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The Reality of Hedge Funds
Presented by: Superman Superwoman Coolman Coolwoman

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Case Against Indexing

Behavioral Arguments

Theoretical Arguments

Empirical Arguments

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Introduction

• Active or passive? • Active manager has not outperformed S&P500 • Behavioral analysis & empirical evidence f argument • Passive investing

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The case for indexing – The Theoretical Case
• Markets are efficient • Assumes
– Investors are perfectly rationale – Markets are “frictionless”

• Harry Markowitz described how rational investors should create portfolios
– Stock’s risk should be evaluated in terms of its contribution to the risk of a diversified portfolio
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The case for indexing – The Theoretical Case

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The case for indexing – The Empirical Evidence
• Active managers underperform passive benchmarks

• Median active fund underperformed the passive index in 12 out of 18 years • Majority of mutual fund investors better off investing in S&P 500 index fund
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• Challenging Assumption: No taxes or Trading Cost • Different tax systems/trading cost affect investors
– An investor who is subjected to high tax/trading cost may not trade even when new information creates a reasonable large change in expected returns

Theoretical Arguments Against Indexing

 Different investors hold different portfolio, meaning there is no single market portfolio
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• Challenging Assumption: Homogeneous Expectations • Investors do not have common expectations
– Different school of thoughts (Keynesians versus Monetarists

Theoretical Arguments Against Indexing

• Investors calculate risk and return differently
– Some have better technology, analytical capabilities
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Theoretical Arguments Against Indexing
• Challenging Efficient Markets
– In perfectly efficient market prices = fair value Someone must estimate fair value else trading will ease Market collapse Means active investors are needed to make market efficient

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Empirical Arguments Against Indexing
• Challenging CAPM
– No positive relationship between CAPM and realized stock returns
• Perhaps because market is not efficient • Or because investors don’t base their expectations on CAPM

– Failure of CAPM beta to explain returns show that no single index is optimal for all investors

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Empirical Arguments Against Indexing
• Challenging Volatility
– If prices reflects all available information, they will only response to new information – However, prices are too volatile to be explained by less volatile changes in i/r and cashflows

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Behavioral Arguments
• EMH assume investors are rational • Human make systematic errors in judgment & probability assessment • Cognitive errors
– – – – Selective perception Illusory correlation Wishful thinking Hindsight bias

• Active managers believe they can generate above average investment returns
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Behavioral Arguments
• Overconfidence prediction with limited information • Overreaction and underreaction to new information due to prior beliefs
– Overreact to supporting information – Underreact to conflicting information

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Behavioral Arguments
• No one behaves the way as stated by theory
– Investors do not hold some combination of riskfree securities and the optimal risky portfolio – Investors do not measure a security’s risk in terms of its contribution to the risk of a diversified portfolio – Investors do not forgo active management

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Conclusion for Behavioral Argument
• If investors do not behave as if the market is efficient  market inefficient • If investors are right  market inefficient • Back to catch-22 of efficient markets
– If market is efficient  passive management – Investor becomes passive market prices no longer reflect available information

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The Verdict
• Active management must exist and do add value
– – – – Theoretical inconsistencies Empirical evidence Behavioral analysis Catch-22 of efficient markets

• Non-existence of pure passive management
– Selection of benchmark is an active decision

• Formation of expectations and how it impact market prices • Active manager who can minimize behavioral biases and develop more realistic expectations and probability assessments can and will add value
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HEDGE FUNDS

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Introduction
• Hedge fund is first originated by Alfred Winslow Jones in 1949
– Long and short positioning
• To protect the portfolio from market risk

– Financial leverage
• To enhance the returns of the portfolio

• Since then,
– Highly performed, increased in the number of hedge funds – Industry does faced several setbacks
• Meltdown of Long Term Capital Management (LTCM) in 1998
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What is a Hedge Fund?
• A privately organized, pooled investment vehicle • Investing primarily in securities and derivatives • Also invest in private investments such as venture capital funds and real estate funds • Using long / short positions and leverage

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Characteristics
• Limited partnerships or limited liability companies • Often domiciled offshore for tax and regulatory reasons • Open to a limited number of accredited & super accredited investors
– New developments in 2005: as little as $25,000, such investors can also invest in hedge funds

• Not more than 25% of the funds may be contributed by ERISA plans • Measure by absolute returns
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Characteristics
• High management fees
– 1% or 2% of assets under management – 20% cumulative profits (performance fees)

• Fund managers are usually partners in their funds
– Invest huge part of their personal wealth in their own funds – Reduce the effects of unifying the interests of the managers with the rest of the investors

• Advance notice for redemption
– From one month to three years – Limit the impact of fund redemptions on investment strategy
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Growth trends

From 1987 to 2005: • Number of hedge funds had increased by 80 times • Amount of funds invested had increased by 46 times
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What are the forces behind the growth?
• High net-worth segment has grown rapidly
– Customer base of hedge funds increase

• Developments of the financial markets
– Eg. Derivatives, mergers and acqusitions

• Fund managers
– Invest huge part of their personal wealth in their own funds – Good reputation

• Attractive returns • Low correlation with traditional funds
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Hedge Fund Strategies and Segmentation
• • • • • Shorting Leverage Concentration Derivatives Efficient execution

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Hedge Fund Strategies: Shorting
Hedge funds regularly use both long and short position • Offset the systematic market risk common to long positions
- profit primarily from selection of securities and not from broad market risk or timing their market exposure - reduce broad market risk → reduce overall risk of the portfolio → return from security selection large relative to total portfolio risk → lever portfolio → increasing expected return relative to total capital

• Doubles opportunity to profit from security selection
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Hedge Fund Strategies: Leverage
Hedge Funds use leverage to increase return on their capital • Several ways of leveraging
- Margin loans - Derivative positions - Unsecured bank loans

• Different models of leverage use
- Jones Model - Market Neutral - Directional Extreme - Levered Extreme
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Hedge Fund Strategies: Leverage

Models of Leverage Usage
1500%

1000%

500%

0%

-500%

-1000%

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-1500%

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Hedge Fund Strategies: Concentration
Hedge Funds usually hold portfolios that are significantly more concentrated than traditionally managed funds • Hedge fund managers typically seek to focus their bets on a smaller number of investment opportunities in which they have a high degree of certainty → high risk but also higher expected return (only when views are accurate) • Traditional managers use diversification as a way to reduce risk.

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Hedge Fund Strategies: Derivatives
• Extensive use of derivative instruments
- Options - Futures and forwards - Swaps, convertible bonds etc

• Derivatives used as an alternative source of leverage and as an alternative method for taking short positions • Derivative also used to express a view more precisely
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Hedge Fund Strategies: Efficient Execution
Hedge Funds managers focus their attention on trading as efficiently as possible • Often hedge funds trade large gross positions to capture relatively small profit opportunities • Aware of negative impact of transaction costs on fund performance

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Hedge Fund Segmentation
Probably as many hedge fund “styles” as hedge funds. Yet, some typical segments are as follows: • Fundamental long/short funds • Quantitative long/short funds • Arbitrage/relative value funds • Macro funds • Funds of funds

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Hedge Fund Segmentation: Fundamental long/short funds
Trade securities that seem mispriced based on the analysis of business prospects for the firm • Similar to traditional asset management, except that they extensively use leverage and short positions • Managers often specialize in some industry or asset class • Leverage position generally between slightly short to 100% long

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Hedge Fund Segmentation: Quantitative long/short funds
Apply statistical analysis to historical data to identify profitable trading opportunities • Entails hypothesizing the existence of a particular type of systematic opportunity for unusual returns and then backtesting • Once a successful strategy is identified, it is normally implemented relatively mechanically • Closely related to works published by finance academics • High degree of leverage is used and therefore risk control is crucial • These funds are the most likely to be market neutral

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Hedge Fund Segmentation: Arbitrage/relative value funds
Seek to identify expected return differentials (mispricings) between closely related securities where these mispricings are not attributable to the business prospects of the issuers of the securities • Eg: merger arbitrage, convertible bond arbitrage • Expected returns are small compared to the value of the securities involved • Among the most aggressive users of leverage

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Hedge Fund Segmentation: Macro funds
Take positions based on their view of global macroeconomic events • Use futures and forwards to bet on currencies, bond markets or equity markets of whole countries • Because of the relatively low degree of correlation between the currencies and indexes in which they trade, macro funds are unable to exercise strict risk control. Therefore they typically use less leverage than other hedge funds • Most macro funds are hybrid funds • They generally have the largest capital and are most widely known in the financial community

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Hedge Fund Segmentation: Funds of funds They gather investor assets and invest them in other hedge funds • Seek to add value by choosing hedge funds that will be successful in the future • Diversify by investing in divergent types of funds • Among the lowest risk hedge funds
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PERFORMANCE

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Rapidly growing community

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Hedge Funds success in the 90s

• Exhaustive and completely reliable data do not exist. • Private organizations gather and sell data on hedge funds
– TASS Management – Van Hedge Fund Advisors – Financial Risk management Ltd

• Imperfect data still concludes hedge funds a success in the 90s
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Quality of the Data

Definition of the universe • Distinctions are often blurred
– Leverage or short-selling – Managed future funds – Trade futures on commodities, securities and indexes

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Quality of the Data

Completeness of the universe • Not all funds can be captured • New funds are added frequently • Vendors aware of them only through WOM • Based mainly on estimation • Numbers have to be grossed up (2.7 – 3) • After discussion with other vendors
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Quality of the Data

Participation is purely voluntary • Certain funds choose not to participate
– Poor performance – Excellent performance and no need for new investments

• Cause discrepancies in actual figures • Funds are dropped when they go out of existence (overstate) • Unsure if new bias is upward or downward
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Quality of the Data

Accuracy of report • Not regulated questionable • Hedge funds trade in illiquid securities
– Accurate marks difficult to obtain – Especially so during market stress

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Should we trust these data?

• Imperfections always exist • Sufficient quality is present • Data confirm our conclusions

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Risk/Return Performance of hedge funds as a class

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Which hedge funds to choose?
– Highest return

• Macro Funds • Funds of funds
– Lowest risk – Lowest return (Surprising result)

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Risk/Return Performance of Average hedge funds over time

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Efficient frontier with and without hedge funds

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Why include Hedge Funds
• Risk and return slightly lower when using S&P 500 as benchmark • Lower risk and higher return for all other benchmarks except for the bond index • Offers low correlations with all other asset class, including S&P 500 • Inclusion of hedge funds increases portfolio return by as much as 200 basis points • Same Return + low correlation = Powerful combination  able to lower risk significantly for the same return

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Correlation of hedge funds and major benchmarks

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Performance of hedge funds during down quarters of S&P 500

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Why include Hedge Funds

• Tend to outperform market during periods of poor market performance • However, some funds of suffered severe financial distress
– Too much leverage (risk relative to capital) – Grossly underestimate extreme moves in values – Deviate from core competence

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Conclusion
• Hedge funds strategies constitute reasonable approaches to profiting in modern capital markets • Risks exist, technology to manage the risks also exist • Historically, hedge funds performance has been very attractive • Diversification tool

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Future outlook
• Expected to grow rapidly • Estimation by Greenwich Alternative Investment House
– Global hedge funds expected to hit US$2 Trillion by 2009 and US$4 Trillion by 2013

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