ACFI333: Topic 5 - Hedge Funds

Define hedge funds as used today.

Lightly regulated, private pooled investment vehicles sourced mainly from institutional investors and high-net-worth individuals. They use leverage, short selling, and derivatives to generate high absolute or risk-adjusted returns.

What seven characteristics distinguish hedge funds from traditional mutual funds?

1. Fewer legal/regulatory constraints
2. Flexible mandates — short selling and derivatives permitted
3. Larger investment universe
4. Aggressive styles — concentrated exposure to credit, vol & liquidity premia
5. Liberal use of leverage
6. Liquidity constraints (lockups, notice periods, gates)
7. High fees — management + performance fees

What are the five strategy categories of hedge funds?

1. Equity hedge funds
2. Event-driven hedge funds
3. Relative value hedge funds
4. Opportunistic hedge funds
5. Multi-manager hedge funds
(+ Funds of hedge funds)

Describe the five equity hedge fund strategies.

1. Fundamental long/short — long cheap, short expensive stocks
2. Fundamental growth — long high-growth companies
3. Fundamental value — long undervalued turnaround candidates
4. Short biased — primarily short overvalued securities
5. Market neutral — balanced long/short targeting zero market beta

What is a market-neutral equity strategy?

Takes simultaneous long and short positions in mispriced stocks to eliminate market risk exposure — targeting a net market beta of approximately zero. Profit comes purely from stock selection (alpha).

Describe the four event-driven hedge fund strategies.

1. Merger arbitrage — long acquired, short acquirer
2. Distress/restructuring — buy distressed debt at a discount, profit from reorganisation
3. Special situations — exploit price inefficiencies around issuances, buy-backs, spin-offs
4. Activist shareholder — acquire large stake, influence corporate strategy

Why does merger arbitrage go LONG the target and SHORT the acquirer?

Targets typically trade at a discount to the offer price until deal close (spread). Acquirers often overpay, causing their shares to fall on announcement. The long/short captures both the spread narrowing and the acquirer's decline.

Describe the four relative value hedge fund strategies.

1. Convertible bond arbitrage — exploit mispricing between convertible bond and underlying equity
2. Fixed income (general) — exploit spreads between similar investment-grade issuers
3. Fixed income (high yield) — exploit mispricings in ABS/MBS and high-yield securities
4. Multi-strategy — relative value across and within asset classes

Describe the two opportunistic hedge fund strategies.

1. Macro — top-down, trade across asset classes based on macroeconomic trends (FX, rates, inflation)
2. Managed futures / CTAs — trade futures markets (historically commodities, now multi-asset), directional, trend-following

What is a master-feeder structure in hedge funds?

An onshore feeder fund and an offshore feeder fund both invest capital into a single master fund. The master fund manages all investments centrally. Common for accessing both US and non-US investors.

What is a Separately Managed Account (SMA) in hedge fund investing?

A structure where the investor creates their own vehicle; assets are registered in THEIR name, but day-to-day management is delegated to the hedge fund manager. Gives more investor control and lower fees, but is operationally complex and may reduce manager motivation.

What is a fund of hedge funds and what are its pros and cons?

Pros: diversified access to multiple strategies/managers; more accessible to smaller investors; reduced lockups; better due diligence
Cons: fee layering — an extra layer of fees on top of underlying fund fees, significantly eroding net returns

From least to most liquid, rank: ETFs, mutual funds, limited partnerships, closed-end funds, separately managed accounts.

Least → Most liquid:
1. Limited partnerships
2. Separately managed accounts
3. Closed-end funds
4. Mutual funds
5. Exchange-traded funds (ETFs)

What are the three sources of hedge fund returns?

1. Market beta — broad market exposure
2. Strategy beta — exposure to specific risk premia (credit, liquidity, volatility); includes market timing
3. Alpha — pure manager skill; identifying mispriced securities or sectors

How do hedge funds differ from traditional mutual funds in their approach to market beta and alpha?

Traditional funds: primarily earn market beta (broad diversification, long-only).
Hedge funds: seek to LIMIT market beta and MAXIMISE alpha — generating returns independent of market direction.

Why is benchmarking hedge fund performance difficult?

• Wide variety of strategies makes selecting a single benchmark impossible
• Low frequency and minimal disclosure hinders performance attribution
• Hedge fund indexes may not be truly investable
• Returns are non-normally distributed (fat tails, negative skewness)

What are the three biases in voluntary hedge fund performance reporting?

1. Survivorship bias — failed funds are excluded from indexes, inflating average performance
2. Backfill bias — only successful historical track records are added to databases ex post
3. Selection bias — inconsistent classification due to low transparency of holdings

What is survivorship bias and why does it distort hedge fund return data?

Hedge funds have a high failure rate within the first three years. When failed funds are excluded from performance indexes, the reported average return looks better than reality because only "survivors" (successful funds) are included.

What is backfill (or instant history) bias?

When a hedge fund decides to start reporting to a database, it also submits its historical track record — but selectively only reports if the history is strong. This inflates reported past performance across the database.

How have hedge fund diversification benefits changed since the 2000s?

Originally, market-neutral hedge funds had low equity correlation (~0.56 in 1990-2014), offering strong diversification benefits. Since 2000s, as the industry grew and strategies moved away from neutrality, correlation with equities INCREASED (~0.86 in 2015-2019), reducing diversification benefits substantially.

From the data (1990-2014 vs 2015-2019), how did FoF performance vs equities change?

1990-2014: FoF returned 7.2% vs equities 6.9% — similar returns but far lower volatility (6% vs 16.5%), better risk-adjusted performance.
2015-2019: FoF returned only 2.48% vs equities 10.41% — significant underperformance with correlation rising to 0.86.

Why might adding market-neutral hedge funds to a long-only portfolio improve its Sharpe Ratio?

Because they add an asset with low (or negative) correlation to existing holdings. This reduces the portfolio's standard deviation without proportionally reducing expected return — mathematically increasing the Sharpe Ratio.