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Hedge Funds and Hedge Fund Derivatives 

Hedge Funds and Hedge Fund Derivatives

 

 
 
Tags:  investment fraud  asset management fund 
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Published:  February 11, 2012
 
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Slide 1: Hedge Funds and Hedge Fund Derivatives Date : 19 Feb 2010 Produced by : Angelo De Pol
Slide 2: Contents 1. 2. 3. 4. 5. 6. 7. 8. 9. Introduction What are Hedge Funds? Who are the Managers? Who are the Investors? Hedge Fund Strategies Funds of Hedge Funds Hedge Fund Market Hedge Fund Derivatives Impact of the Credit Crisis 10. Key Risks 11. Risk Management Produced by Angelo De Pol Slide 2
Slide 3: Introduction  Personal introduction  Explain hedge funds & what makes them a unique investment class  Describe market characteristics, investors and managers  Review the most common hedge fund derivatives  Explain how and why the credit crisis impacted the hedge fund industry  Highlight the key risks of the industry / hedge fund portfolio  Provide examples of how hedge fund risk is managed Produced by Angelo De Pol Slide 3
Slide 4: What are Hedge Funds?  Umbrella term for collective investment vehicles employing a huge range of different strategies  Highly specialised…rely on specific expertise of manager  Largely offered as private investments  Typically structured as limited partnerships  Generally set up in tax havens  Narrow range of investors  Use of leverage and derivatives is widespread  Hedge Funds aim to i) Preserve capital, ii) Reduce volatility and risk and iii) Deliver positive returns under all market conditions Produced by Angelo De Pol Slide 4
Slide 5: Comparison of Hedge Funds vs Traditional Funds Traditional Funds Hedge Funds $2 trillion Absolute Long or Short High Lower Yes Higher Turnover High - based on AUM and Performance Restrictions & Lock-ups Low Large Produced by Angelo De Pol Slide 5 Indust ry Size Returns Investment Strategy Complexity Correlation t o Market Leverage Trading Presence Fees Liquidity Transparency Minimum Investment $26 trillion Versus a benchmark Long Only Low High No Lower Turnover Low - Based on AUM Relatively Liquid Relatively High Relatively Small
Slide 6: Who are the Managers? Ex bankers typically with investor contacts and trading expertise Vary considerably in size - Top 15% control 75% of Industry Assets Most managers based in New York, Connecticut and London But funds typically registered in tax havens like Cayman Islands New York London Cayman Islands Produced by Angelo De Pol Slide 6
Slide 7: Who are the Investors?  High Net Worth individuals, Funds of Fund Managers & Institutional investors  Minimum Investment size is very high – usually at least $1million  Acceptance has grown substantially…viable alternative to traditional markets  Investors seek attractive, stable and non-market correlated returns Produced by Angelo De Pol Slide 7
Slide 8: Hedge Fund Strategies…help represent the hedge fund universe Breakdown as at end of 2009; Source : CS/Tremont Produced by Angelo De Pol Slide 8
Slide 9: Hedge Fund Strategies Statistics for 2009 Produced by Angelo De Pol Slide 9
Slide 10: Event Driven Strategy Exploits pricing inefficiencies caused by anticipated corporate events. Many variations… Event Driven Distressed Merger Special Credit Securities Arbitrage Companies Merging Restructuring Corporate near companies Fixed bankruptcy Income Securities Reg’n D Private Equity Act ivist Active management and influence of companies Produced by Angelo De Pol Slide 10
Slide 11: Managed Futures Strategy  Also called Commodity Trading Advisors (“CTAs”)  Systematic approach to investing in futures contracts in bond, equity, commodity and currency markets  Highly quantitative model based trading  No trader decisions – all model based  Use mean reversion, trend and pattern recognition models  Operate in highly liquid markets, providing flexibility  Models can break down in very volatile markets Produced by Angelo De Pol Slide 11
Slide 12: Funds of Hedge Funds  Invest in other Hedge Funds  Portfolio diversification main aim (strategy, manager and fund)  Important and very influential in industry  Have access to extensive resources and systems  Regularly rebalance portfolio and perform due diligence  But additional layer of fees and leverage  Suffered major blow in crisis as diversification benefit muted Produced by Angelo De Pol Slide 12
Slide 13: Growth of Hedge Fund Market (AUM in $ Billions) C ORRE LATIO N LE VE RAG E TRANS P ARE N CY S TAB IL ITY INF LUE NC E RE G ULATION LIQUIDIT Y Produced by Angelo De Pol Slide 13
Slide 14: Hedge Fund Market Performance vs. Equities Rus s ia/ L TC M C ris is E quity B ear Market C orrelation Increas ing C redit C ris is Average Annualised Volatility - Hedge Funds : 6%, Equities : 15% Produced by Angelo De Pol Slide 14
Slide 15: •Seller gives return on hedge fund  Demand for more basket and gets LIBOR plus spread participation and leverage  Many variations… Total • Simple products  Volatility linked notes, Aries • Appeal to broad investor base Return notes,“Best of” options, • Exposed to both upside and S waps Enhanced calls... downside performance Hedge Fund Derivatives E xotics F unds of Hedg e F unds L everag ed certificates Delta 1 certificates C P P I notes • Upside exposure to underlying fund • Guaranteed principal (at maturity) • Final return = combination of risky and non-risky asset Produced by Angelo De Pol Slide 15  Offer leverage of up to 300%  Poor performance may result in investor losing entire investment
Slide 16: What is CPPI?  Constant Proportion P ortfolio Insurance  Helps ensure 100% of investor’s capital is protected (at maturity)  And investor also gets participation in underlying asset growth  Simple formula based hedging mechanism with set minimum “cushion”  Determines composition of investment between : 1. Risky Asset (e.g. Hedge Fund of Funds) and 2. Non- Risky Asset (Cash, Fixed Term Deposits) • Sell Risky Asset to buy more Non- Risky Asset • Possibly end up with no Risky Asset exposure  Poor Performance  Delev erage  Good Performance  Lev erage up Risky Asset exposure Produced by Angelo De Pol Slide 16
Slide 17: The following graph illustrates how Risky Asset exposure is determined by the CPPI mechanism The Reference Portfolio’s allocation to the Risky Asset is determined by applying a pre-determined Multiplier to the Cushion. What is CPPI? Re fe re n c e Po rtfo lio Va lu e Cu s h io n 1 00% 70% Bo n d Flo o r Target Exposure = Cushion x Multiplier The Capital is 100% protected on Maturity Date Cu s h io n (t)= Re fe re n c e Po rtfo lio Va lu e (t) - Bo n d Flo o r (t) Re fe re n c e Po rtfo lio Va lu e (t) The Bond Floor is a fixed line starting at 70% (for example) and reaching the level of protection of 100% by the Maturity Date Produced by Angelo De Pol Slide 17
Slide 18: Impact of the Credit Crisis…the perfect storm Gates & Suspensions Redemptions Madof f Fraud Lehma n Failure Short selling ban Deleveraging  2000 hedge funds liquidated ( 25%), industr y benchmar ks los t 20%  Industry AUM dow n $1.2 trillion ( 42%), massive risk & lev er age reduction Produced by Angelo De Pol Slide 18  Huge loss of investor confidence and lots of litigation
Slide 19: Impact of the Credit Crisis…Performance vs. Equities Peak Current Drawdown -5% -20% Trough -27% -53% Hedge Funds : Credit Suisse / Tremont Hedge Fund Index Equities : MSCI World Index Produced by Angelo De Pol Slide 19
Slide 20: Hedge Fund Industry Outlook Growth starting to pick up again… Industry Assets Under Management (AUM) now $2 trillion Before Credit Crisis Growth was around 20% per year 2009 one of best performing years ever in industry But Investors much more demanding now… More transparency and liquidity demanded Also better controls, risk management and infrastructure And of course lower fees Industry consolidation… Largest managers getting bigger Managers targeting more traditional institutional investors Produced by Angelo De Pol Slide 20
Slide 21: Key Risks Lack of Trans parency Opera tional Ris ks P oor L iquidity Lack of Regulation High Leverage Produced by Angelo De Pol Slide 21
Slide 22: Key Risks - Operational Risk Distribution of Reasons for Fund Failures Breakdown of Operational Risk Failures S o urc e : Und e rs ta nd ing a nd Mit iga t ing Op e ra tio na l R is k in He d ge F und Inv e s t m e nt s : A Ca pc o Whit e P a pe r Produced by Angelo De Pol Slide 22
Slide 23: Key Risks - Hedge Fund Portfolio Risks Gap Risk • CPPI notes have built in rebalancing mechanism • But in stressed markets this mechanism can fail… • Bank would make-up shortfall • Collateral has gap risk too •Hedge Fund Liquidity is poor •Hedging effectiveness is reduced •In stressed markets actual liquidity may be worse Liquidity R isk •High levels of operational risk Concentration •Poor transparency in industry •Manager, fund and strategy diversification critical Produced by Angelo De Pol Slide 23
Slide 24: • Active risk management at all levels is critical • Market, Credit, Operational and Legal risk management overlap • Successful risk management is dependent upon : Crash Scenario Limits Diversification Active Due Diligence Risk Management Gap Option Hedges Good Manager Relationships Conservative Model Reserves Strong Legal Documentation Produced by Angelo De Pol Slide 24
Slide 25:  Bespoke Scenario based model for risk management of hedge fund derivatives portfolio  Captures : Risk Management - Crash Scenario Model • • • • Gap risk (important for CPPI products and hedge fund collateral) Hedge Fund price risk Strategy specific risk Some concentration risks  The level of fund and strategy diversification in the portfolio determines shock size (calculated using variances of the fund and strategy weights)  The shock is somewhere between general and specific portfolio shock determined by a power function : Where : G = General Shock, S= Specific Shock α and β are determined by solving F (1) = S and F (0) = G and the power p is determined by calibration Produced by Angelo De Pol Slide 25 F ( x) = α x p + β = ( S − G ) x p + G
Slide 26: Risk Management - Crash Scenario Model Variances Power Function Final Shock Produced by Angelo De Pol Slide 26
Slide 27: Suggested Research Topics and Sources  Non-traditional performance statistics more suitable for Hedge Funds (e.g. moving away from Sharpe ratios)  Unbiased hedge fund industry benchmarks (industry replication via strategies, investable indices vs. non-investable indices)  Hedge Fund portfolio risk management techniques and scenario development (to include operational risks, leverage, funding risk and liquidity)  Implied leverage in the hedge fund industry based upon available performance, costs and strategy information S ou rc e s  www.hedgeindex.com  www.hedgefundresearch.com  Bloomberg Markets Magazine (Feb 2010)  www.emagazine.credit-suisse.com (About Us / In Focus / Dossiers / Derivatives & Hedge Funds)  www.credit-suisse.com  www.hedgefundintelligence.com  www.hedgefund.net  www.greenwich.com Produced by Angelo De Pol Slide 27

   
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