Hedge Funds

Types of Funds:

1. Convertible Arbitrage – buy undervalue convertibles and short equities

2. Distressed Securities (difficult to short)

3. Emerging market (difficult to short)

4. Equity market neutral – exploit discrepancies in price, long+short position, eliminate market risk

5. Fixed-income arbitrage – long+short in fixed income

6. Funds of funds

7. Global macro strategies – focus on an entire group and area

8. Hedged equity strategies – like quity market neutral but have net long or net short (long undervalued + short overvalued)

9. Merger Arbitrage – e.g. short acquiring company and long acquired company

OR:

1. Relative value: Exploit price discrepancies
2. Event-driven
3. Equity Hedge
4. Global asset allocators
5. Short selling

Hedge Funds Terms:

1. Asset Under Management (AUM) fee: 1-2%

2. Incentive fee: 20% (may have hurdle rate)

3. High Water Mark: Investors only have to pay incentive fee when the return exceeds previous HWM. This is irrelevant to new subscribers after the HWM was attained. This is to avoid incentive fee double dipping.

4. Lock-up Period: 1-3 years to prevent withdrawal

Fund of Funds (FOF)

1. 10-30 funds
2. Double layer of management fees
3. More correlated to equity market (not good for diversification)
4. Good for entry-level
5. More liquid but also means more cash-drag (keep extra cash to meet potential withdrawal)
6. Suffer style drift (investors do not know what he’s getting) but better indicator of aggregate hedge fund performance

Younger, smaller and shorter lock-up period funds perform better.

Shape Ratio is not good for hedge fund because:

1)    Assumed normal distribution. But hedge fund return is usually Leptokurtic.

2)    Assumed returns are not correlated: But usually is time-series with serial correlation, therefore, underestimated sigma

3)    Sigma is time dependency by square root: hedge fund is not reported often

4)    Assumed liquidity: missing observations resulting downward bias of sigma

5)    Stand-alone measure: did not consider diversifications

Downside Standard deviation:

= sqrt(sum(min(return – threshold, 0)^2)/(n-1))

When threshold is average, this becomes a semivariance.