment criteria are developed and tested quantitatively. The goal is to find variables with explanatory value for future performance which then are implemented in proprietary forecasting models. Many of the added decision criteria are derived from various forms of practical experience.

Step 2. Quantitative Analysis

Initially a smaller group of funds are selected for further analysis. The selection is made with our own proprietary forecasting models developed in step 1 above. Over 95% of all funds are eliminated in this step. All funds must go through this part of the process before any fundamental analysis is made.

Step 3. Fundamental Analysis

In this step traditional fundamental analysis is performed including meetings and conferences and calls to references are made. We look for reliable, talented and motivated managers with logical strategies amongst the managers that made it through the quantitative analysis. An understanding of the risk that the management strategy entails is obtained by deeply analyzing the strategy. In many respects, the methodology used is similar to that used in traditional business analysis.

Step 4. Due diligence

The most time consuming step is the due diligence process which takes 3-6 months. The main focus is on the legal and operating structure and the audited financial statements. In this step we also try to negotiate better terms in the form of better liquidity and rebates. 

Step 5. Portfolio Allocation Process

The portfolio allocation process aims to optimize the portfolios expected risk-adjusted returns. It also aims to minimize the expected correlation with equities and bonds and to minimize the risk of “draw downs” (losses). The process is based on a number of methodologies since the correlation patterns are relatively unstable. The optimization is carried out with the restriction that the expected risk (measured as annual standard deviation) in the portfolio may not exceed the funds specified goal risk. The prognosis for the strategies attractiveness the coming 18 months is considered but the main focus is to construct a portfolio of talented managers.

Step 6. Continuous monitoring

All funds are analyzed monthly and compared with each other as well as with new options. Important variables to monitor include the derivative of the development of indicators and operational news. The macro environment is also analyzed to identify emerging risks and opportunities that may affect managers’ ability. Finally various forms of risk parameters are analyzed to ensure that the portfolio is optimal and is within established risk limits.

Risk management

The main risks of hedge fund investments can be divided into market risks and operational risks. OPM has developed detailed procedures for effective risk control of the various components.

Market risks

Each month the portfolio and its underlying hedge funds, in which OPM has invested, are analyzed regarding market risk. Different statistical parameters such as Maximum drawdown, Standard deviation, Downside deviation, Kurtosis and Skewness are analyzed for each individual fund and for the portfolio as a whole.  An important parameter that complicates the analysis is that the distribution patterns are not normally distributed. Further fundamental risk assessments are made and especially in the cases where historical observations are judged to be a weak basis for the analysis of future risk patterns. Another important component of the analysis is different forms of correlation analysis between the funds. The analysis is complicated by the fact that the relationships in many cases are weak and affected by general market conditions. This can simply be expressed as that correlation is often increased when you least wish it to.

When the statistical analysis is ready further market risk elements in the OPM funds are added to the analysis. Finally, the proposed investment allocation should imply an expected risk which cannot exceed the Fund’s goal risk. All OPM funds uses currency forwards to hedge currency risk.

Risk Analysis System: PerTrac 2000 from Strategic Financial Solutions, LLC.

Operational risks

Each hedge fund has a number of unique risks that must be identified and analyzed. Examples of unique risks are administrative and legal risks which needs to be taken care of in the due diligence process.
 
OPM initially studies material from the hedge fund such as its investment memorandum, subscription documents, audited financial statements, marketing materials and the performance. If the hedge fund is considered interesting a telephone conference is arranged with the fund managers. At the conference it’s made sure that the investment process has been understood correctly and that an understanding for the funds specific risks has been achieved.

After the conference call with the fund managers a number of more specific issues are raised with the Fund’s Chief Financial Officer/Risk Manager. The first priority is to understand the methodology and the process used in determining the fund price (NAV). Corporate partners such as investment banks, brokers, providers of stock lending etc, other hedge funds as well as references are also contacted. The due diligence process is normally finished, after 3-6 months, with a visit to the fund manager to make a final reconciliation and to ensure that everything looks good.

All hedge funds, in which OPM is invested, are continuously monitored. Result data is scanned to identify any anomalies and frequent conversations are held with the managers. Information about the hedge fund market is also obtained from contacts at investment banks, brokerage firms and other companies in the industry.