Professional Documents
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Contents
1
What is an Event
Driven Hedge Fund?
Brief Definition:
Hedge funds are companies that manage pools of investment capital on
behalf of sophisticated investors and frequently seek to manage their
level of risk of loss by “hedging” their risks. The level of understanding of
the fund’s investment strategy that the fund’s investors are required to
have allows the hedge fund to make more complex investments than
typical investment managers. This offers them the freedom to take
advantage of investment opportunities that a lot of firms cannot and
gives them the ability to make money in both rising and falling markets.
Their sophistication and specialism are used to justify their relatively high
fees that are charged to their investors. These often take the form of a
2% charge of assets under management and a 20% cut of any positive
performance of the investment; you may often hear this referred to as
the “two and twenty” fee structure.
More Detail:
To provide a complete definition of an event driven hedge fund we
should first examine what a hedge fund is. Hedge funds are named as
such because their investment management styles offer them the
flexibility to manage their risk of losing money by placing an offsetting
trade when executing their particular investment ideas. This practice of
managing their risk can be referred to as hedging.
For example, where a UK based hedge fund with investors who invest
with British pounds buys shares in an US based company then, at a high
level, the hedge fund is running two risks from this investment. Since the
UK hedge fund would have to pay for these shares in US dollars and the
2
future share price of the US company would continue to be pricing in US
dollars the risks are:
1. The risk that the price of the shares of the US company fall.
2. The risk that the value of the US dollar compared to the value of
the British pound falls.
There are a few ways a hedge fund may typically mitigate some of the
risk presented above, but I’d like to use this opportunity to cover a key
practice of hedging foreign currency exposure risk. This practice applies
to many companies worldwide who pay, or accept payment, for goods
and services in currencies other than their own domestic currency. In our
above example let us consider the UK hedge fund buying shares in Apple.
Since Apple is a US company with shares listed on the New York Stock
Exchange, which price in US dollars, when the UK fund buys these shares
the fund is simultaneously converting British pounds to US dollars and
also buying Apple shares with those dollars. Let’s say the GBP/USD rate at
the time they buy is 1.37 meaning every British pound is worth 1.37 US
dollars. In this case a £100,000 investment would yield $137,000 worth of
Apple shares (we are excluding the costs of any commissions or trading
fees for simplicity here). If each share of Apple was worth $110 at the
time and three months later continues to trade at $110 per share, but
the GBP/USD rate has moved to 1.41 then the investment that the fund
made would still be worth $137,000. However, in GBP terms it has
changed and would now be worth £97,163.12. For a fund to eliminate
the risk posed by changing foreign exchange rates then in addition to
making the initial trade of buying the Apple shares a fund could make
another trade to remove the FX risk, selling US dollars; this trade would
be referred to as a “hedge”. In the above example, the fund could sell
$137,00 against £100,000 at the same time that it buys the Apple shares.
This would mean that if the US dollar were to fall in price relative to the
British pound, then whilst the fund would lose money on their
investment in Apple shares, even if the US dollar price of those shares
doesn’t move from $110, then they would make an equal gain on their FX
trade and therefore offset any loss and eliminate this risk. Of course, in
this instance it also means that were the US dollar to gain in value against
the British pound and cause their investment in Apple shares to gain
value, even without a move in Apple share price, then the FX trade would
create a loss equal to any FX gain on the Apple shares.
3
Investors
4
Structure
5
Another structure for funds with non-US and US tax-exempt investors
works in a similar way, but has the investors invest in an offshore
domiciled company rather than an LLP. The offshore domiciled company
is usually established in a tax heaven, such as the Cayman Islands, Jersey
or Bermuda. Funds established in the Cayman Islands are required to
register with the Cayman Islands Regulatory Authority (CIMA) and will
have to pay an annual fee for this, usually no more than a few thousand
dollars. That company will then be run by the investment manager. This
structure is illustrated below.
6
For funds which have a combination of investor types, one of the most
commonly used structures is the master-feeder structure. It is a
combination of the two previously discussed structures whereby the LLP
and the offshore company function as “feeders” for assets to flow
through into an additional, separate company, which acts as the ultimate
investing company known as the “master fund”. This structure is a
frequently adopted one as it offers flexibility to investors who often have
different considerations. For example, a US taxable investor will opt for
the transparent limited partnership feeder whilst non- US investors, who
wish to remain anonymous to US authorities, will prefer the opaque tax
structure of the offshore feeder.
7
It is also worth noting that other structures, should a fund wish to have
different types of investors, could require the fund to operate parallel
funds. This is a situation where the investment manager will be managing
multiple entities, which hold the investors assets, and this can create
extra operational, legal and regulatory work all of which can be avoided
by running a single investment entity through the master feeder
structure. In each of these situations, the investors act as silent partners
whilst the general partner, the investment manager, will be responsible
for all of the day-to-day operations. Double taxation is a situation where
company profits are taxed and then those profits are returned to
investors and taxed again. Since the above structures also benefit from
pass-through taxation, meaning that the partnership itself does not pay
tax on investors returns and instead tax is paid directly by each investor
at their own personal rate, these structures help avoid double taxation.
This structure is illustrated below.
8
Funds
A hedge fund will typically follow one particular strategy and in doing
so will have a main fund, commonly referred to as their “flagship”
fund. This fund may have many different investors invested in it all
following the exact same strategy and holding the exact same
investments. However, a fund itself as a business e.g., Bridge water
Capital, won’t necessarily have just one fund with investors in. They will
likely have multiple funds; each one will be set up differently based on
what the investors feel comfortable with and have agreed upon with the
investment manager. For instance, it may be that a large corporate
investor approaches a hedge fund and asks them to set up a fund, this
would be known as a managed account. The investor may like the overall
strategy that a hedge fund is running, but not be comfortable with a
certain part of the strategy. It could be that in this instance they could
request that the fund manages their money in the way that they do for all
their other clients, except for partaking in the part they are not
comfortable with. An example of this could be partaking in IPOs. An
investor may have the view that IPOs are particularly unsuccessful or of
high risk and so ask the fund, the business, to set up a new fund within
itself to manage the investor’s money using the fund’s strategy, but not
to invest in IPOs. Hence, hedge funds will typically end up with multiple
funds within their whole business whereby each fund could have only
one investor, or multiple investors, in it. Each fund could then be
managed in a different way to another.
A hedge fund would be happy to take on the extra work of setting up a
new fund and trading an adjusted version of their strategy for just one
client so long as the client is large enough i.e., it will not affect the
performance for other clients and will generate enough fees to make it
worthwhile. The adjustments to the current strategy that the new
9
investor desires from the investment manager will be agreed and
documented in a mandate with the investor. Similarly, funds may also set
up a UCITS fund, as explored below, to attract other investors. Where a
hedge fund manages multiple funds, but all funds contain the same
investments in the same proportions, the funds are said to be traded
‘pari passu’, a Latin term meaning ‘on equal footing’ used to refer to
things that are treated in the same way.
10
Strategies
E ach hedge fund will be set up with the intention of trading particular
assets in a particular way. Dependent upon which assets a fund
trades and how they trade them a fund can be labelled with a strategy.
Some funds may even be classified under multiple, or a mix of, strategies
whilst some will specialise and strictly follow one. The scope of this guide
is concentrated to provide information relating mainly to the event
driven strategy and as such will not cover, in detail, some of the most
common strategies listed below. Most of the processes and practices
covered in this guide will be shared across most funds regardless of their
strategy. There are also some example names of famous hedge funds,
and their managers, that follow some of the strategies below for you to
research independently if the strategy interests you.
11
• Credit – Trading the arbitrage between different debt
instruments. Algebris Investments - Davide Serra
• Fixed-Income Arbitrage – Trading the arbitrage in fixed-income
securities such as Treasury bonds.
• Global Macro – Trading macroeconomic trends in interest rate,
currencies, shares or commodities. Bridge Water capital – Ray
Dalio
• Short-Only – Funds that exclusively short shares.
• Quantitative – Using quantitative techniques derived from
mathematics to form statistical models to generate and execute
trade ideas. Renaissance Technologies – Jim Simons
• Distressed Debt – Trading in the debt, or remaining assets, of
companies near or already in bankruptcy. Elliot Management –
Paul Singer
12
Trading Taxes
13
of merger payments’ to be completed. This is a form where the investor
provides evidence of them not being a US tax resident and shows that
they have ‘meaningfully reduced’ their ownership in the new company to
less than 80% of what it was prior to the merger. In confirming this the
US will treat their payment as a ‘payment of proceeds of a sale or
exchange’ and exempt this from WHT.
F unds will also encounter some taxes levied directly on the products
that they trade in certain jurisdictions. A few main ones are
discussed below.
Sec Fee
SEC fee is a US tax charged by the Securities and Exchange commission
on sales of US exchange listed shares. As of February 25th, 2021, this rate
stands at $5.10 per million dollars of equities traded. For example, a
trade of $2,000,000 of Apple stock would attract $10.20 in SEC fee. The
tax is prorated and does not require the trade value to be a minimum of
$1,000,000, instead the tax can be applied to any sales trade at the rate
of 0.00051% ($5.1/ $1,000,000). This tax is collected by broker-dealers
when they trade equities on behalf of their clients and is then paid on to
the U.S Treasury to help fund regulation over the broker-dealer market.
This tax is formally defined in Section 31 of the Securities Exchange Act of
1934 and can be found on the SEC’s website if you wish to read more
details on it.
14
Stamp Duty Reserve Tax (SDRT)
SDRT is a tax levied by the UK government on the purchases of UK listed
shares and on the purchases of options to buy UK listed shares. The SDRT
levy is charged at 0.5% of the value of the trade. SDRT covers any shares
that trade on a UK exchange and the charge is payable on all shares
which are purchased electronically and on transactions through stock
transfer forms of value greater than £1,000. A stock transfer form, known
as a J30, is a document used to agree the transfer of ownership of shares
between two parties, these are frequently used for private companies
shares.
Carried Interest
15
Subscriptions and
Redemptions
16
Alongside lock ups funds can also agree ‘gates’ with investors that
stipulate a certain level of redemption that can take place in any given
redemption period. Gates effectively restrict the overall percentage of
assets that all investors can redeem in any period. This would help to
prevent a large number of investors redeeming a large percentage of
their money at the same time. Where a fund only has a few investors
who each make up a significant percentage of the fund's assets then by
imposing a hard lock the fund can ensure they will keep most of the
investors' money and therefore ensure stability over the management
fees they will receive.
In the case that a fund's investments are relatively illiquid, meaning they
can be hard to sell, it may be necessary for a fund to set up gates to
ensure that investors who remain in the fund after the redemption are
not penalised. An example of this penalisation could be that if a fund has
to sell of their most liquid investments to pay for an investors redemption
it would leave the remaining investors with a greater percentage of
illiquid investments.
Each of these restrictions are completely negotiable and all down to the
investment managers discretion, but of course if they want the business
from the investors, they will be willing to be flexible. The degree of
flexibility a fund manager may offer an investor is very likely to be altered
by the amount of capital an investor is looking to invest. As such, when a
large investor approaches a fund, it is often the case that a ‘side letter’ is
drawn up agreeing custom terms for that investor. Some of these terms
maybe more favourable redemption terms, although the redemption
dates themselves are likely to remain fixed.
17
UCITS
18
AIFMD
19
Investor’s Fees
Hurdles
Another important thing to understand about fees are hurdles. Hurdles
are pre-agreed amounts of return on investment the fund must make for
an investor before they can begin to charge investors a performance fee.
Hurdles can be based on an agreed percentage such as 8% or based on a
benchmark such as the S&P 500 for that year. Where a fund doesn’t
meet its hurdle rate, no performance fees will be charged to that
investor.
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High Watermark
To properly understand the concept of a high watermark it is best to
cover the concept of Net Asset Value (NAV) as well. A fund’s NAV per
share is the value of its assets minus its liabilities divided by the number
of shares it has issued and is an attempt to derive a fair value of the fund
at any given point in time. Recall from the “Structure” section that hedge
funds are established as companies which issue shares to investors,
effectively making investors silent partners since these investors have no
input in the day to day running of the fund. These shares will have their
value based on the fund's total NAV divided by the total number of
shares outstanding in the fund. A fund’s assets will be made up of all of
the investments that have been made, typically shares in various
companies. It is worth pointing out here that some funds may hold assets
that are unique or obscure and because of these characteristics valuing
the assets may be difficult. Due to the lower regulatory restrictions on
hedge funds, they are able to, in conjunction with their administrators,
determine their own fair value of certain assets using in-house models.
Whereas a more liquid and well traded investment, such as shares of
Apple, could easily be valued by looking at the current share price quoted
by a stock exchange. Some examples of liabilities that will be included in
NAV calculations are: performance fees, management fees, any legal fees
incurred in the period and administration fees. Across different time
periods a funds NAV will change with the value of its investments and the
costs it incurs, which leads us onto the definition of a high watermark.
The high watermark refers to the highest valuation a fund has reached;
the highest NAV achieved. The concept is important in the industry as
funds will only be able to start charging performance fees once the funds
valuation has exceeded its most recent high watermark. High watermarks
are used to help align the incentives of investment managers with those
of investors such that an investment manager could not charge
performance fees to investors on positive performance in one period
where the overall performance across multiple periods has been
negative. Take for example an investor’s £1,000,000 holding in a fund
that returns 10% in one year. At the end of year one they have a
£1,100,000 holding and would pay the investment manager 20% of their
performance as a fee such that the investor now has £1,080,000 (since
20% of their £100,000 performance is £20,000). The funds valuation at
the point where the investors holding reached £1,100,000 (£1,080,000
21
after fees) would be known as the high watermark. If in the following
year the fund lost 30% then the investors £1,080,000 would be worth
£756,000 and since there is no positive performance, no performance
fees would be charged. If in the next year the fund returns 20%, giving
the investor a holding worth £907,200 then since this holding is still
below the previously establish high water mark then the investor would
still not have to pay any performance fees despite having gained
£151,200 in that year.
As briefly alluded to in the “Subscriptions and Redemptions” section a
fund manager may agree a whole different set of fees, hurdles or high
watermarks via a side letter agreement when onboarding an investor,
and so any of these details would likely vary between investors within the
same fund as well in different funds.
22
Leverage
23
their total return, 8% to 16%. Clearly, leverage can be a huge help
in achieving returns for investors, but it can be equally powerful in
destroying investor capital. Take the same example above, but instead of
the shares gaining 8% in one year, let’s look at how the fund would
fair using leverage if the price of the shares fell by 8%. Without leverage
the fund would lose 8% on its $100m investment resulting in a $8m loss.
With the use of 2x leverage the fund would lose 8% on its $200m
investment: a $16m loss.
Since leverage is achieved by borrowing capital there is an associated
charge for using the money. The capital is normally lent to a fund by its
prime broker. The amount they are willing to lend will depend greatly
upon the type of securities being traded, how much a fund can post up as
collateral for the loan as well on the fund’s relationship with the prime
broker. A prime broker will be more willing to provide leverage to a fund
that trades in more liquid securities, shares in blue chip companies for
example, as they know that if the fund started to lose money, they would
be able to quickly, and cheaply, sell these shares to pay back at
least some of the money to the broker. Due to the complex trading
strategies that hedge funds tend to use, prime brokers will dedicate a
whole department to monitoring and adjusting the collateral provided by
a hedge fund to secure their leverage. The collateral department can go
into the detail of each share holding by a fund and decide how much
leverage to give that one position; they will then repeat this exercise for
the fund’s entire portfolio. Let’s break this down into a small portfolio
example below:
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Before the example is explored you should be aware that leverage is
often referred to in terms of “X”, e.g., “2X levered”, and is spoken as
“Two times levered” and is capital that is lent to a fund to trade with
should they want it; much like an overdraft. Whilst margin, the amount of
money that is required to be held as collateral, is expressed as a
percentage and is the amount of money required for a fund to open a
position in a given security.
The above example shows a hypothetical portfolio of five assets. The first
one, shares in Glaxo, is a blue-chip stock meaning that the company has
a well-established track record of financial stability suggesting it is of
lower risk. This blue-chip status enables a prime broker to offer a
relatively low margin requirement of 15%, although this rate is arbitrary
and completely down to the prime brokers discretion. This would mean
that for a fund to open a trade in 1,000 shares of Glaxo they would have
previously agreed with their prime broker that blue chip stocks are
margined at 15% of their cost. In agreeing that, the fund knows that to
open this £15,100 position they only need £2,265 in cash, 15%; this
equates to a leverage level of 6.66666X which is calculated by dividing 1
by the margin requirements. Restore PLC and ASOS PLC are AIM listed
shares. AIM is The Alternative Investment Market and is a less regulated
sub-set of the London Stock Exchange, as such AIM listed shares tend to
carry more risk of price volatility and so prime brokers will demand a
higher margin level.
The next two securities are bonds. Since the UK government is far less
likely to default on its requirements to pay coupons to the bond holder
than almost any corporation, prime brokers will margin government
bonds much lower than corporate bonds. Note also that both bonds are
margined lower than any of the shares, this is typical of margin rates as
bonds tend to have less risk due to the relative certainty of what it will
pay and be worth at different points in time.
As per the table you can see how the entire portfolio is worth £90,049
but only £14,619.95 is required as margin giving a weighted average
margin requirement of 16.24%. This means that this funds positions
would be levered at roughly 6.2X.
Margin levels will be agreed with prime brokers, but are subject to
change. Given the dynamic nature of financial markets
certain circumstances or events may cause the required margin levels to
25
change. Should certain securities experience large changes in
their liquidity levels or volume then margin rates may be altered. This is a
particularly prevalent case for event driven hedge funds as corporate
action such as mergers can have a huge effect on a security’s volume and
volatility.
26
27
Front Office / Trading
The front office, otherwise known as “the desk”, is the team that make
investment decisions for the fund. It will typically include portfolio
managers, traders and trading assistants working together to generate
and execute trade ideas. As will be covered in the below “trading
strategies” section, traders at hedge funds can execute a wide variety
of trade ideas by implementing sophisticated strategies. Whilst there may
be certain trading restrictions imposed on a trader by the mandate
agreed with an investor, traders in hedge funds typically enjoy the
freedom of being able to trade any security in the world. This is made
possible due to their investors level of sophistication and capacity for
loss. Roles in the front office can be incredibly demanding with long
hours of high pressured, time sensitive and technical work. These roles
best suit sharp, well organised people with an affinity for numbers and a
handle on their emotions. A front office at a hedge fund will be in regular
contact with: executing brokers, who they will trade securities with;
prime brokers, who will be the custodian of the investors assets; and
securities lending desks, where they will agree any desired borrows - a
process to be covered in the “Securities Lending / Borrowing” section.
Risk
The risk department of a hedge fund are responsible for monitoring the
investment positions of the fund and any associated counterparty risks.
They will be monitoring current positions to ensure the size of the
investment positions are within the mandates agreed with investors and
do not pose too much downside risk to the fund as a whole. Given that
most hedge funds will trade on margin using leverage a large part of the
risk department's role will involve monitoring and optimising margin
usage to enable the investment team to optimise their use of capital.
They will also be monitoring the credit worthiness of custodians like
prime brokers to try to reduce any risks to client money if the prime
brokers were to go bankrupt. These risks could be monitored by regularly
reviewing the spread on credit default swaps, effectively insurance
products, on the specific financial institutions that they have as
custodians.
It could be that certain funds run by investment managers have different
risk limits to other funds managed by the same investment manager. For
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example, some funds may contain investors who have specifically
required in their mandate that the fund does not invest in any IPOs (this
could be almost anything agreed to in the mandate, not just IPOs). In this
case the risk department would be responsible for ensuring that no IPO
trades that the hedge fund may have done for investors in their other
funds had been incorrectly allocated to the fund that cannot hold IPO
investments.
Operations
What is “Operations”?
You will often hear the Operations department referred to as the engine
room of a hedge fund; this title is well deserved. Whilst operations is not
an income generating department, it is a department responsible for a
broad range of tasks and often collaborates with other departments to
produce reporting or provide support. An operations department
is typically responsible for all post trade execution related matters. The
below will explore some of the main processes that an operations
department is responsible for.
29
related to a specific trade e.g., 100 Shares of Vodafone traded with
Goldman Sachs at 10 basis points commission. A portfolio management
system is, typically, an electronic system used to store all data related to
trades. The user interface of this system could be crudely described as
looking something like an iTunes library, containing a vast amount of data
related to historic and current trading activity allowing the operations
department to track the quantity and performance of those trades. A
vast amount of data is captured, calculated and displayed within a PMA.
We will go on to discuss processes within the PMA in other sections so as
to give each process a proper and full explanation.
Tender Offers
On some occasions companies offer to buy shares via a tender offer
where shareholders can elect to sell their shares for a preannounced
price by a set date. On that date shareholders will exchange their shares
for cash. As such, the operations department would be responsible for
booking into the PMA to sell the shares in the PMA and reflect the cash
that is received. In the UK market if a tender reaches 90% acceptance by
shareholders, then there will be a 6-week period after that where its
declared unconditional and you can tender (if haven’t already) at any
time and get paid out within 2 weeks. After then the predator company
can force the minority shareholders to sell their shares.
Dividends
A dividend is a cash payment received by a shareholder from a company.
Companies chose to pay out dividends to return cash to shareholders
where the company believes they cannot invest it as well as the
shareholder may. Also, where a company has had a particularly good
30
trading period, or has had some sort of windfall, they may decide to
return this excess profit to shareholders through a special dividend. The
PMA maintained by the operations department will also contain
information related to any dividends that a fund is due to receive or owes
to other investors. Inside of the PMA the operations team will be
responsible for booking in dividends due to be received at the
appropriate tax rate and booking any dividends due to be paid to lenders
of stock.
Dividends have an ex-date, record-date and a pay-date. Investors will be
paid dividends based on who holds on record date which is typically the
day after ex-date. Given that equities settle on a T+2 basis an investor
would need to buy the shares the day before ex-date in order to be
eligible to receive the dividend. If the trade did not settle correctly on T+2
and fails, then the counterparty will have a claim submitted against them
for the dividend amount to ensure the investor received the dividend.
In Australia, an arrangement that eliminates the double taxation of
dividends has been established which is known as franking. The dividends
paid to the investor is accompanied by a tax credit equal to the
percentage tax rate applicable to the firm. So, if a 100 % franked
dividend's is paid by a firm that pays 30% tax the investor can obtain 30%
tax relief. So, if the investor normally pays 30% tax, then they will receive
100% of the dividend, a tax-free dividend.
Stock Split
A stock split is where a company gives shareholders extra shares in
proportion to their current holding for zero cost. The effect of this is to
increase the number of shares in circulation without increasing the
market value of the company. The result is that each share now trades
for a lower price, but the overall ownership stake of each investor
remains the same. By reducing the per share price, it can open up
opportunities for smaller investors who may not have been able to afford
a whole share. For example, in 2020 when Tesla’s stock price reached
$1500 per share Tesla performed a five to one stock split meaning for
every one share you owned you would receive four more meaning each
share became worth $300. See below for the calculation. Whilst the
argument for stock splits is that it will allow a greater number of investors
to able to afford the stock, the argument becomes less valid since its
31
more common for brokerage firms to offer fractional shares now and so
an investor wouldn’t need to be able to afford an entire stock anyway.
Some firms enact reverse stock splits, following the same logic as a stock
split, but in reverse. All things being equal this has the effect of raising the
per share price and should not affect the value of the company as a
whole. Firms may do this to attract a particular type of investor. For
example, Warren Buffett’s firm, Berkshire Hathaway, keeps the per share
price of their class A shares very high at $474,000 per share as of
February 2022 to ensure they attract more serious and long-term
investors. This helps to reduce the trading volume in the shares and
therefore the price volatility.
The company will announce the ratio of new shares to be received per x
number of shares held. E.g., Three new shares per two held, this will be
framed as 3:2. You can then use the below formula to calculate the
theoretical stock split price. The stock split ratio is calculated using the
numbers announced by the company. Take the number of new shares to
be given per x number of shares held, in the above example it is 3, and
divide this by the x number of shares stated. Going back to the above
example the x number would be 2. Dividing 3 by 2 yields a stock split ratio
of 1.5.
Spin Offs
A spin off is a situation where a company separates out part of itself as a
separate entity, resulting in two independent companies. Some of the
most common reasons for this to occur is that management believes that
the share price of the company as a whole does not properly reflect the
values of the companies if they were separately listed companies. This
can come about as the company maybe carrying out multiple unrelated
business lines. For example, when eBay, which previously sold second-
hand goods through its website and charged a fee to sellers through its
payment system, span off this payment system into a separate company
called PayPal. The companies together are harder for shareholders to
value and often valuations are determined by applying multiples to yearly
earnings, but these vary by industry. As such, when a company is made
32
up of businesses straddling multiple industries their share prices may not
be in line with industry expectations.
Reconciliations
The reconciliation process will feature prominently within operations role
job adverts and simply put is a critical procedure, often done on a daily
basis, whereby one set of information is compared against another set;
where differences are found they will be explained or resolved. In
practice an operations department will do this by comparing various
different data sets between custodians and the hedge fund in question.
Typical examples of data sets compared include the positions in securities
that a hedge fund may hold, the known value of positions in securities
33
held by a fund and the fund’s cash balances. With the huge sums of
money involved, the relatively high trading frequency and the large
number of complex moving parts within a hedge fund, the regular
comparisons of data sets are essential. Using a portfolio management
application (PMA) as a data source a hedge fund will compare their data
against that of a custodian to ensure that the custodian agrees the same
information as the fund knows.
For example, a fund may hold positions in hundreds of securities, and
these could have values running into the millions of pounds. It is a
regulatory requirement to ensure that assets that a fund “knows” it has
are checked against what a custodian “knows” that the funds has “as
regularly as necessary”, which is typically deemed to be daily. An
equivalent process undertaken by the average person is that of checking
your bank account. The average person will frequently log into their
online banking to check recent activity. More often than not people are
checking the online activity statement, data presented by the bank,
against what they remember spending, a mentally held data set. This is a
reconciliation process, albeit a much less formalised one.
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that relates to more than one day ago this can cause “breaks”. A break is
a term used to refer to where there is a difference between two
numbers. In an operations role much of the work relates to proving out
and understanding any breaks to ensure there is a valid reason for them.
For instance, it could be that a trade was booked into the PMA for three
days ago with the wrong price. If a trade has the wrong price, then the
P&L being calculated on it will also be wrong. Once this mistake is spotted
and corrected then it will change the P&L that has been saved down
previously and as such, when the operations team next run their P&L
process, they will spot the break and must explain how the trade was
misbooked and later corrected.
Slippage
The concept of slippage is very important, and it is a concept to explain
the difference in P&L between two funds that should experience the
same percentage P&L. When a fund manages money for many investors
in a number of funds, if those funds have the same mandate i.e., should
be invested in the same securities at the same percentage allocations
then they should experience the same percentage P&L. Where they do
not there is said to be slippage and this needs to be understood and
corrected if deemed significant because otherwise investors are not
being treated equally and it could indicate some manipulation of P&L.
Slippage can come about innocently through the rounding of share
allocations across funds leading to one fund having an extra share from a
few trades and therefore experiencing different P&L, however this should
be minimal and monitored in case it becomes significant.
Marking of Securities
Marking is a process whereby a price is given to a security that is
not derived from the open market. Whereas on most days that markets
trade, highly liquid securities like shares in GlaxoSmithKline will have a
closing price determined by supply and demand, sometimes it can be
appropriate for a fund to “mark” the price of any given security to a
different price than that of an exchange. This can be the case where
there was no price printed on the exchange because the security did not
trade, or where the price printed on the exchange provides a very
inaccurate measure of the security’s value. In most cases prices of
securities are marked because the security has been involved in a
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corporate action. For instance, where a company is being taken over and
all the required regulatory, financial, and other requirements have been
met, and it is a certainty that the company will be taken over it may be
appropriate to mark the price of that security to the value being offered
for it as part of the takeover.
Fund Accounting
The fund accounting team are responsible for maintaining accounting
records which track income earned and fees incurred by investors. Funds
accounts will collect information on performance fees, charges as well as
performance of investments in order to calculate NAVs for each investor.
They will also track any cash flowing in or out of the hedge fund related
to subscriptions or redemptions.
Fund accounts will work closely with fund administrators who are third
party service providers who maintain “shadow accounts” of a hedge
fund. Shadow accounting is the process of replicating the accounting
entries, trade history and investment performance of a fund on a
separate set of accounts, which are held externally to the hedge fund, by
a fund administrator. This gives comfort and security to investors that the
value of investments the fund is reporting to investors is close to a true
value and there is no manipulation taking place. Fund accountants will
need to work with fund administrators to help explain why their shadow
accounts may not align with the fund’s accounts at certain times. There
will also be a significant amount of work needed to prepare for annual
audits.
Investor Relations
As the name of this department suggests the investor relations
department are the interface between external investors in a hedge fund
and the rest of the departments in the hedge fund. They will deal directly
with any questions from investors which could range from queries
related to any costs of their investment through to questions related to
the performance of their investment. The investor relations department
are also responsible for sourcing more capital for investment if the fund is
still looking for more investment. They will try to source this through
networking or through their prime broker capital introduction
departments, which is another service provided by a prime broker
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whereby they try to match up investors with investment managers. As
covered in the “Subscriptions and Redemptions” section the investor
relations department will also work to monitor any subscriptions
(incoming investments) or redemptions (withdrawals of investment) for
the fund.
Legal / Compliance
Legal and compliance are two similar departments in a fund which are
responsible for ensuring the fund abides by any regulations or laws where
it is investing or operating. Below are a few key tasks which fall under this
remit for most funds.
13F Filing
A 13F filing is a regularity report filed to the Securities and Exchange
Commission (SEC) each quarter by investment managers operating in the
US with more than $100 million in assets under management. Firms
meeting these criteria are required to disclose publicly the positions in
securities they held on the last day of the previous quarter that were
greater than 10,000 shares and $200,000 in value. The disclosure is
expected to be submitted to the SEC no later than 45 days after the
quarter end. The SEC will publish a list of securities that they wish to be
disclosed, most of these are US securities and so not all securities in the
world are subject to this requirement. There are various rules on how the
13F disclose should be calculated for various securities. For instance, the
value of options should be given not as the value of the options
themselves but the value of the underlying shares which they represent.
There are also adjustments that are required for warrants which are near
to expiry. A useful link for more information on the SEC 13F filing rules is
below.
https://www.sec.gov/pdf/form13f.pdf
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things like a short squeeze as covered in the “Short Squeeze” section.
There are a few main types of disclosures that event driven hedge funds
regularly make and these are explored below. Each global jurisdiction has
different regulations regarding share ownership and trading. The variety
and complications of these disclosures means funds often use legal
service providers to help guide them with up-to-date reporting
thresholds and disclosure requirements for various global regions.
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• Further disclosure required if the net short position reaches or
exceeds each 0.1% threshold thereafter (i.e., at 0.3%, 0.4% etc)
and on falling below the relevant thresholds
• On reaching a net short position of 0.5% or more of issued share
capital. On reaching, exceeding, or falling below each 0.1%
threshold thereafter and on falling below 0.5%, the net short
position must also be reported to the market
Money Laundering
Money laundering is a process which criminals employ to make their
criminal proceeds appear to have come from legitimate activities. It can
be done in a variety of ways and can be extremely difficult to prevent or
detect. It commonly entails three stages: Placement, taking their money
obtained through illegal activities and depositing into a legitimate
financial institution; layering, transferring the money to another account
usually via multiple wire transfers; and integration, having moved the
money around and hidden its original source the money is usually
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withdrawn as what seems like a legitimate loan, or held as some other
form of asset which the criminal can draw from having successfully
disguised its illegal origins.
Money laundering is widely considered to be prevalent, and its
prevalence exists because it can be difficult to detect and combat.
Following the September 11 attacks on the World Trade Center, which
were financed by means of money laundering, the US introduced more
stringent money laundering regulations through the US Patriot Act. The
Patriot Act set up a wide variety of new controls that impact financial
institutions that hedge funds engage with, such as banks, as well controls
that directly impact the funds themselves. This act is also considered as a
landmark act that encouraged other global governments to review their
own money laundering regulations and introduce anti-money laundering
regulations (AML). The act and other subsequent measures introduced by
other governments lead to more robust know your customer (KYC)
measures to ensure the identify of individuals or companies was better
understood when new accounts where being set up.
One other such act that was set up in the UK is the Proceeds of Crime Act
2002. One measure introduced by this act was aimed at putting the
responsibility of spotting and preventing money laundering on the
investment managers in a regulated financial firm by requiring even
suspicions of money laundering to be reported. Similar acts like the UK's
Money Laundering Regulations 2007 require all regulated financial
service providers to have a member of staff appointed as a Money
Laundering Reporting Officer.
Best Execution
Markets in Financial Instruments Directive (MiFID and MiFID II) are
European regulations that govern the behaviour of financial firms
operating in the EU. MiFID II introduced a host of new regulations for
hedge funds to adhere to including the explicit splitting out of
commission cost and research costs charged by execution brokers, which
were previously merged as one number. As part of these regulations,
hedge funds are required to create a best execution policy that will
outline all the necessary steps to obtain “the best possible result for their
clients taking into account price, costs, speed, likelihood of execution and
settlement, size, nature or any other consideration relevant to
execution”. This regulation puts the obligation on the investment
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manager to ensure that when executing trades the investor gets the best
possible result over all times frames, not just individual trades and aims
to optimise any explicit (commissions, taxes), or implicit costs (market
impact). Firms are required to justify their execution strategies and show
how this works for best execution. These checks are carried out by the
compliance teams. Depending on the type of product traded, the
frequency of the trading and various other factors that change between
investment managers, the fund will be required to prioritise the different
considerations of the best execution regulations and to create and
adhere to the policy they agree with their investors.
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Products Traded
Equities
Equities, otherwise referred to as shares or stocks, are financial securities
that represent part ownership of an underlying business. If you own
shares, you are a part owner of a company. As a co-owner of a business
through a shareholding you are entitled to a share of the company’s
profits. Companies may choose to pay out part of this share in profits as
cash to shareholders as a dividend, although this is not the case for all
companies and the company is under no obligation to pay a dividend.
Some companies take the view that profits are best retained by the
company and used to fund further projects and grow with the intention
of raising the market value of the overall firm, and therefore the value of
each share. As a shareholder you are also, according to your voting rights,
entitled to vote at the Annual General Meeting (AGM), an annual
presentation by a company’s board to discuss key topics such as
executive pay, the dividend policy and the selection of auditors.
The vast majority of companies begin life as a private company (one
notable exception to this is spin off companies of already publicly traded
companies, this will be covered in the “Spin Offs” section) and that means
in order to become a shareholder you need to be invited to, or directly
asked to, buy shares from the owner. When a company ‘goes public’ it is
typically done in two main ways.
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1. Via an initial public offering (IPO) where the company meets
various regulatory requirements to list its shares on a public stock
exchange enabling any eligible investor to purchase the shares.
The company will create more shares and usually hires an
underwriter to ensure that enough of the shares are sold on the
first day of trading. Motivations for IPOs are that the company
can sell shares to raise cash which may work out cheaper than
taking a loan. Once shares are publicly listed, directors and
current shareholders now have a liquid market in which to sell
some of their ownership.
2. Via a direct listing. Very similar to an IPO, but no new shares are
created, and no underwriter is used hence this tends to be much
cheaper for the company. Direct listings offer the benefits of no
hefty underwriter fees and directors are then able to sell their
ownership to the public. Also, since no new shares were issued
there is no dilution of ownership. However, there is also no new
cash raised.
Dual Listings
Companies may have their shares listed for sale on more than one public
stock exchange and when this is the case the company is said to have a
“dual listing”. For example, the oil company Royal Dutch Shell has its
shares listed in the Netherlands under the ticker RDSA NA and in London
under the ticker RDSA LN. Dual listings enable the company to access
capital from different investors globally and if the exchanges are in
different times zones it can allow them to trade for longer each day
which can improve the liquidity of the stock. It can also be cheaper for a
company to engage a new listing in a new market rather than undergo a
secondary placing in the same market.
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stock exchange. Similarly, ADRs can be ‘broken’ back in shares of the
foreign company. Of course, the depository will charge a fee for their
services, and it should be noted that some ADRs are created to represent
more than one share per ADR. Since hedge funds will hold their assets
with a separate custodian hedge funds normally instruct their custodians
to break or create ADRs, and these custodians will charge an extra fee on
top of the depository fee to do so. The fee is normally a few cents per
ADR, but this can vary and of course can become a significant cost on
hundreds of thousands of shares.
CFD
A CFD, a contract for difference, is a financial contract agreed between
two parties to exchange the difference in price of an asset. A CFD could
be written to exchange the difference in price of shares of Asos from the
date that the contract is entered into until the date at which the contract
is ended. Say, on the 10th of November 2020 the shares are trading at
£40 each and then by the 30th of November they are at £45 each, then
the person who bought a CFD for Asos shares would be owed £5 by the
person that they agreed that CFD with. Traders frequently use these
contracts because they can offer a distinct tax advantage in some
markets such as the UK, as discussed below. To fully understand this tax
advantage, we need to cover a key point regarding prime brokers, if you
are not familiar with prime brokers then please refer to the “Prime
Broker” section in this guide.
This tax advantage is secured for the hedge fund since when they want to
trade an equity, e.g., Asos shares, they may contact an executing broker,
let’s say Goldman Sachs (GS), who may have Asos shares to sell. The fund
will discuss the price and then ask them to “give up” the trade to a prime
broker, say Credit Suisse. This practice of “giving up” is where the
executing broker will technically be selling the shares to the prime
broker, and since the prime broker will be a registered broker-dealer they
will be exempt from SDRT, hence no SDRT is paid. The prime broker will
then write a CFD to the hedge fund giving the fund the exposure to the
security that they wanted without the fund having to pay the SDRT. Here
it would be prudent to point out that the prime broker has not charged
the hedge fund for the full value of the trade. Let’s say that the Asos
shares being sold by GS were for £46 each and the hedge fund wanted
1000 shares giving a total value of £46,000 for the trade. The prime
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broker, Credit Suisse would have paid Goldman’s this full amount,
received the shares in and wrote the contract to the hedge fund, but
would not charge the hedge fund the £46,000. Of course, the prime
broker isn’t doing this for charity and instead the hedge fund would
effectively be borrowing that money from the prime broker at an agreed
interest rate. Also, given the ever-present risk to the prime broker that
the hedge fund may default on this loan they would require some
amount of money as collateral. This would be referred to as margin and
will vary based upon the level of risk the prime broker determines that
they face against the hedge fund as well as the risk of the specific
investment. These margin rates are normally agreed with the prime
brokers in advance, for more on these please refer to the “Leverage”
section in this guide. Whilst this concept of trading on margin is
advantageous to the hedge fund it is not necessarily an advantage of just
CFDs since hedge funds are typically structured with their prime brokers
to offer margin trading for most assets.
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to buy would be referred to as the target company and would then
become the company that they run. SPACs have of huge amounts of cash
raised from investors who put their faith into the management of the
SPAC to find a company to acquire, improve and run. When these SPACs
are launched, whilst they may state the industry that they are looking to
acquire a company from, there is often no information given about
exactly which company they are looking to buy. The absence of any
underlying business activity, the obscurity about the target company and
the large cash balance held in these SPACs has given rise to the name
“blank check companies” which is commonly used to refer to them. The
investors in SPACs provide cash in the hope of a deal being announced,
agreed and completed. However, in their agreement with the SPAC
management there are various terms. These terms typically stipulate that
the SPACs management team will hold the investors cash for up to two
years whilst searching for a target company. Should they fail to buy a
company within the agreed timeframe the investors have the right to
redeem their cash investment plus interest. Similarly, should a target be
announced the investors have the right to vote for or against buying the
company and may also be able to redeem their cash at this point.
Options
Understanding options can be difficult since they can be used to
structure trades with complex payoffs, are priced using advanced
mathematical models and can be held over many different financial
instruments. Here we will break down the key things to understand about
options on shares.
Options are financial contracts entered into by two parties who are
agreeing to exchange shares in a company at a future date at a pre-
agreed price, subject to the market price of those shares at that point in
time. Options come in two forms:
Put options: An agreement that gives the holder (buyer) of the option the
right, but not the obligation, to sell shares of a company at the strike
price (a pre-agreed price) at a specified date in the future.
Call options: An agreement that gives the holder (buyer) of the option the
right, but not the obligation, to buy shares of a company at the strike
price (a pre-agreed price) at a specified date in the future.
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Options contracts can allow investors to be extremely flexible since an
investor can use options to speculate on the price of shares rising, falling
or staying the same. Since there are two contract types, puts and calls,
and an investor can either be a holder (buyer) of a put or call, or can be a
writer (seller) of a put or call there are four main “set ups” an investor
can assume, each with differing pay offs.
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can be 10 shares. American style options can be “early exercised”
meaning that at any point up until the expiry date the holder of the
option could make a claim against their option whereas in other option
styles the holder would have to wait until that expiry date.
Remembering that there are two parties involved in this contract, the
writer (seller) and the holder (buyer), each making a bet on the price of
the underlying shares then only one of them can “win”. In the case of the
above put the holder paid the seller some cash in order to be able to sell
100 shares of Twitter for $72.50 at or before the 14th of March 2021.
If shares in Twitter were trading at $70 by the 14th of March 2021, then
the buyer of the option would have an incentive to exercise their option
since the seller of the option is obligated to buy 100 shares of Twitter at
$72.50, $2.50 above the market price.
Whilst options are set up to agree the purchase and sale of shares, they
can also be cash settled whereby parties simply exchange the cash
difference in the values under the terms of the contract rather than
actual shares. In this case it would be the $2.50 price difference
multiplied by the lot size of 100, for a total of $250. In this circumstance
the writer of the option is the loser of the trade since although they were
paid a premium to write the contract, they will have to pay the $250 to
the holder which would likely be larger than the premium received. If,
however, come the expiry date Twitter shares were worth $75 then the
options would be known as “out of the money” and the contracts would
expire worthless since the holder would have no incentive to sell the
shares worth $75 to the seller of the put option for $72.50. In this case
the holder is the loser since they would have paid the seller a cash
premium for the contract which is now “out of the money” and therefore
worthless. A key point to note is that writers of both call and put options
can be exposing themselves to the risk of huge loses. Going back to the
above example if the price of Twitter stock went to $0 then the writer of
the put would be on the hook to pay the holder $72.50 multiplied by the
lot size of 100 for a total cost of $7250 per contract. Even more
alarmingly a writer of a call option exposes themselves to potentially
unlimited losses since they are willing to sell stock at a pre-agreed price
when, hypothetically, the highest price a stock could trade for is infinity
whereas the lowest price can only be 0. Options normally expire on the
third Friday of every month. If an option is in the money and a writer of a
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contract is obligated to buy or sell shares on that basis this is referred to
as being “assigned” on the contract.
Options contracts have a more complex way of being priced when
compared to their underlying shares. Their price is made up of both the
intrinsic value and the extrinsic value. The intrinsic value is what the
option is worth now if it were to be exercised, otherwise known as its
moneyness. This can be measured by seeing how far the current market
price of the underlying shares is from the strike price of the option. If the
market price is below the strike price and the option is a call option, then
it is in the money. If it were a put it would be out of the money and have
no intrinsic value. In reality, options don’t trade at exactly their intrinsic
value and the difference between their market price and intrinsic value is
known as their extrinsic value. This value is determined by their time left
until expiry and the implied volatility of the underlying stock. The implied
volatility refers to how much the stock price is expected to change over
time, and this is predominantly estimated using previous price behaviour.
The value of an option with an expiry date much further into the future
than another identical one which expires sooner will be greater. This is
because there is a greater time frame within which the stock’s price could
move into the money and give the option intrinsic value. Options can be
priced using various mathematical models, but the most common of all is
the Black-Scholes Model.
The Greeks
The Greeks are some factors that help an investor understand the
different factors effecting the price of options. Given the complexity of
options pricing models and their abstract nature, an entry level role
would likely only require a high-level understanding of the Greeks. We
would suggest that the Greeks would be best understood by starting a
practice trading accounts and opening some options positions to see how
the Greeks interact to determine options prices. The five Greeks are
defined below:
Delta
Delta is the rate of change of the options price with respect to the price
of the underlying asset. E.g., 0.6 delta means for every £1 change in the
price of the underlying asset, the options price will change by £0.60.
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Theta
Otherwise known as time value or the time decay. Theta measures the
rate of change in the value of an option with respect to the passage of
time. As an out of the money option approaches its expiry date the value
of the options theta will decline since there is less time left for it to move
into the money.
Gamma
The gamma of an option is the rate of change of the options delta with
respect to the price of the underlying asset.
Vega
The Vega of an option is the amount by which an options contract is
expected to change in value in response to a 1% change in the implied
volatility of the underlying asset.
Rho
The Rho of an option is the sensitivity of an options price with respect to
interest rates. This measures the price impact on the option following a
change in the rate of interest in an economy.
Units
Units, or unit shares, are financial packages containing one or more
securities. Typically, units contain common shares along with a number of
warrants. These trade as whole units which can be “split” or converted
into the contained securities at a predetermined ratio. If a unit is made
up of shares and warrants, then it stands to reason that the value of the
unit should be determined by the value of the number of shares and
warrants that are contained within it minus any costs associated with
splitting the units. The composition of a unit can be found on documents
issued by the company. For example, the below 8-K filing for the SPAC
Neuberger Principal Holdings shows that each unit contains one ordinary
share and one fifth of a warrant.
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Screenshot taken from Neuberger Principal Holdings 8-K filing on the
SEC’s website
Warrants
Warrants are securities that give the owner the right to buy or sell
another security at a pre-agreed price at a future date. They are most
commonly related to equities and give the right to buy or sell shares in
the issuing company. Although similar in structure these should not be
confused with options and are typically much longer dated with
expiration dates years into the future. It is worth noting that in line with
the naming convention for options warrants can be either put warrants,
giving the owner the right to sell a security at a future date, or call
warrants giving the owner the right to buy at a future date. Although,
unlike options most investors will not be able to “write” a warrant in the
way they could an option and hence would have to trade a call warrant
“over – the – counter”. It should also be noted that warrants do not
typically entitle an owner to any dividends that a shareholder may get
during their holding period. Also, when exercised the holder will be given
newly issued stock in exchange for the warrant, whereas with options
they would be selling or buying existing shares from the market. This
means that the exercising of warrants can dilute the ownership of
shareholders since more shares will be outstanding against the same
amount of company profits. Warrants have become less common in the
United States over the last few decades but have grown in popularity in
Asia.
Bonds
A bond is a loan of cash made by an investor to a borrower in return for a
fixed amount of interest where at the end of the loan period the initial
loan amount, the principal, will be repaid. Bonds have fixed interest
amounts, known as the yield or coupon, payable on them. For example, a
bond that is issued for £100 at 5% will have an annual payment of £5 in
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interest each year. Over the bond’s lifetime its face value may change so
the £100 bond may trade hands for £102 meaning the yield have
dropped to 4.9%, but the interest payment stays fixed at £5. Here you
can see the inverse relationship between bond prices and bond yields: as
one rises, the other falls. Bonds can be issued by governments which
typically pay interest annually, or by corporations which pay interest
semi-annually. Given the lower risk of default of any given government
versus the risk of default posed by any company in the same country
government bonds tend to have lower rates of interest to reflect their
lower risk. Governments can, and do, default on their bond payments
from time-to-time e.g., Russia in August 1998. The US government is
considered such low risk that investors use the interest rate on the 10-
year government bond as a “risk-free” rate to compare their portfolio
returns against.
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exchanges like equities, and this means they can be customised to the
exact size and future date that the investor would like.
Commodities
Commodities include raw materials like precious metals (gold, platinum),
energy (oil, gas) or agricultural commodities (coffee, pork bellies, sugar).
Funds can gain exposure to this asset class either indirectly, by trading
shares in the companies that produce the underlying commodity, or
directly by trading futures contracts on the underlying commodity. The
use of futures contracts offers much better correlation to the spot price
of the commodity since companies may produce more than one product
e.g., a gold mine that also produces platinum would be correlated to both
commodities rather than just one. It isn’t likely that a fund would choose
to physically acquire a commodity and attempt to sell it at a later day
because this would require logistical planning, and associated costs that
can all be avoided by using a futures contract.
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Security Identifiers
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ISIN
ISIN stands for: International Securities Identification Number. This is a
twelve-character identifier for a security that is recognised globally. Its
first two digits represent the country of registration of the issuing
company. For example, shares in the company Apple, which is
incorporated in the United States has an ISIN beginning with US and
shares in the company Boohoo, which is incorporated in Jersey has an
ISIN beginning with JE.
SEDOL
SEDOL stands for: Stock Exchange Daily Official List. This is a seven-
character identifier for UK listed securities that is exchange specific and
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so will not only tell you what security it is, but also which specific
exchange this security is trading on. The SEDOL helps build on the ISIN
identifier since ISINs relate to a security, e.g., IBM which trades on 25
different exchanges hence the SEDOL for IBM is even more specific since
it denotes which exchange it trades on.
CUSIP
CUSIP stands for: Committee on Uniform Securities Identification
Procedures. It is another identifier for US and Canadian registered
securities. It is composed of nine characters where the first six characters
identify the issuer. The seventh and eight identify the type of security and
the ninth and last are used as checks to ensure the correct naming
conventions have been used.
Ticker
A ticker, or stock symbol, is a unique and short list of letters used to
represent the name of a company. E.g., Apple, the iPhone maker has the
ticker “AAPL” it is normally followed by a further two characters e.g.,
“AAPL US”, the last two indicate which exchange it is trading on, in the
case of “US” it is referring to the Nasdaq, a US based stock exchange in
New York City.
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Trading Strategies
Shorting
Buying shares in a company and holding them is known as being “long”
the stock. Conversely hedge funds can sometimes take short positions.
This involves the fund borrowing the stock from another shareholder,
selling that stock in the market with the hopes of eventually buying the
stock back at a lower price and returning the stock to the original
borrower. The fund will keep the difference between the original sale
price and the price at which they bought the stock back at as profit. They
will be required to pay some fees for this borrowing, and these are
explained in the “Interest and Financing” section. Do not confuse a short
trade with a sell trade since to sell a stock the fund would own it first and
then sell it in the market, when shorting they are borrowing the stock to
go and sell it (and eventually buy it back to return it to the stock lender).
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Risk / Merger Arbitrage
Risk or merger arbitrage is the main trading strategy of an event driven
fund and is probably the most important one to have an understanding of
when looking to join an event driven fund. A merger is simply the joining
of two companies, and this will happen when one company buys another.
They will do this by looking to buy at least 51% of the shares in the
company they are looking to acquire (buy). The company being taken
over is known as the target company and where the target company’s
management are happy being taken over by the acquiring firm the
takeover is referred to as friendly; where they wish not to be taken over
it is known as a hostile takeover.
In order to secure a 51% ownership stake, a company will need to
encourage current shareholders to sell them their shares in the target
company. They will do this by paying more than the current market value
per share. Sometimes this value is made up purely of a cash payment in
exchange for their shares, sometimes it is paid for by exchanging their
current shares in the target company for shares in the new company (the
one that will be created when the target is bought by the acquiring
company) and other times there is a mix of cash and stock. To illustrate a
simple example let’s look at when Horizon Therapeutics bought Viela Bio
in early 2021. In January 2021 Viela’s share price was around $37 and
when Horizon announced to the market that they were looking to
acquire Viela Bio, and were willing to pay $53 a share, the price of Viela’s
shares jumped up to around $52.3. The price that Viela’s shares were
trading at before the deal was announced is known as the pre-
speculation price and it is very possible that if Horizon cancelled the deal
that the share price of Viela would fall back to around this region.
The below screenshot from Bloomberg shows Viela’s price jump following
the announcement from Horizon to buy it for $53 a share. Note that for a
time in February Viela traded greater than $53 a share which is higher
than the offer. This is known as “trading through the terms of the deal”
and was a result of speculation that Horizon would increase their offer,
which they did not.
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The opportunity here for hedge funds is that they could buy shares in
Viela, after hearing of the deal, for $52.3 and later sell them to Horizon
for the $53 they are offering. This $0.70 difference between the current
share price and the eventual offer price is known as the spread and is
typically larger where the deal is considered to be less likely to complete.
In this case the deal was relatively straight forward and was due to
complete only six weeks after it was announced, as such the spread here
is only about 1.3% ((0.7/52.5) *100). Deals more typically take around a
year to complete and face a number of obstacles depending on which
type of companies are joining. For instance, it could be that a countries
competition monitoring body may want to review the potential effects
that the two firms merging could have on an industry.
Deal Break
Where a merger deal fails to go through it is referred to as a deal break.
Hedge funds who trade these mergers typically face large risks as per the
above should Horizon cancel this deal, or it is blocked for any other
reason, if a fund had bought shares at $52.3 hoping for a 1.3% gain, then
it is likely the shares would fall back to the $37 region making for a 29.3%
loss (((52.3-37)/52.3) *100). As you can see the downside risk is
significant and so funds will perform their own due diligence to form their
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own opinion on how likely a deal is to succeed, and from there can
determine if they are happy with the current spread the deal is offering.
Funds can also use options to hedge the downside risk of a deal break. In
other deal types, where both cash and shares are offered as part of the
deal, funds will buy shares in the target company and simultaneously
short shares in the acquiring company who is offering shares. This
practice enables the fund to “lock in the spread” on a deal and reduce
the downside risk on their investment in the event of a deal break,
because should that occur the shares in the acquiring company would
likely fall and therefore create a profitable return on their short. Going
back to the above example offering a 1.3% return it is also noteworthy
that the return seems small and hence requires funds to use a larger
amount of capital, often with leverage, to help gear up this return to a
more significant number. For instance, a fund with 5:1 leverage would
achieve a 6.7% return over the lifetime of this deal which is more
significant. Funds will also be considering these returns on an annualised
basis which in this case, given the deal completed in a very short period
of six weeks, gives a compounded annualised return of close to 60%: a
very good return.
The industry refers to the news announcements and the different
milestones that need to be completed for a deal to go ahead e.g.,
approvement from regulators, as catalysts. These are broken down
further into hard catalysts, which are confirmed and widely known
hurdles being achieved, or soft catalysts such as rumours.
Dead Spread
The spread in a deal, as explained above, is the difference in value
between the shares of companies merging and represents the perceived
risk in the deal by the market. Throughout a trading day the shares in the
two companies will trade together in the sense that if the value of one of
the companies rises then the value of the other should rise by an equal
percentage since their overall values are intrinsically linked as they will
soon become one company. If the shares of the two companies trade in
different times zones, then there may be a period of the day where only
one of the companies’ shares can trade since the shares of the other
company may only trade on another exchange which is shut at that point.
E.g., an EU company joining with a US company where their shares are
only traded on their respective local exchanges. Most times during the
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year the US stock exchange will open at 14:30 UK time, but since the UK
market will shut at 16:30 UK time the two shares can only trade at a
spread during these two cross-over hours. After the UK shuts, the UK
shares will be said to be trading at a “dead spread”.
Placements / IPOs
Companies can use IPOs, primary placements or secondary placements to
raise capital. IPOs are initial public offerings and are where a stock first
lists on a public exchange and is available for investors to buy. This is a
long and expensive method of capital raising as the company will need to
meet a host of regulations and criteria to ensure it meets with regulations
set out to protect less sophisticated investors. Primary and secondary
placements are a form of capital raising similar to IPOs but targeted for
sophisticated investors like investment banks or hedge funds. Funds may
invest in these where they believe in the long-term prospects of the
company. Typically, investments in IPOs have a 90 day lock up whereby
an investor cannot sell their investment until 90 days after the IPO.
Rights Issue
A rights issue is another form of capital raising for a company whereby
the company offers current shareholders the right to buy new shares in
the company in proportion to their current holding. Shareholders who
hold their shares on “ex-date” will be entitled to these rights which give
them the option to buy more shares if they so wish. Following the ex-date
shareholders will receive rights which they can either exercise and
choose to subscribe for more shares at the offer price, or deicide to sell in
the market; these rights known as “nil-paid rights”. The rights usually give
the holder the option to buy shares at a discount to the current market
price. Rights will be distributed to shareholders based on the number of
shares they currently own e.g., 5 rights per 12 shares held and then each
right normally gives the holder the right to buy one more share at
whatever price the company is offering them for. Following the pay out
of the rights issue the company will have more shares outstanding than
before the issue and so their total earnings are spread out over more
shares meaning each shares has less earnings attributable to it; this is
known as a dilution of earnings.
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It is also possible in some rights issues that a shareholder can subscribe
for more shares than they are entitled to as per their current
shareholding. This is known as an oversubscription and is at the
company's discretion.
Following a rights issue, the dilution effect from a greater number of
shares outstanding results in an expected change in the price of the
shares, all other things being equal. This price is known as the theoretical
ex-rights price (TERP).
Calculation Of TERP
An example of how the TERP is calculated is explored below:
Company A’s shares are trading at £7, and it begins a 2 for 7 rights issue
at £5 per share. This means that for every 7 shares held in company A the
shareholder will be given the right to buy a further two shares at £5 each.
The price at which they subscribe for new shares is known as the
subscription price and is set by the issuing company. Say an investor held
700 shares in company A then they would be entitled to buy 200 extra
shares at £5 each. They could also opt to sell their nil-paid rights to
someone else if they didn’t want to pay for more shares. The value of the
nil-paid rights would be determined by the TERP of the shares and the
subscription price of the rights issue. In this case before the rights issue,
the investor held 700 shares at £7 each giving a total market value of
£4,900. Following the rights issue, if the investor were to fully subscribe
for all of their 200 rights and pay £1,000 for their additional 200 shares
then their total shareholding would be worth the £4,900 market value of
the 700 shares plus the £1,000 paid for the additional 200 shares. This
makes for a total of £5,900 and 900 shares which gives an average price
per share of £6.56 per shares, this price is the TERP price. The difference
between the market value of the shares and the TERP price would be the
value of the nil–paid rights. In theory an investor should be no worse off
by electing to sell their nil-paid rights than if they elected to subscribe for
the newly issued shares. However, if they choose to sell their nil-paid
rights then their percentage ownership of the company will be reduced.
Whilst if they choose to elect on their rights, they will maintain their
percentage holding but be required to invest more cash to buy the new
shares at the subscription price.
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Securities Lending /
Borrowing
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aside an agreed number of shares for the fund to be able to sell if they
want to. They may choose to only sell short half of the agreed facility or
all of it, in either case they will be charged a fee for the number of shares
they are able to sell.
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Stock Loan Fees
T o borrow shares for the purposes of shorting the stock the borrower
will be required to pay the lender a daily fee based on how difficult
the shares are to find and borrower from a lender. Prime brokers will
have a stock loan desk, which will be an entire team, who will help
facilitate borrows for a fund and agree rates on borrows. The rate is
typically around 35 basis points (0.35%) of the market value of the
security per year, although it can be much higher if the stock is becoming
difficult for the desk to source. In the US, borrows can be “re-rated” daily
meaning that each day the annualised borrow rate could change. The
industry nomenclature for borrows of US stock is that they are referred
to as “locates” and not borrows like they are in the UK, for example. Once
a stock has been sold short by a fund, they receive a cash payment from
this which will be held at their prime brokers. So long as rates aren’t
negative, like they have been in Japan, then a fund will be paid interest
on the cash received from short selling. The cash received is referred to
as short sale proceeds and goes some way toward reduces the overall
cost of the borrow.
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Short Squeeze
Trading on Margin
M ost funds will “trade on margin” this is where the fund will have a
relationship with a prime broker that will allow them to trade
assets using borrowed money. This means that a fund could open a
position without needing to pay for the full value of it. E.g., they could
buy $1,000,000 of Apple shares, but their prime broker may only ask
them to “pay” $200,000 and the prime broker will lend them the rest.
Trading on margin is also referred to as being levered or having leverage.
In the previous example the fund only had to put up 1/5th of the capital
needed which equates to 20% and so it would be said that the margin
rate 20% and the leverage is 5:1, read this as “five to one”.
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"Locking Up a Stock”,
Hypothecation and
Rehypothecation
W hen trading on margin (see above section) a fund will “put up”
stock as collateral which simply means that they will allow their
custodian, the prime broker, to hold their assets in case the fund starts to
lose money then the prime broker will be able to sell these assets to
recover any debt the fund may owe them. The act of the prime broker
holding these assets this is called hypothecation. Prime brokers may seek
to make more money by lending out the assets that a fund has agreed to
let them hold. The act of a prime broker lending out the assets that have
been hypothecated with them is called rehypothecation and is usually
agreed to by the fund in the prime broker agreement they set up when
the relationship is established. There are certain circumstances in which a
fund may need to access their assets to sell or otherwise transact in, but
they would not be able to do so if the prime broker had rehypothecated
them and so the fund could request for whichever assets they like to be
“locked up”. This is an agreement between the fund and prime broker,
typically done on an ad-hoc basis, to not rehypothecate particular assets
and means the fund has access to those assets at all times.
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Trade Matching /
Affirmation and
Settlement
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Trade Life Cycle
• Pre trade
• Execution
• Post trade
The pre trade stage is the initial stage of the trade lifecycle where a fund
will reach out to a broker to request a trade. This could be a trader calling
a broker like BTIG and saying, “I’d like to buy 1,000 shares of Apple at the
market rate”. If the broker is willing to sell the shares to the fund they
may provisionally agree to do so and hang up the phone. At that point,
their compliance team should step in to perform various checks on the
fund the trader works for and the security they have requested to buy.
The broker will then put the order from the trader into the market on an
order book. An order book is an electronic document containing all the
current orders from various investors in the market for a security. When
the price at which an investor is willing to sell at matches the price at
which another investor is willing to buy at an order is said to be “filled”.
The execution stage of the trade lifecycle is where an order has been
filled in the market for an investor. After the order is filled the trade
lifecycle moves to the post trade stages. This involves the use of the
previously described trade matching systems where both parties
reconfirm that they agree the various trade details. Following this the
trade will be moved to a clearing house which will act as an independent
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third party who guarantees settlement and will transfer the ownership of
the securities from the broker to the investor and give the investors cash
to the broker. This post trade stage is the settlement stage and can take
different amount of time based on the type of security.
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Security Depositories
DTC
DTC stands for Depository Trust Company. The DTC is an automated
record keeping company based in the US that stores the records of
ownership of financial assets for investors. They provide many other
services including the announcement and distribution of dividends from
companies to shareholders. Being regulated by the SEC and co-owned by
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several large financial companies the DTC are trusted as third parties to
be the custodian of stocks, bonds and money market instruments. Their
automated systems have helped to reduce inefficiencies in record
keeping making transactions both faster and cheaper for investors.
CREST
CREST stands for Certificateless Registry for Electronic Share Transfer.
CREST is a central securities depository meaning that it is the UK’s main
company for holding various securities on behalf of investors. CREST also
has its own clearing system it allows counterparties to use its electronic
trade confirmation system to enable fast and accurate settlement of
trades.
CHESS
CHESS stands for Clearing House Electronic Subregister System and is the
Australian depository and clearing house system.
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Failing Trades
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failing party since if they originally agreed to sell their shares for $4 each,
but failed to make delivery and were subsequently “bought in” by the
other party, the counterparty could have bought those shares in the
market for $5 meaning the failing party would owe them the $1. These
"buy ins" can be initiated 24hours after a fail in any market and are at the
brokers discretion with short sales needing to be bought in by T+3 and
long sales bought in by T+5. In some markets there are fines as well as
buy ins based on the percentage value of the unsettled trade and these
are in addition to buys ins. E.g., Japan.
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Interest and Financing
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Cash Interest
Prime brokers typically charge interest on any borrowed money at a pre-
agreed benchmark rate plus, or minus, a “spread”. In financing terms, a
spread is a rate of interest a fund is charged by their prime broker. These
are usually in addition to a market benchmark because the market rate
can be considered to be what the prime broker is paying, whilst the
spread is effectively their profit. The spread is usually quoted in basis
points (bps), spoken as “bips”, and represents the profit being made by
the prime broker. Where a fund has a long cash balance, that is a positive
cash balance, and where the benchmark interest rate is positive, they will
be paid the benchmark interest rate minus the spread charged by the
prime broker. Where a fund has a short cash balance, that is a negative
cash balance, and where the benchmark interest rate is positive, they will
be charged the benchmark interest rate plus the spread charged by the
prime broker.
Swap Financing
Once a fund has entered into a swap agreement, alongside the actual
profit and loss they will experience from the change in price of the
underlying asset, there will also be a financing charge applicable to the
contract each day. The charge will be based on the market value of the
underlying security multiplied by an agreed benchmark index rate plus, or
minus, a spread (depending on whether the contact is to short the
underlying security or to buy it). The charge will be applied daily from the
settlement date until the end of the contract.
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Ticket Charges
As part of a funds needs to ensure a smooth communication of known
investment positions with its prime broker the fund will send down data
in a file to its prime broker on a regular basis. The data will contain
information on transactions and trades made. The prime broker will
replicate this information in its own system, so it has its own record of
the fund's holdings. As the custodians of the fund's assets, the prime
broker needs this information to identify any discrepancies between what
the fund believes its prime broker is holding on its behalf, and what the
prime broker believes it should be holding for them. This is part of the
reconciliation steps that the operations teams will run. The prime broker
will charge a fee to the fund based on the amount of data they are sent
to record. Prime brokers refer to these fees as ticket fees and are usually
applied to each trade sent to them by a fund. Fees across the industry
can vary and are typically small per trade but can add up substantially
depending on the trading volume of the funds. As with most other
charges these sort of fees are negotiable and will be agreed during the
onboarding process of the fund to the prime broker’s platform.
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Glossary
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CUSIP - Stands for: Committee on Uniform Securities Identification
Procedures. It is another identifier for US and Canadian registered
securities.
Double taxation - This occurs where multiple taxation claims are made
against one amount of return, income or financial asset. E.g., Where
income tax is paid on dividends sent to investor after being paid out by
companies which have already paid corporation tax.
Dual listing - Companies may have their shares listed for sale on more
than one public stock exchange and when this is the case the company is
said to have a “dual listing”.
Flagship fund - Where a hedge fund manages multiple funds but has one
fund which best represents their strategy, and ideas, it is referred to as
their flagship fund e.g., Bridgewater Capital’s flagship fund is their Pure
Alpha fund.
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Hard lock up - An agreement between an investor and an investment
manager which restricts the amount of capital an investor can redeem
over a set period, usually several years.
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Long - A term used to refer to an investment which has a positive pay off
if the asset increases in price e.g., buying shares.
Net Asset value (NAV) - The value of a fund’s assets minus its liabilities.
Pay to hold - Similar to a stock loan but where the security is on swap
(CFD) and the borrower doesn’t need to use the securities for a short
sale, they just have the option to use them to short sell.
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SEC fee - A US tax charged by the Securities and Exchange commission on
sales of US exchange listed shares.
SEDOL - Stands for: Stock Exchange Daily Official List. This is a seven-
character identifier for UK listed securities that is exchange specific and
so will not only tell you what security it is, but also which specific
exchange this security is trading on.
Shorting/Short sale - This involves the fund borrowing the stock from
another shareholder, selling that stock in the market with the hopes of
eventually buying the stock back at a lower price and returning the stock
to the original borrower.
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Spin Off - The new company which is created when a company splits itself
into two, separate, entities. The remaining company is referred to as the
parent company.
Stamp Duty Reserve tax - A 0.5% tax levied by the UK government on the
purchases of UK listed shares and on the purchases of options to buy UK
listed shares.
Ticker - A ticker, or stock symbol, is a unique and short list of letters used
to represent the name of a company.
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