What Is A Hedge Fund?

By Kai Zhang, CFAPortfolio ManagerLIM Advisors Ltd

17 January 2009

Private & Confidential

What is a hedge fund?

• Basic definition

• History

– The very early years: 1930s

– The formative years: 1949-1968

– The dark ages: 1969-1974

– The renaissance: 1975-1997

– The Asian and Russian crises: 1997-1998

– The modern years: 1999 - ?

• Characteristics

• Hedge fund strategies

– Long/Short

– Merger Arbitrage

– Convertible Arbitrage

• Challenges in 2008

• Future of HF strategies

• All in a day’s work

Basic Definition

• Absolute return fund

• Long / Short, leverage, flexibility

• Wide range of financial instruments

• Performance related compensation

• Activist vs. passive

• Directional vs. non-directional

• Trading oriented vs. buy & hold

History

• The very early years: 1930s

– Karl Karsten, statistical researcher, “Scientific Forecasting” (1931)

• Volume of trade, interest rates, building activity, wholesale price level, industries (auto, oil, steel, railroad, store, utility).

• Hedging principal: buy two best groups out of six and short the two worst.

• No large losses, large permanent gains at times, independent of the direction of the whole market.

• Performance: 78% return in six months or 250% compounded annually

History

• The formative years: 1949-1968

– Alfred Winslow Jones, Australian, Harvard grad, diplomat, journalist, PhD in sociology from Columbia, editor at Fortune magazine

• Launched first hedge fund in 1949 with 100k (40k own money)

• Hedging principal: superior stock selection ability, no market-timing skills, “investment edge”

• Long / short stocks with leverage (double alpha, small beta - low net sensitivity to the market)

• Model portfolio, broker analyst, 0% management fees, 20% performance fees

• Multi-manager approach later on

• Performance: 17.3% gain in the first year, 325% from 1960-1965 vs Fidelity fund 225%; 670% from 1955-1965 vs Dreyfuss fund 358%.

• 1982 at age 80, Jones converted the partnership into a fund of funds.

History

• The formative years: 1949-1968 (continued)

– Warren Buffett

• Launched Buffett Partnership LP in 1956 with $100,100

• Strategies: special situations, merger arbitrage, spin-offs, distressed debt, relative value arbitrage

• 25% performance fees above 6% hurdle rate

• Disbanded partnership in 1969 and transformed Berkshire Hathaway into a holding company.

• Performance: Original partnership averaged 29.5% annual compounded return from 1956-1969 vs. average 7-11%. Berkshire Hathaway 21.5% average annual gain from 1965-2005.

• $100 in 1956 invested in Buffett Partnership , reinvested cash distribution in 1969 into shares of Berkshire Hathaway, your investment would be worth $2.1 million in 2006 after all fees and expenses.

History

• The dark ages: 1969-1974

– Bull market of 1960s hurt haphazard short selling due to the lack of experience.

– “swim naked” - many new hedge funds simply leveraged long only positions and ignored the shorting.

– 1969-1970 bear market and then 1973-1974 recession destroyed most hedge funds.

– Oil crisis, Nixon resignation

– Warren Buffet stayed out of stocks until 1974 when Berkshire Hathaway started buying undervalued companies.

History

• The renaissance: 1975-1997

– From 1975 to 1982, market mostly moved sideways. Only a handful of hedge funds operated in secrecy – not registered with SEC.

– Prohibited from advertising, relying on word of mouth to grow assets.

– 1986 Institutional Investor reported performance of Julian Robertson’s Tiger Fund - compounded annual return of 43% in six years net of expenses/fees. S&P returned 18.7% in the same time period.

– Tiger Fund - global macro strategy focusing on macroeconomic analysis, directional bets, no particular hedging policy, futures, options.

– Late 1980s, weakening US dollar, surging gold and commodity prices, >10% interest rates, falling bond markets and bullish equity markets.

– October 19, 1987 “Black Monday” Dow Jones dropped 22.6%. Market recovered quickly though.

– In 1992 George Soro’s Quantum Fund forced the British pound to exit from the European Monetary System. Devaluation netted him $1 billion profit.

History

• The Asian and Russian crises: 1997-1998

– 1994 Mexican financial market crash was rescued by IMF led and US Treasury. Asian emerging markets Thailand, Indonesia, Korea and Taiwan saw unlimited capital rapidly flowing into the region which caused bubbles in real estate and stock markets.

– Hedge funds were blamed for mid 1997 currencies decline because of the FX short positions.

– 1998 Russia devalued the ruble and defaulted on the on ruble-denominated debt.

– Quantum Fund lost $2 billion and LTCM collapsed. LTCM used quant models to bet the spread between low-quality and high-quality bond yield to shrink. Leverage of 25 times turned $4 billion fund into $100 billion of assets which were used as collateral for more than a trillion dollars of notional in OTC derivatives. EM debt and US T-bonds spread increased from 6% in July to 17% in September 1998. Margin calls wiped out LTCM.

– New York Fed led a consortium of 14 banks and securities firms to inject $3.5 billion to bail out the fund.

– Moral hazard -> future recklessness? Enron is a good example

History

• The modern years: 1999 - ?

– Technology stock bubble

– Similar to the bull market in 1960s, most hedge funds decided to tilt portfolios towards internet stocks without offsetting with short positions or derivatives.

– March 2000 Tiger Fund was liquidated (peak >$20 billion)

– April 2000 Quantum Fund was converted into an endowment (peak >$20 billion)

– In March 2004, Merrill Lynch and Cap Gemini Ernst & Young reported that 73% of high net worth investors in US (>$1M) held hedge fund investments.

– In 2008, hedge funds lost 18.3%, worst year on record (HFRI since 1990). Industry assets dropped to $1.1 trn from $1.9 trn in June.

– 693 funds closed in first three quarters of 2008 out of 10,000

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Asian Hedge Fund Growth

Source: Eurekahedge, Mar 2007

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120

140

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

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AuM (US$ bn) No. of Funds Source: Eurekahedge

Characteristics

• Hedge funds are actively managed

– Beta vs. alpha

– Efficient Market Hypothesis

• Hedge funds = proprietary trading desk

• Hedge funds have flexible investment policies vs. mutual funds

– Concentrated vs. diversified

– Short-selling

– Illiquid investments

– Derivatives

– Unlisted securities

• Terms

– Subscription lock-up

– Terms of redemption (advance notice, gate, pay-in-kind)

– Management fees, incentive fees, hurdle rate, high-water mark

• Hedge funds have limited transparency

• Hedge fund strategies are not scalable

– Unscalable - manager skills and available investment opportunities

– Small is better for single strategy funds, close fund to new subscriptions

Category Investable assets Major distribution channels

Ultra-high net worth individuals

More than $25 million Private banks, trust companies, family offices, financial advisers

High net worth individuals $1 million - $50 million Private banks, trust companies, brokerage firms, attorneys, financial advisers

Affluent investors $500,000 - $1 million Commercial banks, mutual fund companies, brokerage firms, attorneys, insurers, financial advisers, funds of funds

Retail investors Less than $500,000 Funds of funds

Characteristics

•Clearing the trades•Consolidated reporting/custodian•Margin financing•Security lending•Research•Capital introduction•Valuation

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Why they make money?

• Over time hedge funds offer equity like returns with lower risk profiles

• Market timing, trading skills, security selections

• Personal incentives (personal capital, incentive fees)

– Superior information (market, instruments)

– Reduced T-costs (lower commissions, tighter quotes from MM)

– Superior market access (DMA, specialist, order depth)

– Size advantage (large or small, slippage)

– Sell-side research (ex. Risk arb)

– Structural inequities (insurance premium for risk assuming)

– Broad investment mandates (beyond long-only)

– Arbitrage (ex. Rights issue)

Strategies

Defined by Credit Suisse Tremont

• Long/Short Equity (30.6% of all funds, 29.8% of all AUM)

• Equity Market Neutral (3.8%, 3.9%)

• Equity Trading (1.1%, 2.4%)

• Event Driven (merger arb, distressed securities, high yield) (11.9%, 16.6%)

• Convertible Arbitrage (3.5%, 4.4%)

• Fixed Income Arbitrage (5.1%, 7.7%)

• Global Macro (4%, 14.9%)

• Dedicated Shorts (0.5%, 0.4%)

• Emerging Markets (5.6%, 3.5%)

• Managed Futures (18.6%, 15.9%)

• Fund of Funds (14.1%, n/a)

Long/Short

• Stock picking is like playing the lottery. It is definitely a game worth winning. But is it a game worth playing?

• Shift styles (value, growth), size (small, med, large caps), direction (net long, net short)

Hedge fund

Prime broker

Stock lender

Market

$1000 $900

Stock A

Stock B

$800

Stock B Collateral

Long/Short

• Net long: stock A $900

• Net short: stock B $800

• Cash: $900

• Total assets: $2600 vs. initial equity capital $1000

So, 90% long exposure, 80% short exposure, 170% gross exposure, 10% net long exposure.

Return = spread performance + short collateral interest rebate + interest on margin deposit + dividend spread

Advantages:

• Value approach

• Sector rotation

• Quantitative approach

• Activist strategies (sell underperforming assets, cash div, sale of company, restructuring /cost-cutting)

• Relative value trades (foreign vs. local, pref vs. ord, index futures vs. ETFs, dual-listing, CEF arbitrage, etc)

Disadvantages:

• Higher trading costs on total exposure

• Higher turnover

• Difficulty in execution

• Lag in bull markets

• Net long bias drift

Long/Short

For example, Dual listings

Major Asian Stocks with Foreign Listings (ADRs)

• PetroChina

• China Mobile

• China Petroleum and Chemical

• BHP Billiton

• China Life Insurance

• Toyota

• Reliance Industries

• Mitsubishi

• Samsung Electronics

• Nintendo

• United Microelectronics

Source: Bloomberg, January 2008

Merger Arbitrage

• Merging for monopoly (1895-1903)

– Horizontal mergers (trusts) - Rockefeller’s Standard Oil, GM, GE, AT&T, Du Pont, US Steel, Coca Cola

– Ended with World War I

• Merging for Oligopoly (1920-1929)

– Vertical integration - electricity and gas utilities, manufacturing firms - Bethlehem Steel

– Ended with 1929 market crash and the Great Depression

• Empire building (1955-1973)

– New source of financing - issues of convertible preferred stocks and debentures

– Large investment banks establishing merger arb desks (Gustave Levy at Goldman Sachs)

– Created large conglomerates for empire building, lack economic sense

– Ended with oil crisis and market decline in 70’s

Merger Arbitrage

• Takeover wave (1974-1989)

– Golden era, low interest rates, easy access to junk bonds

– Hostile predatory takeovers, LBOs

– Synergistic gains, eliminate excessive diversification by breaking up inefficient conglomerates, purchase poor performing targets, replacing incumbent management, using junk debt to generate tax savings.

– Announced merger -> insider trading:

• Ivan Boesky (pre-announcement merger plays), Martin Siegel (Kidder Peabody), Dennis Levine (Drexel Burnham Lambert) $600m junk offering, rake in $24m fees, Michael Milken ($200m fine, $400m in settlements, 22 months in jail, banned for life from the securities industry.)

• Strategic merger wave (1993 - now)

– Citibank and Travellers, Chrysler and Daimler Benz, Exxon and Mobil, Boeing and McDonnell Douglas, AOL and Time Warner

– Europe single currency

– Deregulation and privatization in utilities and financial services

– Foreign ownership of domestic firms (Japan, Korea)

– Rising stock market valuation. Stock becomes the preferred medium of payment.

Merger Arbitrage

Current Situation•Publicly announced merger•Market price is known•Arbitrage spread is known•Large holdings are known

Successful takeover•Market price should equal tender price•Liquidate positions with a profit equal to the arbitrage spread

Failed takeover•Market price might drop significantly•Liquidate positions with a loss

Merger Arbitrage

• Cash tender offer

– Capital tied up

– Market risk of the long positions - sell short equity index futures

• Stock for stock offer

– Estimate the merger spread to narrow - short the spread

– Buy target, sell short the bidder - removing market risk

• Collar offers

– Fixed collar (fix exchange ratio), if outside the range, option to cancel or reneg

– Floating collar (optionality of the bull spread)

Merger ArbitrageRisks:

• Transaction risk (deal risk)

– Acquirer’s attitude (friendly vs. hostile 20 times more likely to succeed)

– Type of deal (flexible better than fixed)

– Takeover premium (higher premium better)

– Ownership structure of target (a lot of merger arbitrageurs as shareholders better)

– Anti-trust considerations (divestment of key holdings)

– Economic conditions

– Target management attitude (loss of jobs, lock-up options)

• Calendar risk

– Announcement and the consummation of the merge (merger in China could take twelve months for regulatory approvals), average deal takes 100 days to complete

– Merger spreads sensitive to rumors

Trading

• Availability of a sufficient volume of M&A for diversified merger arb portfolio

• Sufficient spread to compensate for failing transactions, low risk with steady returns

• Position limits

• Reverse positions

Convertible Bond Arbitrage

• Bond with an option to convert to equity

• Identifying components– Coupon

– Redemption value

– Conversion to equity

– Investor put option

– Issuer call option

– Conversion price reset options

• Valuation– Bond Value plus option

– Bond valuation inputs

– Interest rate, credit spread

– Option valuation inputs:

– Strike price, Stock price, Interest rate, Stock volatility, dividends, stock borrow cost.

Convertible Bond Arbitrage

• Fixed income components:

– Issuer is company XYZ, a company with a BBB rating

– CB has a five-year time to maturity

– 2% annual coupon, first coupon paid in exactly one-year

– Par value of each bond is $1000

– Yield to Maturity: 2% p.a.

• Equity components:

– Stock price $80

– 20% annualized realized volatility

– No stock dividend

• Market valuation

– Convertible price: 100 (100% of face value)

– Parity 80 (80% of face value)

– Conversion premium: 25%

• Conversion components:

– Conversion ratio: 10

– Conversion price: $100

– Call/put protection: none

Convertible Bond Arbitrage

Convertible Bond Arbitrage

• Convertible bond = straight bond + option

• Convertible bond = parity + put option + value of income

• Put option - right to sell a prespecified number of shares at the convertible bond redemption price

• Income - present value of the stream of income provided by the convertible bond

Convertible Bond Arbitrage

Convertible Bond Arbitrage

Region 1. Equity Proxy

• Also viewed as a “cheap put” – deep-in-the-money option

• Equity sensitivity is high (delta -> 1) and fixed income sensitivity is low.

• Main component of return:

– Coupon income

– Plus Interest earned from short stock position

– Less Cost of stock borrow

– Less Share Dividends foregone

• These trades are usually highly leveraged as the proceeds from the short stock position can be used to buy more convertibles.

• Small credit risk taken, downside is parity. Risks: dividend growth (special divs), bonds get called, stock borrow recalled or re-priced.

• High leverage is required to get returns. No directional view required.

Convertible Bond Arbitrage

Region 2. Volatility Trade

• Buy convertible and sell stock to create a delta neutral position.

• Calculate delta from theoretical model. Convertible strike prices dynamic and changes with interest rates, credit quality of the issuer.

• Long gamma / volatility position . i.e., long “change in delta” position. Region 2 exhibits the greatest amount of gamma as it is near-the-money. The higher the volatility the greater the re-hedging.

• There is an element of “art” in estimating a bond’s delta, particularly in Asia where stock borrow might be limited e.g., Taiwan.

• Stock is sold when shares rise and is bought when shares fall maintaining a market neutral position.

• Returns come from return as in Region 1 (coupon + interest rebate from short stock -stock borrow fee –dividends foregone) and profits made from re-hedging.

• Risks include: incorrect assumptions of interest rates, issuer credit deterioration, stock volatility, stock borrow recall risk, takeover of the issuer which does not include provisions for convertible holders.

Convertible Bond Arbitrage

Region 3. “Busted” - Fixed Income Trade

• Out-of-the-money convertibles with little equity sensitivity (delta -> 0) “busted convertibles”

• Often mispriced compared with straight bonds.

• As the convertible falls to this region, hedge fund owners often unwind positions regardless of what the credit is worth. Bonds shift to a different investor base.

• Even though the optionality is small, any significant rise in the stock will benefit convertible holders.

• As the issuing company approaches a bankruptcy situation, or there is a significant macro change in the economy (the Asian crisis in 1997 and 1998), the convertible bond will trade on a higher delta.

• Basically trades like a distressed bond. This strategy requires intense credit analysis for the default risk, although many of these skills are also required for Region 2.

Convertible Bond Arbitrage

• Mitigate credit risk in practice (many convertible bonds are unsecured, subordinated and issued by firms with high volatility of earnings, high leverage and/or intangible assets.

– Short stock (borrow, reasonable rates)

– Short a straight bond of the same issuer (needs to be actively traded and can be borrowed easily)

– Buy Credit Default Swap (counterparty risk, deliverable CB carries call risk)

– Use OTC asset swap

Hedge fund Stock marketCredit investor

Convertible market

Short stocks

CB priceCB

CB

Bond option

Challenges in 2008

Challenges in 2008

Challenges in 2008

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The Old Hedge Fund Model is Over!

• Many hedge funds produced positive returns because of leveraged beta and not alpha.

• In this cycle the inappropriate use of leverage has blown up many hedge funds and many hedge fund investors.

• Leverage and short selling will become more expensive and difficult.

• There is no point in paying 2 and 20 for beta including leveraged beta.

• The trend to separate pure beta returns via index products on one hand and true alpha on the other hand will accelerate and will decimate those hedge funds and other players that are just leveraged beta players.

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End of Abundant Cheap Leverage

• Borrowing costs for hedge funds are moving from LIBOR plus 30-50 basis points to LIBOR plus 200-500 basis points.

• Collateral margins will go up to protect the lender. Each dollar of collateral will support less leverage.

• The following assets are no longer readily acceptable as collateral: CBs, emerging market bonds and equities, smaller stocks, and high yield bonds.

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Short Selling and Securities Lending Restrictions

• Many stock lenders are no longer willing to lend their securities because of counterparty risks, minimal returns, lack of transparency and flawed documentation.

• Many governments are going to permanently restrict or limit short selling. Naked short selling will virtually cease to exist.

• There may be additional government regulations on securities lendingand collateral arrangements.

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What Prime Brokers Are Doing?

• Force up borrowing costs for HFs since PB cost of borrowing has gone up.

• Require more collateral to protect against volatility and counterparty failures.

• Will not accepting some types of collateral.

• Will not deal with smaller funds since economies of scale have changed.

• Will not make their balance sheets as readily available.

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What HF Strategies Work in Future?• Wide credit spreads in high yield and busted converts market produce

excellent returns without leverage.

• Extremely cheap equities are abundant but require long-term time horizon and absolute return mentality since monthly/quarterly mark to market volatility may remain high.

• Private financing transactions usually involve debt with equity kickers for capital constrained companies.

• Lots of arbitrage or semi-arbitrage opportunities since spreads are now wider but not necessarily scalable since stock borrow may be difficult/expensive.

• Macro trading using exchange derivatives will be remain viable strategy.

Future of HF Strategies

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Our Approach• Multi-strategy with no or low leverage and able to move between

credit and equity markets.

• Never relied upon financial leverage to produce returns but accept some balance sheet leverage that comes from some hedging.

• High yield credit (either straight public high yield or busted converts) will become main driver of returns in this cycle.

• Relative value trades and other arbitrage strategies will round out returns and lower portfolio risk.

• Deep value equities in a limited amount will add longer term returns.

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Specific Asian Opportunities

ASSET CLASS EXPECTED US$ ANNUAL IRR

Public High Yield Bonds 20-30%

High Yield Convertible Bonds 20%+

REITs 10-15% annual dividend yield

Closed End Funds 25%+

Preference Shares 20%+

Merger Arbitrage 20%+

Forced Asset Disposals 40-50%+

Distressed Debt/Loans 40%+

Special Situations 30%+

All in a day’s work

• 7:30 global meeting

• 8:00 – 9:00 news, overnight executions, models refresh

• Bloomberg, Excel, software

• Half an hour lunch break

• 12-hour in the office

• Night trading

• Board meeting, client visit, marketing trip, conference

• Some real-life trades– Hang Lung holding company

– A/H arbitrage

– DBS rights issue

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Q & A

Kai Zhang, CFA

852-2533-0926 (O)

852-9388-9266 (M)

Kai.zhang@limadvisors.com

gizmofish@gmail.com