Document Sample

Text of speech given by James Eldershaw to the Financial Standard Hedge Fund
Workshop held in Melbourne 11 Feb 2004 and Sydney 12 Feb 2004.

Today’s focus on hedge funds is from the viewpoint of an asset allocator or fund of funds
manager looking to invest in a portfolio of hedge funds. To understand hedge fund
trading strategies we need to look at the definition of hedge funds so that we can extricate
hedge funds from the universe of investment managers. Indeed hedge funds have
sometimes been given a bad name by funds which by many measures would not
necessarily meet the definition of a hedge fund. There is no standard definition of a hedge
fund , but most industry insiders would agree on the following key points :

        Non-institutional and evolutionary nature
        Incentive based compensation
        Absolute return or non traditional market correlated return
        Superior risk adjusted returns

Let us consider the main hedge fund strategies. The following strategy names are those
used by Van Global Hedge Fund Advisors as there is no universal naming convention for
hedge fund strategies. Note also that there may be some overlap in the strategy

       Aggressive growth
       Distressed securities
       Emerging markets
       Income
       Global Macro
       Market Neutral - Arbitrage
       Market Neutral – Securities hedging
       Market timing
       Opportunistic
       Event driven
       Short selling
       Value

Aggressive growth : The manager invests in high growth equities. May rely on
fundamental analysis or technical factors such as charting and momentum. Likely to have
high risks and returns and to have high correlation to the equity indices. Although such
funds were very common in the infancy of the hedge fund industry their classification as
hedge funds is contentious dues to the correlation to market indexes.
Distressed securities : The manager invests in securities (both equities and bonds) of
companies which face bankruptcy, re-organisation or a low credit rating generally. Profit
can come from the companies emerging from bankruptcy or from high rates of interest
paid on the securities. Some strategies involve securitised or direct lending to low credit
rating companies at high rates of interest, whereby the loan is secured by quality assets
within the company. This strategy profits from the reluctance of traditional lenders to
touch companies with poor credit ratings, even though they may have high quality assets
for use as collateral.

Risks to capital growth can come from company specific factors and market specific
factors (e.g. credit spreads). During periods of market stability returns from high yielding
securities can look deceptively risk free when subject to quantitative analysis such as the
Sharpe ratio.

Emerging markets : Investments in equities and bonds of non-OECD markets.
Historically it has had high risks and returns . It is contentious as to whether this is a
genuine hedge fund strategy due to the correlation of returns to equity indexes and some
fund of hedge funds exclude these strategies from their portfolios.

Income : The manager invests in income producing securities such as bonds or floating
rate notes. Returns are generally lower than most hedge fund strategies with
correspondingly lower risk levels. Such funds are often marked to institutional investors
as alternatives to holding cash balances.

Global Macro : Typically a “top down” investing style where the manager identifies and
bets on international trends in currencies, equity markets and interest rates. Instruments
used are typically futures, equities and derivatives. Global Macro was one of the main
strategies of the hedge fund industry in its infancy but is greatly reduced now.
Historically it has had high risks and returns , although this is very dependent on the
amount of leverage employed by the individual manager.

Market Neutral – Arbitrage : The most common strategy is convertible arbitrage. Typical
convertible trades involve buying a convertible bond and short selling the underlying
stock. Accordingly the position is largely hedged from movements in the general market
and the individual stock. It is complex strategy which combines elements of option
theory, deep understanding of corporate structure/actions and probability theory.
Because the risk level is low and the profit margin low, large amounts of leverage can be
employed. Leverage of up to 8 or 10 times is not unusual for in the money convertible
trades, although lesser leverage is employed for harder to value out of the money
convertibles. The risks in convertible arbitrage involve the usual option theory “greeks”,
unexpected takeovers and market liquidity.

Other market neutral strategies include Index arbitrage - usually done by computers in a
fraction of a second is another sub-strategy in this category and Fixed income arbitrage -
although classic arbitrage and yield curve plays are often used much of this strategy,
particularly in the USA, is based around mortgage bonds – because these bonds have a
prepayment option valuation is more complex (involving option theory) and increases the
arbitrage possibilities. Derivatives are often used to hedge positions. Leverage may be
used in small amounts.

Market Neutral – Securities hedging : Long/Short market neutral strategies are a classic
hedge fund strategy and measured by value are a large part of the hedge fund industry.
Typically an equal value of long and short securities, usually equities, is held. Thus if
there is an overall market decline the portfolio will not necessarily lose value. Within the
market neutral definition there can be a number of investment and portfolio sub-styles.
For example the portfolio could be constructed on the basis of value, opportunistic or
market timing. The stocks in the portfolio may be selected purely on the basis of
individual stock analysis, or they might be further categorized into sectors or correlations
such as in “pairs” trading ( a classic “pairs” trade might be long Toyota and short

Low to moderate leverage is typically used as returns can be surprisingly low on an un-
levered basis.

Market timing : The manager uses proprietary technical analysis to determine the
direction and movement of market sectors. Most quantitative (computer) trading falls into
this category. Instruments which are liquid and which can be electronically traded , such
as futures and stocks, are most commonly used. Returns and correlations are very
dependent on the proprietary models used and the leverage employed.

Opportunistic : The manager does not follow a consistent investment strategy. The
investment style can be expected to vary according to market changes and sector changes.
Value is added by taking advantage of changes in market situations. Returns and
correlations are very manager specific.

Event driven : The manager takes a position in relation to a specific corporate event.
Examples can include mergers, capital raisings, stock buy backs and legal events (e.g.
anti-trust decisions, bankruptcies). Event driven is a classic hedge fund style in that it has
low correlation to traditional markets. Sources of profit to the manager can be from (a)
classic arbitrage due to initial mis-pricing of the individual or combined events and/or
(b) betting on the outcome . Risks include failure/success of the event, delays and market
liquidity. At times the mergers market can dry up altogether, thus reducing the manager’s
return to a cash rate. Small to medium amounts of leverage are a common way of
boosting returns.

Short selling : Funds that primarily short sell and attempt to add value by shorting stocks
which under-perform the index. The appeal to investors is to use short funds to hedge out
any long correlation in an absolute return portfolio.

Value : A bottom up approach where the manager invests in equities in which he
believes the underlying value of the business , as measured by fundamental analysis,
exceeds the market price. Short selling is also common where fundamental analysis
indicates an oversold situation.
Multi-strategy : some or all of the above.

Event driven arbitrage
The following example copyright “Event Investing” by Richard B. Nye and Roy C. Smith as published in “Evaluating and
Implementing Hedge Fund Strategies” , Edited by Ronald A Lake, Euromoney books, 1999.

Announcement                  1 August 1995
Announced terms               1 share CCB to be exchanged for US$65 in cash
                                                   and 1 share of DIS.

Value of deal at              US$65 + US$57.25 = US$122.25 (a 29% premium
announcement                  over CCB stock at US$96.125, its closing price on
                              July 31).

Stock Prices :
DIS                           Pre-deal                                                                      57.25
                              Next day                                                                      58.875
                              Following day                                                                 59.6
CCB                           Pre-deal                                                                      96.125
                              Next day                                                                      116.75
                              Following day                                                                 117.625
Estimated time to             5 to 6 months (165 days)
Other factors                 Players very sophisticated, Deal will be looked at
                              by various regulators, Unlikely to attract
Arbitrage strategy            (1) Purchase CCB shares                                                       (117.63)
on 3 August
                              Received cash                                                                 65.00
                              Sell short DIS                                                                59.45
                              Lose DIS dividend, Receive CCB dividend net                                   (.08)
                              (2) Net proceeds                                                              125.61
                              (3) Gross profit (2) – (1)                                                    7.98
                              (4) ROI = 7.98 / 117.63 * 360/165                                             14.8%

– Convertible arbitrage

Details : A convertible trades at 105% of par with a 19.65% conversion premium that
converts into 22.5 shares of stock and trades with a delta of .594. The manager buys 1000
bonds for a long investment of $1,050,000 and shorts the underlying stock an equivalent
$ hedge based on the .594 delta. With the stock trading at $39 per share the delta hedge is
16,000 shares. The convertible trades based on an implied volatility of 35%.

                                         Quantity             Price               Value       P/L
Convertible long                         1,000                1,050               1,050,000
Short stock                              16,000               39                  (624,000)

If the stock price moves up 1%

Convertible long                         1,000                1,056.24            1,056,240   6,240
Short stock                              16,000               39.39               (630,240)   (6,240)

The new delta becomes .605 and the hedge has to be adjusted. Profit can come from :

     1) an increase in actual volatility from the implied volatility at which it was
        purchased, assuming the delta hedge is maintained and the strategy is held
     2) or trading out of the position as a result of an increase in implied volatility of the

Consider an increase in implied volatility from 35% to 40 % and the stock price moves
down 1%.

                                         Quantity             Price               Value       P/L
Convertible long                         1,000                1,050               1,050,000
Short stock                              16,000               39                  (624,000)

If the stock price moves down 1%

Convertible long                         1,000                1,055               1,055,000   5,000
Short stock                              16,000               38.61               (617,760)   6,240
Total P/L                                                                                     11,240

Example from “Convertible arbitrage”, Nick P. Calamos, 2003 John Wiley and Sons

Sharpe ratio : Derived by Professor William F Sharpe, Stanford University, 1966 as a
measure of mutual fund performance.

= [ Return – risk free return ] / Standard deviation of return

Practical calculation steps :

Get the monthly returns over a reasonable period (e.g. 2 years).
Work out the average monthly return over this period.
Annualise the monthly return by multiplying by 12
Multiply the standard deviation of the monthly return by the square root of 12 to get the
annualized standard deviation
Work out the annualised cash rate as the risk free rate of return

Any Sharpe ratio over 2 is considered very good.

Drawbacks of the Sharpe ratio :

      Is based on history. Remember the standard offering document disclaimer “Past
       performance is no guarantee of future performance”.
      Can change significantly over longer time periods
      Cost of capital is usually not the risk free rate (especially for leverage)
      Upside and downside risk treated the same
      Statistics ignore non-statistical risks (e.g Sep. 1998 Russia crisis)

Sortino ratio : A variation of the Sharpe ratio which distinguishes downside volatility
from upside volatility. To calculate it the denominator of the Sharpe ratio is replaced with
the standard deviation of the downside movements.

The Sortino ratio is often used by CTA’s who have rigid stop loss limits on the downside
and thus show an impressive Sortino ratio.

Benchmarks :

Although many hedge fund strategies exhibit low levels of correlation to traditional
benchmarks (E.G. S&P 500, MCSI World index, ) , benchmarking is still common.
Hedge fund indices, such as those produced by Van, CSFB/Tremont and HFR, have
become a more common way of measuring hedge fund performance, particularly as these
indices often provide a breakdown by strategy. Use of these indices provides a good
measure of real performance versus a manager’s peers.
Drawbacks of hedge fund industry statistical comparisons

      Extent to which managers are included
      Weighting of managers : by size or existence?
      How are failures reported


Why have a hedge fund due diligence program? It is a professional, ethical and legal
obligation of an asset allocator. Professional, because if you are taking a fee for making
investment decisions it is market practice to have a comprehensive due diligence
program, as it is in any other type of investment. Think of the reputational risk, in
addition to the actual losses, if your star investment manager turned out to be a criminal
and mis-appropriated funds. Ethical because it is a fundamental responsibility of the asset
allocator to ensure that appropriate care is taken in investment decisions on behalf of the
ultimate investing clients. Legal, because failure to provide a duty of care to the investor,
which may be evidenced by standards of market practice, could leave an asset allocator
exposed to legal action in the event of investment losses.

Accordingly if you intend to meet best practices you should develop a comprehensive
due diligence program. If you are investing through a fund of funds you should ensure
that it has a similar comprehensive due diligence program.

What are the principal elements of a hedge fund investment due diligence program?

Manager identification : It is not the intention of this dissertation to go through manager
selection in detail , except to the extent that it shares common ground with the due
diligence process. There are now thousands of hedge fund managers in the hedge fund
universe, with new managers coming and going every day. How do you identify the best
managers in an environment where a large amount of money is coming into the industry
and many successful managers are closed? The best new managers rarely wait around for
capital to be thrown at them. Often they leave a financial institution with a good track
record and set up a hedge fund with committed capital. Given that the majority of a hedge
fund portfolio is likely to be invested with US based managers, identification be
logistically difficult, unless you plan to have a permanent presence in the USA.
Realistically if you are not domiciled in the USA, and arguably even if you are, you will
need the assistance of industry consultants or as a minimum one of the electronic industry
information providers. Industry consultants can also help you get into “closed” funds.
Once you have selected your shortlist Manager visits are essential. If possible make sure
you have sent and received the due diligence questionnaire responses prior to the visits.

Peer group checks : Check with industry peers either through your consultants or
directly. Remember that peers are very well paced to know the business of their rivals
and judge them accordingly. However they rarely say anything negative about others in
the industry, so plan on reading between the lines and look for what is not said.

Strategy analysis : Review the strategy against the performance history. Does it add up?
Look for consistency of style. Quite apart from the risks arising when a manager departs
from his area of expertise, it is also an issue for your portfolio allocation which will now
be askew. Ask to see the performance history of all the portfolios managed by manager (
including “closed” and “matured” portfolios), not just the successful ones which he has
no doubt shown you. A lack of consistency across the portfolios is a warning sign as is a
results set which does not match the investment style/objectives (e.g. Manhattan Fund).

Background checks : You should plan on performing background checks on all but the
most well known hedge fund managers. The checks should be on the fund company, the
investment manager and the principals of the investment manager. I would strongly
recommend using a private investigation firm to do the majority of this work. Apart from
saving you time, private investigators are familiar with investigative techniques and
information sources and will also be located in the USA. Try to pick an investigator with
financial markets experience. Given that more and more information is now being put on-
line such investigations are becoming cheaper and more extensive than ever. The checks
should cover as a minimum civil litigation, criminal records, regulatory proceedings,
press, company registration, verification of academic credentials, verification of
employment history.

Operational review : Review the set up of the operational and administrative functions.
Keep in mind that you are not dealing with a large institution and that the approach has to
be practical and tailored to the risks. Asking an office of 4 persons to show you their state
of the art off-site disaster recovery centre will probably produce an unprintable response (
or a floppy disk in the top pocket)! In a typical hedge fund manager settlements and
accounting/administration functions will be performed by a prime broker and the
administrator respectively. It is a mistake to assume that either of these parties performs
a control function. The prime broker acts as a custodian, facilities trade execution and
margin lending for transactions conducted through them. They do not verify that
transactions are executed at market prices or perform the risk and control checks that one
might find in the trading room of a large institution. They will not perform a risk
management function, except to the extent of ensuring that their margin collateral is safe.

Similarly the administrator prepares the books based on the information provided to it
(hopefully this comes from independent parties such as the Prime Broker). It does not
perform a check on the quality of that information. Prime broker and administration
contracts usually exclude all legal liability for the service providers, so there may not be
much comfort from a legal perspective if the manager convinces them to engage in some
creative accounting. Auditing usually occurs once per year, which is normally not
frequent enough to prevent a blow up and , as recent events have shown, does not always
identify manager fraud or deception.
Critical things to look for in the operational set up that can give comfort are :

   a) An experienced person in charge of the back office. Preferably someone who
      understands the consequences of what they are doing and will not bend to
      pressure from the principals to perform unethical actions. Ideally it is a partner
      level person with a legal or senior financial background.

   b) Resources and systems capable of managing the transaction volume

   c) Controls over cash movements.

Generally this is an area that does not bring much comfort and rarely meets institutional
levels of control. This means that other due diligence checks need to compensate.

Legal due diligence : Ask for and read carefully the information memorandum, the
investment management agreement, the administration agreement and custodian
contracts. Legally the investment manager is supposed to disclose all relevant
information in the information memorandum. It is probably too expensive to have a
formal legal review done of the documents of every potential manager, but if you are new
to the industry it is worth considering for the first few offering documents so as to have
the main issues highlighted. You should establish a relationship with a lawyer who is
very familiar with the hedge fund industry so as to keep you legal bills to a reasonable
level. In the review you may find reference to things that they are not so keen to talk
about , such as conflicts of interest, high expenses or soft commissions.

Check whether the auditors, lawyers and incorporation jurisdiction are respectable and
commonly in use in the industry. Ask for copies of other contracts that they may have
regarding trading activities e.g. Repo agreements, Prime Broker agreements, Forex
margin agreements. Although this may be a lot of reading it can be relevant in
understanding the risks (think “force majeure” clauses in FX agreements in the case of
the September 1998 Russia meltdown).

Consider also tax aspects. It may be worth getting legal advice at the start of your
investment program summarising the main tax issues in the hedge fund industry.
Scrutinise any structure that departs from the industry norm.

If you are investing a significant amount consider having it invested in a separate
exclusive managed account. This brings the benefits of direct access to the portfolio and
customised strategy/investment guidelines. You will need to provide a legal mandate to
the financial institutions with whom the account will be dealing and you should ensure
the appropriate restrictions on this authority are in place. In most cases you should also
set up a separate legal vehicle so that you can limit liability to the amount invested.
Normally the additional costs of the legal vehicle, accounting fees and administration
costs preclude doing this for investment amounts less than $50 million.

Financial statement review : Review the formal financial statements. Often this can
reveal information which the manager is unlikely to publicise such as high expense levels
or major capital withdrawals.

Investors : The manager may not be prepared to reveal the investors in a fund, however if
you can obtain the names of some investors it can be useful to contact them and solicit
their investment experience. Beware of investing just because other large names have
invested. Large names can get burned as often as small names and can often withdraw
capital at short notice.

Manager Questionnaire : Develop a standard Manager Questionnaire. There are now
some standard questionnaires in the market place such as those provided by AIMA. The
Questionnaire should be comprehensive, but ensure you take the time to customise it to
the manager concerned. Remember that the manager is there to make money for investors
and will not appreciate spending days answering pages of irrelevant questions –
especially if they are a “hot” manager with lots of investors knocking on the door. So
make it concise and relevant, keeping in mind that you are dealing with a different type
of animal from a major institution. Alternatively some managers will send you their
standard response rather than directly answering your questionnaire. The questionnaire
responses will often form the basis of your other due diligence checks (by providing
biographies etc..) , so send it out early in the manager selection process. Remember that
the manager’s response to questions like “have you ever been investigated by the SEC?”
can often make an interesting comparison with an investigator’s report.

Ongoing due diligence : Plan on regular visits. A typical schedule might be to visit
managers quarterly and do a brief monthly telephone call. Do not overburden the
manager – remember that he may have 100 investors and needs to find time to trade.
Conduct regular (at least monthly) performance reviews. Unusual performance, with
respect to the stated investment style, is often the first early warning of a problem.

Ask for regular reports of the positions from the manager. All managers are aware that
transparency is now a major issue and will have received this request before. Even better
ask for the reports to be sent directly to you by the Prime Broker. As many or most hedge
fund blow ups involve deception by the manager, getting data from an independent
source can provide an early warning signal of problems which the hedge fund manager
might otherwise cover up.

There are service providers in the USA who will checking manager’s reported positions
vs positions obtained directly from the Prime Broker. Similarly there are service
providers who will run positions through Risk Management systems. However remember
that if you are going to receive large quantities of data make sure you have the resources
to analyse it. Not all Managers will provide position data and some are understandably
sensitive about it. Sometimes a compromise has to be worked out such as providing
delayed reports of positions or not providing sensitive short positions.

Check for changes in personnel. This can often be an early warning signal. Consider
contacting departing personnel to understand their reasons for leaving.

Outsourcing due diligence : Firstly consider the relationships with the consultants to
whom you may outsource. Many consultants have commission agreements with
managers. Check whether a consultant receives commissions for placing you with a
manager. Make sure that the consultancy agreement either disallows this or, if you agree
to it, that the commission details are disclosed upfront.

Outsourcing due diligence to a consultant , particularly one based in manager’s country ,
often makes good business sense. As with any other outsourced contract you need to
manage the service provider closely to ensure that they are performing their job and
adding value.

Investment time line :

      Receive lists of candidate managers from consultants and/or market sources.
      Select likely candidates
      Obtain offering document and other legal documents
      Initial manager visit
      Send due diligence questionnaire
      Receive back questionnaire
      Perform background checks
      Review offering document and other legal documents
      Follow up visit to discuss strategy and due diligence items
      Make investment(complete subscription agreement and money transfers).
      Ongoing due diligence

James Eldershaw 11 February, 2004
Mr Eldershaw is a director of Pacific Fund Systems, a software provider to the hedge
fund industry.

Shared By: