Financial Modelling & Analytics
Week 1
Video #1: Introduction to Hedge Funds
Hedge Funds
Hedge funds are one of the prime users of the portfolio and risk management models discussed in this
course.
Hedge fund: A private investment pool, open to institutional or wealthy investors, that is largely exempt
from SEC regulation and can pursue more speculative investment policies than mutual funds
- Idea: sophisticated/wealthier investors need less protection – because they have more knowledge
and can absorb more financial losses
- Broad term that encompasses funds that follow very different strategies and have different risk
and return profile
- Hedge fund strategies focused on absolute returns
o Expected to do well in all market conditions
Hedge funds vs mutual funds
Hedge Funds Mutual Funds
Private investment vehicle SEC registered (in US)
May use extensive leverage Limited use of leverage
May engage in short selling Usually no short selling
May use derivatives Usually no derivatives
Large minimum investment Small minimum investment
Liquidity often low Daily redemption
Flexible strategies Limited strategy flexibility
Manager pay based on performance Manager paid salary and bonus
Manager invests own capital (align interests) Typically no own capital invested
Aim for absolute return Aim to outperform benchmark
Full spectrum investing
,Many hedge funds seek to exploit arbitrage opportunities and hence their capacity is limited as compared
to index funds, such as mutual funds and ETFs (exchange-traded funds). If the fund grows too big, it
cannot profit from those arbitrage opportunities (due to too much price impact). Hedge funds’ fees tend to
be high to cover transaction costs, management salaries and research costs.
The number of hedge funds has been growing steadily over time (especially til ’07, then dropped, but
continued to grow). The number of funds of funds (funds that invest in hedge funds) has witnessed a
decline in the recent years (since 2008). This is due to their poor performance, which is due to high fees.
Hedge funds have underperformed in the past years (high outflows)
,Assets under management have steadily grown in the past years (still much smaller than assets under
management of mutual funds, mutual fund industry is still much larger). In recent years, the performance
of hedge funds has declined. It is associated with the fact that markets have become more efficient (less
arbitrage) and the fact that there is more competition in the industry.
Biggest investors in Hedge funds 1999 vs 2019:
Investment portfolios of pension funds: pie chart shows the average asset allocation of US pension funds
Why do institutions invest in hedge funds?
- Portfolio diversification
o Mostly: pensions (!), banks, consultants, endowments & foundations (around 30%)
- Downside/tail risk protection
o Small percentage
- Alpha generation: generation of risk adjusted returns
o Biggest reason for most investors, especially insurance companies, fund of funds, banks
- Access to select/niche opportunities
, o Consultants, family offices
- Correlation benefits
o Small percentage, highest for pensions
Investor concerns about hedge funds:
- Crowding: a lot of funds are following very similar strategies and therefore are in similar
positions, assets might become overpriced (=lower returns). Crowding also might lead to an
increase in risk
- Style drift
- Lack of liquidity
- Lack of communication/transparency
- Macro-economic factors
Video #2 Hedge fund fees and performance
FEES: Management fee + incentive/performance fee
- Usually 2% of AUM (assets under management) + 20% of gains (2/20 scheme)
- Incentive fee can be modelled as call option (underlying: end of year fund value)
o Incentive fee should align the interests of managers and hedge fund investors
o However, this asymmetric payoff structure may lead to excessive risk taking by HF
manager
- High water mark
o If fund experiences losses, incentive fee is only paid when the fund makes up for these
losses -> creates incentive to shut down fund after poor performance and simply start new
fund
o May be the reason for a large number of funds
- Funds of funds:
o Hedge funds that invest in other hedge funds
o Little diversification if underlying HF follow similar strategies
o Usually 1% management fee and 10% incentive fee
o FoF pays incentive fee to each underlying HF (FoF – fee on fee) -> double fees
o Number of FoFs has dropped after 2008 due to high fees
Hedge fund fees: FoF example
- Investor may pay incentive fee even if aggregate FoF performance is poor
- Fund of Funds has $1 million invested in each of 3 hedge funds
- Assume hurdle rate and management fee are zero
- Each underlying fund charges 20% incentive fee
Week 1
Video #1: Introduction to Hedge Funds
Hedge Funds
Hedge funds are one of the prime users of the portfolio and risk management models discussed in this
course.
Hedge fund: A private investment pool, open to institutional or wealthy investors, that is largely exempt
from SEC regulation and can pursue more speculative investment policies than mutual funds
- Idea: sophisticated/wealthier investors need less protection – because they have more knowledge
and can absorb more financial losses
- Broad term that encompasses funds that follow very different strategies and have different risk
and return profile
- Hedge fund strategies focused on absolute returns
o Expected to do well in all market conditions
Hedge funds vs mutual funds
Hedge Funds Mutual Funds
Private investment vehicle SEC registered (in US)
May use extensive leverage Limited use of leverage
May engage in short selling Usually no short selling
May use derivatives Usually no derivatives
Large minimum investment Small minimum investment
Liquidity often low Daily redemption
Flexible strategies Limited strategy flexibility
Manager pay based on performance Manager paid salary and bonus
Manager invests own capital (align interests) Typically no own capital invested
Aim for absolute return Aim to outperform benchmark
Full spectrum investing
,Many hedge funds seek to exploit arbitrage opportunities and hence their capacity is limited as compared
to index funds, such as mutual funds and ETFs (exchange-traded funds). If the fund grows too big, it
cannot profit from those arbitrage opportunities (due to too much price impact). Hedge funds’ fees tend to
be high to cover transaction costs, management salaries and research costs.
The number of hedge funds has been growing steadily over time (especially til ’07, then dropped, but
continued to grow). The number of funds of funds (funds that invest in hedge funds) has witnessed a
decline in the recent years (since 2008). This is due to their poor performance, which is due to high fees.
Hedge funds have underperformed in the past years (high outflows)
,Assets under management have steadily grown in the past years (still much smaller than assets under
management of mutual funds, mutual fund industry is still much larger). In recent years, the performance
of hedge funds has declined. It is associated with the fact that markets have become more efficient (less
arbitrage) and the fact that there is more competition in the industry.
Biggest investors in Hedge funds 1999 vs 2019:
Investment portfolios of pension funds: pie chart shows the average asset allocation of US pension funds
Why do institutions invest in hedge funds?
- Portfolio diversification
o Mostly: pensions (!), banks, consultants, endowments & foundations (around 30%)
- Downside/tail risk protection
o Small percentage
- Alpha generation: generation of risk adjusted returns
o Biggest reason for most investors, especially insurance companies, fund of funds, banks
- Access to select/niche opportunities
, o Consultants, family offices
- Correlation benefits
o Small percentage, highest for pensions
Investor concerns about hedge funds:
- Crowding: a lot of funds are following very similar strategies and therefore are in similar
positions, assets might become overpriced (=lower returns). Crowding also might lead to an
increase in risk
- Style drift
- Lack of liquidity
- Lack of communication/transparency
- Macro-economic factors
Video #2 Hedge fund fees and performance
FEES: Management fee + incentive/performance fee
- Usually 2% of AUM (assets under management) + 20% of gains (2/20 scheme)
- Incentive fee can be modelled as call option (underlying: end of year fund value)
o Incentive fee should align the interests of managers and hedge fund investors
o However, this asymmetric payoff structure may lead to excessive risk taking by HF
manager
- High water mark
o If fund experiences losses, incentive fee is only paid when the fund makes up for these
losses -> creates incentive to shut down fund after poor performance and simply start new
fund
o May be the reason for a large number of funds
- Funds of funds:
o Hedge funds that invest in other hedge funds
o Little diversification if underlying HF follow similar strategies
o Usually 1% management fee and 10% incentive fee
o FoF pays incentive fee to each underlying HF (FoF – fee on fee) -> double fees
o Number of FoFs has dropped after 2008 due to high fees
Hedge fund fees: FoF example
- Investor may pay incentive fee even if aggregate FoF performance is poor
- Fund of Funds has $1 million invested in each of 3 hedge funds
- Assume hurdle rate and management fee are zero
- Each underlying fund charges 20% incentive fee
