Financial Education

Private equity investments are investments made in companies that are not publicly traded. They can take a number of forms:

• Financing of private businesses by venture capitalists
• Leveraged buyouts of public companies
• Investments in distressed debt
• Financing public infrastructure projects

Characteristics of private investments include:

• Illiquidity (lack of a secondary market)
• Requirement of long term commitments
• Higher risk relative to public equities
• Need for a high internal rate of return (25-30%)
• Limited information availability, particularly for venture investments in novel technologies

The Sharpe ratio is often used for evaluating hedge fund performance. However, it has often been criticized for relying on the assumption that returns are normally distributed.

In the September 2007 Journal of Banking and Finance, Eling and Schuhmacher examine the Sharpe ratio and other performance measurement tools for evaluating hedge funds. By ranking hedge fund returns against 12 different performance measures, they find a high correlation between the different measures, suggesting that the choice of measure may not be a significant concern. The lowest correlations are between the Sharpe ratio, the Treynor ratio and Jensen’s alpha.

Given its practical advantages over other return measures, the Sharpe ratio’s popularity is now supported by empirical evidence. The authors find it to be an adequate measure of hedge fund performance.

In the May 2007 Review of Financial Studies, Duarte, Longstaff and Yu examine the risk/return characteristics of commonly used fixed-income arbitrage strategies. They find that the strategies that require high levels of modeling produce significant positive excess returns even after adjusting for risk, transaction costs and management fees.

Fixed income arbitrage strategies tend to exploit small differences between intrinsic value and market prices for securities. There has been some debate as to whether they are truly low risk arbitrage or whether the small positive returns most frequently earned are offset by infrequent but dramatic losses.

Of five strategies tested, the ones requiring the greatest intellectual capital – yield curve, mortgage and capital structure arbitrage – produced the highest excess returns after controlling for risk and costs. Swap spread arbitrage also produced positive risk adjusted returns.

Volatility arbitrage, or selling options on fixed income instruments and hedging the underlying asset exposure, produced positive excess returns but also had periods of significant losses.

Hedge funds come in many flavors, including:

• Equity market neutral funds, which offset long positions in stocks with equal short positions in order to eliminate systematic market exposure (beta).
• Convertible arbitrage funds attempt to exploit anomalies between the price of a stock and the prices of instruments convertible into the stock.
• Fixed income arbitrage tries to predict changes in credit ratings or the term structure of interest rates. Typically these funds strive for market-neutral positions by offsetting long and short positions.
• Distressed securities funds exploit the fact that many investors lack the desire to participate in the bankruptcy process or the ability to identify their value.
• Merger arbitrage captures any spread between the price of a company and the price that a planned acquiror has offered.
• Hedged equity funds hold both long and short positions but typically remain net long.
• Global macro funds exploit systematic market moves in currencies, futures and option contracts.
• Emerging markets funds focus on less mature investment markets.
• Funds of funds invest in a number of other hedge funds, offering diversification at the cost of double fees.

Hedge fund styles, more generally, include:

• Relative value, which seeks to exploit valuation discrepancies between their long and short positions
• Event-driven, which focus on opportunities created by corporate actions such as mergers or offerings
• Equity hedge, which invest long and short for varying degrees of market exposure and leverage
• Global asset allocation, which opportunistically go long or short a variety of assets
• Short selling, which shorts equities in anticipation of a market decline

Long only active portfolios have exposure to both beta (market return) and alpha (manager skill).  A long-short market neutral portfolio, by contrast, is designed to have no beta exposure.

Some investors prefer to separate alpha and beta by getting beta exposure from passive (indexed) strategies and alpha exposure from long-short market neutral portfolios. This offers several advantages:

• Beta exposure can be obtained cheaply through indexed portfolios.
• Fees paid for alpha can be explicitly specified
• Broadens the opportunities to gain alpha
• Allows mixing of alpha of one style or asset class with beta of another when a particular benchmark may offer few opportunities to generate alpha

Such strategies are often called portable alpha.

This article was originally written by Richard Wilson in his Hedge Fund Blog.

Prime Broker Definition
A large bank or securities firm that provides various administrative, back-office and financing services to hedge funds and other professional investors. Prime brokers can provide a wide variety of services, including trade reconciliation clearing and settlement, custody services, risk management, margin financing, securities lending for the purpose of carrying out short sales, record keeping, and investor reporting. A prime brokerage relationship doesn’t preclude hedge funds from carrying out trades with other brokers, or even employing others as prime brokers. To compete for business, some prime brokers act as incubators for funds, providing office space and services to help new fund managers get off the ground.

This article was originally written by Richard Wilson in his Hedge Fund Blog

Risk arbitrage hedge fund strategies usually involve purchasing stocks of companies that are likely takeover targets, while assuming short positions in the would-be acquiring companies. Risk arbitrage hedge fund managers can employ an event-driven investment strategy or merger arbitrage investment strategy, seeking situations such as hostile takeovers, mergers and leveraged buyouts. Such funds typically experience moderate amounts of volatility. Technically arbitrage is riskless but this is not realistic, the amount of risk taken on within each arbitrage situation is decided by the portfolio management team and traders.

Financial futures markets typically use one instrument to hedge a position. For example, a 10-year note future might be used to hedge a position in 10-year Treasury securities. However, such hedges can often be imperfect due to the structure of futures markets. A futures position can be satisfied by delivery of a wide range of bonds, and the cheapest to deliver (CTD) option may have qualities that differ significantly from the bond being hedged.

In the January/February 2008 Financial Analysts Journal, Lawrence Morgan addresses this issue and provides an example: in February 2007, the 10-year T-note was yielding 4.625%, but the CTD for the June 2007 10-year note futures was the 4.25% November 2013 note – a 7 year instrument.

Morgan examines whether combination hedges, made by combining two hedging instruments, would provide a better match. Leschhorn (2001) developed and tested an approach for the German bond market in which the weights of the two hedging instruments were determined by their yield differentials. Morgan notes that this approach can frequently result in unstable hedge ratios.

Morgan extends the analysis to combination hedges weighted by option-adjusted and non-option adjusted modified durations, and finds that in general option-adjusted modified duration weighted combination hedges performed best.

Long-short extension strategies allow portfolio managers to reduce implementation strategies associated with the long-only constraint. These strategies are often called 130-30 strategies after the commonly-used ratio of 130% long and 30% short positions used to generate a net 100% long exposure to a given market.

The long-short extension allows managers to increase alpha by selecting both the best-performing and worst-performing stocks. Further, such managers are not forced to buy or sell stocks due solely to capital constraints rather than their outlook for the company’s performance.

In the January/February 2008 Financial Analysts Journal, Clarke, de Silva, Sapra and Thorley develop a model to determine the optimal extension ratio. They find that the extension should be larger in relation to the manager’s active risk, with the number of securities in the benchmark, and with the correlation between benchmark securities. The extension should be smaller when shorting costs or security-specific risks are high.

Finding a benchmark for hedge funds can be complicated when the hedge fund uses short selling as part of its strategy. In the extreme case of a perfectly market-neutral portfolio (100% long/short matching) there would be no starting portfolio value, and the return in any period would be either positive or negative infinity.  Even when there are small directional exposures, the resulting return measure could be significantly distorted.

Benchmarks for such funds should also be market-neutral long-short portfolios, which would allow the portfolio’s return to be measured against the benchmark.