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Handbook of Hedge Funds

Handbook of Hedge Funds

François-Serge Lhabitant

ISBN: 978-1-119-20202-8

Oct 2015

656 pages

Description

A comprehensive guide to the burgeoning hedge fund industry

Intended as a comprehensive reference for investors and fund and portfolio managers, Handbook of Hedge Funds combines new material with updated information from Francois-Serge L’habitant’s two other successful hedge fund books. This book features up-to-date regulatory and historical information, new case studies and trade examples, detailed analyses of investment strategies, discussions of hedge fund indices and databases, and tips on portfolio construction.

Francois-Serge L’habitant (Geneva, Switzerland) is the Head of Investment Research at Kedge Capital. He is Professor of Finance at the University of Lausanne and at EDHEC Business School, as well as the author of five books, including Hedge Funds: Quantitative Insights (0-470-85667-X) and Hedge Funds: Myths & Limits (0-470-84477-9), both from Wiley.

Foreword by Mark Anson xv

1 Introduction 1

PART I HEDGE FUND OVERVIEW

2 History Revisited 7

2.1 The very early years: The 1930s 7

2.2 The formative years (1949–1968) 8

2.3 The dark ages (1969–1974) 11

2.4 The renaissance (1975–1997) 12

2.5 The Asian and Russian crises (1997–1998) 15

2.6 The equity bubble years 18

2.7 Hedge funds today 19

2.8 The key characteristics of modern hedge funds 24

2.9 The future 35

3 Legal Environment 37

3.1 The situation in the US 39

3.1.1 The Securities Act (1933) 39

3.1.2 Securities Exchange Act (1934) 44

3.1.3 Investment Company Act 46

3.1.4 Investment Advisers Act (1940) 48

3.1.5 Blue-sky laws 55

3.1.6 National Securities Markets Improvement Act (1996) 55

3.1.7 Employee Retirement Income Security Act (1974) 56

3.1.8 Other regulations 56

3.1.9 The Commodity Futures Trading Commission 57

3.2 The situation in Europe 59

3.2.1 The UCITS directives and mutual fund regulation 59

3.2.2 The case of European hedge funds 62

3.2.3 Germany 63

3.2.4 France 69

3.2.5 Italy 75

3.2.6 Switzerland 76

3.2.7 Ireland 78

3.2.8 Spain 80

3.3 The situation in Asia 81

3.4 Internet and the global village 81

4 Operational and Organizational Structures 85

4.1 Legal structures for stand-alone funds 85

4.1.1 In the United States (“onshore”) 85

4.1.2 Outside the United States (“offshore”) 87

4.2 A network of service providers 90

4.2.1 The sponsor and the investors 91

4.2.2 The board of directors 91

4.2.3 The investment adviser 92

4.2.4 The investment manager or management company 92

4.2.5 The brokers 93

4.2.6 The fund administrator 99

4.2.7 The custodian/trustee 103

4.2.8 The legal counsel(s) 103

4.2.9 The auditors 105

4.2.10 The registrar and transfer agent 106

4.2.11 The distributors 106

4.2.12 The listing sponsor 107

4.3 Specific investment structures 108

4.3.1 Mirror funds 108

4.3.2 Master/feeder structures 109

4.3.3 Managed accounts 112

4.3.4 Umbrella funds 114

4.3.5 Multi-class/multi-series funds 115

4.3.6 Side pockets 116

4.3.7 Structured products 117

4.4 Disclosure and documents 118

4.4.1 Private placement memorandum (PPM) 118

4.4.2 Memorandum and articles of association 118

4.4.3 ADV form 118

4.4.4 Limited partnership agreements 119

4.4.5 Side letters 119

5 Understanding the Tools Used by Hedge Funds 121

5.1 Buying and selling using a cash account 121

5.2 Buying on margin 122

5.2.1 Mechanics 122

5.2.2 Buying on margin: an example 124

5.3 Short selling and securities lending 126

5.3.1 Mechanics of short selling 127

5.3.2 A detailed example 134

5.3.3 Restrictions on short selling 135

5.3.4 Potential benefits of short selling 139

5.3.5 Alternatives to securities lending: repos and buys/sell backs 140

5.4 Derivatives 142

5.4.1 Terminology 144

5.4.2 Basic derivatives contracts 144

5.4.3 Credit derivatives 146

5.4.4 Benefits and uses of derivatives 149

5.5 Leverage 151

PART II HEDGE FUND STRATEGIES AND TRADE EXAMPLES

6 Introduction 159

7 Long/Short Equity Strategies 163

7.1 The mechanics of long/short equity investing 163

7.1.1 A single position 163

7.1.2 Sources of return and feasible portfolios 165

7.1.3 Disadvantages of long/short equity investing 169

7.2 Investment approaches 170

7.2.1 The valuation-based approach 170

7.2.2 Sector specialist hedge funds 174

7.2.3 Quantitative approaches 175

7.2.4 Equity non-hedge hedge funds 175

7.2.5 Activist strategies 176

7.3 Historical performance 181

8 Dedicated Short 187

8.1 The pros and cons of dedicated short selling 187

8.2 Typical target companies and reactions 188

8.3 Historical performance 193

9 Equity Market Neutral 197

9.1 Definitions of market neutrality 197

9.1.1 Dollar neutrality 197

9.1.2 Beta neutrality 198

9.1.3 Sector neutrality 200

9.1.4 Factor neutrality 200

9.1.5 A double alpha strategy 202

9.2 Examples of equity market neutral strategies and trades 203

9.2.1 Pairs trading 203

9.2.2 Statistical arbitrage 207

9.2.3 Very-high-frequency trading 208

9.2.4 Other strategies 211

9.3 Historical performance 211

10 Distressed Securities 215

10.1 Distressed securities markets 215

10.1.1 The origins: railways 215

10.1.2 From high yield to distressed securities 216

10.1.3 The distressed securities market today 219

10.2 Distressed securities investing 226

10.2.1 Why distressed securities? 226

10.2.2 Legal framework 227

10.2.3 Valuation 228

10.2.4 Active versus passive 230

10.2.5 Risks 232

10.3 Examples of distressed trades 233

10.3.1 Kmart 233

10.3.2 Failed leveraged buyouts 234

10.3.3 Direct lending 235

10.3.4 The case of airlines 236

10.4 Historical performance 239

11 Merger Arbitrage 243

11.1 Mergers and acquisitions: a historical perspective 243

11.2 Implementing merger arbitrage: basic principles 246

11.2.1 Arbitraging a cash tender offer 247

11.2.2 Arbitraging a stock-for-stock offer (fixed exchange rate) 250

11.2.3 Arbitraging more complex offers 252

11.3 The risks inherent in merger arbitrage 254

11.4 Historical performance 263

12 Convertible Arbitrage 269

12.1 The terminology of convertible bonds 269

12.2 Valuation of convertible bonds 272

12.2.1 Valuation from an academic perspective 272

12.2.2 Valuation from a practitioner perspective (the component approach) 273

12.2.3 Risk measurement and the Greek alphabet 277

12.3 Convertible arbitrage: the basic delta hedge strategy 279

12.4 Convertible Arbitrage in practice: stripping and swapping 285

12.5 The strategy evolution 287

12.6 Historical performance 293

13 Fixed Income Arbitrage 297

13.1 The basic tools of fixed income arbitrage 297

13.2 Examples of sub-strategies 299

13.2.1 Treasuries stripping 299

13.2.2 Carry trades 301

13.2.3 On-the-run versus off-the-run Treasuries 301

13.2.4 Yield-curve arbitrage 303

13.2.5 Swap-spread arbitrage 304

13.2.6 The Treasury–Eurodollar spread (TED) 305

13.3 Historical performance 306

14 Emerging Markets 311

14.1 The case for emerging market hedge funds 311

14.2 Examples of strategies 314

14.2.1 Equity strategies 314

14.2.2 Fixed income strategies 319

14.3 Historical performance 323

15 Global Macro 327

15.1 Global macro investment approaches 327

15.2 Examples of global macro trades 328

15.2.1 The ERM crisis (1992) 329

15.2.2 The ECU arbitrage 332

15.2.3 The Asian crisis (1997) 333

15.2.4 The euro convergence (1995–1997) 337

15.2.5 Carry trades 340

15.2.6 The twin deficits 344

15.2.7 Risk management and portfolio construction 345

15.3 Historical performance 346

16 Managed Futures and Commodity Trading Advisors (CTAs) 351

16.1 The various styles of managed futures 352

16.1.1 Trading approach: discretionary versus systematic 352

16.1.2 Type of analysis: fundamental versus technical 354

16.1.3 Source of returns: trend followers and non trend followers 354

16.1.4 Timeframe for trades 355

16.2 Examples of systematic trading rules 355

16.2.1 Moving Average Convergence/Divergence (MACD) 355

16.2.2 Examples of trading ranges signals 361

16.2.3 Portfolio construction 363

16.2.4 Transparency or regulated black boxes? 363

16.2.5 Investment vehicles 365

16.2.6 Back-testing and calibration 365

16.3 Historical Performance 366

16.4 The future of managed futures 370

17 A Smorgasbord of Other Strategies 373

17.1 Capital structure arbitrage and credit strategies 373

17.2 Weather derivatives, weather insurance and catastrophe bonds 381

17.3 Mutual Fund Arbitrage 382

17.3.1 The forward pricing mechanism 383

17.3.2 The loopholes in forward pricing 384

17.3.3 Unethical, but persistent 386

17.3.4 A brutal ending 387

17.4 Arbitraging between NAVs and quoted price: Altin AG 388

17.5 Split strike conversion 390

17.6 Event-Driven Special Situations 392

17.7 Cross-listing and dual-listing arbitrage 393

17.7.1 Cross-listed companies and ADRs 393

17.7.2 Dual-listed companies 394

17.8 From public to private equity 395

17.9 Regulation D and PIPEs funds 397

17.10 IPO Lock-up Expirations 398

PART III MEASURING RETURNS, RISKS AND PERFORMANCE

18 Measuring Net Asset Values and Returns 403

18.1 The difficulties of obtaining information 404

18.2 Equalization, crystallization and multiple share classes 406

18.3 The inequitable allocation of incentive fees 406

18.4 The free-ride syndrome 407

18.5 Onshore versus Offshore Funds 408

18.6 The multiple share approach 409

18.7 The equalization factor/depreciation deposit approach 410

18.8 Simple Equalization 414

18.9 Consequences for performance calculation 414

18.10 The holding period return 415

18.11 Annualizing 417

18.12 Multiple hedge fund aggregation 418

18.13 Continuous compounding 419

19 Return Statistics and Risk 423

19.1 Calculating return statistics 423

19.1.1 Central tendency statistics 426

19.1.2 Gains versus losses 428

19.2 Measuring risk 429

19.2.1 What is risk? 430

19.2.2 Range, quartiles and percentiles 430

19.2.3 Variance and volatility (standard deviation) 431

19.2.4 Back to histograms, return distributions and z-scores 434

19.3 Downside risk measures 439

19.3.1 From volatility to downside risk 439

19.3.2 Semi-variance and semi-deviation 440

19.3.3 The shortfall risk measures 443

19.3.4 Value at risk 443

19.3.5 Drawdown statistics 446

19.4 Benchmark-related statistics 447

19.4.1 Intuitive benchmark-related statistics 447

19.4.2 Beta and market risk 448

19.4.3 Tracking error 449

20 Risk-Adjusted Performance Measures 451

20.1 The Sharpe ratio 455

20.1.1 Definition and interpretation 455

20.1.2 The Sharpe ratio as a long/short position 457

20.1.3 The statistics of Sharpe ratios 457

20.2 The Treynor ratio and Jensen alpha 460

20.2.1 The CAPM 460

20.2.2 The market model 462

20.2.3 The Jensen alpha 463

20.2.4 The Treynor (1965) ratio 465

20.2.5 Statistical significance 466

20.2.6 Comparing Sharpe, Treynor and Jensen 466

20.2.7 Generalizing the Jensen alpha and the Treynor ratio 467

20.3 M2, M3 and Graham–Harvey 468

20.3.1 The M2 performance measure 468

20.3.2 GH1 and GH2 470

20.4 Performance measures based on downside risk 472

20.4.1 The Sortino ratio 472

20.4.2 The upside potential ratio 473

20.4.3 The Sterling and Burke ratios 474

20.4.4 Return on VaR (RoVaR) 475

20.5 Conclusions 476

21 Databases, Indices and Benchmarks 479

21.1 Hedge fund databases 479

21.2 The various biases in hedge fund databases 479

21.2.1 Self-selection bias 480

21.2.2 Database/sample selection bias 482

21.2.3 Survivorship bias 482

21.2.4 Backfill or instant history bias 484

21.2.5 Infrequent pricing and illiquidity bias 485

21.3 From databases to indices 487

21.3.1 Index construction 487

21.3.2 The various indices available and their differences 490

21.3.3 Different indices – different returns 503

21.3.4 Towards pure hedge fund indices 505

21.4 From indices to benchmarks 508

21.4.1 Absolute benchmarks and peer groups 509

21.4.2 The need for true benchmarks 510

PART IV INVESTING IN HEDGE FUNDS

22 Introduction 515

23 Revisiting the Benefits and Risks of Hedge Fund Investing 517

23.1 The benefits of hedge funds 518

23.1.1 Superior historical risk/reward trade-off 518

23.1.2 Low correlation to traditional assets 520

23.1.3 Negative vs positive market environments 523

23.2 The benefits of individual hedge fund strategies 527

23.3 Caveats of hedge fund investing 534

24 Asset Allocation and Hedge Funds 537

24.1 Diversification and portfolio construction: an overview 537

24.1.1 Diversification 538

24.1.2 Portfolio construction 539

24.1.3 Asset allocation 541

24.2 Strategic asset allocation without hedge funds 543

24.2.1 Identifying the investor’s financial profile: the concept of utility functions 543

24.2.2 Establishing the strategic asset allocation 546

24.3 Introducing hedge funds in the asset allocation 547

24.3.1 Hedge funds as a separate asset class 547

24.3.2 Hedge funds vs traditional asset classes 548

24.3.3 Hedge funds as traditional asset class substitutes 549

24.4 How much should be allocated to hedge funds? 551

24.4.1 An informal approach 552

24.4.2 The optimizers’ answer: 100% in hedge funds 553

24.4.3 Static versus dynamic allocations 554

24.4.4 Dealing with “return management” 555

24.4.5 Optimizer’s inputs and the GIGO syndrome 556

24.4.6 Non-standard efficient frontiers 560

24.4.7 How much should we allocate to hedge funds? 561

24.5 Hedge funds as portable alpha overlays 561

24.6 Hedge funds as sources of alternative risk exposure 564

24.7 Risk budgeting and the separation of alpha from beta 565

25 Hedge Fund Selection: A Route Through the Maze 569

25.1 Stating objectives 569

25.2 Filtering the universe 570

25.3 Quantitative Analysis 571

25.4 Qualitative Analysis 572

25.5 Due Diligence: between art and science 573

25.5.1 The strategy 573

25.5.2 The fund itself 574

25.5.3 The management team 575

25.5.4 The infrastructure 575

25.5.5 The process 576

25.6 Ongoing monitoring 576

25.7 Common mistakes in the selection process 577

26 Funds of Hedge Funds 579

26.1 What are funds of hedge funds? 579

26.2 Advantages of funds of funds 579

26.2.1 Efficient Risk Diversification 580

26.2.2 Affordability and Accessibility 582

26.2.3 Professional management and built-in asset allocation 583

26.2.4 Access to closed funds 583

26.2.5 Better internal and external transparency 584

26.3 The dark side of funds of funds 584

26.3.1 Yet another layer of fees! 584

26.3.2 Extra liquidity 585

26.3.3 Lack of control, overdiversification and duplication 587

26.4 Selecting a fund of funds 587

26.5 Fund allocation: A look inside the “black box” 588

26.5.1 Qualitative approaches 588

26.5.2 Quantitative approaches 589

26.6 The future of funds of funds 589

27 Structured Products on Hedge Funds 591

27.1 Total return swaps linked to hedge funds 591

27.2 Call options on hedge funds 592

27.3 Basic notes and certificates 593

27.4 Capital protected notes 594

27.4.1 The financial engineering process of capital protected notes 595

27.4.2 The first generation: the naive approach 595

27.5 The second generation: The option-based approach 598

27.6 The third generation: the dynamic trading approach 602

27.7 The fourth generation: options on CPPI 608

27.8 The flies in the ointment 608

27.9 The future of capital guaranteed products 610

27.10 Collateralized hedge fund obligations 610

28 Conclusions 615

Bibliography 617

Index 625