Hedge Fund Investing Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more For a list of available titles, visit our website at www.WileyFinance.com Hedge Fund Investing A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance Second Edition Kevin R Mirabile Cover image: (top) © Rawpixel / Shutterstock; (bottom) © isak55 / Shutterstock Cover design: Wiley Copyright © 2016 by John Wiley & Sons, Inc All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993, or fax (317) 572-4002 Wiley publishes in a variety of print and electronic formats and by print-on-demand Some material included with standard print versions of this book may not be included in e-books or in print-on-demand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about Wiley products, visit www.wiley.com ISBN 978-1-119-21035-1 (Hardcover) ISBN 978-1-119-21039-9 (ePDF) ISBN 978-1-119-21037-5 (ePub) Printed in the United States of America This book is dedicated to my wife, Maureen, and my children, Sarah, Andrew, and Will Contents Preface ix Acknowledgments xiii About the Author xv Part One Overview Chapter The Basics of Hedge Fund Investing Chapter Hedge Fund Strategies, Performance Measurement, and Risk 21 Chapter Who Invests in Hedge Funds and Why? 39 Chapter Industry Trends, Flows, and Characteristics 65 Part Two Understanding the Strategies Chapter Global Macro Investing 87 Chapter Equity-Oriented Styles 109 vii viii Contents Chapter Fixed-Income–Oriented Strategies 143 Chapter Multistrategy Funds, Funds of Hedge Funds, and Replication Products 173 Chapter Portfolio Financing and Secondary Market Trading  191 Part Three Evaluating Individual Fund Risk and Reward Chapter 10 Measuring Performance and Performance Persistence 213 Chapter 11 Impact of Fund Characteristics and Terms on Performance 233 Chapter 12 Performing Due Diligence on Specific Managers and Funds 247 Chapter 13 Evaluating the Roles of Service Providers 271 Chapter 14 Observations and Outlook 299 Glossary 309 References and Additional Reading 319 Index 335 Preface T his book is designed to provide an overview of alternative investments and, in particular, instill in readers a working knowledge of that portion of alternative investments known as hedge fund investing The second edition of this book includes important updates related to industry flows and performance, plus new material covering the exciting new world of hedged mutual funds, secondary trading in hedge fund investments, and more information about the various techniques and instruments used by hedge fund managers to finance their portfolios The original motivation to write this book was to deliver a holistic view of hedge fund investing That has not changed The intention was to provide a cradle‐to‐grave perspective for first‐time investors, for practitioners dealing with hedge funds as clients or counterparties, and for students wishing to learn how the sector operates from both a theoretical and a practical perspective My personal experiences as a banker, accountant, service provider, investor, and partner in a hedge fund and a fund of hedge funds allows me to deliver some practical insights that I believe will facilitate learning The goal for this second edition is to once again present a comprehensive view of the reasons people invest in the sector, discuss how the managers, funds, and strategies interact, and recommend criteria people can use to select managers and funds—all without getting lost in too much detail The approach is to cover a wide range of material in sufficient detail to familiarize readers with the issues, without getting lost in the multitude of regulations and mathematics needed to fully investigate any single topic The hope is that by “keeping it simple” readers will learn enough about the asset class and the process of investing to give them confidence to move forward with asking the questions needed to become a great investor Importantly, one of the goals for this book, if not its primary goal, is to make the asset class accessible and to demystify what is at times presented as an overly complex and esoteric category of investing My approach is to deliver a balanced discussion of the broad spectrum of information needed to invest in hedge funds; however, it is inevitable that certain sections garner more emphasis than others The vast majority of information in this text comes from my personal experience in providing services to, trading with, lending to, or investing in hedge funds over the past 25 years It also includes the advice and input ix x Preface of former colleagues and friends in the industry who share my interest in promoting educational efforts about hedge fund investing It is only through education that the myths of hedge fund investing can be debunked and the opportunities can be assessed objectively In this way, more people can reap the rewards and benefits of hedge fund investing while also fully understanding the risks of this exciting asset class The book is designed for those who have a basic knowledge of financial instruments, markets, asset allocation, and portfolio management A rudimentary knowledge of statistics and some of the basic principles of calculus is also helpful, although not a requirement The book is organized into three parts related to basic concepts and market characteristics, an explanation of the individual strategies and financing tools used by hedge fund managers, and an overview of the process needed for the evaluation and analysis of individual managers and funds, including approaches to performing a due diligence process on any one fund Each chapter has its own individual objectives and illustrations that can be read on their own or as part of the complete text Part One of the book provides readers with an overview of alternative investments It highlights the similarities and differences among various types of alternatives, including hedge funds It establishes the framework for understanding fund‐level profit or loss calculations, performance measurement, and risk It also provides readers with an understanding of the rationale for investing in hedge funds as well as the flows experienced by the sector over time Part Two is designed to explore several of the most prominent hedge fund investing strategies in more detail It provides straightforward explanations of the important terms, definitions, trades, organization structures, portfolio constructions, performance measurements, and risk assessments used in each strategy Strategies are organized into those that are not directly correlated to the traditional stock and bond market, those that are equity or fixed‐income oriented, and those that are multistrategy in nature It also includes new sections on the financing market and the secondary market for trading in hedge fund investments Part Three explores the nature of absolute, relative, and risk‐adjusted performance measures; the impact of fund characteristics related to compensation arrangements; fund terms; and environmental conditions that motivate behavior and influence performance This section also covers the due diligence process for selecting a single hedge fund for investment from a universe of peers Topics covered include how to quickly assess and evaluate the people, pedigree, and processes that establish the DNA of any fund; understanding the investment and risk management process of a fund; the impact of the fund’s business model and counterparty risk on the fund’s Preface xi performance and sustainability; and the role of a fund’s service providers in creating opportunities for a fund, influencing a fund’s performance, or protecting investors from fraud, blowups, or other calamities The book ends with some final observations, a review of the challenges faced by the industry today, and the outlook or trends that are likely to continue going forward This book can be used by commercial practitioners on a stand‐alone basis or by educators in conjunction with supplemental material available online that includes PowerPoint slides, Excel spreadsheets, end‐of‐chapter discussion questions, and a test bank of over 100 questions Educators can download the test bank and other learning tools at Wiley’s Instructor Site Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance, Second Edition By Kevin R Mirabile Copyright © 2016 by John Wiley & Sons, Inc Index Absolute return, 215–216 Accounting quality of, 274–275 shadow, 277–278 Accounting firms See Auditors Accredited investors, 79 Administrators, fund See Fund administrators Age (of fund managers), 41–42, 239–240 Agencies bonds, 143 Agency theory, 234–240 Agglomeration, 242–245 AIG, 57 Akin Gump, 293 Alpha, 35, 56, 73, 74, 122, 218–219, 226 equity-oriented funds, 140 fixed-income-oriented funds, 167 global macro funds, 107 Alternative beta, 74, 189–190 Alternative Investment Management Industry Association, 278, 297–298 Alternative investments, 3–7, 208 “Alternative Investment Survey,” 304–305 Annualized returns, 213 Antitrust laws, 124 Apollo, 151 AQR, 88, 122, 302 Arbitrage strategies, 24 Ares Capital, 151 Arithmetic average returns, 215–216 Arithmetic mean, 34 Arnold, John, 72 Arthur Bell, 290 Asset allocation, 43–49 Asset-based lending products, 151 Asset classes, traditional, 3, 15 Asset management, 201–202 Assets, hard, Assets under management (AUM), 10 At-the-money options, 192 Auditors, 242, 259, 271, 289–292 costs, 290 firm profiles, 291–292 by number of funds serviced, 290 scope of services, 289–290 Background checks, 254 Bacon, Louis, 104 Balance sheet, 261 Balyasny Asset Management, 179–180 Bank loans, 145, 147 Bank of America/Merrill Lynch, 287 Bank of New York Mellon, 208, 279 Bankruptcy, 204–205 Banks custodian, 207 private, 51 Barclay’s Aggregate Bond Index, 216 Barclay’s Capital, 141, 287 Barriers to entry, 6, 76, 262–263 Basis swap, 156 Baskets, 143 Baupost L.P., 134, 137 Bausano, Barry, 304 Bayou Hedge Fund Group, 56 Bayou Management, 254 BDO, 290 Bear Stearns, 123, 204–205, 280, 284, 287 335 336 Benchmarks, 40, 73, 120, 216, 218, 219, 237 Bermuda, 7, Beta, 35, 36, 73, 74, 213, 218–219, 226, 228 equity-oriented funds, 140 fixed-income-oriented funds, 167 global macro funds, 107 Beta-adjusted gross exposure, 127 Beta-adjusted market values, 127 Biases, 24, 228–229 Bilateral repos, 207–208 Blackstone, 57, 302 BlueCrest Capital Management, 163, 165 BNP Paribas, 287 Board of directors, Boesky, Ivan, 123 Bogle, John, 14 Bond floor, 148 Bonds, 3, 24, 143 corporate (See Corporate bonds) futures, 192 government (See Government bonds) and interest rates, 227 maturity, 219 Borrow fees, 27, 127 Bottom-up analysis, 152, 153–154 Brevan Howard Asset Management, 39, 72, 88 Bridgewater Associates, 39, 72, 88, 102, 104, 302 British Virgin Islands, 8, Brokers, 83 Brolin, Jonathan, 137 Business model risk, 262–266 Business risk, 60–63 Business skills, 247–248 Calmar ratio, 169 CalPERS, 55, 57 Capital introduction, 283 Capital structure arbitrage funds, 147 Caps, 143 Carlyle, 302 Index Carry trades, 74, 156 Cash flow, 194–195 versus futures arbitrage, 152 versus futures carry trade, 156 Caxton Associates, 72, 88 Cayman Islands, 7, 8, CCO, 11 CDOs, CDS (credit default swaps), 143, 144, 145, 147 CEA (Commodity Exchange Act), 81 Centaurus Energy, 72 CEOs, 258 CFO, 11, 12 CFTC (Commodity Futures Trading Commission), 78, 81, 267 Chief compliance officer, 12 Chi-square test, 225 CIO, 11 Citadel Investments, 175, 178, 179 Citco Fund Services, 279, 280 Citi Fund Services, 279 Citigroup, 305 Citi Prime Finance, 60, 287 Clearance, 281 Clients, number of, 276 CLOs, Closure risk, 60–63 Coatue Capital Management, 111 Code of ethics, 259 Co-investment, manager, 5, 44–45 Collateral, 195–197, 203, 205, 206, 207 Collectables, 3, Comac, 88 Commissions, 27 Commodities, Commodities futures, 192 Commodity Exchange Act (CEA), 81 Commodity Futures Trading Commission (CFTC), 78, 81, 267 Commodity pool operators (CPOs), 81 Commodity pools, 88–89 Commodity price exposure, 152 Index Commodity trading advisers (CTAs), 81, 88–89, 100, 238 Compensation, 15, 44–45, 71–73, 233, 236 Compliance, 12, 259, 260, 275–276 Compound growth rate, 34 Concentration risk, 60 Conflict of interest, 14, 83, 260 Consistency, 213 Consultants, 83–84, 276, 283–284 Controller, 11 Conversion premium, 148 Conversion ratio, 148 Conversion value, 148 Convertible arbitrage funds, 26, 143, 144, 145 AUM, 163 investing strategies, 153–154 liquidity, 149 net basis computing, 199 performance, 171 returns, 168 risk and return, 170 trading example, 160–161 trading strategies, 146 typical focus of, 147–148 Convertible bond arbitrage funds, 24, 148–149 Convertible bonds, 143, 145 Convexity, 35, 152, 227 Convexity Capital Management, 178 COO, 11, 12 Corporate bonds, 143, 147, 193, 204, 207 Corporate credit, 144–145 Corporate debt instruments, 145 Correlation statistics equity-oriented funds, 140 fixed-income-oriented funds, 167 global macro funds, 107 Cost control, 264 Cost of carry, 27 Counterparty risk, 195–198, 259, 286 Coupons, 27 CPOs (commodity pool operators), 81 337 Credit arbitrage funds, 24, 143, 144–145 flows and performance, 161 leverage, 147 top-down investing strategy, 153 trading strategies, 146, 147 Credit balance, 30 Credit default swaps (CDS), 143, 144, 145, 147 Credit derivatives, 145 Credit funds, 143 returns and risk, 166–172 Credit-oriented funds, 144, 147, 161 Credit spreads, 35, 40, 144, 219, 227–228 Credit Suisse, 287, 289 Credit trade, 158–160 Creditworthiness, 227–228 Cross-sectional analysis, 105 CS Dow Jones Indices, 26 CSFB/Dow Jones, 65 CTAs (commodity trading advisers), 81, 88–89, 100, 238 Cumulative returns, 215, 225 Currency markets, 146, 192 Custodian banks, 207 Dalio, Ray, 72, 104 Data reliability, 228–229 Debit balance, 30 Dechert, 293 Declining markets, 15 Defaults, bank, 205 Delaware, 8, Deloitte, 242, 290, 291 Delta, 148 De minimis exemption, 81–82 Demographics, investor, 303 Derivatives, 7, 13, 15, 30, 70, 116, 144, 145, 146, 205–206 defined, 29 D.E Shaw, 72, 88, 122 Deutsche Bank, 287, 304–305 Direct investment, 83 Directional trading, 88, 93–96 338 Director of research, 11 Disclosure, 7, 13–14, 259–262 Discretion, managerial, 240–241 Discretionary global macro investing, 26, 88, 92–93 Distressed investing, 150–151, 153 Diversification, 8, 40, 175, 177, 303 Dividends, 27, 127 Documentation, fund, 257–262 Dodd-Frank Act, 82, 123, 276 Domicile, fund, 242 Downside capture, 35, 216 Downside deviation, 169 Drawdown, 221–223 Druckenmiller, Stanley, 72 Due diligence, 123, 247–270 common elements of, 251–257 defined, 247 operational, 257–258 questionnaire, 268–269 Duquesne Capital Management, 72 Duration, 35, 36–37, 152, 227 DV01 exposure, 152 DV01 risk spread, 152 Economies of agglomeration, 242–245 Edenbrook Capital Management, 137–138 Edge Technology Group, 296, 297 Efficiency, 193–194 Efficient frontier, 46, 47 Eight-factor model, 229, 230 Eisner Amper, 290 Emerging markets, 304 Employee trading, 259 Endowment funds, 51–52, 110 Equities, 145, 147, 204 Equity liquid, 115 markets, 205–208 ownership, 253 swaps, 115 U.S., 191 variable bias, 24 Index Equity event-driven funds, 112, 114, 118 Equity hedge fund, 24, 69 Equity market neutral funds, 24, 111, 112, 115, 116, 118 characteristics of, 125–126 investment process, 119–120 portfolio creation, 122 sample description of, 114 Equity-oriented funds, 109–142 characteristics of, 112–113, 125–126 evaluating risk, 138–141 exposure reporting, 127–132 flows and performance, 133–137 investment process, 119–126 measuring returns, 138–141 organizational structure, 116–118 overview, 109–115 portfolio characteristics, 119–126 quarterly performance 1998-2015, 135 sample portfolios, 128–132 strategy profit or loss, 127–132 terms and conditions, 133 top funds, 137 Ernst & Young, 242, 290, 291, 304 Estates, 51 Eurekahedge, 26, 65 Event-driven funds, 25, 69, 109, 111, 115 characteristics of, 125–126 investment process, 119–120 liquidity, 133 long and short equity funds, 133 organizational structure, 118 quarterly performance 1998-2015, 136 redemption period, 133 terms and conditions, 133 Exchange rates, 152 Expectations, investor, 213, 301–302 Expenses, 27–28, 76, 305 dividend, 127 fixed-income-oriented funds, 156 interest, 27, 127 Index manager’s, 60 summary of fund’s, 128 Exposure, 35–37, 152 equity-oriented funds, 127–132 fixed-income-oriented funds, 155–161 Externalities, 213 EzeCastle Integration, 294, 296–297 Factor exposure, 219 Family offices, 51 Fama and French factors, 40 Farmland, FBI, 267 FCM (futures commission merchant), 92 Federal Reserve Regulation T, 30, 31, 33, 115, 193, 281 Fees, 15, 27–28, 71–73, 76–77, 233, 262, 272, 305 borrow (See Borrow fees) credit-oriented funds, 161 funds of hedge funds, 174 incentive (See Incentive fees) long and short equity funds, 133 multistrategy fund, 173 performance (See Performance fees) Fiduciary, 83 Finance, portfolio, 191–210 basic tools, 192–194 Financial advisers, 83 Financial Stability Oversight Council (FSOC), 82 Financial statements, 257–262 FINRA (Financial Industry Regulatory Authority), 80 Fixed costs, 60 Fixed-income financing markets, 205–208 Fixed income hedge funds, 195 Fixed-income-oriented funds, 24, 143–172 evaluating risk, 166–172 exposure reporting, 155–161 flows and performance, 161–163 339 income and expense items, 156 investment process and portfolios, 152–154 liquidity, 161 manager profile, 163–166 organizational structure, 149–152 overview, 143–149 redemption period, 161 returns, 166–172 strategies, 163 strategy profit or loss, 155–161 terms and conditions, 161 volatility, 167 Fixed-income relative value funds, 143, 149 flows and performance, 161 growth of investment, 168 investment objectives, 145 leverage, 146 performance 1998-2015, 164 returns and risk, 166–172 sample description of, 145–146 terms and conditions, 161 trading example, 156–158 trading strategies, 144, 146 Floors, 143 Foreign exchange, Form ADV, 260 Fortress Investment Group, 151, 306–307 Forward-looking returns, 213–214 Forwards, 192 Foundations, 51 Fraud, 56, 60, 249, 254, 266–268, 274 Fraud risk, Free credits, 203, 205 Frontier markets, 304 Fund administrators, 242, 271, 272–280 See also Managers, hedge fund choosing, 274 firm profiles, 278–280 importance to investors, 273–278 offshore, 277 scope of services, 273 340 Fund constraint, 37 Fund domicile, 242 Fund offering memo, 260 Fund operating expenses, 27 Funds of hedge funds (FoFs), 52, 55–57, 173 asset losses, 76 criticisms of, 174 defined, 173–174 flows and performance, 185–187 leverage, 183 liquidity, 185 manager profile, 187–189 organizational structure, 182–184 overview, 180–182 and pension plans, 184 performance, 188 performance persistence, 230 risk and opportunities, 184–185 size of, 17 transparency, 185 Futures, commodities, 192 contract price, 206 interest rates, 22 margin on, 146 treasury notes, 23 Futures arbitrage, 152 Futures carry trade, 156 Futures commission merchant (FCM), 92 FX Concepts, 72 Gamma value, 154 Gates, 57, 73, 208 General counsel See Legal counsel General partner, 8, 11 Geometric mean, 34 Geometric monthly returns, 215–216 Global equity long and short hedge funds, 199 Global macro funds, 26, 68–69, 87–108, 149, 152 flows and performance, 102–104 instruments used by, 90 Index manager profile, 104–105 measuring returns and risk, 105–108 objectives of, 89 organizational structure, 91–92 overview, 87–91 portfolio characteristics, 92–100 profile of typical, 101–102 statistics, 108 terms and conditions, 101–102 Goldman Sachs, 123, 205, 242, 287, 288 Governance, 289 Government bonds, 90, 143, 191, 193, 207 Graham Capital, 88 Grant Thornton, 290 Greenwich Roundtable, 253 Griffin, Ken, 123, 179 Gross, Bill, 302 Gross computation method, 199–201 Gross exposure, 35–37, 127 Gross interest, 194–195 Gross leverage, 158 Gross margin, 198 Grosvenor Capital Management, 55, 189 “Growing Up: A New Environment Hedge Funds,,” 303–304 “Guide to Institutional Investors Views and Preferences,” 297–298 Haircuts, 192–193, 196, 197 Harding, David, 72 Head trader, 11 Hedge Fund Research (HRF), 17, 26 Hedge Fund Review, 65 Hedge funds, 4–5 See also Managers, hedge fund academic research, 39–43 age of industry, 58 age of managers, 41–42, 239–240 asset allocation, 43–49 assets, 40, 66 basics, 3–19 buying and selling, 82–84 Index characteristics and structures, 7–13 classifications, 23–25 common jurisdictions, controlling agency costs, 236–237 critics of, 67–68 current state of industry, 75–78 and dealer bankruptcy/insolvency, 204–205 dealers, 202–204 defined, 78 development stages, 62–63 documentation, 257–262 domiciles, 7–8 due diligence (See Due diligence) expenses, 76 fees, 233–234, 238 finance, 191–210 focus of investments, 69 funding, 202–204 and high-net worth individuals, 45, 49–51 history, 14 industry associations, 65 industry challenges, 299–303 industry characteristics, 68–75 industry growth periods, 66–68 industry surveys, 303–305 industry trends, 65–84 investors, 39–63 liquidity, 15, 59 location, domicile, and partners, 242 losses, 73 major benefits of investing in, 42–43 management company responsibility and organizational design, 8–13 during market crash of 2008, 70–71vs mutual funds, 13–19 necessary positions within, 11–13 necessary skills for running, 247–248 new launches vs closures, 61–62 observations and outlook, 299–308 operational environment, 257–262 ownership structure, 253 performance measurements, 14, 34–37 341 performance since 1993, 300 principals, 253–254 procedures, 258–259 purpose of contracting with administrator, 272 reasons for failure, 249 reasons investors don’t allocate more to, 58–63 regulation of, 6–7, 10, 14–15, 78–82 reputation of, 60 research resources, 65 returns, 26–29, 40, 46–47, 71, 74–75 revenue to Wall Street, 77–78 risk, 34–37, 43, 46–47 sample calculation of performance, 28–29 and secondary trading, 208–209 service providers, 271–298 size and scope of industry, 16–19 size effects, 41 strategies, 68–69 strategy classifications, 25–26 theoretical valuation of, 305–308 total investments in, track record, 253 types of strategies, 21–29 “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” 268 Hedge ratio, 148 Hennessee Group, 65 HFRI Fund Weighted Composite Index (HFRIFWI), 189 High-net worth individuals (HNWI), 45, 47, 49–51, 55, 102 High-water mark, 234, 239, 261 Historical returns, 213, 214–223 Hostile takeovers, 124 Howard, Alan, 72 Hudson Bay Company, 236 Human resources, 11, 12 Hurdle rate, 234, 239, 261 Hybrid securities, 143, 145 Hypothesis testing, 97 342 Icahn, Carl, 123 Illiquidity, 6, 47, 74 “Implications of the Growth of Hedge Funds,” 268 Incentive fees, 5, 28, 44–45, 60–61, 71–72, 233–234, 236, 264 Incentives, 238 Income dividend, 127 fixed-income-oriented funds, 156 interest, 27, 127 summary of fund’s, 128 Income statement, 261 Index fees, 74 Index replication product, 189–190 Indices, 143, 144 Inefficiencies, 143 Inflation, 152 Information ratio, 169 Information technology, 11, 12 Initial margin, 197 Insider trading, 123 Insolvency, 204–205 Institutional investors, 44–45, 84, 102, 110, 301, 303–304 Insurance carriers, 271 Insurance companies, 51 Interactive Brokers, 287 Intercept coefficient, 218 Interest, 27, 194–195 costs, 194–195 expense, 199–201 income, 127, 199–201 netting, 199 Interest rates, 7, 22, 36, 146, 219, 227 Interest rate swaps, 143, 192 Intermediaries, 305 Intermediation, 282 Internal controls, 258–259, 276 International Fund Services, 279 International Investment Funds Association, 16 Investing distressed, 150–151, 153 due diligence, 251–254 Index equity market neutral funds, 119–120 event-driven funds, 119–120 fixed-income-oriented funds, 152–154 by fund managers, long and short equity funds, 119–126 long bias funds, 119–120 risk arbitrage funds, 119–120 skills, 247–248 strategies, 252–253 variable bias funds, 119–120 Investment advisers, 79 Investment Advisers Act of 1940, 79 Investment Company Act of 1940, 8, 11, 13–14, 80–82 Investment management agreement, 260 Investor relations, 12 Investors, 39–63 communicating with, 275 demographics, 303 expectations, 301–302 frequency of reports to, 256–257 fund managers as, individual vs institutional, 7, 44–45 institutional (See Institutional investors) reasons to not use hedge funds, 58–63 retail, 7, 47 Ireland, 7, IT firms See Technology providers Jefferies, 287 Jensen’s alpha, 221 JOBS Act, 10–11 Jones, Alfred Winslow, 14, 39, 109 Jones, Paul Tudor, 39, 89, 104, 105, 249 JP Morgan Chase, 67, 205, 208, 242, 287 King Street Capital Management, 134, 137 KKR, 302 Knowledge clusters, 242–243, 244 343 Index Kolmogorov-Smirnov test, 225 Kovner, Bruce, 72 KPMG, 242, 290, 291, 303 Kurtosis, 35, 224, 225, 226 Laffont, Philippe, 111 Lansdowne Developed Markets Fund, 137 Larch Lane, 57 Large private fund advisor, 82 Law firms See Legal counsel Legal counsel, 12, 259–260, 271, 292–294 Legg Mason Group, 187 Lehman Brothers, 70, 204–205, 259, 280, 284 Leverage, 5, 7, 8, 15, 69–70, 78, 191, 226, 241 capital structure arbitrage funds, 147 convertible bond arbitrage funds, 148–149 credit arbitrage funds, 147 defined, 29 example, 30–32, 32–33 fixed-income relative value funds, 146 funds of hedge funds, 183 global macro funds, 90–91 impact of, 29–33 and long and short equity funds, 115, 116–117 and mutual funds, 13 portfolio, 256 primary sources of, 29 regulations, 6–7 Liability management, 201–202 Life insurance settlements, Limited capital entities, 201 Limited liability companies (LLC), 7, Limited partnership agreement, 260 Limited partnerships, 7, Liquidity, 5, 6, 8, 15, 30, 59 and alternative investments, 208 convertible arbitrage funds, 149 event-driven funds, 133 fixed-income-oriented funds, 161 funds of hedge funds, 185 portfolio, 202, 256 quantitative equity market neutral funds, 133 Litigation, 276 Lo, Andrew, 70 Loans, 145, 147, 281–282 See also Margin loans Lockup period, 240 Lone Pine, 121 Long and short equity funds, 22, 24, 69, 109 assets, 110 flows and performance, 133 investment objectives, 113 investment process, 119–126 leverage, 116–117 manager profile, 137–138 performance, 140–141 portfolio characteristics, 119–126 redemption period, 133 sample description of, 113 terms and conditions, 133 Long and short hedge funds, 199 Long bias funds, 111, 112, 115, 116, 118 characteristics of, 125–126 investment process, 119–120 Long calls, 22 Long position, 30–32, 191 Long-Term Capital Management (LTCM), 55–56, 60, 268 Loss, trading, 27 Luxembourg, 7, 8, Macro funds, 24 Madoff fraud, 56, 60, 67, 213, 254, 274 Main office, hedge funds, 242 Maintenance margin, 198 Managed account platforms, 84 Managed futures, 3, 4, Management fees, 27, 233, 305 344 Managers, hedge fund, 5, 6, 8–13, 239– 241 See also Fund administrators compensation, 15, 44–45, 71–73, 233, 236 discretion, 240–241 evaluating, 252–253 fixed-income-oriented funds, 149–152, 163–166 funds of hedge funds (FoFs), 187–189 global macro funds, 104–105 long and short equity funds, 137–138 multistrategy funds, 179–180 powers of, 261 Manhattan Fund, 56 Mankodi, Nikhil, 165 Maples and Calder, 293 Margin accounts, 22, 29, 30, 147 example, 30–32, 32–33 Margin calls, 178, 197 Margin loans, 191, 192–193, 205, 281–282 and hedge fund dealers, 202–203 Margins bank loans, 147 corporate bonds, 147 and counterparty risk, 195–198 on futures contracts, 146 initial, 197 and portfolio risk measurement, 198–201 on repo transactions, 146, 147 Markets, declining, 15 Mark to market gain/loss, 127 Massachusetts Investors’ Trust, 13 Maturity, bond, 219 Maverick, 121 Maximum drawdown, 35 McGladrey, 290 Mean reversion model, 97–98 Mean value, 215 Measurement performance, 14 risk, 34–37, 68, 198–201, 255–256 Mergers and acquisitions, 123 Merlin Securities, 62–63, 263, 264–265 Index Merrill Lynch, 67 MF Global, 259, 284 MFS Investment Management, 13 Middle office services, 275 Millennium Management, 178 Mitsubishi Fund Services, 279 Momentum investing, 74 Momentum premiums, 74 Monthly returns, 225 Moore Capital Management, 88, 104–105, 144 Morgan Stanley, 123, 205, 242, 279, 287, 288–289 Morningstar, 65 Mortgage-backed securities, 152 Multifactor regression, 219 Multistrategy funds, 25, 173 flows and performance, 178–179 manager profiles, 179–180 opportunities and risk, 177–178 organizational structure, 175–176 overview, 174–175 strategy performance and risk, 180 Mutual funds, 3–4, 8, 233 vs hedge funds, 13–19 history, 13 incentives, 237 regulation of, 14–15 and SEC, 11 size and scope of industry, 16 size effects, 41 NASD Investor Complaint Center, 267 National Futures Association (NFA), 78, 81 National pension schemes, 54 Negative skewness, 223 Nekos, Jim, 296 Net beta-adjusted exposure, 127 Net computation method, 199–201 Net debtors, 204 Net equity, 197 Net equity value, 115 Net exposure, 35–37 Net inflows, 75 Index Net interest, 194–195 Net margin, 198 Net market value exposure, 127 Net outflows, 66 Net returns, 215 Netting, 194–195 risk, 198–199 New York, NFA (National Futures Association), 78, 81 Noble, George, 110 Nonparametric test design, 229, 230 Nonrecourse basis, 201 Normality, 223–226 Northern Trust, 279 Notice period, 240 Och, Danny, 123 Och-Ziff Capital Management, 178, 306–307 Offering memo (OM), 260 Offshore funds, 8, Ogier, 293 Onshore funds, Operating expenses, 27 Operational skills, 247–248 Operations head, 11, 12 Opportunism, 236 Opportunity costs, 237 Optimization models, 45–46, 49 Options, 22, 145, 147, 192 Organizational structure equity-oriented funds, 116–118 event-driven funds, 118 fixed-income-oriented funds, 149–152 funds of hedge funds, 182–184 global macro funds, 91–92 hedge funds, 8–13 multistrategy funds, 175–176 risk arbitrage funds, 118 OTC derivatives, 29, 30 Ownership, equity, 253 Parametric test design, 229 Patterns, 96–97, 99, 117 345 Paulson, John, 72, 123 Paulson & Co, 72 Payroll provider, 271 Pension funds, 51, 55, 110, 303 Pension plans, 52–54, 184 Performance See also Returns convertible arbitrage funds, 171 equity-oriented funds, 133–137 factors related to, 233–245 fixed-income-oriented funds, 161–163 funds of hedge funds, 185–187, 188 global macro funds, 102–104 growth 1990-2015, 186 hedge funds, since 1993, 300 and incentives, 238 and managerial discretion, 240–241 measuring, 14, 34–37, 213–231 multistrategy funds, 178–179, 180 risk-reward, 220 Performance fees, 5, 6, 28, 77, 78, 233–234, 264, 265, 305 “Performance of Mutual Funds,” 237 Performance persistence, 40–41, 213–231 academic research, 229–230 Permal, 187, 189 Perry Partners, 124 Pershing Square Capital Management, 134, 137 Persistence, performance See Performance persistence PEX Global, 209 Pine River Capital Management, 39, 163, 165 Platt, Michael, 165 Portable alpha strategy, 56–57 Portfolio asset allocation, 47–49 equity-oriented funds, 119–126 fixed-income-oriented funds, 152–154 global macro funds, 92–100 leverage, 256 liquidation, 202 346 Portfolio (continued) liquidity, 59, 256 optimizing, 45–46 risk measurement, 198–201 sample equity-oriented funds, 128–132 sensitivity, 35, 213, 227, 228 subjective pricing, valuation, 275 Portfolio manager, 11 Portfolio margin swaps, 115 Positive skewness, 223 Prequin, 65 President’s Working Group on Financial Markets, 268 Price impact of changes, 227–229 inefficiencies, 143 patterns, 96–97, 99 subjective, PricewaterhouseCoopers (PwC), 242, 290, 291–292 Prime brokers, 192–193, 203–204, 242, 271, 280–289 defined, 280 firm profiles, 288–289 importance to investors, 284–285 by number of funds serviced, 287 potential exposures, 287 questions to ask about, 285–288 scope of services, 281–284 Private equity, 3, Profit, trading, 27 Profit and loss, 127–132 Profiteering, 236 Profit skimming, 236 Public pension plans, 52–54 Puts, 22 PwC (PricewaterhouseCoopers), 242, 290, 291–292 QFS, 88 Qualified purchaser, 80–81 Qualitative analysis, 248 Quantitative analysis, 88, 248 Index Quantitative equity market neutral funds, 112, 117, 118, 122–123 characteristics of, 125–126 redemption cycle, 133 terms and conditions, 133 Quarterly time horizon, 229, 230 Railroads, 123 Rate of return, 34, 124 Raymond James, 50 Real estate, 3, 4, Realized gain/loss, 127 Recession of 2008, 57, 67, 70–71 Redemption fees, 238 Redemption period, 240 equity-oriented funds, 133 fixed-income funds, 161 funds of funds, 174 Reeves, William, 165 Refco, 204–205, 259, 284 Registration, 260 Regression analysis, 229 Regression equation, 218–219 Regulations, 6–7, 10, 13–14, 14–15, 78–82 Regulation T, 30, 31, 33, 115, 193, 281 Related-party transactions, 259 Relative return, 216 Relative value funds, 24, 26, 69, 152, 177 Reliability, data, 228–229 Renaissance Technologies Corp., 72, 122, 137, 138 Replication products, 173, 189–190 Reporting bias, 229 Repo transactions, 29, 30, 191, 193, 195, 207–208 example of, 30–32, 32–33 margin on, 146, 147 Research, academic hedge funds, 39–43 and incentives, 235–240 on performance persistence, 229–230 Research director, 11 Retail investors, 7, 47 347 Index Return on investment, 215 Returns See also Performance assumptions about future, 223 convertible arbitrage funds, 168, 170 convertible bond arbitrage funds, 148 equity-oriented funds, 138–141 fixed-income-oriented funds, 166–172 global macro funds, 105–108 hedge funds, 26–29, 40 historical, 213, 214–223 long and short equity funds, 109 Return since inception, 213 Revenues, 264, 305 Reverse repo interest, 195 Risk, 7, 43, 46–47, 60–63 business model, 262–266 convertible arbitrage funds, 170 counterparty, 195–198, 259, 286 equity-oriented funds, 138–141 factors, 260 fixed-income-oriented funds, 166–172 fraud, 266–268 funds of hedge funds, 184–185 global macro funds, 102, 105–108 of loss event, 286 management, 255–257, 274, 283 margin, 198–201 measurement, 34–37, 68, 198–201, 255–256 multistrategy funds, 177–178, 180 netting, 198–199 operational, 178 reducing, 30 reporting, 59–60 risk arbitrage funds, 124 and short selling, 121 tail, 256 Risk arbitrage funds, 111, 112, 115, 116 characteristics of, 125–126 investment process, 119–120 organizational structure, 118 portfolio creation, 123–124 rate of return, 124 risk management, 124 sample description of, 114 sample portfolio, 130–132 terms and conditions, 133 Risk-free rate, 225 Risk manager, 12 Risk-reward performance, 220 Risk-taking, 236, 238 Robertson, Julian, 89, 104 Rothstein Kass, 242 Royal African Company, 236 Rubin, Robert, 123 Sadis Goldberg, 293 Safe harbor rules, 10, 80 Salomon, 123 Sandell, Tom, 123 SAS 70 Type I/II letter, 276–277 Saut, Jeffrey D., 50 Scandals, 67, 274 See also Fraud Scenario analysis, 228 Scotia Bank, 287 SEC (Securities and Exchange Commission), 8, 10, 11, 13, 78, 275–276 Secondary market trading, 191–210 Securities, 143 issued by U.S government, 144 mortgage-backed, 152 primary lending institutions, 206–207 valuation of, 256 Securities Act of 1933, 13, 79–80 Securities and Exchange Commission Enforcement, 267 Securities Exchange Act of 1934, 80 Securities lending, 282–283 Seed investors, 57–58 Segregation rules, 286 Self-reporting bias, 228 Sensitivity, portfolio, 35, 213, 227, 228 Service level agreements (SLAs), 277 Service providers, 257–262, 271–298 Setter Capital, 209 Seward and Kissel, 293 348 Shadow accounting, 277–278 Shapiro-Francia test, 225 Sharpe ratio, 35, 68, 220, 225 equity-oriented funds, 140 fixed-income-oriented funds, 167, 169 global macro funds, 105, 107 Shaw, David, 72 “Shifting Strategies: Winning investor assets in a competitive landscape,” 304 Short bias funds, 113 Short-only funds, 111 Short selling, 6–7, 8, 13, 15, 22, 78, 116–117, 121, 204, 226, 282–283 defined, 29 example of, 32–33 Shulte Roth and Zabel, 293 Side pocket funds, 208, 209 Sidley Austin, 292–293 Silverpoint, 151 Simmons, Jim, 137 Simmons and Simmons, 293 Simons, James, 72 Simons, Jim, 249 Sizing, position, 120, 121 Skew, 35, 223–224, 225, 226 Small-cap securities, 115 Soros, George, 39, 72, 89, 249 Soros Fund Management, 72 Sortino ratio, 35, 220 fixed-income-oriented funds, 169 global macro funds, 105 Sovereign wealth funds, 54, 303 S&P 500, 73, 111, 121, 167, 228, 300, 301 Spicer Jeffries, 290 Spread, 203–204 SS&C Globe Op, 279 Standard deviation, 34, 169, 217, 225 Standard Life Investments, 178 State Street Investors, 13, 279 Stocks, 3, 24, 192, 219 Stolt, Jeff, 165 Stress testing, 228 Structured products, 151 Subscription agreement, 260 Index Subscription rights, 261 Survivorship bias, 228–229 Suspension, 208 Swap bias trading, 152 Swaps, 115, 143, 152, 192, 193, 195 Swaptions, 143 Systematic global macro funds, 88, 96–100 Tail risk, 256 Tax havens, Tax services, 289 Taylor, Brian, 165 Taylor, John Jr., 72 T-bill rates, 220 Technology providers, 271, 294–297 Tenor Capital Management, 163, 166 Third Point Management, 134, 137 Tiger Management, 88, 104, 111, 121 Time horizon, 229, 230 Time series analysis, 105, 169 TIPS (Treasury inflation-protected securities), 143 Top-down analysis, 152, 153–154 Top-down discretionary trading, 93–96 Total return swaps, 193 Trade clearance, 281 Transparency, 5, 6, 7, 37, 47, 59–60, 185 Treasurer, 12 Treasury inflation-protected securities (TIPS), 143 Treasury notes, 23 Trend following strategy, 24, 96–100 Tri-party repos, 207–208 Trusts, 51 Trustworthiness, 253 Tudor Group, 39, 88, 89, 104, 105, 144 “2 and 20” fees, 73 Two Sigma, 122 UBS, 67, 287 UCITS (Undertakings for Collective Investing in Tradable Securities), 8, 9–10, 276 Uncertainty, 241 University endowments, 51–52 349 Index Upside capture, 35, 216–217 Upside deviation, 169 U.S Bancorp, 279 Utilities, 123 Valuation, 6, 256, 274, 275 theoretical, 305–308 Valuation bias, 228, 229 Value at risk (VAR), 37, 105, 152, 169 Value versus growth investing, 74 Vanguard Group, 14 VAR (value at risk), 37, 105, 152, 169 Variable bias funds, 111, 112, 115, 116, 118 benchmarks, 120 characteristics of, 125–126 example, 113–114 investment process, 119–120 managers, 121 returns, 139 risk management, 121 sample portfolio, 128–130 typical fund details, 134 Variation margin, 197 Venture capital, 3, Viking Global Equities, 39, 137 Volatility, 7, 34, 40, 42, 68, 217, 300 fixed-income-oriented funds, 167 and global macro funds, 102 trading, 145 Walkers, 293–294 Wall Street, 77–78 Weather derivatives, Website, fund, 260 Wells Fargo Bank, 14 Winton Capital Management, 72, 88 Worst-case drawdown, 221–223, 225 Wyser-Pratte, Guy, 123 Xenon, 88 Yeary, Aaron, 165 Yield curve arbitrage, 152 Yield curve trade, 156, 199 ... the hedge fund man- The Basics of Hedge Fund Investing  Fund A Onshore L.P Attorneys Auditors Management Company or Gernal Partner Brokers Prime Brokers Banks Exchanges Mutual Funds or UCITS Fund. .. both hedge funds and funds of hedge fund managers The number Figure 1.3  Size of the U.S and Global Mutual Fund Industry Source: The International Investment Funds Association The Basics of Hedge. .. by Fund AUM Tier as of Q1 2015 Source: HFR Industry Reports © HFR, Inc 2015, www.hedgefundresearch.com The Basics of Hedge Fund Investing  19 Mutual funds, pension plans, sovereign wealth funds,