Foreword by Mark Anson xv
1 Introduction 1
PART I HEDGE FUND OVERVIEW
2 History Revisited 7
2.1 The very early years: The 1930s 7
2.2 The formative years (1949-1968) 8
2.3 The dark ages (1969-1974) 11
2.4 The renaissance (1975-1997) 12
2.5 The Asian and Russian crises (1997-1998) 15
2.6 The equity bubble years 18
2.7 Hedge funds today 19
2.8 The key characteristics of modern hedge funds 24
2.9 The future 35
3 Legal Environment 37
3.1 The situation in the US 39
3.1.1 The Securities Act (1933) 39
3.1.2 Securities Exchange Act (1934) 44
3.1.3 Investment Company Act 46
3.1.4 Investment Advisers Act (1940) 48
3.1.5 Blue-sky laws 55
3.1.6 National Securities Markets Improvement Act (1996) 55
3.1.7 Employee Retirement Income Security Act (1974) 56
3.1.8 Other regulations 56
3.1.9 The Commodity Futures Trading Commission 57
3.2 The situation in Europe 59
3.2.1 The UCITS directives and mutual fund regulation 59
3.2.2 The case of European hedge funds 62
3.2.3 Germany 63
3.2.4 France 69
3.2.5 Italy 75
3.2.6 Switzerland 76
3.2.7 Ireland 78
3.2.8 Spain 80
3.3 The situation in Asia 81
3.4 Internet and the global village 81
4 Operational and Organizational Structures 85
4.1 Legal structures for stand-alone funds 85
4.1.1 In the United States (onshore) 85
4.1.2 Outside the United States (offshore) 87
4.2 A network of service providers 90
4.2.1 The sponsor and the investors 91
4.2.2 The board of directors 91
4.2.3 The investment adviser 92
4.2.4 The investment manager or management company 92
4.2.5 The brokers 93
4.2.6 The fund administrator 99
4.2.7 The custodian/trustee 103
4.2.8 The legal counsel(s) 103
4.2.9 The auditors 105
4.2.10 The registrar and transfer agent 106
4.2.11 The distributors 106
4.2.12 The listing sponsor 107
4.3 Specific investment structures 108
4.3.1 Mirror funds 108
4.3.2 Master/feeder structures 109
4.3.3 Managed accounts 112
4.3.4 Umbrella funds 114
4.3.5 Multi-class/multi-series funds 115
4.3.6 Side pockets 116
4.3.7 Structured products 117
4.4 Disclosure and documents 118
4.4.1 Private placement memorandum (PPM) 118
4.4.2 Memorandum and articles of association 118
4.4.3 ADV form 118
4.4.4 Limited partnership agreements 119
4.4.5 Side letters 119
5 Understanding the Tools Used by Hedge Funds 121
5.1 Buying and selling using a cash account 121
5.2 Buying on margin 122
5.2.1 Mechanics 122
5.2.2 Buying on margin: an example 124
5.3 Short selling and securities lending 126
5.3.1 Mechanics of short selling 127
5.3.2 A detailed example 134
5.3.3 Restrictions on short selling 135
5.3.4 Potential benefits of short selling 139
5.3.5 Alternatives to securities lending: repos and buys/sell backs 140
5.4 Derivatives 142
5.4.1 Terminology 144
5.4.2 Basic derivatives contracts 144
5.4.3 Credit derivatives 146
5.4.4 Benefits and uses of derivatives 149
5.5 Leverage 151
PART II HEDGE FUND STRATEGIES AND TRADE EXAMPLES
6 Introduction 159
7 Long/Short Equity Strategies 163
7.1 The mechanics of long/short equity investing 163
7.1.1 A single position 163
7.1.2 Sources of return and feasible portfolios 165
7.1.3 Disadvantages of long/short equity investing 169
7.2 Investment approaches 170
7.2.1 The valuation-based approach 170
7.2.2 Sector specialist hedge funds 174
7.2.3 Quantitative approaches 175
7.2.4 Equity non-hedge hedge funds 175
7.2.5 Activist strategies 176
7.3 Historical performance 181
8 Dedicated Short 187
8.1 The pros and cons of dedicated short selling 187
8.2 Typical target companies and reactions 188
8.3 Historical performance 193
9 Equity Market Neutral 197
9.1 Definitions of market neutrality 197
9.1.1 Dollar neutrality 197
9.1.2 Beta neutrality 198
9.1.3 Sector neutrality 200
9.1.4 Factor neutrality 200
9.1.5 A double alpha strategy 202
9.2 Examples of equity market neutral strategies and trades 203
9.2.1 Pairs trading 203
9.2.2 Statistical arbitrage 207
9.2.3 Very-high-frequency trading 208
9.2.4 Other strategies 211
9.3 Historical performance 211
10 Distressed Securities 215
10.1 Distressed securities markets 215
10.1.1 The origins: railways 215
10.1.2 From high yield to distressed securities 216
10.1.3 The distressed securities market today 219
10.2 Distressed securities investing 226
10.2.1 Why distressed securities? 226
10.2.2 Legal framework 227
10.2.3 Valuation 228
10.2.4 Active versus passive 230
10.2.5 Risks 232
10.3 Examples of distressed trades 233
10.3.1 Kmart 233
10.3.2 Failed leveraged buyouts 234
10.3.3 Direct lending 235
10.3.4 The case of airlines 236
10.4 Historical performance 239
11 Merger Arbitrage 243
11.1 Mergers and acquisitions: a historical perspective 243
11.2 Implementing merger arbitrage: basic principles 246
11.2.1 Arbitraging a cash tender offer 247
11.2.2 Arbitraging a stock-for-stock offer (fixed exchange rate) 250
11.2.3 Arbitraging more complex offers 252
11.3 The risks inherent in merger arbitrage 254
11.4 Historical performance 263
12 Convertible Arbitrage 269
12.1 The terminology of convertible bonds 269
12.2 Valuation of convertible bonds 272
12.2.1 Valuation from an academic perspective 272
12.2.2 Valuation from a practitioner perspective (the component approach) 273
12.2.3 Risk measurement and the Greek alphabet 277
12.3 Convertible arbitrage: the basic delta hedge strategy 279
12.4 Convertible Arbitrage in practice: stripping and swapping 285
12.5 The strategy evolution 287
12.6 Historical performance 293
13 Fixed Income Arbitrage 297
13.1 The basic tools of fixed income arbitrage 297
13.2 Examples of sub-strategies 299
13.2.1 Treasuries stripping 299
13.2.2 Carry trades 301
13.2.3 On-the-run versus off-the-run Treasuries 301
13.2.4 Yield-curve arbitrage 303
13.2.5 Swap-spread arbitrage 304
13.2.6 The Treasury-Eurodollar spread (TED) 305
13.3 Historical performance 306
14 Emerging Markets 311
14.1 The case for emerging market hedge funds 311
14.2 Examples of strategies 314
14.2.1 Equity strategies 314
14.2.2 Fixed income strategies 319
14.3 Historical performance 323
15 Global Macro 327
15.1 Global macro investment approaches 327
15.2 Examples of global macro trades 328
15.2.1 The ERM crisis (1992) 329
15.2.2 The ECU arbitrage 332
15.2.3 The Asian crisis (1997) 333
15.2.4 The euro convergence (1995-1997) 337
15.2.5 Carry trades 340
15.2.6 The twin deficits 344
15.2.7 Risk management and portfolio construction 345
15.3 Historical performance 346
16 Managed Futures and Commodity Trading Advisors (CTAs) 351
16.1 The various styles of managed futures 352
16.1.1 Trading approach: discretionary versus systematic 352
16.1.2 Type of analysis: fundamental versus technical 354
16.1.3 Source of returns: trend followers and non trend followers 354
16.1.4 Timeframe for trades 355
16.2 Examples of systematic trading rules 355
16.2.1 Moving Average Convergence/Divergence (MACD) 355
16.2.2 Examples of trading ranges signals 361
16.2.3 Portfolio construction 363
16.2.4 Transparency or regulated black boxes? 363
16.2.5 Investment vehicles 365
16.2.6 Back-testing and calibration 365
16.3 Historical Performance 366
16.4 The future of managed futures 370
17 A Smorgasbord of Other Strategies 373
17.1 Capital structure arbitrage and credit strategies 373
17.2 Weather derivatives, weather insurance and catastrophe bonds 381
17.3 Mutual Fund Arbitrage 382
17.3.1 The forward pricing mechanism 383
17.3.2 The loopholes in forward pricing 384
17.3.3 Unethical, but persistent 386
17.3.4 A brutal ending 387
17.4 Arbitraging between NAVs and quoted price: Altin AG 388
17.5 Split strike conversion 390
17.6 Event-Driven Special Situations 392
17.7 Cross-listing and dual-listing arbitrage 393
17.7.1 Cross-listed companies and ADRs 393
17.7.2 Dual-listed companies 394
17.8 From public to private equity 395
17.9 Regulation D and PIPEs funds 397
17.10 IPO Lock-up Expirations 398
PART III MEASURING RETURNS, RISKS AND PERFORMANCE
18 Measuring Net Asset Values and Returns 403
18.1 The difficulties of obtaining information 404
18.2 Equalization, crystallization and multiple share classes 406
18.3 The inequitable allocation of incentive fees 406
18.4 The free-ride syndrome 407
18.5 Onshore versus Offshore Funds 408
18.6 The multiple share approach 409
18.7 The equalization factor/depreciation deposit approach 410
18.8 Simple Equalization 414
18.9 Consequences for performance calculation 414
18.10 The holding period return 415
18.11 Annualizing 417
18.12 Multiple hedge fund aggregation 418
18.13 Continuous compounding 419
19 Return Statistics and Risk 423
19.1 Calculating return statistics 423
19.1.1 Central tendency statistics 426
19.1.2 Gains versus losses 428
19.2 Measuring risk 429
19.2.1 What is risk? 430
19.2.2 Range, quartiles and percentiles 430
19.2.3 Variance and volatility (standard deviation) 431
19.2.4 Back to histograms, return distributions and z-scores 434
19.3 Downside risk measures 439
19.3.1 From volatility to downside risk 439
19.3.2 Semi-variance and semi-deviation 440
19.3.3 The shortfall risk measures 443
19.3.4 Value at risk 443
19.3.5 Drawdown statistics 446
19.4 Benchmark-related statistics 447
19.4.1 Intuitive benchmark-related statistics 447
19.4.2 Beta and market risk 448
19.4.3 Tracking error 449
20 Risk-Adjusted Performance Measures 451
20.1 The Sharpe ratio 455
20.1.1 Definition and interpretation 455
20.1.2 The Sharpe ratio as a long/short position 457
20.1.3 The statistics of Sharpe ratios 457
20.2 The Treynor ratio and Jensen alpha 460
20.2.1 The CAPM 460
20.2.2 The market model 462
20.2.3 The Jensen alpha 463
20.2.4 The Treynor (1965) ratio 465
20.2.5 Statistical significance 466
20.2.6 Comparing Sharpe, Treynor and Jensen 466
20.2.7 Generalizing the Jensen alpha and the Treynor ratio 467
20.3 M2, M3 and Graham-Harvey 468
20.3.1 The M2 performance measure 468
20.3.2 GH1 and GH2 470
20.4 Performance measures based on downside risk 472
20.4.1 The Sortino ratio 472
20.4.2 The upside potential ratio 473
20.4.3 The Sterling and Burke ratios 474
20.4.4 Return on VaR (RoVaR) 475
20.5 Conclusions 476
21 Databases, Indices and Benchmarks 479
21.1 Hedge fund databases 479
21.2 The various biases in hedge fund databases 479
21.2.1 Self-selection bias 480
21.2.2 Database/sample selection bias 482
21.2.3 Survivorship bias 482
21.2.4 Backfill or instant history bias 484
21.2.5 Infrequent pricing and illiquidity bias 485
21.3 From databases to indices 487
21.3.1 Index construction 487
21.3.2 The various indices available and their differences 490
21.3.3 Different indices - different returns 503
21.3.4 Towards pure hedge fund indices 505
21.4 From indices to benchmarks 508
21.4.1 Absolute benchmarks and peer groups 509
21.4.2 The need for true benchmarks 510
PART IV INVESTING IN HEDGE FUNDS
22 Introduction 515
23 Revisiting the Benefits and Risks of Hedge Fund Investing 517
23.1 The benefits of hedge funds 518
23.1.1 Superior historical risk/reward trade-off 518
23.1.2 Low correlation to traditional assets 520
23.1.3 Negative vs positive market environments 523
23.2 The benefits of individual hedge fund strategies 527
23.3 Caveats of hedge fund investing 534
24 Asset Allocation and Hedge Funds 537
24.1 Diversification and portfolio construction: an overview 537
24.1.1 Diversification 538
24.1.2 Portfolio construction 539
24.1.3 Asset allocation 541
24.2 Strategic asset allocation without hedge funds 543
24.2.1 Identifying the investor's financial profile: the concept of utility functions 543
24.2.2 Establishing the strategic asset allocation 546
24.3 Introducing hedge funds in the asset allocation 547
24.3.1 Hedge funds as a separate asset class 547
24.3.2 Hedge funds vs traditional asset classes 548
24.3.3 Hedge funds as traditional asset class substitutes 549
24.4 How much should be allocated to hedge funds? 551
24.4.1 An informal approach 552
24.4.2 The optimizers' answer: 100% in hedge funds 553
24.4.3 Static versus dynamic allocations 554
24.4.4 Dealing with return management 555
24.4.5 Optimizer's inputs and the GIGO syndrome 556
24.4.6 Non-standard efficient frontiers 560
24.4.7 How much should we allocate to hedge funds? 561
24.5 Hedge funds as portable alpha overlays 561
24.6 Hedge funds as sources of alternative risk exposure 564
24.7 Risk budgeting and the separation of alpha from beta 565
25 Hedge Fund Selection: A Route Through the Maze 569
25.1 Stating objectives 569
25.2 Filtering the universe 570
25.3 Quantitative Analysis 571
25.4 Qualitative Analysis 572
25.5 Due Diligence: between art and science 573
25.5.1 The strategy 573
25.5.2 The fund itself 574
25.5.3 The management team 575
25.5.4 The infrastructure 575
25.5.5 The process 576
25.6 Ongoing monitoring 576
25.7 Common mistakes in the selection process 577
26 Funds of Hedge Funds 579
26.1 What are funds of hedge funds? 579
26.2 Advantages of funds of funds 579
26.2.1 Efficient Risk Diversification 580
26.2.2 Affordability and Accessibility 582
26.2.3 Professional management and built-in asset allocation 583
26.2.4 Access to closed funds 583
26.2.5 Better internal and external transparency 584
26.3 The dark side of funds of funds 584
26.3.1 Yet another layer of fees! 584
26.3.2 Extra liquidity 585
26.3.3 Lack of control, overdiversification and duplication 587
26.4 Selecting a fund of funds 587
26.5 Fund allocation: A look inside the black box 588
26.5.1 Qualitative approaches 588
26.5.2 Quantitative approaches 589
26.6 The future of funds of funds 589
27 Structured Products on Hedge Funds 591
27.1 Total return swaps linked to hedge funds 591
27.2 Call options on hedge funds 592
27.3 Basic notes and certificates 593
27.4 Capital protected notes 594
27.4.1 The financial engineering process of capital protected notes 595
27.4.2 The first generation: the naive approach 595
27.5 The second generation: The option-based approach 598
27.6 The third generation: the dynamic trading approach 602
27.7 The fourth generation: options on CPPI 608
27.8 The flies in the ointment 608
27.9 The future of capital guaranteed products 610
27.10 Collateralized hedge fund obligations 610
28 Conclusions 615
Bibliography 617
Index 625
