Hedge Fund Investing - Mirabile Kevin R.

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to interest rates, U.S. government bonds, or currencies. A fund can take a net short position in interest rate futures if the manager believes the value of the underlying Treasury note will fall due to rising interest rates. Another fund could go long interest rate futures to take a bullish view on bond prices and a bearish view on rates. Figure 2.2 shows how hedge funds changed their position in the 10-year note contract from net short to net long over a 12-month period.

FIGURE 2.2 Speculative Use of Treasury Note Futures Contracts

      Source: http://articles.businessinsider.com/2010-09-30/wall_street/30089785_1_government-bonds-funds-chicken.

Still others who are macro-oriented might attempt to profit from either directional bets or changes in relative values of various asset classes, such as stocks, bonds, or currencies. Those funds might be buying or selling equity futures contracts on the Dow Jones or S&P Index while buying or selling interest rate futures on the 10-year U.S. government bond. Fund managers who believe equity prices would generate a better total return than bonds might go long equity futures and short Treasury futures during certain periods and reverse the position when they anticipate the relationships changing. Figure 2.3 shows the periods over the past 200 years when stocks have beaten bonds and vice versa. Each run-up or dip in the relationship represents a trading opportunity for a fund manager who believes the relationships may revert to back to historical levels.

FIGURE 2.3 Stock versus Bond Cumulative Relative Performance, 1801 through 2009

      Source: Michael Santoli, “Stocks vs. Bonds,” Barron’s, March 27, 2009, http://online.barrons.com/article/SB123819638720161459.html.

      Broadly speaking, hedge funds can be classified as being macro or directional in nature, equity long- and short-oriented, designed to take advantage of relative value opportunities, or intended to profit from specific binary events – or a combination of all of these. The terminology is somewhat inconsistently applied, and designating any individual manager as part of a specific style bucket is not always straightforward. Generally speaking, a fund fits into one of a few broad styles, as follows:

      • Macro: This style includes funds that opportunistically go long and short multiple financial assets using a wide range of instruments. Strategies are either discretionary or trend-following.

      • Equity hedge: This style includes strategies that go long and short equity securities with varying degrees of exposure and leverage known as equity variable bias. Strategies can be long or short biased and can be domestic-, international-, emerging-market–, global-, sector-, region-, or industry-focused.

      • Relative value: This style includes arbitrage strategies and those that seek to take advantage of mispricing or relative differences in similar securities that exist for short time frames. This style includes strategies such as fixed income and credit arbitrage and convertible bond arbitrage, and sometimes equity strategies, such as market neutral or long and short equity that are not directionally biased.

      • Event-driven: This style includes strategies that involve corporate transactions and special situations such as risk arbitrage (long and short equity securities of companies involved in corporate transactions) or distressed (long undervalued securities of companies usually in financial distress or operating under Chapter 11) or those that are opportunistic and profit from patent approval, regulatory actions, spin-offs, strategic repositioning, or other significant binary one-time events.

      • Multistrategy: This style includes funds that seek to allocate capital in a dynamic fashion across any or all of these broad styles or individual strategies. Many funds of hedge funds also fall into this category.

This broad classification of hedge fund styles can be further segregated into many more individual fund strategies. There are many different terms used to describe individual fund strategies in evaluating or researching hedge fund investments. Each strategy has its own performance and risk characteristics that can also often influence the structure of the fund and the terms of the fund that are ultimately offered to investors. Figure 2.4 shows the standard strategy classification used by Hedge Fund Research (HFR) to categorize various types of hedge fund strategies.

FIGURE 2.4 Hedge Fund Research Strategy Classifications

      Source: HFR Industry Reports © HFR, Inc. 2015, www.hedgefundresearch.com.

      There is currently no consensus on the way each underlying hedge fund strategy should map to the broad macro or discretionary, relative value, long and short equity, or event classifications, nor is there a consensus on what constitutes a multistrategy fund. Each investor, fund, and allocator needs to either choose a vendor scheme or develop its own classification scheme. Most investors and vendors agree that a global macro fund is a type of discretionary hedge fund investment and that a convertible arbitrage fund is a form of relative value investing. However, once you go beyond a handful of styles or strategies, there is little agreement among industry participants, and there is no regulatory definition to fall back on. Some investors do the classification of substrategies and styles on a bespoke basis, and each data provider who tracks fund performance tends to use a slightly different methodology and strategy definition. Other investors formally adopt a scheme used by one of the major commercial database providers, such as Hedge Fund Research (HFR), Eurekahedge, or CS Dow Jones Indices. The most important part is that you are consistent and evaluate peer groups, funds, and indices with as similar a set of definitions as possible.

      The approach taken in this book is to organize the various hedge fund trading strategies into those that are not correlated to traditional portfolios (such as, for example, global macro), those that are equity-oriented (such as long and short equity), those that are fixed-income–oriented (such as fixed-income arbitrage or convertibles) and, finally, those that are multistrategy in nature. Event-driven strategies are included in either the equity-oriented strategy discussion, as is the case of risk arbitrage and activist investing, or, in the fixed-income–oriented strategy, as is the case with distressed investing.

      Hedge Fund Returns

      Hedge funds provide investors with periodic reports of their returns and their risk profiles, either directly or via a third-party service provider or database. There are no standard methodologies that are mandated, and many forms of reporting and aggregation have limited value, are misleading, or are not accurate. Fund performance is generally reported on a monthly basis and is calculated net of all fees.

      The components of hedge fund returns can be broken down into several pieces. There is the return from trading in the stock, bond, commodity, or derivative contract; the return from interest on cash or the expense associated with borrowing cash; the cost of borrowing a stock or bond to sell short; and the return or costs associated with coupons and dividends that are paid or received by the fund.

      Security purchases and sales, leverage, and short selling generate the trading profits or loss and carry components of a fund’s return each month before fund expenses, management fees, incentive fees, and other charges. Carry can vary widely from strategy to strategy, depending on the nature of the portfolio and the use of leverage and short selling.

      A fund’s monthly return is composed of the following items:

      • Trading profit or loss measures the gain or loss from buying and selling stocks, bonds, currencies, or any other investments, less any commissions or spreads paid to the dealers who were used for

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