Читать книгу Hedge Fund Investing - Mirabile Kevin R. - Страница 9

This chapter provides an initial introduction to some of the most common hedge fund strategies. In addition, it will show you how to use monthly returns and the exposure data reported to investors to measure performance and risk and how leverage, short selling, and derivatives impact performance.

TYPES OF HEDGE FUND STRATEGIES

It is useful to understand the diversity of styles, strategies, and substrategies that fall under the category of hedge fund investing before delving into any one strategy or fund. It is also important to appreciate that hedge funds can profit from trading in a variety of instruments, using a wide array of financing tools, and using derivatives. Hedge funds typically actively trade individual stocks, bonds, options, or derivative instruments that provide asset class exposure, such as the S&P 500 or interest rates futures and sometimes ETFs. Hedge funds that invest in individual stocks may go either long or short, based on the results of their company-specific research and level of conviction in the ideas or trends supporting each position. A manager who buys IBM and profits from its increase in value can at the same time sell Microsoft short and profit from its fall in value. A manager using this strategy would be relatively insulated from a fall in the overall technology sector and would seek to profit from the relative performance of IBM versus Microsoft in both rising and falling markets. Figure 2.1 shows the changes in prices for IBM, Microsoft, and the Nasdaq Composite over a 12-month period.

FIGURE 2.1 Long and Short Equity Opportunities

Source: Yahoo! Finance.

Some equity-oriented funds may buy or sell stocks and trade options to profit or enhance their particular views on volatility or market direction while investing only a small portion of their capital to take large amounts of risk. Managers using options are attracted to the higher degree of leverage embedded in the product relative to traditional margin loans, borrowing from a bank, or short selling. Long calls can create exposure similar to a purchase in a margin account, and long puts can create exposure similar to a short sale. Options can also be used to buy or sell volatility on the equity market or on individual stocks and bonds, or they can also be written to generate income and enhance performance.

Some funds that are fixed-income–oriented may take varying exposures to interest rates, U.S. government bonds, or currencies. A fund can take a net short position in interest rate futures if the manager believes the value of the underlying Treasury note will fall due to rising interest rates. Another fund could go long interest rate futures to take a bullish view on bond prices and a bearish view on rates. Figure 2.2 shows how hedge funds changed their position in the 10-year note contract from net short to net long over a 12-month period.

FIGURE 2.2 Speculative Use of Treasury Note Futures Contracts

Source: http://articles.businessinsider.com/2010-09-30/wall_street/30089785_1_government-bonds-funds-chicken.

Still others who are macro-oriented might attempt to profit from either directional bets or changes in relative values of various asset classes, such as stocks, bonds, or currencies. Those funds might be buying or selling equity futures contracts on the Dow Jones or S&P Index while buying or selling interest rate futures on the 10-year U.S. government bond. Fund managers who believe equity prices would generate a better total return than bonds might go long equity futures and short Treasury futures during certain periods and reverse the position when they anticipate the relationships changing. Figure 2.3 shows the periods over the past 200 years when stocks have beaten bonds and vice versa. Each run-up or dip in the relationship represents a trading opportunity for a fund manager who believes the relationships may revert to back to historical levels.

FIGURE 2.3 Stock versus Bond Cumulative Relative Performance, 1801 through 2009

Source: Michael Santoli, “Stocks vs. Bonds,” Barron’s, March 27, 2009, http://online.barrons.com/article/SB123819638720161459.html.

Broadly speaking, hedge funds can be classified as being macro or directional in nature, equity long- and short-oriented, designed to take advantage of relative value opportunities, or intended to profit from specific binary events – or a combination of all of these. The terminology is somewhat inconsistently applied, and designating any individual manager as part of a specific style bucket is not always straightforward. Generally speaking, a fund fits into one of a few broad styles, as follows:

• Macro: This style includes funds that opportunistically go long and short multiple financial assets using a wide range of instruments. Strategies are either discretionary or trend-following.

• Equity hedge: This style includes strategies that go long and short equity securities with varying degrees of exposure and leverage known as equity variable bias. Strategies can be long or short biased and can be domestic-, international-, emerging-market–, global-, sector-, region-, or industry-focused.

• Relative value: This style includes arbitrage strategies and those that seek to take advantage of mispricing or relative differences in similar securities that exist for short time frames. This style includes strategies such as fixed income and credit arbitrage and convertible bond arbitrage, and sometimes equity strategies, such as market neutral or long and short equity that are not directionally biased.

• Event-driven: This style includes strategies that involve corporate transactions and special situations such as risk arbitrage (long and short equity securities of companies involved in corporate transactions) or distressed (long undervalued securities of companies usually in financial distress or operating under Chapter 11) or those that are opportunistic and profit from patent approval, regulatory actions, spin-offs, strategic repositioning, or other significant binary one-time events.

• Multistrategy: This style includes funds that seek to allocate capital in a dynamic fashion across any or all of these broad styles or individual strategies. Many funds of hedge funds also fall into this category.

This broad classification of hedge fund styles can be further segregated into many more individual fund strategies. There are many different terms used to describe individual fund strategies in evaluating or researching hedge fund investments. Each strategy has its own performance and risk characteristics that can also often influence the structure of the fund and the terms of the fund that are ultimately offered to investors. Figure 2.4 shows the standard strategy classification used by Hedge Fund Research (HFR) to categorize various types of hedge fund strategies.

FIGURE 2.4 Hedge Fund Research Strategy Classifications

Source: HFR Industry Reports © HFR, Inc. 2015, www.hedgefundresearch.com.

There is currently no consensus on the way each underlying hedge fund strategy should map to the broad macro or discretionary, relative value, long and short equity, or event classifications, nor is there a consensus on what constitutes a multistrategy fund. Each investor, fund, and allocator needs to either choose a vendor scheme or develop its own classification scheme. Most investors and vendors agree that a global macro fund is a type of discretionary hedge fund investment and that a convertible arbitrage fund is a form of relative value investing. However, once you go beyond a handful of styles or strategies, there is little agreement among industry participants, and there is no regulatory definition to fall back on. Some investors do the classification of substrategies and styles on a bespoke basis, and each data provider who tracks fund performance tends to use a slightly different methodology and strategy definition. Other investors formally adopt a scheme used by one of the major commercial database providers, such as Hedge Fund Research (HFR), Eurekahedge, or CS Dow Jones Indices. The most important part is that you are consistent and evaluate peer groups, funds, and indices with as similar a set of definitions as possible.

The approach taken in this book is to organize the various hedge fund trading strategies into those that are not correlated to traditional portfolios (such as, for example, global macro), those that are equity-oriented (such as long and short equity), those that are fixed-income–oriented (such as fixed-income arbitrage or convertibles) and, finally, those that are multistrategy in nature. Event-driven strategies are included in either the equity-oriented strategy discussion, as is the case of risk arbitrage and activist investing, or, in the fixed-income–oriented strategy, as is the case with distressed investing.

Hedge Fund Returns

Hedge funds provide investors with periodic reports of their returns and their risk profiles, either directly or via a third-party service provider or database. There are no standard methodologies that are mandated, and many forms of reporting and aggregation have limited value, are misleading, or are not accurate. Fund performance is generally reported on a monthly basis and is calculated net of all fees.

The components of hedge fund returns can be broken down into several pieces. There is the return from trading in the stock, bond, commodity, or derivative contract; the return from interest on cash or the expense associated with borrowing cash; the cost of borrowing a stock or bond to sell short; and the return or costs associated with coupons and dividends that are paid or received by the fund.

Security purchases and sales, leverage, and short selling generate the trading profits or loss and carry components of a fund’s return each month before fund expenses, management fees, incentive fees, and other charges. Carry can vary widely from strategy to strategy, depending on the nature of the portfolio and the use of leverage and short selling.

A fund’s monthly return is composed of the following items:

• Trading profit or loss measures the gain or loss from buying and selling stocks, bonds, currencies, or any other investments, less any commissions or spreads paid to the dealers who were used for execution or positioning trades for the fund.

• Commissions are fees paid to dealers to buy and sell stocks or other investments on behalf of a fund. Commissions are normally included in the net purchase or sale price of a security and are a reduction of trading profit or loss.

• Cost of carry refers to the net interest, dividend and coupon, and borrow fee to hold a position for the term of investment or annualized for one year. Carry can be positive or negative.

• Interest income or expense measures the amount paid to or received from dealers who provided financing to buy securities or where the fund held cash on deposit that was received from investors or generated via short sales. Interest is generally incurred or earned related to cash balances, margin activity, or the use of repurchase agreements.

• Coupons and dividend income or expense are the receipts or payments of income associated with stock or bond positions held by the fund. Owners of the stock or bond receive coupons or dividends, and short sellers of stocks or bonds pay coupons or pay dividends to those institutions or banks that provided the securities loans to the funds.

• Borrow fees are incurred by funds to rent the securities borrowed from a bank or institution to sell short.

• Fees and expenses are usually deducted after the computation of the gross trading profit and carry figures each month. Fund expenses include the legal, audit, or research-related expenses chargeable to the fund plus the fund’s management fee payable to the fund manager and any performance or incentive fees.

• Fund operating expenses can be related to audit fees, legal fees, and other costs borne by the fund directly. Only certain types of operating expenses can be charged directly to the fund according to each fund’s operating agreement.

• Management fees refer to fixed fees charged by a manager to the fund for its services. These fees can typically range from a 1 percent to a 5 percent flat fee.

• Performance or incentive fees refer to the variable fees charged by a manager to the fund for its services. These fees typically range from 0 to 50 percent of the fund’s performance, after all costs and after deducting the fixed management fee.

Every strategy and fund generates a unique combination of trading, coupon, dividend, and financing sources of income and expense. In addition, different funds generate varying degrees of long- and short-term capital gains. When reviewing a manager, make sure the components of performance are consistent with the nature of the fund. For example, funds with lots of leverage, such as a relative value fund, should show significant interest income and expense. Funds with low degrees of leverage and little trading, such as a distressed fund, should show very little interest expense, high coupons on debt, and few borrow fees. Funds that use listed futures, such as global macro funds, should not incur any interest costs and should, in fact, generate interest income.

Funds normally report results to investors monthly. It is common practice that funds report performance net of all fees, including the management and performance fees they pay to the manager.

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Illustration 1

A sample calculation of a fund’s net performance for a single month is illustrated here for a fund whose manager charges a typical 2 percent management fee and a 20 percent performance fee, known as a 2 and 20 deal:

In this example, the manager received approximately 31 percent of total gross return on investment, and the investor received 69 percent. A manager who generates a loss in any year is not entitled to any incentive compensation.

In fact, a manager who generates a loss in any given year is not entitled to any incentive compensation going forward until the loss is recovered. This feature in a hedge fund compensation contract is referred to as a high-water mark. Some managers may also have an annual minimum performance that must be achieved before an incentive fee is earned. This is referred to as a hurdle rate.

IMPACT OF LEVERAGE, SHORT SELLING, AND DERIVATIVES

One of the essential parts of a hedge fund’s value proposition is its ability to enhance the basic return from security selection and directionality with leverage, short selling, and derivatives.

Hedge funds effectively combine traditional securities with leverage, short selling, and the use of derivatives to generate unique outcomes, such as higher returns and lower volatility.

Leverage refers to the ability of a hedge fund to buy or sell more market value in shares or derivatives than the amount of capital it has raised from its investors. A fund that raises $100 million and buys $150 million or short-sells $200 million does so by combining its capital with money or shares borrowed from a bank or obtained via a derivative instrument, such as a listed or OTC option or futures contract.

Short selling refers to the ability of a fund to sell a stock, bond, or futures contract today that it plans on buying in the future. A short seller profits from a fall in the value of the instrument or security sold. A fund can borrow shares for short selling from a bank or dealer or can obtain short exposure and profits via a derivative instrument or futures contract.

A derivative can be a listed instrument, such as an option or a futures contract, that is exchange traded or an OTC instrument negotiated with a bank directly. The derivative can be used to provide leverage and short selling capability and can also modify income, tax, or other payoffs associated with the underlying stock, bond, or currency.

The primary sources of leverage and the ability to sell a security short come from the use of a margin account, repo transaction, or OTC derivatives with a bank, or it is embedded in products such as futures or options. The use of leverage and short selling by hedge fund managers is fundamental to their ability to create unique results relative to traditional managers. In the most basic sense, leverage allows a manager to magnify the effects of both gains and losses. Short selling permits a manager to profit from falling prices on stocks, bonds, or indices and can give the manager the ability to lower portfolio volatility. Access to OTC and listed derivatives can improve fund liquidity, allow a fund to change the character of its income or expense, and improve access to new trade opportunities, sources of leverage, or ability to sell short certain types of securities. Derivative instruments can enhance performance and reduce risk or provide additional sources of profits beyond those available in the traditional stock or bond market. Derivatives can also introduce unwanted credit exposure to a fund based on the country party with whom the fund executed the contract or the exchange on which it was traded.

In the United States, leverage is created for hedge funds as a result of their access to margin accounts, repo agreements, and derivatives. The Federal Reserve Regulation T regulates the amount of credit that can be extended using margin accounts. Its purpose is to regulate the extension of credit by brokers and dealers to third-party customers. The regulation provides details for the use of margin accounts to buy or short-sell securities. Margin accounts are primarily used by hedge funds to finance equity and some corporate bond securities. The Federal Reserve also governs repo transactions. They are used by hedge funds to finance short-term positions in government bonds and, sometimes, corporate bonds. In addition to regulating the market, the Federal Reserve is also a repo market participant and uses the market to inject or contract the money supply based on instructions from the open market committee and the board of governors.

A debit balance in a margin account is the amount that a fund is currently borrowing to finance securities purchased from a bank or dealer. A debit balance will cause a fund to incur margin interest expense. A credit balance is any excess cash in a margin account. A fund receives interest income on any unused cash balances held at a bank or dealer. A repo transaction is the borrowing or selling of a fixed-income security under an agreement to return or receive the security back in a short period of time, usually overnight. The difference in the opening and closing repo values represents interest income or expense.

An Example of a Leveraged Long Position in a Margin Account or via a Repo Transaction

A fund that raises $50 million in assets and buys $100 million in securities needs to borrow $50 million from a broker or bank. It has $100 million in long market value and $50 million of AUM. It will also have a negative finance balance in its margin account or from borrowing in the repo market.

The fund will receive income on $100 million of securities appreciation or depreciation in value and any coupons or dividends. It will also pay interest expense on any funds borrowed from its broker or bank related to the purchase of securities.

Illustration 2

Cash Account

Annual Financing Activity

• Annual financing expense at a 5 percent interest rate would equal $2.5 million per year.

• Dividend or coupon income or expense based on a 4 percent dividend yield or coupon payment would generate a positive $4 million per year.

The fund has an ending cash balance of negative $50 million. Accounts with a negative cash balance have to borrow money from their broker or bank to pay for the purchase of securities. Borrowing cash to buy shares normally occurs automatically in a securities margin account for amounts that are within a fund’s borrowing limit. In the United States, borrowing limits for specific types of securities are set forth under U.S. Federal Reserve Regulation T. Fixed-income–oriented investments will generally be funded via the repo market on a security by security basis. The fund will have a net profit from its financing activity of $1.5 million, given the excess income from dividends or coupons over the amount of interest paid to carry the position.

Assuming the fund had a trading gain of 10 percent on its $100 million portfolio, its gross return on investment before any fees would be 23.0 percent. The fund return is simply the trading profit of $10 million plus the net financing and dividends of positive $1.5 million divided by the beginning-of-the-year AUM of $50 million. The use of leverage has transformed a market gain of 10 percent plus a dividend yield or coupon payment of 4 percent into an investor return of 23.0 percent. The return from leverage in this case is a positive 9 percent.

• Fund return on investment is 23 percent.

• Return on assets plus dividends yield is 14 percent.

• Return from leverage is 9 percent, which equals the return on an incremental $50 million of assets of 10 percent plus the dividend of 4 percent less the 5 percent cost of carrying the position.

If the portfolio had lost 10 percent, the effects of leverage would have generated a significant loss. The loss of $10 million, however, would be reduced by the positive carry of $1.5 million, resulting in an $8.5 million loss on a $50 million fund or negative 17 percent. The loss without leverage would have been only negative 6 percent. The additional loss due to the use of leverage is negative 11 percent.

An Example of a Leveraged Short-Sale Position in a Margin Account or via a Repo Transaction

A fund that raises $50 million and sells short $100 million in securities will generate $100 million in cash, but also needs to borrow $100 million in securities from a broker or bank via a stock borrow or repo transaction. The fund has $100 million in short market value and $50 million of AUM. It will also have a credit balance in the margin account related to its short sale proceeds or will have an overnight cash investment in a repo market transaction.

The fund will receive income on $100 million of securities appreciation or depreciation in value and must pay any coupons or dividends that occur to the entity from which it borrowed the stock or bonds, usually a broker or bank.

A fund that enters into a short sale must also pay a fee to borrow or rent securities from its broker or bank to make a delivery against the short sale.

Illustration 3

Cash Account

Annual Financing Activity

• Annual interest income at a 4 percent rate would equal $6 million per year.

• Dividend or coupon income or expense based on a 1 percent dividend yield or coupon would generate a negative $1 million per year.

• Annual borrow fees of 1 percent of the value of the short sale would result in $1 million of additional expense.

The fund has an ending cash account credit balance or repo of positive $150 million. Accounts with a positive cash account or repo balance earn interest from their broker or bank at a rate that is lower than when they borrow. A fund that has a short position also owes the dividend or coupon to the broker or bank from which it borrowed the shares or bonds to execute the short sale. Borrowing shares normally occurs automatically in a securities margin account, subject to limits set forth under U.S. Federal Reserve Regulation T or the NYSE. Borrowing bonds to cover short sales normally occurs in the repo market.

The fund will have a profit from its financing activity, given the excess interest income from margin interest of $6 million versus dividends or coupons owed and borrow fees of $2 million. In the case of a short sale, the effects of leverage are even more powerful; the fund could actually lose $4 million in trading and still break even for the year before expenses!

Assuming the fund had a trading gain of 10 percent based on a decline in value on its $100 million short portfolio, its gross return on investment before any fees would be 28 percent. The fund return is simply the profit of $10 million on the short sale plus the net margin interest and dividends or coupons of positive $4 million ($6 million less $2 million) divided by the beginning of the year AUM of $50 million. The use of leverage and short selling has transformed a market decline of 10 percent into a positive return of 28 percent.

• Fund return on investment is 28 percent.

• Return on short position of 10 percent, positive carry of 2 percent, plus margin interest on initial deposit of 4 percent is 16 percent.

• Return from leverage is 12 percent, which equals the return on an incremental $50 million of assets of 10 percent plus the positive carry on the additional short position of 2 percent.

If the short portfolio had increased in value by 10 percent, the effects of leverage and short selling would have generated a significant loss. However, the loss of $10 million from the change in market value would be reduced by the positive carry and margin interest of $4 million, resulting in only a $6 million loss on a $50 million fund, or negative 12 percent. The additional loss due to the use of leverage is a negative 8 percent.

Most funds use a combination of long and short positions in a single portfolio so that they can cancel out the effects of overall market changes and just capture the relative effects and profits from small changes in the value of long positions relative to the short position or relative to the market as a whole. The effects of leveraged long positions and leveraged short selling on a stand-alone basis can increase risk and generate extreme outcomes. Long and short investing allows funds to use leverage and short selling in tandem to reduce risk and lower volatility while magnifying gains.

INTRODUCTION TO PERFORMANCE AND RISK MEASUREMENT

Hedge funds provide investors with periodic reports of their returns and their risk profile, either directly or via a third-party service provider or database. There are no standard methodologies that are mandated, and many forms of reporting and aggregation have limited value, are misleading, or are not accurate. Fund performance is generally reported on a monthly basis and is calculated net of all fees. Some of the basic values reported to an investor are those related to the fund’s returns, volatility, and fund exposure.

Arithmetic and Geometric Mean Returns

The average monthly return is simply the sum of all monthly returns in a reporting period divided by the number of periods. A fund generating monthly returns of 2 percent, 4 percent, 2 percent, and 1 percent would have an arithmetic mean of 2.25 percent per month and a 27 percent annualized return.

The geometric mean or compound growth rate is the rate of return that equates the beginning value to the ending value of an investment over the number of periods of the investment. A fund generating monthly returns of 2 percent, 4 percent, 2 percent, and 1 percent would have a geometric mean that is slightly lower at 2.24 percent per month and an annualized return that is slightly higher at 31 percent.

Funds should normally use the geometric mean or compound growth rate when reporting results to an investor; however, this may not always be the case.

Standard Deviation, Skew, and Kurtosis

The primary source of risk of investing in a fund is the variation of the fund’s monthly returns and the risk you will lose money or that returns will be unpredictable. This variation is commonly referred to as the fund’s volatility or standard deviation.