Lecture 1 (pre videos)
• Key questions in understanding hedge funds:
o How do hedge fund differ from mutual fund?
o Hod does the HF industry look like?
o What strategies do HF follow?
o Do hedge funds outperform? If so, why?
• What are HF?
• HF do not care about performance against a benchmark
• Let’s compare HF and mutual fund:
• Risk exposure of HF is very complex, HF strategies have limited capacity because they try to
exploit arbitrage opportunity, HF fees tend to be very large (research cost, manager cost
since they are active funds)
• Funds of Funds = a HF that invest in other HF
o The number of HF has been growing steadily until 2007-2008 and after there has been a
recovery
o FoF have been decreasing due to double layer of fees
• Mutual fund industry is the largest industry among HF and ETF
• Who invests in HF?
o Major shift during the years
,• Pension plans in US:
o 40 % both in equity and debt
o 5% in HF à PF have a lot of money which flows into HF
• Why do they invest in HF?
o Alpha generation
o Portfolio diversification à important for pension funds which invest in HF
• How do they choose which HF to invest in?
o Past returns
o Strategies
o Liquidity profile
o Risk profile
o Management background
• Concerns about HF:
o Crowding à the funds follow similar strategies (herding) à it can increase risk (a lot of HF
exits position and the price of the assets decreases)
o Lack of liquidity, transparency
o Macroeconomic issues
• Key challenges for HF:
o Poor performance in recent years
o Challenging fundraising
o Tightening of financial regulations
• Hedge Funds fees and performance
• Fee structure of HF has 2 components:
o Management fee (based on the size of the fund)
,o Incentive fee depends on fund performance
o If a fund value is below the hurdle rate à incentive fee is zero, so the manager is taking
more risk
o High water mark à if a firm experience loss, the incentive fee is paid only when the fund
makes up for these losses
EXAMPLE OF FUND OF FUNDS FEE:
o If the gross rate of return is lower than the hurdle rate à there won’t be any incentive fee
, o FoF pays still the incentive fee to the manager of fund 1 and 2 because they did good during
the year (see above)
• Sharpe ratio = measure of risk adjusted performance à compensation per unit of risk
o Sharpe ratio could not be the best way to understand HF performance à HF returns do not
follow a normal distribution
• Correlations tend to increase during recession periods for HF à worst period to have high
correlations
o Diversification of HF may be lower as expected, especially in recession periods
• Downward trend of alphas (excess returns), due to:
o Anomalies are smaller
o Tightening of regulations after 2008
o Increase in AUM mean that managers are satisfied just with the management fee
• Diversification benefits of HF have decreased over time à but for a lot of pension funds
their first reason to invest in HF is diversification
• After 2008, HF index underperformed the S&P 500, for all the strategies they perform
• Why do HF underperform?
o Too many HF
o Low interest rate environment
o Central bank monetary policy
• During the last years there have been more than 10% liquidations of HF à the total
number of HF has been very stable during the last 10 years which could imply a mature
market
• Hedge Funds strategies
• Alpha = measures abnormal return relative to a benchmark
Hedge fund strategies, a summary:
• Non directional = exploit mispricing
• Key questions in understanding hedge funds:
o How do hedge fund differ from mutual fund?
o Hod does the HF industry look like?
o What strategies do HF follow?
o Do hedge funds outperform? If so, why?
• What are HF?
• HF do not care about performance against a benchmark
• Let’s compare HF and mutual fund:
• Risk exposure of HF is very complex, HF strategies have limited capacity because they try to
exploit arbitrage opportunity, HF fees tend to be very large (research cost, manager cost
since they are active funds)
• Funds of Funds = a HF that invest in other HF
o The number of HF has been growing steadily until 2007-2008 and after there has been a
recovery
o FoF have been decreasing due to double layer of fees
• Mutual fund industry is the largest industry among HF and ETF
• Who invests in HF?
o Major shift during the years
,• Pension plans in US:
o 40 % both in equity and debt
o 5% in HF à PF have a lot of money which flows into HF
• Why do they invest in HF?
o Alpha generation
o Portfolio diversification à important for pension funds which invest in HF
• How do they choose which HF to invest in?
o Past returns
o Strategies
o Liquidity profile
o Risk profile
o Management background
• Concerns about HF:
o Crowding à the funds follow similar strategies (herding) à it can increase risk (a lot of HF
exits position and the price of the assets decreases)
o Lack of liquidity, transparency
o Macroeconomic issues
• Key challenges for HF:
o Poor performance in recent years
o Challenging fundraising
o Tightening of financial regulations
• Hedge Funds fees and performance
• Fee structure of HF has 2 components:
o Management fee (based on the size of the fund)
,o Incentive fee depends on fund performance
o If a fund value is below the hurdle rate à incentive fee is zero, so the manager is taking
more risk
o High water mark à if a firm experience loss, the incentive fee is paid only when the fund
makes up for these losses
EXAMPLE OF FUND OF FUNDS FEE:
o If the gross rate of return is lower than the hurdle rate à there won’t be any incentive fee
, o FoF pays still the incentive fee to the manager of fund 1 and 2 because they did good during
the year (see above)
• Sharpe ratio = measure of risk adjusted performance à compensation per unit of risk
o Sharpe ratio could not be the best way to understand HF performance à HF returns do not
follow a normal distribution
• Correlations tend to increase during recession periods for HF à worst period to have high
correlations
o Diversification of HF may be lower as expected, especially in recession periods
• Downward trend of alphas (excess returns), due to:
o Anomalies are smaller
o Tightening of regulations after 2008
o Increase in AUM mean that managers are satisfied just with the management fee
• Diversification benefits of HF have decreased over time à but for a lot of pension funds
their first reason to invest in HF is diversification
• After 2008, HF index underperformed the S&P 500, for all the strategies they perform
• Why do HF underperform?
o Too many HF
o Low interest rate environment
o Central bank monetary policy
• During the last years there have been more than 10% liquidations of HF à the total
number of HF has been very stable during the last 10 years which could imply a mature
market
• Hedge Funds strategies
• Alpha = measures abnormal return relative to a benchmark
Hedge fund strategies, a summary:
• Non directional = exploit mispricing
