Book of the Week: All About Hedge Funds

27 May 2016

This week, I read All About Hedge Funds, 2nd edition by Ezra Zask. First thing I noticed is that the 1st and 2nd edition have different authors. Since the 1st edition was published in 2002, I recommend reading the 2nd edition instead. The financial crisis and increased regulation have changed things. The book goes over what is a hedge fund, the history, how they are structured, how they work, what the different strategies are and how they are measured. The books tries to be objective without giving a moral judgement on whether or not hedge funds are bad. They just are. They exist. Private Placement Memorandum Under the U.S. Investment Company Act of 1940, companies must issues a private placement memorandum (PPM) that typically includes.

• Investment objective and policies
• Risk factors
• Fees and expenses
• Management of fund
• The manager
• The investment adviser
• The prime broker and custodian
• The subadministrator
• Brokerage
• Net asset value
• Tax considerations
• Subscription and redemption of shares
• Distribution and selling of restrictions
• Dividends and distributions
• Shareholder reports
• Legal consul and auditors
• Anti-money laundering regulations

Hedges funds under $100M assets under management aren’t required to register with the SEC. The typical minimum investment in a hedge fund is usually 1M+. The fund typically takes a 2% management fee and 20% of the profits. There is a hurdle rate that represents the risk-free rate of return that the fund needs to get over before the manager can take profit incentive. The high-water mark prevents a fund from getting incentive fee if it has lost money. If the fund dropped 50% the previous year and went up 100% this year, you are where you began. The fund should not get a profit incentive. Investors are also restricted on when and how much money they can take out of the fund. The fund manager also has the discretion to put a hold on redemption. This prevents a downward spiral of the fund trying to get rid of assets for less than what they are worth, further driving down the price of those assets. After the mortgage crisis when no broker had any idea of the total risk taken by a fund, the prime broker rose to provide services all in one place for a complete view of risk. As part of being unregulated, they cannot advertise directly and publicly to people. FINRA looks at buy and sell orders to detect insider trading. Hedge funds justify their existence by saying

• Sources of financial innovation - they aren’t restricted or regulated, so they can do whatever
• Provide market liquidity - lots of trading makes market liquid
• Assume market risks - counterparty to make the market
• Encourage price discovery and market efficiency - shorting gives information, that should let prices move down. arbitrage makes things efficient.

Hedging Tools Hedging is made possible by shorting, leverage (borrowing) and derivatives. There are additional risks associated with short selling.

• Unlimited loss potential - the price of the stock can keep going up
• Stock loan difficulties - impossible to borrow shares, high cost of borrowing shares
• Stock “call-in” - may need to buy stock at market price when “called-in” resulting at loss
• Margin call - need additional collateral because price went up
• Short squeezes - prices go up when people need to cover their shorts when there is limited supply

95% of derivatives are traded over the counter (OTC), meaning they are not traded on an exchange. The two parties are usually the hedge fund and the bank. Below are the creative ways derivatives can be used to make speculative wagers. You profit when you’re above the line. The y axis is profit and the x-axis is the price of the underlying security. [caption id=”attachment_5116” align=”aligncenter” width=”840”] Profit and loss diagrams for different option strategies. Adapted from Options Industry Council[/caption] Credit Default Swaps The difference between insurance and credit default swaps (CDS) is that for insurance, you need to own the underlying asset. CDS you don’t need to own anything to bet on it. If something defaults, then money changes hands. Measures ofPerformance Zask describes how hedge funds performance measures changed through different periods of time. These changes are due events where people lost a lot of money (When Genius Failed and the credit crisis) and the changing profile of investors. Currently many institutional investor are looking for portfolio diversification. Previously they were high net worth individuals looking for high returns. Period I (1980s to mid-1990s): high returns Phase II (1990 to mid-2000s): absolute returns, staying positive when market goes down Period III (mid-2000s to 2007): risk-adjusted return, alpha Period IV (2008 to present): portfolio diversifier Typical Portfolio Limits Regulation T limits how much a firm can leverage. Most hedge funds hold stocks for weeks.

• Maximum of 35-40 long positions
• Maximum of 50-60 short positions
• No long position will be allowed to exceed 5% at market.
• No short position will be allowed to exceed 3% at market.
• Gross long position will be between 75% and 150%.
• Gross short position will be between 30% and 50%.
• Maximum sector exposure, 25%.
• Maximum group exposure, 15%.
• Maximum gross exposure not to exceed 200%.

Statistical Arbitrage There are three most common forms of statistical arbitrage are pairs trading, stub trading and multiclass trading. The all involve buying and shorting. Pair trading is between stocks in same sector. Stub is between part and subsidiary. Mutliclass is between different classes of stock of the same company. Arbitrage is supposed to be free money. Statistical arbitrage means it has a chance of being free money. Purchase All About Hedge Funds, 2nd edition on Amazon.com or check it out from your local library.