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15 Week 6 Hedge funds OverheadsBackground:1. What are they?(a) Legal, regulatory(b) Many strategies. Many not strategies(c) “Hedge funds are investment pools that are relatively unconstrained in what they do.They are relatively unregulated (for now), charge very high fees, will not necessarilygive you your money back when you want it, and will generally not tell you what theydo. They are supposed to make money all the time, and when they fail at this, theirinvestors redeem and go to someone else who has recently been making money. Everythree or four years they deliver a one-in-a-hundred year flood. They are generally runfor ric h people in Geneva, Switzerland, by rich people in Greenwich, Connecticut.” -CliffAsness, Journal of Portfolio Management 2004.2. Looks like some great returns (Warning: large selection/survival/backfill bias).1994 1996 1998 2000 2002 2004 2006 2008 2010 2012−40−30−20−10010203040Hedge Fund Index Annual Returns to 2008 HF3. Survivor/backfill/self-reported bias2800 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5−0.6−0.4−0.200.20.40.60.81YearsCumulative ReturnReturn history−40 −30 −20 −10 0 10 20 30 4005001000150020002500ReturnsHistogramDistribution of survivor’s 5 year returns TrueSample281Statistics across funds Raw SelectedMean 0.05% 3.12%Std. Dev 8.87% 7.00%1994 1996 1998 2000 2002 2004 2006 2008 2010 2012−40−30−20−10010203040Hedge Fund Index Annual Returns HF1994 1996 1998 2000 2002 2004 2006 2008 2010 2012−50−40−30−20−100102030405060HFIndex Hedge FundMarket2821994 1996 1998 2000 2002 2004 2006 2008 2010 2012−40−30−20−10010203040HFIndex HFRmDefSome overall themes:4. Option-like returns.(a) Non-Normal, hard to evaluate by regressions.(b) Writing puts; “pic king up pennies in front of a steamroller”Stock priceProfitLarge chance of a small, “riskless” gainSmall chance of a huge lossWriting puts2830ProbabilityProfitPut expires out of money; pocket put priceStock falls more than, say, 20%. Lose big!Write OTM put returnsTimeReturn(c) Small samples may not see the left tail at all(d) Small samples will see too lo w v olatility.(e) Regression methods may miss the exposure.(f) Dynamic trading can synthesize an option.i. Example 1:“Contrarian” is like writing puts.Stock priceWriting put profit“Contrarian” – more stocks at lower pricePut valueFigure 16:284ii. Example 2: “double or nothing” Start with $100, your goal is to beat the market by1%.value bet prob (101)100 1.&101 99 2 12.&101 97 4 34.&101 93 8 78.&101 85 16 1516.&101 69 32 3132.&101 37 636415.1 Comments on hedge funds• Strategies and betas — see Matlab graphs15.2 A few big, important poin ts1. Does the style/selection alpha/beta active/passive concept still make sense? Or “beta youknow and beta you don’t know.”2. “Equilibrium accounting” “Beta is earned from people who think they are earning Beta,Alpha is earned from people who think they are earning Alpha. With Beta, it’s possible forboth sides to be correct and happ y, they just have diffent numeraires. With Alpha, one sideis wrong.”3. Alpha vs. exotic beta. “Alpha” should be idiosyncratic. ‘factor” results like hml, suggest“exotic beta.”4. Selection bias. This is why you can’t “evaluate this fund.” To evaluate a fund, you mustevaluate the process that led you to look at this fund and not others in the first place.5. Both hedge funds and m utufal funds provide “liquidity” to investors.6. You cannot synthesize a free put option with a stop-loss order.15.3 Comments on hedge fund investing15.3.1 Those pesky fees1. Management + performance. Often 2% + 20% of gains. Funds of funds charge 1% + 10%on top of that!2852. Option:Portfolio valueBenchmarkManager compensation2%2%+20%!(a) Incentive for volatiility.(b) What do funds do to avoid this?i. General partners invest a large part of their own wealth. ?ii. Reputation?iii. High water mark?iv. Clear risk / beta / reporting and monitoring!.15.3.2 Hot money and magic alpha1. Example: Fall 20082. Why should losses lead to withdrawals?3. Counterintuitive conclusion: High water marks can be bad for investors, Lock-in can be goodfor investors!4. General point. The fee and contract structure is important.5. A stop-loss order is not a free put option!15.3.3 Building portfolios with hedge funds1. Question: How do you put hedge funds in a portfolio?2862. Example, from a major university endowment3. Risk management? Portfolio? You must know betas!4. Cost and fee explosion(a) Is HF shorting something you already own?(b) Is HF A shorting what HF B is buying?(c) Cost explosion — portfolio of options 6= option on portfolio.i. 100 mean zero stocks in one fund: 2% for sure.ii. 100 stocks in 100 funds: 2% + 0.5×(20%) for sure!5. Silliness in HF investing.(a) “Hedge funds give us more diversification”(b) “We need to add ‘alternative investments,’ ‘new asset classes’(c) “We hold a lot of funds to diversify across managers”(d) “We need to move to “alternative inv estments” since we aren’t “making our rate ofreturn targets” in conventional equities.15.3.4 Another view: MarketingA brilliant marketing success in a marketing business.1. “Absolute Returns,” ”Market-Neutral,” “Alternative asset,” “Near-Arbitrage”  “Alterna-tive beta,” “Entrepreneur”2. 2% + 20% “We only charge if we win.”28716 Week 6 Hedge fundsBackground:1. Hedge funds are an increasing part of the investment landscape.2. What are they?(a) “Hedge fund” is a le gal term; an investment partnership(b) Not all do high frequency trading! Some long-only, low turnover; some private-equity,some do monthly long-short, some do 10 second computerized trades. All these are verydifferent risk and reward.(c) “Hedge funds are investment pools that are relatively unconstrained in what they do.They are relatively unregulated (for now), charge very high fees, will not necessarilygive you your money back when you want it, and will generally not tell you what theydo. They are supposed to make money all the time, and when they fail at this, theirinvestors redeem and go to someone else who has recently been making money. Everythree or four years they deliver a one-in-a-hundred year flood. They are generally runfor ric h people in Geneva, Switzerland, by rich people in Green wich, Connecticut.” -CliffAsness, Journal of Portfolio Management 2004.3. Looks like some great returns (Warning:


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Chicago Booth BUSF 35150 - Week 6 Hedge funds Overheads

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