Hedge Fund Fundamentals

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 Hedge Fund Overview

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 What Is a Hedge Fund

Although hedge funds are difficult to define, here are some common characteristics:

Actively Managed Unregulated Limited Investors

• Aiming for profitability • Limited regulation • Can only target

regardless of market • Limited transparency accredited investors
circumstances (remains discreet) • Target a limited
• Collect management • Can’t market number of primarily
and incentive themselves institutional investors
(performance) fees (restrictions on ads /
websites)

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 What Is a Hedge Fund

Although hedge funds are difficult to define, here are some common characteristics:

Structure Features

• Hedge fund managers are normally • Defined by strategy (ex. long/short)

investment partners (sharing • Often highly leveraged (sometimes
upside/downside risk) called leveraged accounts)
• This is unconventional for asset • Limited liquidity (initial lock-up
management firms periods)

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 Hedge Funds vs. Traditional Funds

Hedge Fund Mutual Fund

Regulation Minimal Extensive

Remuneration Incentive Assets under management

Leverage High Low

Objective Absolute returns Outperform a benchmark

Market Exposure Long or short Long

Correlation With Low High
Traditional Markets

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 Timeline

Alfred Jones started the first modern day hedge fund in 1949. Many of the features of his fund are core
elements of most hedge funds today.

1923 Graduates from Harvard

• Purser on a steamer
1920s & 1930s • Diplomat to Germany
• Journalist covering Spanish civil war

1941 Ph.D. in sociology from Columbia

1940s Worked for Fortune Magazine

1949 Starts an investment fund

Fortune reporter Carol J. Loomis publishes “The

1966 Jones Nobody Keeps Up With” - first to use term
“hedge fund”

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 Alfred Jones’ Fund

How did he attract investors?

He invested personal wealth He invested $40,000 of his own money, as he believed it was
unfair to receive fees for only risking his partners’ capital.

The fund was a limited partnership The fund was limited to 99 investors and structured as a limited
partnership to avoid regulations.

He only charged performance fees He didn’t charge a management fee. Instead, 20% of profits were
charged as a performance/incentive fee.

He used leverage and short selling He used leverage to buy more shares and used short selling to
manage (hedge) stock market movements.

Jones’s Wealth $40,000

Other Investors $60,000

Fund’s Capital $100,000

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 Alfred Jones’ Fund Performance

How well did Jones’ fund perform?

First Year Return: 17.3%

5-Year Return Outperformed the best mutual fund by

to 1966 44% despite its 20% performance fee.

10-Year Return Outperformed the top performing Dreyfus

to 1966 Fund by 87%.

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 Leverage

Leverage can take several forms, such as borrowing external funds or using financial instruments such
as derivatives.
Doing so allows investors/funds to establish positions by posting margins rather than the full face value of
the position.

Cash Lender

Collateral Cash

Cash
Market
Hedge Fund
(Seller)
Security

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 Leverage Effect on Profits & Losses

House prices House prices

rise by 10%: fall by 10%:
$500,000 $550,000 $450,000

Mr. No Leverage
Mortgage $0k Mortgage $0k Mortgage $0k
Equity $500k Equity $550k Equity $450k

10% return -10% return

$500,000 $550,000 $450,000

Mr. Leverage
Mortgage $475k Mortgage $475k Mortgage $475k
Equity $25k Equity $75k Equity ($25k)

200% return -200% return

This is a directional bet on the housing market.

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 Hedge Fund Strategy Styles

Strategy Styles

Equity Fixed Income Equity / Fixed

Other
Related Related Income Hybrid

Equity Long / Fixed Income Convertible

Global Macro
Short Arbitrage Arbitrage

Capital Structure
Dedicated Short Distressed Debt
Arbitrage

Equity Market
Neutral

Merger (Risk)
Arbitrage

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 Hedge Fund Structures

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 The Fund and the Fund Manager

The fund and the fund manager are separate entities.

Fund Management Company

• Owned by principals
Fund • Employs fund managers and other staff
• Owned by investors • Earns management and performance fees
• Owns assets • Risk management
• Marketing
• Administration

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 Typical Corporate Structure

Dividends

Corporation Investors

Tax on Tax on
Earnings Dividends

Double Taxation

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 Typical Hedge Fund Structure

Hedge funds are often structured as flow-through (pass-through) entities.

Gains

Hedge Fund Limited Partners

(Investors)

No Tax on Tax on
Earnings Gains

Single Taxation

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 The Bigger Picture

Hedge Fund Mgmt. Company.

General Partner
Prime Broker
(Operational)

Hedge Fund
(Limited Partnership)

Limited Partners (Investors) Executing Broker

Legal Advisors, Accountants,

Auditors

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 Main Types of Limited Partners (LPs) / Investors

Public & Private Pension Endowments, Charities Banks & Insurance

Plans & Foundations Companies

Sovereign Wealth Asset Managers Family Offices

Funds

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 General Partner (GP)

The general partner (GP) is responsible for fund operations:

• Essentially they are a fund investor with additional responsibilities

• They select the fund manager, prime broker, legal advisors, etc.
• Collect fees and pay these to the fund manager
• Pay any necessary expenses (primarily operating expenses)
• The general partner in a limited liability partnership structure has
unlimited liability
• The general partner typically receives the performance or
incentive fee

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 Hedge Fund Management Company

The general partner typically delegates operational management

decisions to a hedge fund management company.
Principal Owners

• Typically hedge fund management companies are called

“[Name] Capital Management Ltd.”
• The hedge fund management company will provide:
General Partner Hedge Fund
o Portfolio management services (Operational) Mgmt. Company.

o Investment fund management

Investment
o Investment advisory Mgmt. Services Mgmt.
Agreement Fee
• Receives a management fee of between 1% and 3%

Hedge Fund
(Limited Partnership)

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 Hedge Fund Managers

Fund managers typically have a background in capital markets. Some careers that fund managers start in
include:
• Investment banking

• Sales & trading (fixed income, equity, commodities, foreign exchange)

• Buy-side asset management firms (e.g., pension funds, mutual fund managers, etc.)
• Alternative investment firms (e.g., other hedge funds, etc.)

• Private equity
• Venture capital

The background of fund managers will vary depending on the strategy of the fund.

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 Prime Broker / Prime Services

Hedge fund management companies are typically made up of small teams and outsource many traditional
middle and back-office trading functions to banks that offer prime brokerage (aka prime services).

Prime services include:

Trade execution, clearing and settlement services

Financing of trading activities

Custodian services

Securities lending

Real-time P&L reporting (realized and unrealized)

Risk management reporting (e.g., VaR)

Introductions to potential hedge fund investors

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 Executing Broker

An executing broker, in contrast, is hired by the hedge fund to process buy and sell orders on behalf of
the hedge fund. The executing broker can be the same firm as the prime broker.

There are sometimes advantages to having separate executing and prime brokers:

Portfolio Executing Prime Broker Prime Broker

Manager Broker Clearing Settlement

Checking details
PM initiates trade Buy or sell order is and ensuring funds Settlement involves
by entering into executed in market and securities are the exchange of
system by executing broker available and cash for securities
sufficient

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 Offshore Stand-Alone Funds

Offshore Corporations
Offshore
Shareholders
Corporation
• Hedge funds outside the US are generally structured as offshore (Investors)
(Fund)
open-ended companies.

• Are taxable entities - but typically operate in tax-free jurisdictions.

• Attractive to non-US residents, as they are subject to US Portfolio

withholding taxes if investing in US domiciled entities. Investments
Advisor
• Attractive to US tax-exempt entities such as foundations and
charitable trusts, as they are subject to tax if they invest in domestic
limited partnerships.

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 Mirror Funds

Onshore US US Tax-Exempt
US Taxable Offshore
Limited & Non-US
Investors Corporation
Partnership Investors

Investments

Mirror funds are also called clone funds, parallel funds, and side-by-side structures.

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 Funds of Hedge Funds

Investors

Fund of Funds

• Said to represent between 30 and 50 percent of assets

Fund of Funds
under management in the hedge fund universe.

• Investors buy a proportionate share of ownership in a

collective portfolio of typically 30 to 60 hedge funds. Hedge Hedge Hedge Hedge Hedge
Fund Fund Fund Fund Fund
• Offers investors affordability, accessibility, and risk
diversification.
Investment Investment Investment
• Funds of funds charge fees on top of the fees of the
Investment Investment
underlying fund managers (typically set at one and 10).

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 Fund Mechanics – Limited Partner’s Interest Example 1

If the fund value increases by $100 million (excluding management/performance fees), the value of each
investor’s share increases.

% of Fund $ Value $ Value

General Partner 15% $75m +$15m $90m

Investor A 10% $50m +$10m $60m

Investor B 5% $25m +$5m $30m

Limited Partners Investor C 25% $125m +$25m $150m

Investor D 20% $100m +$20m $120m

Investor E 25% $125m +$25m $150m

Total Fund Capital 100% $500m +$100m $600m

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 Fund Mechanics – Limited Partner’s Interest Example 2

After the fund increases from $500 million to $600 million, Investor A decides to withdraw their 10%
stake. The 10% stake is then allocated to the remaining investors in the fund.

$ Value $ Value % of Fund % of Fund

General Partner $90m $90m 15% +1.67% 16.67%

Investor A $60m -$60m $0m 10% -10% 0%

Investor B $30m $30m 5% +0.56% 5.56%

Investor C $150m $150m 25% +2.78% 27.78%

Investor D $120m $120m 20% +2.22% 22.22%

Investor E $150m $150m 25% +2.78% 27.78%

Total Fund Capital $600m -$60m $540m 100% 100%

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 Redemption and Liquidity

Hedge funds may incorporate restrictions on when investors can make withdrawals or redemptions
from the fund.

01 Lock-up periods

02 Notice periods

03 Redemption schedules and restriction on

redemptions (e.g. 20% per year)

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 Investment Restrictions

Some examples of restrictions:

Leverage Restrictions: Example – a fund’s short positions may not exceed 125% of its Net Asset Value (NAV).

Illiquid Securities: Example – a fund may be restricted from buying and selling illiquid securities such as
private equity.

Cash: Example – a fund may be required to hold a certain amount of cash at all times.

Concentration – Long / Short Example – a fund may not invest more than 30% of the NAV in a single long or
Positions: short position.

Securities Lending: Example – a fund may be restricted from various types of securities lending.

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 Hedge Fund Fees

While traditional fund managers only charge a management fee, hedge fund managers charge both
management and performance fees (paid monthly, quarterly, or annually).

Management Fees Performance Fees

• Typically 1-3% • Typically 15-25%

• Paid to the management • Paid to the general partner
company • Often called an incentive fee
• Covers operating expenses • Subject to a high-water mark
(salaries, rent, computers, etc.) and/or a hurdle rate
• Typically based on opening net • Based on net profits (net change
asset value in NAV) above high-water mark

Most common structure is a 2% management fee and 20% incentive fee (“2 and 20” or “2/20”)

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 General Partner vs. Management Company

Principal Owners

General Partner Hedge Fund

(Operational) Mgmt. Company.

Performance Mgmt.
Fee (~20%) Fee (~2%)

Hedge Fund
(Limited Partnership)

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 Management Fee Example

Management fees are typically paid monthly but can be paid quarterly or annually. All numbers are in
millions.

Open NAV Mgmt. Fee

Dec $500.000
Management Fee
Jan $525.000 0.875 = $525m x 2%/12 = $0.875m
Feb $535.000 0.892

Mar $560.000 0.933

Apr $535.000 0.892

May $530.000 0.883

Jun $540.000 0.900

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 Performance Fees – High-Water Marks

Performance fees are only paid out if performance of the fund exceeds a high-water mark and/or a
hurdle rate.

Performance Fees

High-Water Mark Hurdle Rate

• A clause which states that any previous losses

must be recouped by new profits before
charging a performance fee.

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 High-Water Mark in More Detail

• Q1: fund $100m -> $110m (performance

fee on $10m gain).
High-Water Mark
> New high-water mark: $110m 130 New High-
Water Mark
Performance
fee on gain 125
120
• Q2: fund $110m -> $90m (no performance
fee – below high-water mark)
Performance High-Water Mark
110 fee on gain
110
• Q3: fund $90m -> $105m (no performance 105
100
fee – below high-water mark) No performance
100
fee
90
• Q4: fund $105m -> $125m (performance 90
fee on the $15m gain above the high-water No performance
80 fee
mark)
> New high-water mark: $125m
70
Initial Q1 Q2 Q3 Q4

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 Performance Fee With High-Water Mark

All numbers are in millions, and we will assume a performance fee of 20%.

Open NAV Mgmt. Fee NAV (*AM) Net Gain Perf. Fee Close NAV HWM

Dec $500.000

Jan $525.000 0.875 $524.125 $24.125 $4.825 $519.300 $519.300

Feb $535.000 0.892 $534.108 $14.808 $2.962 $531.147 $531.147

Mar $560.000 0.933 $559.067 $27.920 $5.584 $553.483 $553.483

Apr $535.000 0.892 $534.108 -$19.374 $- $534.108 $553.483

May $530.000 0.883 $529.117 -$24.366 $- $529.117 $553.483

Jun $540.000 0.900 $539.100 -$14.383 $- $539.100 $553.483

Net gain Performance Fee

= $534.108 – HWM $519.300 = $14.808m = $14.808 x 20% = $2.962m
*AM: After management fee
Note: There may be slight differences due to rounding.

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 Performance Fees – Hurdle Rates

Performance fees are only paid out if performance of the fund exceeds a high-water mark and/or a
hurdle rate.
Performance Fees

High-Water Mark Hurdle Rate

• A clause which states that any previous losses • The minimum performance required before
must be recouped by new profits before charging a performance fee (can be a
charging a performance fee. percentage or related to an index as a
benchmark).
• Example: if the hurdle rate is 4%, and the fund
achieves a return of 10% for the period, the
performance fee is charged on the additional
6% (10%-4%).

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 Performance Fee With High-Water Mark & Hurdle Rate

All numbers are in millions, and we will assume a hurdle rate of 4% and a performance fee of 20%.

NAV Mgmt. Fee NAV (*AM) Net Gain Hurd. Rate Perf. Fee Close NAV HWM

Dec (closing) $500.000

Jan $525.000 0.875 $524.125 $24.125 $1.667 $4.492 $519.633 $519.633

Feb $535.000 0.892 $534.108 $14.475 $1.732 $2.549 $531.560 $531.560

Mar $560.000 0.933 $559.067 $27.507 $1.772 $5.147 $553.920 $553.920

Apr $535.000 0.892 $534.108 -$19.811 $1.846 $- $534.108 $553.920

May $530.000 0.883 $529.117 -$24.803 $1.780 $- $529.117 $553.920

Jun $540.000 0.900 $539.100 -$14.820 $1.764 $- $539.100 $553.920

Hurdle Rate Calculation Performance Fee

= $500m x 4%/12 = $1.667m = ($24.125m - $1.667m) x 20% = $4.492m

*AM: After management fee

Note: There may be slight differences due to rounding.

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 Hedge Fund Fees Question

• In year 1, the fund increases from $150m to $200m (gross asset value).
• In year 2, after fees are paid, the fund value increases from $188.75m to $205m (gross asset value).
• 3 and 15 structure, with a hurdle rate of 6%
• High-water mark clause
% of Fund

Questions: General Partner 15%

1) What are the management and performance fees for year 1? Investor A 10%
2) What are the management and performance fees for year 2? Investor B 20%
3) What are the new limited partner interest and investment values? Investor C 10%

Investor D 25%

Investor E 15%
Total Fund Capital 100%

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 Hedge Fund Fees Answer 1

What are the management and incentive fees for year 1?

Management Fee
= 3% x $200m = $6m

Fund Value
Beginning Ending Fund Value (after mgmt. fees)
-$6m
Total Fund Capital $150m $200m $200m $194m

Incentive Fee
= 15% x [$200m – $150m – $6m – (6% x $150m)] = $5.25m -$5.25m

Incentive Ending – Mgmt. Hurdle Rate

% Beginning Fee x Beginning $188.75m

Fund Value
(NAV)

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 Hedge Fund Fees Answer 2

What are the management and incentive fees for year 2?

Management Fee
= 3% x $205m = $6.15m

Fund Value
Beginning Ending Fund Value (after mgmt. fees)
-$6.15m
Total Fund Capital $188.75m $205m $205m $198.85m

-$0m
Incentive Fee
(incentive
= 15% x [$205m – $188.75m – $6.15m – (6% x $188.75m)] = -$0.18375m
fees cannot
be negative)
Incentive Ending – Mgmt. Fee Hurdle Rate
% Beginning x Beginning $198.85m

Fund Value
This is $188.75m since the firm has a high-water mark
(NAV)
clause (the fund had its highest NAV at $188.75m).

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 Hedge Fund Fees Answer 3

What are the new limited partner interest and investment values?

% of Fund $ Value $ Value

15% x $198.85m
Hedge Fund, Inc. 15% $22.5m $29.828m
5% x $198.85m
Investor A 5% $7.5m $9.943m
20% x $198.85m
Investor B 20% $30m $39.770m
20% x $198.85m
Investor C 20% $30m $39.770m
25% x $198.85m
Investor D 25% $37.5m $49.713m
15% x $198.85m
Investor E 15% $22.5m $29.828m
Total Fund Capital 100% $150m $198.85m

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 Performance Measurement

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 Databases, Indices, and Benchmarks

Because hedge funds cannot advertise, being included in databases is very important in terms of visibility.

Some hedge fund databases and indices include:

Hedge Fund
Altvest Barclay Hedge Preqin
Research

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 Absolute Returns

Hedge fund managers aim to achieve the best possible absolute returns.

Value
Fund value

Absolute
performance

Initial value

Time

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 Sharpe Ratio

Devised by the Nobel Prize-winning economics professor, William Sharpe, the Sharpe ratio is the most
commonly used measure of risk-adjusted performance.

Sharpe Rp - Rf
=
Ratio σp

Rp = Average return on the portfolio

Rf = Return on a risk-free asset (e.g., treasuries)
σp = Standard deviation of the portfolio (a measure of risk)

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 Sharpe Ratio Example

Q Date ABC Fund Risk-Free Rate

20X1 4.30% 2.00%
20X2 9.50% 2.00%
What is the Sharpe ratio for ABC Fund?
20X3 7.80% 2.00%
20X4 9.40% 2.00%

Sharpe Rp - R f 20X5 2.80% 2.00%

=
Ratio σp 20X6 6.20% 2.00%
20X7 3.70% 2.00%
20X8 8.70% 2.00%
20X9 9.40% 2.00%
20X10 6.10% 2.00%
20X11 1.60% 2.00%
20X12 12.20% 2.00%
Total 81.70% 24.00%
Average 6.81% 2.00%

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 Sharpe Ratio Example Answer

A Date ABC Fund Risk-Free Rate

20X1 4.30% 2.00%
20X2 9.50% 2.00%
What is the Sharpe ratio for ABC Fund?
20X3 7.80% 2.00%
20X4 9.40% 2.00%

Sharpe Rp - R f 20X5 2.80% 2.00%

= σp
Ratio 20X6 6.20% 2.00%
20X7 3.70% 2.00%
20X8 8.70% 2.00%
Excess
= 6.81% - 2.00% 20X9 9.40% 2.00%
Return
20X10 6.10% 2.00%
20X11 1.60% 2.00%
Excess
= 4.81% 20X12 12.20% 2.00%
Return
Total 81.70% 24.00%
Average/Mean (x̄) 6.81% 2.00%

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 Sharpe Ratio Example Answer

A Date Rp - x̄ (Rp - x̄)2

20X1 -2.51 6.29
20X2 2.69 7.25
Sharpe 6.81% - 2.00%
= 20X3
Ratio σp 0.99 0.98
20X4 2.59 6.72
20X5 -4.01 16.07
114.33 20X6 -0.61 0.37
σp =
12 periods − 1 20X7 -3.11 9.66
20X8 1.89 3.58
20X9
σp = 3.22% 2.59 6.72
20X10 -0.71 0.50
20X11 -5.21 27.13
Sharpe 4.81% 20X12 5.39 29.07
= = 1.49
Ratio 3.22% Total 0.00 114.33

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 Sharpe Ratio Example Answer

Sharpe 4.81%
= = 1.49
Ratio 3.22%

For every 1% increase in volatility, the investor receives an additional 1.49% return.

Generally Accepted Sharpe Ratio Brackets:

Less than 1 Poor
1 - 1.99 Reasonable
2 - 2.99 Very good
More than 3 Excellent

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 Information Ratio

Most assets/portfolios are measured relative to a benchmark (hedge funds aren’t, as they’re measured
on an absolute basis, not relative basis).
The information ratio measures the performance of an asset/portfolio relative to a benchmark and
compares this with volatility.

Information Rp - Rb
=
Ratio Tracking Error

Rp = Average return on portfolio P

Rb = Return on a comparable benchmark (such as an index)
Tracking Error = Standard deviation of Rp - Rb

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 Information Ratio Example

Q Date ABC Fund Benchmark

20X1 4.30% 6.80%
20X2 9.50% 4.10%
What is the information ratio for ABC Fund?
20X3 7.80% 7.20%
20X4 9.40% 10.10%
Information Rp - Rb 20X5 2.80% 3.20%
=
Ratio Tracking Error 20X6 6.20% 3.10%
20X7 3.70% 1.20%
20X8 8.70% 9.00%
20X9 9.40% 7.50%
20X10 6.10% 2.00%
20X11 1.60% -1.00%
20X12 12.20% 10.50%
Total 81.70% 63.70%
Average 6.81% 5.31%

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 Information Ratio Example

A Date ABC Fund Benchmark

20X1 4.30% 6.80%
20X2 9.50% 4.10%
What is the information ratio for ABC Fund?
20X3 7.80% 7.20%
20X4 9.40% 10.10%
Information Rp - Rb 20X5 2.80% 3.20%
=
Ratio Tracking Error 20X6 6.20% 3.10%
20X7 3.70% 1.20%
20X8 8.70% 9.00%
Excess
6.81% - 5.31%
Return = 20X9 9.40% 7.50%
20X10 6.10% 2.00%
20X11 1.60% -1.00%
Excess
= 1.50% 20X12 12.20% 10.50%
Return
Total 81.70% 63.70%
Average 6.81% 5.31%

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 Information Ratio Example

A Date Excess Return Excess Return - x̄ (Rp - x̄)2

20X1 -2.50 -4.00 16.0
20X2 5.40 3.90 15.2
Information Rp - Rb 20X3 0.60 -0.90 0.81
=
Ratio Tracking Error
20X4 -0.70 -2.20 4.84
20X5 -0.40 -1.90 3.61
20X6 3.10 1.60 2.56
Tracking 55.44 20X7 2.50 1.00 1.00
=
Error 12 periods − 1 20X8 -0.30 -1.80 3.24
20X9 1.90 0.40 0.16
Tracking 20X10 4.10 2.60 6.76
= 2.24%
Error 20X11 2.60 1.10 1.21
20X12 1.70 0.20 0.04
Total 18.00 55.44
Information 1.50%
= = 0.67 Average/
Ratio 2.24% 1.50
Mean (x̄)

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 Which Fund – Sharpe Ratio Question

Assume the risk-free rate was constant at 3% over the 12-year period.

Fund A Fund B Fund C

20X1 4.10% 20X1 2.60% 20X1 6.30%
20X2 21.90% 20X2 16.40% 20X2 20.20%
20X3 10.60% 20X3 8.50% 20X3 11.70%
20X4 9.40% 20X4 10.10% 20X4 8.80%
20X5 3.60% 20X5 6.60% 20X5 5.20%
20X6 7.50% 20X6 5.50% 20X6 6.10%
20X7 3.20% 20X7 2.90% 20X7 4.90%
20X8 8.10% 20X8 7.10% 20X8 8.70%
20X9 2.70% 20X9 1.60% 20X9 3.40%
20X10 8.20% 20X10 5.70% 20X10 7.30%
20X11 2.00% 20X11 3.50% 20X11 3.50%
20X12 9.90% 20X12 7.20% 20X12 7.70%
Average 7.60% Average 6.48% Total 7.82%

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 Which Fund – Sharpe Ratio Answer

Assume the risk-free rate was constant at 3% over the 12-year period.

Fund A (Rp - x̄)2 Fund B (Rp - x̄)2 Fund C (Rp - x̄)2

20X1 4.10% 12.25 20X1 2.60% 15.02 20X1 6.3% 2.30
20X2 21.90% 204.49 20X2 16.40% 98.51 20X2 20.2% 153.35
20X3 10.60% 9.00 20X3 8.50% 4.10 20X3 11.7% 15.08
20X4 9.40% 3.24 20X4 10.10% 13.14 20X4 8.8% 0.97
20X5 3.60% 16.00 20X5 6.60% 0.02 20X5 5.2% 6.85
20X6 7.50% 0.01 20X6 5.50% 0.95 20X6 6.1% 2.95
20X7 3.20% 19.36 20X7 2.90% 12.78 20X7 4.9% 8.51
20X8 8.10% 0.25 20X8 7.10% 0.39 20X8 8.7% 0.78
20X9 2.70% 24.01 20X9 1.60% 23.77 20X9 3.4% 19.51
20X10 8.20% 0.36 20X10 5.70% 0.60 20X10 7.3% 0.27
20X11 2.00% 31.36 20X11 3.50% 8.85 20X11 3.5% 18.63
20X12 9.90% 5.29 20X12 7.20% 0.53 20X12 7.7% 0.01
Total 325.62 Total 178.64 Total 229.20

Corporate Finance Institute®

 Which Fund – Sharpe Ratio Answer

Assume the risk-free rate was constant at 3% over the 12-year duration.

Fund A Fund B Fund C

20X1 Q1 4.1% 0.17% 20X1 Q1 2.6% 0.07% 20X1 Q1 6.3% 0.40%
20X1 Q2 325.62
21.9% 4.80% 20X1 Q2 178.64 2.69%
16.4% 20X1 Q2 20.2%229.20
4.08%
σp = σp = σp =
20X1 Q3 12 − 11.12%
10.6% 20X1 Q3 12 − 1 0.72%
8.5% 20X1 Q3 11.7%12 − 1
1.37%
20X1 Q4 9.4% 0.88% 20X1 Q4 10.1% 1.02% 20X1 Q4 8.8% 0.77%
20X2
σp Q1= 5.44% 0.13%
3.6% 20X2
σp =Q1 6.6%
4.03% 0.44% 20X2
σp Q1
= 5.2%
4.56% 0.27%
20X2 Q2 7.5% 0.56% 20X2 Q2 5.5% 0.30% 20X2 Q2 6.1% 0.37%
20X2 Q3
Sharpe 3.2%7.6%0.10%
- 3% 20X2 Q3
Sharpe
6.48% 0.08%
2.9% - 3% 20X2 Q3
Sharpe 4.9%7.82%0.24%
- 3%
= 5.44% = 4.03% = 4.56%
Ratio
20X2 Q4 8.1% 0.66% Ratio
20X2 Q4 7.1% 0.50% Ratio
20X2 Q4 8.7% 0.76%
20X3 Q1 2.7% 0.07% 20X3 Q1 1.6% 0.03% 20X3 Q1 3.4% 0.12%
Sharpe Sharpe Sharpe
20X3 Q2 =
8.2% 0.85
0.67% 20X3 Q2 =5.7% 0.86
0.32% 20X3 Q2 =
7.3% 1.06
0.53%
Ratio Ratio Ratio
20X3 Q3 2.0% 0.04% 20X3 Q3 3.5% 0.12% 20X3 Q3 3.5% 0.12%
Rp (Rp - x̄)2 Rp (Rp - x̄)2 Rp (Rp - x̄)2
Total 7.60% 325.62 Total 6.48% 178.64 Total 7.82% 229.20

Corporate Finance Institute®

 Which Fund – Information Ratio Question

Date Fund D Benchmark Date Fund E Benchmark

20X1 4.30% 11.00% 20X1 4.50% 11.00%
20X2 9.50% 7.40% 20X2 9.70% 7.40%
20X3 7.80% 5.50% 20X3 5.80% 5.50%
20X4 9.40% 3.00% 20X4 4.50% 3.00%
20X5 2.80% 2.00% 20X5 2.80% 2.00%
20X6 6.20% 6.00% 20X6 6.20% 6.00%
20X7 3.70% 10.00% 20X7 9.80% 10.00%
20X8 8.70% 11.00% 20X8 10.50% 11.00%
20X9 9.40% 4.00% 20X9 5.50% 4.00%
20X10 6.10% 2.00% 20X10 3.20% 2.00%
20X11 1.60% -1.00% 20X11 0.50% -1.00%
20X12 12.20% 2.00% 20X12 4.00% 2.00%
Total 81.70% 62.90% Total 67.00% 62.90%
Average 6.81% 5.24% Average 5.58% 5.24%

Corporate Finance Institute®

 Which Fund – Information Ratio Answer

Fund D Fund E
20X1 4.3% 11.00% 20X1 4.50% 11.00%
Excess Excess
20X2 = 9.5% 6.81% - 5.24%
7.40% 20X2 = 9.70%5.58% - 5.24%
7.40%
Return Return
20X3 7.8% 5.50% 20X3 5.80% 5.50%
Excess Excess
20X4 = 9.4% 1.57%
3.00% 20X4 = 4.50% 3.00%
0.34%
Return Return
20X5 2.8% 2.00% 20X5 2.80% 2.00%
20X6 6.2% 6.00% 20X6 6.20% 6.00%
20X7 3.7% 10.00% 20X7 9.80% 10.00%
20X8 8.7% 11.00% 20X8 10.50% 11.00%
20X9 9.4% 4.00% 20X9 5.50% 4.00%
20X10 6.1% 2.00% 20X10 3.20% 2.00%
20X11 1.6% -1.00% 20X11 0.50% -1.00%
20X12 12.2% 2.00% 20X12 4.00% 2.00%
Rp Rb Rp Rb
Average 6.81% 5.24% Average 5.58% 5.24%

Corporate Finance Institute®

 Which Fund – Information Ratio Answer

Date Excess Return Excess Return - x̄ (Rp - x̄)2 Date Excess Return Excess Return - x̄ (Rp - x̄)2
20X1 -6.70 -8.27 68.34 20X1 -6.50 -6.84 46.81
20X2 2.10 0.53 0.28 20X2 2.30 1.96 3.84
20X3 2.30 0.73 0.54 20X3 0.30 -0.04 0.00
20X4 6.40 4.83 23.36 20X4 1.50 1.16 1.34
20X5 0.80 -0.77 0.59 20X5 0.80 0.46 0.21
20X6 0.20 -1.37 1.87 20X6 0.20 -0.14 0.02
20X7 -6.30 -7.87 61.88 20X7 -0.20 -0.54 0.29
20X8 -2.30 -3.87 14.95 20X8 -0.50 -0.84 0.71
20X9 5.40 3.83 14.69 20X9 1.50 1.16 1.34
20X10 4.10 2.53 6.42 20X10 1.20 0.86 0.74
20X11 2.60 1.03 1.07 20X11 1.50 1.16 1.34
20X12 10.20 8.63 74.53 20X12 2.00 1.66 2.75
Total 18.80 268.53 Total 4.10 59.39
Average/ Average/
1.57 0.34
Mean (x̄) Mean (x̄)

Corporate Finance Institute®

 Which Fund – Information Ratio Answer

Fund D Fund E
20X1 4.3% 11.00% 20X1 4.50% 11.00%
Excess Excess
20X2 = 9.5% 1.57%
7.40% 20X2 = 9.70% 0.34%
7.40%
Return Return
20X3 7.8% 5.50% 20X3 5.80% 5.50%
20X4 9.4% 3.00% 20X4 4.50% 3.00%
Tracking 268.53 Tracking 59.39
20X5 = 2.8% 2.00% 20X5 = 2.80% 2.00%
Error 12 periods − 1 Error 12 periods − 1
20X6 6.2% 6.00% 20X6 6.20% 6.00%
20X7 3.7% 10.00% 20X7 9.80% 10.00%
Tracking Tracking
20X8 = 8.7% 4.94% 11.00% 20X8 = 10.50% 2.32%11.00%
Error Error
20X9 9.4% 4.00% 20X9 5.50% 4.00%
20X10 6.1% 2.00% 20X10 3.20% 2.00%
Information 1.57% Information 0.34%
20X11 =
1.6% -1.00% 20X11 =
0.50% -1.00%
Ratio 4.94% Ratio 2.32%
20X12 12.2% 2.00% 20X12 4.00% 2.00%
Information Rp Rb Information Rp Rb
= 0.32 = 0.15
Ratio
Average 6.81% 5.24% Ratio
Average 5.58% 5.24%

Corporate Finance Institute®

 Directional Strategies

Corporate Finance Institute®

 Dedicated Short Strategies

Dedicated short hedge funds look exclusively for overvalued companies, borrow their shares, and sell
them short.

• Short sellers were once a significant hedge fund category but are now rare.

• Many of them have migrated to the long/short equity space where they
operate with a net short bias.

• Dedicated short strategies can be extremely risky, as the downside can be

significant.

Corporate Finance Institute®

 Short Selling Process

Borrow a stock
from stock lender
$

Sell stock for $100 100

80

Repurchase
stock for $80

Time
Return stock to Sell Buy
stock lender

Corporate Finance Institute®

 Covered vs. Naked Short

Covered Short Naked Short

If the stock has already been • Seller doesn’t own the stock they
borrowed or is known to be are selling
available at the time of sale • Seller has made no provision to
borrow the stock for delivery to
the purchaser by the settlement
date

Corporate Finance Institute®

 Short Selling Risks

Market The shorted stock rises rather than falls.

Borrowed securities can be recalled at any time by the

Recall lender. If the short seller is unable to find an alternate lender,
they will be forced to close their position.

Liquidity With less liquid securities, the short seller may be unable to
find securities to buy, making it difficult to close positions.

If the borrowed securities declare dividends, the borrower

Dividends will be required to pay the lender the dividend (if shorting
the stock before the ex-dividend date).

Corporate Finance Institute®

 Long/Short Strategies

Long/short strategies combine long and short positions in equities, which reduces market risk.

• Finds its roots in the original Alfred Winslow Jones model.

• Represents one of the largest segments within alternative investments.

• Long/short equity funds tend to have a long bias (where total long position value > total short position value).

• Sometimes referred to as an “equity hedge”.

• To reduce consequences of possible wrong stock selection, portfolios may contain more than 100 or 200 positions.

Long Short

Corporate Finance Institute®

 Pairs Trading – a Simple Long / Short Equity Strategy

A very simple form of a long short equity strategy is pairs trading.

1 Find stocks whose prices normally move together (i.e., they are highly correlated with each other).

2 Take a long/short position when their prices diverge sufficiently.

3 Hold the position until the two stock prices converge.

! Pairs trading is a mean-reverting strategy.

Corporate Finance Institute®

 Pairs Trading

Q How would this trade be initiated and closed?

Price

Stock B
Stock A

1 2 3 4 5 6 7 8 Time

Corporate Finance Institute®

 Pairs Trading

Q How would this trade be initiated and closed?

Short B
Long A
Price

Stock B
Stock A

1 2 3 4 5 6 7 8 Time

Corporate Finance Institute®

 The Long/Short Equity Mechanics

A manager believes stock A is undervalued and stock B is overvalued.

1 Manager deposits $1,000 with prime broker.

2 Manager buys $900 of stock A, leaving cash of $100. Stock A is held by the prime broker.

Manager short sells $800 worth of stock B and prime broker arranges to borrow stock B
3
from a large institutional investor to settle trade.

Prime broker freezes some collateral to secure transaction (e.g., $800 from short sale and
4
some of stock A) and charges a stock lending fee.

Corporate Finance Institute®

 Flows in Long/Short Investing

Hedge Fund

Hedge Fund Assets: $1,000

Stock A (long): $900 Stock B

Stock B (short): $800 $800
Cash: $900 ($100+$800) Prime Broker

Total: $2,600 Market

Stock B Collateral

Stock Lender

Corporate Finance Institute®

 Hedge Fund Returns Example

Q What if A goes up by 11% and B goes up by 9%?

A long position: 900 x 11% = $99

B short position: 800 x (9%) = $(72)
Net gain: = $27
Return: 27 / 1,000 = 2.7%

Q What if A goes up by 11% and B goes down by 9%?

A long position: 900 x 11% = $99

B short position: 800 x 9% = $72
Net gain: = $171
Return: 171 / 1,000 = 17.1%

Corporate Finance Institute®

 Walmart Inc. vs. Target Corporation Graph

Walmart Inc. vs. Target Corporation

160

Convergence
140

Divergence
Divergence
120
Share Price (in $ USD)

Convergence

100

Convergence
80

60

40
Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19 Mar-20 Jun-20

Target Data (NYSE: TGT) Walmart Data (NYSE: WMT)

Corporate Finance Institute®

 Real Long/Short Profit Question 1

A hedge fund manager identifies back in 2016 that Walmart Inc. and Target Corporation, two companies in the
same industry are positively correlated with each other.

Then in May 2017, the hedge fund manager notices the two stocks diverge. The hedge fund manager decides to enter
a pairs trade (or a “mean-reversion strategy”).

The hedge fund manager decides to take a short position in Walmart for $30 million and a long position in Target
for $30 million.

How much profit will they make if they enter the positions on May 1, 2017 and closes them on Jun. 1, 2018, assuming a
20bp stock lending fee?

May 1, 2017 Jun. 1, 2018 May 1, 2017 Jun. 1, 2018

Share Price: $55.77 $72.80 Share Price: $75.23 $82.99

Corporate Finance Institute®

 Real Long/Short Profit Answer 1

396 Days
May 1, 2017 Jun. 1, 2018 May 1, 2017 Jun. 1, 2018

+$17.03 +$7.76
Share Price: $55.77 $72.80 Share Price: $75.23 $82.99

$30 million ÷ $55.77 = ~537,924 shares $30 million ÷ $75.23 = ~398,777 shares

Target long position: 537,924 shares x $17.03 (share price increase) = $9,160,846
Walmart short position: 398,777 shares x -$7.76 (share price increase) = -$3,094,510
Stock lending fee: 0.20% x $30 million x (396/365 days) = -$65,096
Net gain: $6,001,240
Return: $6,001,240 ÷ $30 million = 20.0%

Corporate Finance Institute®

 Walmart Inc. vs. Target Corporation Graph

Walmart Inc. vs. Target Corporation

115

Close Both
105
Positions
Short Walmart
95
Long Target
Share Price (in $USD)

85

75

65

55

45
Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18

Target Data (NYSE: TGT) Walmart Data (NYSE: WMT)

Corporate Finance Institute®

 Real Long/Short Profit Question 2

A hedge fund manager decides to take a long position on Target for $40 million and a short position
on Walmart for $40 million (assuming no transaction costs).

How much profit will they make if they enter the positions on Feb. 1, 2019, and closes them on Dec. 2,
2019, assuming a 20 basis point stock lending fee?

Feb. 1, 2019 Dec. 2, 2019 Feb. 1, 2019 Dec. 2, 2019

Share Price: $71.17 $123.98 Share Price: $93.86 $119.28

Corporate Finance Institute®

 Real Long/Short Profit Answer 2

304 Days
Feb. 1, 2019 Dec. 2, 2019 Feb. 1, 2019 Dec. 2, 2019

+$52.81 +$25.42
Share Price: $71.17 $123.98 Share Price: $93.86 $119.28

$40 million ÷ $71.17 = ~562,035 shares $40 million ÷ $93.86 = ~426,167 shares

Target long position: 562,035 shares x $52.81 (share price increase) = $29,681,068
Walmart short position: 426,167 shares x -$25.42 (share price increase) = -$10,833,165
Stock lending fee: 0.20% x $40 million x (304/365 days) = -$66,630
Net gain: $18,781,273
Return: $18,781,273 ÷ $40 million = 46.95%

Corporate Finance Institute®

 Walmart Inc. vs. Target Corporation Graph

Walmart Inc. vs. Target Corporation

135
Close Both
Positions
125
Short Walmart
115 Long Target
Share Price (in $USD)

105

95

85

75

65

55

45
Nov-18 Dec-18 Jan-19 Feb-19 Mar-19 Apr-19 May-19 Jun-19 Jul-19 Aug-19 Sep-19 Oct-19 Nov-19 Dec-19

Target Data (NYSE: TGT) Walmart Data (NYSE: WMT)

Corporate Finance Institute®

Arbitrage Strategies
 Fixed Income Arbitrage Strategies

• There is a high level of leverage necessary to successfully implement these strategies.

• Long-Term Capital Management: established in 1993 and collapsed in 1998 due to unexpected price
changes.

• The fundamental tool in fixed income arbitrage is the term structure of interest rates (yield curve).

• Fixed income strategies rely heavily on mathematical and/or statistical valuation models.

Fixed Income Arbitrage Sub-Strategies

• Yield-curve arbitrage
• On-the-run vs. off-the-run Treasuries
• Treasuries stripping
• Carry trades

Corporate Finance Institute®

 Yield-Curve Arbitrage Example

If an investor predicts long-term yields will increase faster than

Q short-term yields, how would this trade be initiated and closed?

Current Yield Curve Predicted Yield Curve

Yield Yield
% %

Maturity Maturity

Corporate Finance Institute®

 Yield-Curve Arbitrage Example

If an investor predicts long-term yields will increase faster than

Q short-term yields, how would this trade be initiated and closed?

Recall that bond yields and prices are inversely correlated (as bond yields fall, bond prices increase).

Predicting a Reduction in Yield Buy (long) the bond (if yield decreases, price increases).

Predicting an Increase in Yield Sell (short) the bond (if yield increases, price decreases).

Corporate Finance Institute®

 Yield-Curve Arbitrage Example

If an investor predicts long-term yields will increase faster than

Q short-term yields, how would this trade be initiated and closed?

Current Yield Curve Predicted Yield Curve

Yield Yield
% %

Long short-dated bonds

Short long-dated bonds

X X
2.25% 2.75%
X
0.75% X
0.50%

Maturity Maturity

Corporate Finance Institute®

 Yield-Curve Arbitrage Example Answer

A Long short-dated bonds: 0.75%

-0.25%
0.50%

2.25% - 0.75% = 2.75% - 0.50% =

1.5% spread 2.25% spread
+0.50%
Short long-dated bonds: 2.25% 2.75%

Long short-dated bonds: gain of 25 basis points (we were betting on a price increase/yield decrease).

Short long-dated bonds: gain of 50 basis points (we were betting on a price decrease/yield increase).

If 1-year bond increased from 0.75% to 1%, and 10-year bond increased from 2.25% to 2.75%:

Spread increases from 1.5% to 1.75% (still positive net gain).

Corporate Finance Institute®

 Treasury Arbitrage Overview

• New Treasury bond issues are referred to as “on-the-run”, are the most liquid and frequently traded, and
are located on the yield curve.

• Older issues then move “off-the-run”, as they’re no longer on the yield curve.

• On-the-run bonds are priced slightly higher due to the enhanced liquidity; this results in a lower yield.

How to Execute the Strategy

• Requires a large capital investment since the return on each bond is marginal.

• Short the on-the-run issue (since we expect yield to increase, resulting in a price decrease).

• Long the off-the-run issue (since we expect yield to increase, resulting in a price increase).

Corporate Finance Institute®

 Treasury Arbitrage Example

Q How would this trade be initiated and closed?

Yield
Off-the-run (A)
% Liquidity
9 years, 11 months - 5.28% Premium
X
Active
X
On-the-run (B) Treasuries
10 year - 5.24%

Maturity

Corporate Finance Institute®

 Treasury Arbitrage Example

Q How would this trade be initiated and closed?

Yield
Off-the-run (A) Long off-the-run (A)
%
9 years, 11 months - 5.28% Short on-the-run (B)
X
Active
X
On-the-run (B) Treasuries
10 year - 5.24%

Maturity

Corporate Finance Institute®

 Treasury Arbitrage Example

Q How would this trade be initiated and closed?

Yield Off-the-run (A)

% 9 years, 10 months - 5.30% Off-the-run (B)
X 9 years, 11 months - 5.28%
X Active
X Treasuries
On-the-run (C)
10 year - 5.24%

Maturity

Corporate Finance Institute®

 Treasury Arbitrage Example Answer

A
New Issue Comes Out
Long off-the-run (A): 5.28% Off-the-run (A): 5.30% (0.02% increase)

New Issue Comes Out

Short on-the-run (B): 5.24% Off-the-run (B): 5.28% (0.04% increase)

Becomes off-the-run, as the new issue comes out

(only the newest issue is on-the-run).

Long off-the-run (A): loss of 0.02% (we were betting on a price increase/yield decrease).

Short on-the-run (B): profit of 0.04% (we were betting on a price decrease/yield increase).

The net gain is 0.02% (2bps) on the trade.

Corporate Finance Institute®

 Leverage in Arbitrage Trading

As mentioned earlier, leverage is essential to magnify the returns of the strategy (sometimes up to 30-
40x may be used).

• Since each strategy had a small profit, hedge funds will perform the strategies on a large scale
(through borrowing capital).

• The cash obtained from the short position can be used to fund the long position.

• Since both assets are closely related, collateral requests will be small.

Fund’s own capital Fund’s borrowed capital

Corporate Finance Institute®

 Event-Driven Strategies

Corporate Finance Institute®

 Global Macro Strategies

01 These strategies aim to identify economic and political drivers of specific national
macroeconomic trends that will impact a country’s currency and or interest rates at a future
date.

02 Global macro strategies may include long and short positions in a wide range of assets
including but not limited to fixed income, currency and futures.

03 Global macro managers often rely on fundamental analysis of economic forecasts, interest
rate and currency outlooks and fiscal and monetary policy.

Corporate Finance Institute®

 Real Global Macro Strategy Example

George Soros Quantum Fund

In 1992, the UK was a member of the Exchange Rate Mechanism (ERM: a predecessor of the Euro). The
UK had effectively pegged its currency to the Deutsche Mark.

George Soros bet the UK would come out of the ERM because:

• The pound was universally deemed to be overvalued.

• The UK was experiencing its worst recession since the Second World War and with unemployment greater than 10%.
• The UK was unable to lower interest rates for fear of breaching its ERM trading bands.
• The pound was already at the lower level of its fluctuation band.

Q What risks did George Soros take on?

Corporate Finance Institute®

 Real Global Macro Strategy Example

Even if the devaluation did not occur, the chances of seeing the pound strengthen
A
relatively to the Deutsche Mark or other major currencies were small.

Downside Risk for Soros

• The risk that the UK might impose capital controls or deal with
speculators for taking large short positions.

Corporate Finance Institute®

 Real Global Macro Strategy Example

$USD/GBP
2.00
~$2.00
1.95

1.90

1.85

1.80
~$1.78
1.75

1.70

1.65
~$1.55
1.60

1.55

1.50
May-92 Jun-92 Jul-92 Aug-92 Sep-92 Oct-92 Nov-92

Corporate Finance Institute®

 1992 ERM Crisis

Soros purportedly pocketed a $1 billion profit. Although his trades were not public, how could he
have made this profit?

1st Trade (Opening) Sell (£5.00Bn) At $2.00:£1.00 Buy $10.00Bn

2nd Trade (Closing) Buy £5.00Bn At $1.80:£1.00 Sell ($9.00Bn)

Profit £0.00Bn $1 Bn

Corporate Finance Institute®