Topic 1 - Lecture notes 1-3 PDF

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Topic 1 Thursday, 20 January 2022

17:27

Outline -

Market Efficiency Hedge Funds Hedge Fund Strategies Hedge Fund Objectives and Fees

Market Efficiency Discussions: Are Markets Efficient? - Efficiency = markets are efficient when all the prices reflect all the available informatio - This course aims to show that markets will be efficient in an inefficient way

Efficient Markets Markets cannot be fully efficient 1. If it were the case there would be little incentive to collect information (financial new various companies) - The aim of collecting news is to benefit from it however if price immediately adj upon the release of news then there would be no opportunity to benefit 2. Logically impossible that asset markets (financial markets) and the markets for asset management are fully efficient - If both were no would pay for active management because it would have no val (incentive because prices reflect the underlying news) 3. Clear evidence against market efficiency Failure of the law of one Price, e.g. - Asset management: Closed end fund discount and EFTs can be of the same asse are priced differently - Stocks: Siamese twin stock spreads (two companies listed on different exchange but owned and operated by one company and have different prices) - Bonds: off the run(older bonds less in demand and less liquid thus trade on a discount?) vs. on the run bond spreads ( newly issued government bonds usual liquid they are easy to buy and sell) these two bonds of the same currency have different prices - Foreign exchange: Covered interest rate parity violations - Credit: CDS - bond basis

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Credit: CDS - bond basis Not subject to "joint hypothesis problem" of markets are efficiently inefficient

Inefficient Markets? Market prices cannot be completely divorced from fundamentals 1. 2. 3.

Money managers compete to buy low and sell high (proof proving markets are not inefficient because they buy low with hopes that price will raise to reflect true value) Free entry of managers and capital If markets were completely divorced from fundamentals - Making money should be very easy - But - Professional managers hardly beat the market

Efficiently Inefficient Markets Markets are efficiently inefficient - Markets must be - Inefficient enough that active investors are compensated for their cost - Efficient enough to discourage additional active investment - Investment implications - Some people must be able to beat the market Market Efficiency

Investment Implications

Efficient market hypothesis

Passive investing

Inefficient market

Active investing

Efficiently inefficient markets Active investing by those with comparative advantage

Efficiently Inefficient Markets: Trading Strategies vs. Finance Theory -

Finance theory tells us what the price of stocks and bonds "should" be ( using present value analysis)

For tutorial look for examples of failure of one price

Hedge Funds What is a hedge fund: Definition 1

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Hedge funds are investment pools that are relatively unconstrained in what they do. T are relatively unregulated (for now), charge very high fees, will not necessarily give yo your money back when you want it, and will generally not tell you what they do. They supposed to make money all the time , and when they fail at this, their investors rede and go to someone else who has recently been making money. Every three or four yea they deliver a one-in a hundred year flood. They are generally run for rich people in Geneva, Switzerland, by reach people in Greenwich Connecticut" - Cliff Asness, Journal of Portfolio management 2004

What is a hedge fund: Definition 2 -

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Hedge fund: - Investment vehicles pursuing a variety of complex trading strategies to make m - "hedge" refers to reducing market risk by long/short investing (make money all time by hedging their positions reducing market risk by going long and short at same time) - "fund" pool of money Can use sophisticated investment strategies and fee structures: - Leverage - Short selling - Derivatives - Incentive fees (mutual funds are restricted) Limited disclosure requirements To achieve this regulatory freedom, hedge funds are e - Restricted in how they raise capital - Non solicitation (for investment cannot advertise how much they make) - Investors must be "accredited investors" - This unregulated nature gives them the ability to employ a wide variety of tradi strategies

Hedge fund Objectives and Fees -

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Objective: - To make money in any environment (bull or bear market) - Absolute return benchmark (c.f. relative return) Fees - Management fees (fees paid regardless of performance used for up keep) - Performance fees - Classic fee structure: two-and-twenty § (2% of funds under management + 20% of the overall profits) § Example: if profits are 14% 2% is management fees and 20% of 12% is f f

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performance fees Other fee characteristics - Hurdle rate § Performance fees are not charged if a hurdle is not met - High water mark § Hedge fund only charges performance fees only if it performs better than it did in the past.

Hedge fund Performance -

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Past returns have been reasonably good (esp. before fees) and diversifying Beware of biases: - Backfill bias § Hedge funds are not obligated to show returns and may only show data th to their advantage - Survivorship bias And risk - Bets that have a big downside relative to the upside § Negative skewness § Excess kurtosis - Low persistence, i.e. winners do not remain winners - High attrition - Liquidity risk

Performance of Active Investors Old consensus in the academic literature: -

Active investors as represented by mutual funds have no skill.

New consensus in the academic literature: -

The average mutual fund underperforms slightly after fees; not before fees, but the average hides significant cross sectional variation across good/bad managers

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Skill exists among mutual funds and can be predicted - "We find that a sizable minority of managers pick stocks well enough to more th cover their costs. Moreover, the superior alphas of these managers persist"

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Skill exists among hedge funds: - ' top hedge fund performance cannot be explained by luck, and hedge fund performance persists at annual horizons… Our results are robust and relevant to

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investors as they are neither confined to small funds, nor driven by incubation b backfill bias, or serial corelation.' -

Skill exists in private equity and VC: - ' we document substantial persistence in LBO and VC performance'

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Consistent with efficiently inefficient markets - For details see "efficiently inefficient markets for assets and asset management

Structure of a hedge fund: Organisation and the Master-Feeder Structure

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Investors invest in the feeder fund which invests to the master fund that is related to master company - This separates the funds that keep the management Separating the feeder funds form the management funds allows the hedge fund to ha different funds for different purposes - E.g. low/ high volatility, different markets/regions etc.

Hedge funds role in the economy

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Investors invest in the feeder fund which invests to the master fund that is related to the master company - This separates the funds that keep the management Separating the feeder funds form the management funds allows the hedge fund to have different funds for different purposes - E.g. low/ high volatility, different markets/regions etc.

Hedge funds role in the economy -

They make markets more efficient - Collect information - Trading impounds information into prices - Monitors managers of companies - This could improve real outcomes e.g. § CEO decisions § Real investments § Capital allocation

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Provide liquidity - To investors who need to by or sell (consumption smoothing) - To investors who need to hedge - To companies who need to issue securities

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Provide insurance against event risk to other investors

Hedge fund Strategies

Hedge fund strategies: Equity Strategies -

Equity long/short - Discretionary trading - Fundamental analysis and catalysts -

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Its easy to be a contrarian, except when its profitable Buy on rumours, sell on news.

Dedicated short bias - Identifying frauds, forensic accounting - While equity long/short is more long than short, the reverse is true for short biased funds Equity market neutral - Quant - Value, momentum, pairs trading, statistical arbitrage, high frequency trading, index arbitrage -

Have a rule. Always follow the rule, but know when to break it.

Hedge fund strategies: Macro strategies -

Global macro - Carry trades, central bank watching, devaluation, thematic, yield curve, country selection -

Soros: when you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. Bulls get rich, bears get rich, but pigs get slaughtered

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Managed futures - Trading in trends and countertrends. - Equity, fixed income, and commodity futures currency forwards -

The trend is your friend. Show me the charts, I'll tell you the news. Cut losses and let your profits run

Hedge fund strategies: Arbitrage Strategies -

Event driven - Merger arbitrage (risk arbitrage), distressed, carve outs, spinoffs, split offs, when issued, IPOs, SEOs, other corporate events, special situations.

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Convertible bond arbitrage - Long converts, hedge with equity, credit, fixed income - Gamma, busted, high-money

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Fixed income arbitrage - Swap spread, yield curve, butterfly, mortgage CDS-bond basis, on-therun/off-the-run -

Keynes: the markets can remain irrational longer than you can remain solvent.

What do great investors have in common? Investment styles...