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2011

Designing an Investment Fund

Proposal for a 130/30 Equity Hedge Fund
Module: Investment Strategy

Rishi Raj Dhingra (090023383)

Cass Business School 4/4/2011

TABLE OF CONTENTS 1. Executive Summary .3 2. What type of fund to pick? 4 a. Listing of various funds . 4 b. Why are Hedge Funds preferred over other funds? .. 5 3. Detailed look at Hedge Funds.7 a. Hedge Fund Styles...7 b. Features of Hedge Funds.7 c. Fund Vehicle of a Hedge Fund.8 d. Target investors in Hedge Funds...8 i. Institutions...8 ii. Private Investors.9 iii. Pension Funds....9 e. Will the fund be quoted or unquoted? ........10 f. Investment Thesis...10 4. Investment Model ........11 a. Fund Structure the 130/30 Fund..................11 b. Product launch and demand........11 c. Benefits of 130/30 funds.................................12 d. Potential 130/30 fund shortfalls.....14 e. Primary benefactors.......................14 5. Fund Strategy......15 6. Fund Process..................................................16 a. Portfolio Management and Efficient Frontier....................16 b. Diversification.................................17 7. Evaluation and Risk-Management of the Hedge Fund.....................................19 8. Conclusion............................................................................................................................21 9. References............................................................................................................................22

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1. Executive Summary

In this coursework, I attempt to design an investment fund. I make a case for hedge funds versus traditional funds. Further, I propose a 130/30 hedge fund, focussing primarily on equities. I walk through the pros and cons of such funds; and give a background on their performance and the type of investors who would invest in them. Fund vehicles for hedge funds are discussed, and a detailed look into the investment model and fund structure of a 130/30 hedge fund are delved into. At this point, a close look at the 130/30 fund strategy is taken into consideration which leads to a critical analysis of the fund process, specifically dealing with portfolio management and asset allocation and diversification approaches. Finally, I end with the risk aspects of the 130/30 equity hedge fund that need to be addressed.

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2. What type of fund to pick?

a. Listing of various funds Investment funds are professionally managed vehicles created to enable retail investors to participate in a wider range of otherwise inaccessible market instruments. Examples of such funds are: Traditional funds - are typically long-only and try to outperform industry benchmarks without use of leverage. Private Equity invest in unlisted securities, resulting in reduced liquidity. Close-end funds. Exchange trade funds. Hedge Funds.

The common way of classifying investment schemes is via the asset allocation of a fund: Public Equity Funds invest in listed companies and can be divided into: 1. 2. 3. 4. Value Funds. Growth Funds. Index Funds. Sector Funds.

Bond Funds invest in long/short term bonds including: 1. Low risk treasury and municipality risk like US T-bonds. 2. High risk corporate bonds like junk bonds.

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b. Why are Hedge Funds preferred over other funds? 1. Historical performance
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2. Volatility is less compared to asset classes like equity and bonds. 3. On average, hedge funds have non-negative alphas when compared to mutual funds, net of any fees. 4. Uncorrelated to traditional equity and bond markets. 5. Hedge Funds are able to invest across different asset classes. 6. Hedge Funds are less regulated allowing managers to pursue aggressive investment strategies leading to higher returns. Some downsides of hedge funds are: 1. High fees. 2. Complex products, investors may not fully comprehend details, especially the derivatives market post 2008.

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3. Detailed look at Hedge Funds

Hedge Funds are considered Alternative Investments and have either a relative or absolute return mandate. In absolute returns, the investments performance is independent of the funds benchmark, whereas in relative returns the returns are dependent on the benchmark. In uncertain times, such investments, if properly managed, can make massive differences in the performance of an investors portfolio. Such strategies aim to yield positive returns regardless of the benchmarks direction. That said the nature of the gains from hedging entail elevated risk levels which can sometimes lead to losses. However, a continued decline in the market performance should not present a material risk for a true alternative investment strategy, for example, the John Paulson Hedge Fund. In September 2008, Paulson bet against four of the five biggest British banks. Markets were down approximately 40% during this time while his funds were up 32%. The hedge fund investment universe includes a broader variety of asset classes as well as long and short positions in equity, FX, commodities and bonds. They hedge their investment risks by using short-selling and derivatives.

a. Hedge Fund Styles Hedge funds are less regulated than mutual funds. Managers retain greater flexibility in portfolio construction with fewer investment restrictions. A few types of hedge funds are: i. ii. iii. iv. v. vi. Equity Market Neutral Fixed-Income Arbitrage Global Macro Long/Short Equity Managed Futures Fund of Funds

b. Features of Hedge Funds i. Liquidity is the ability to withdraw your investment from the hedge fund. Typical lock-up periods are about a year. In difficult periods, gates may be put up to manage the fund, increasing this period. Quoted hedge funds generally tend to be more liquid than unquoted ones.

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ii.

Transparency is the ability to see the trades and transactions made by the manager. Hedge funds tend to be less transparent. Portfolio transparency can show you if the manager has deviated from strategy.

c. Fund vehicle of a Hedge Fund The founder of a hedge fund is the General Partner and an investor in his own fund. Typically, funds insulate your assets from losses over and above your investment. US hedge funds are organized as limited liability companies (LLC) or limited partnerships. Investors are only risking their contribution and profits. If something goes wrong in a LLC, the fund is sued, not the investor or fund manager, whereas in the case of a partnership, the liability sits on the manager. d. Target investors in Hedge Funds Hedge funds, on average require a minimum of USD 100K to invest. i. Institutions

Corporate and public pension plans make up the majority of institutional assets. They make massive allocations to equities with 60% of assets committed to stocks, which is even higher when you throw in private equity allocations. However, they are hesitant to make allocations to hedge funds and long/short managers.

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ii.

Private Investors

Private investors are flexible and can act much quicker than institutions, but are generally more unsophisticated and use a bottom-up building process to construct portfolios. Asset allocation is an afterthought, but they understand basic concepts of portfolio diversification. High-net-worthindividuals (HNWI) are generally more aggressive investors to hedge funds, accounting for 85% of its assets by some calculations and invest up to 50% of their portfolios in it.
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Pension Funds

The hedge fund industry has grown to $1.1 trillion in AUM (Assets-Under-Management), primarily due to institutions and pension funds. Approximately 20% of American and European, and 40% Japanese pension funds have invested in hedge funds. However, adoption is cautious and their assets dedicated to these funds are small. After a period of poor performance and underfunding of equity markets, pension funds have diversified into hedge funds for a couple of reasons the need to match assets with liabilities to avoid underfunding, and to have hedge funds manage, reduce and hedge such liability risks. Page 9 of 22

e. Will the Fund be quoted or unquoted? Setting up an unquoted fund makes sense as it has lower setup costs, no listing fees and few red-tape issues. Stability will be better as the sophisticated investors it attracts are less likely to remove their funds. Fewer fluctuations are seen since the fund is not quoted. However, lowered transparency, regulatory issues and high-counterparty risks are drawbacks to contend with. f. Investment Thesis The process should most likely be fundamentals-based and more bottom-up than top-down. As positions should be in individual stocks in small to medium companies, rather than indices, they would be longs and naked shorts (short-selling without first borrowing the security or ensuring it can be borrowed) rather than in pairs. 130/30 funds net exposure is always a 100%, gross exposure would range from 30 to 130.

The choice would be to go into emerging markets due to their economic potential versus developed markets.

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4. Investment Model

a. Fund Structure - The 130/30 fund Alternative and traditional asset-management experts predict an increase in demand for 130/30 funds. They resemble long-only in that they build their portfolio by allocating 100% of Net Asset Value (NAV) to long positions. The difference is that they short-sell securities to the value of 30% of NAV. The earnings from this are reinvested to gain additional long positions, bringing the total exposure to 130% long and 30% short. This product provides market exposure (beta) and enables the fund to generate additional alpha. 130/30 funds also charge higher fees compared to long-only funds by about 10-50 basis points.

b. Product launch and demand The current demand stems from pension funds and institutions. The appeal of these products is set to spread to retail investors as they are progressively being offered within a UCITs (Undertakings for Collective Investment in Transferable Securities Directives) structure. Traded under the UCITs-banner, the funds due diligence is done, standardizing it and taking away counterparty risk for the investor. Page 11 of 22

New York-based BlackRock, London-based Investec Asset Management, UBS Global Asset Management and JP Morgan Asset Management are just a handful of the buy-side firms to have launched such funds in recent months. Under UCITs III, funds are allowed the opportunity to go short, through use of synthetic instruments, such as options and contracts. This created the opportunity for managers to devise more creative products like the 130/30 fund. c. Benefits of 130/30 Funds Appropriately structured investment vehicles can be freely sold across member states. The 130/30 funds main attraction is this relaxation of a no-shorting constraint seen in a long-only fund. This permits the 130/30 fund generate more alpha than a long-only on a risk-adjusted basis. An enhancement in the trade-off between alpha and risk is visible. Another benefit is the use of leverage. The 130/30 structure allows $160 to be invested for every $100 of investor monies. This provides the potential for increased returns.

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Equity has always been the best performing asset-class in the long-term. This comes at a price as the level of risk associated to holding equities, compared to bonds, is higher.

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d. Potential 130/30 fund shortfalls The luxury of short-position exposure can work against you if the manager is a poor stock picker. The 130/30 structure accentuates the managers stock picking abilities. Moreover, short positions are harder to manage since with long positions your losses are capped at 100%, but with short positions it is infinite. e. Primary benefactors Existing investors in long-only funds stand to benefit through access to products which might not only be better able to manage their downside risks but potentially also offer investors better performance. Prime brokers will undoubtedly benefit from this new asset class, given that it opens a whole new market of possibly enormous size, attracting retail investors in large numbers. Credit Suisse, Deutsche Bank, Goldman Sachs, Morgan Stanley and UBS are all pursuing 130/30 mandates.

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5. Fund Strategy
Active or Passive Investment Hedge funds typically follow an active investing approach. The aim is to generate high risk-adjusted returns. Typically there are two strategies that one can follow, a market neutral one where the number of longs are equal to the number of shorts, or a long/short fund which is biased to the long but has an actively managed short book. Though your likelihood to get returns as high as the market potential in a long-only approach is not possible, what this does is protect you against losses on the scale that the market would incur in case of another economic slump. Such hedge funds focus on alpha-generation and maintaining high Sharpe ratios.

The 130/30 allows the manager to go long and short simultaneously. In long-only portfolios, managers expect future appreciation of purchased stocks. In a 130/30 setup, when a manager shorts a stock, he is expecting to profit from a decrease in stock value. To execute the short, he borrows stock shares and sells them in the open market. The manager then expects to buy back these shares from the market at a lower price and make a profit. Implementing derivatives allows you to increase your gross exposure. This decreases your operational and financial risk. Otherwise, small fluctuations in stock positions can wipe out your capital base. This is either done by the manager carrying a large position in the index making certain tangential bets by going short or long on certain stocks expected to underperform or outperform respectively. Conversely, the stock selection could be managed by actively committing a small amount of leverage to the hedge fund strategy. Page 15 of 22

6. Fund Process
a. Portfolio Management and Efficient Frontier The attraction of hedge funds has been in their promise of providing positive risk-adjusted returns with narrow volatility, regardless of market direction. Unfortunately though, just because a fund calls itself a hedge fund does not mean it will perform according to its mandate. An efficient portfolio has assets that enhance portfolio returns and/or mitigate portfolio risk. However, it should be noted that they dont increase risk in trying to increase returns or conversely, diminish returns in trying to mitigate risk. It is not possible to judge assets on a stand-alone basis. One of the marvels of portfolio diversification is that it is possible for a low-return asset to enhance portfolio returns and highrisk asset to reduce portfolio risk (if this asset is shorted) thus, creating an efficient frontier. Whether the asset added will contribute efficiently depends on its own return and risk characteristics and how this asset performs with respect to the market, how its returns correlate to other capital market returns. An optimally diversified portfolio consists of assets with reasonable returns and low correlations. Assets whose returns are negatively correlated to the other asset class returns are even better, especially those with negative correlation to equity markets as they serve to mitigate risk better. Long/short managers are able to create an Asymmetrical risk-return profile, meaning they generate higher correlation to equity in advancing markets and a lower correlation to equity in declining markets. A perfectly efficient portfolio is where assets are negatively correlated to falling markets (enhancing returns, mitigating risk) and positively correlated to rising markets (increasing returns). Keep in mind, assets with negative correlations to others decrease a portfolios return when other assets are producing positive ones. There is no prefixed asset allocation scheme in long/short hedge funds; rather it depends on the managers current positions and portfolio management structure. This can include allocating to an aggregate long/short category and populating the space by investing broadly (global macro). Alternatively, one can distinguish between geographic markets (developed, emerging) or invest in styles (value/growth) as part of the overall asset allocation.

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b. Diversification Diversification is measured by the correlation between the various assets to each other. i. Portfolio Diversification Styles Horizontal Diversification is when you hold multiple investments within the same class, such as different companies equities within the FTSE would be broad horizontal diversification and owning multiple stocks within the information technology sector would be a type of narrow horizontal diversification. Vertical diversification is characterized by owning multiple classes of investments. A typical stock and bond portfolio is broad vertical diversification, while having a portfolio comprised of stocks of different branches is an example narrow diversification. ii. Construction of a Relative 130/30 hedge fund Many 130/30 indices have been launched by providers like Standard and Poors and Credit Suisse following the growing 130/30 fund market. Steps: Identify a market benchmark such as the S&P500 index. Setup variables that best trace the appeal of index components, devising a composite scoring algorithm. Algorithm output weights the components with applicable risks which are then applied to beta, standard deviations (volatility) and deviation from benchmarks.

The aim should be to to include alpha-generating capabilities and beta exposure of long/short managers in the asset allocation process. iii. Modification If the investment strategy, risk tolerance or market conditions change, you may choose to rebalance your existing portfolio by one of two means: a. Closeness to original portfolio:

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b. Performance-gain over original portfolio: Consider these four variables: i. ii. iii. iv. Implied 1 day Value At Risk (VAR) Expected Return Total Risk Sharpe Ratio

The aim would be to try and have the new portfolio try and outperform the older one on as many of the above four variables as possible.

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7. Evaluation and Risk-Management of the Hedge Fund

When investing in a fund, you should be aware of what internal control mechanisms are in place to protect your assets from misuse. Regular external audits should be performed on the fund. Regulatory scrutiny is important. For example, in the US, hedge funds dont need to register with the SEC (Securities and Exchange Commission). Hedge fund managers may fail to integrate two sources of risk that may arise from asset allocation approaches by their active strategies: 1. Systematic or market risk 2. Active or stock selection risk A Risk Allocation Framework is used to mitigate these risks, allowing investors to: 1. Implement active management decisions used in allocation to increase portfolio flexibility, precision in assessment of alternatives and risk-return tradeoffs. 2. Correctly assess risks of individual hedge funds and synergize their strategies into overall portfolio structure. Such a framework focuses on risk exposures instead of asset class exposures where systematic and active risks are combined into the same optimization process. This permits greater freedom in evaluation and implementation of portfolio alternatives since original process constraints are relaxed.

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8. Conclusion
Traditional funds with lowered risk have historically been outperformed by hedge funds. Long-only managers are realizing that their investors are starting to allocate or increasing allocations to hedge funds. This seems to be a growing trend as the existence of a product that possesses a mechanism to generate alpha must attract investors. This alpha generation is shown by long/short managers ability to select stocks, move in and out of cash and timely shifts in market exposures. They maintain an asymmetrical risk-return profile. A genuine danger exists in managers with little or no knowledge of shorting. They may bring products which not only underperform by failing to deliver alpha but also negatively impact beta production. Higher risk-adjusted returns from 130/30 funds will threaten other hedge fund managers who have limited shorting capabilities. The 130/30 fund index has shown to outperform other long-only indices like the S&P500, Russell 2000 and the Credit Suisse Tremont Hedge Fund. They have lower volatility, with higher annualized returns, resulting in a positive impact on portfolio performance.

The graph exemplifies that short-side does not add as much value since short positions of the 130/30 portfolio hurt performance. But what this analysis fails to consider is the diversification benefits that a short position yields, and the flexibility provided to take a higher active risk on the long-side while maintaining (unit) beta and a 100% exposure with the portfolio. Established managers will continue to attract investors, without having their performance fees come under pressure, even with the propagation of the 130/30 fund as long as they consistently perform in a superior fashion. Page 21 of 22

9. References:

1. Hedge Funds: Past, Present and Future, Rene M. Stulz, February 11, 2007. 2. Hedge Funds versus Mutual Funds, CXO Advisory Group, February 13, 2007. 3. Performance, Benefits and Risks of Active-Extension Strategies, Carl Armfelt and Daniel Somos, February 8, 2008. 4. ProShares 130/30 Fund: Giant Leap for ETFs? Matthew Hougan, December 13, 2007. 5. Hedge Fund Investments, Pennsylvania Securities Commission, February 5, 2008. 6. Sovereign wealth funds take an active approach, Giler Turner, January 25, 2011. 7. UCITs and Hedge Funds, Nick Terras and Josh Dambacher, Schulte, Roth & Zabel, April 2009. 8. How to Incorporate Hedge Funds and Active Portfolio Management into an Asset Allocation Framework, Dennis M. Bein and Brett H. Wander, 2002. 9. US hedge funds embrace the benefits of UCITs, Sam Jones, August 5, 2010. 10. Portfolio suggestion with Efficient Frontier, Macroaxis, 2011. 11. Benefits of alternative investments, MAN Investments, 2011. 12. A Pocket Guide to Equities (Asset Management), Goldman Sachs, Investors Friend, Shawn Allen, February 13, 2011. 13. Benefits of 130/30 vision, Risk Magazine, October 1, 2007. 14. 130/30 funds A new middle-ground? Andrew Collins, Fortis Prime Fund Solutions, 2007. 15. 130/30 Fund Strategies, Sharpe Investing, August 10, 2007. 16. 130/30: The New Long-Only, Andrew W. Lo and Pankaj N. Patel, January 28, 2008. 17. Hedge Funds and Portfolio Diversification, The Wallbridge Long-Short Strategies Fund, Albert J. Brenner, CFA, August 20, 2010.

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