Hedge Fund Derivatives Date : 18 Feb 2011 Produced by : Angelo De - PowerPoint PPT Presentation

Hedge Funds and Hedge Fund Derivatives Date : 18 Feb 2011 Produced by : Angelo De Pol

Contents 1. Introduction 2. What are Hedge Funds? 3. Who are the Managers? 4. Who are the Investors? 5. Hedge Fund Strategies 6. Funds of Hedge Funds 7. Hedge Fund Market 8. Hedge Fund Derivatives 9. Impact of the Credit Crisis 10. Key Risks 11. Risk Management Produced by Angelo De Pol Slide 2

Introduction  Personal introduction  Explain hedge funds & what makes them a unique investment class  Describe market characteristics, investors and managers  Review the most common hedge fund derivatives  Explain how and why the credit crisis impacted the hedge fund industry  Highlight the key risks of the industry / hedge fund portfolio  Provide examples of how hedge fund risk is managed Produced by Angelo De Pol Slide 3

What are Hedge Funds?  Umbrella term for collective investment vehicles employing a huge range of different strategies  Highly specialised…rely on specific expertise of manager  Largely offered as private ate inves estm tment ents  Typically structured as limited ted partners ershi hips ps  Generally set up in tax havens ns  Narrow range of investors  Use of leverag rage e and deriva vatives tives is widespread  Hedge Funds aim to i) Preser erve ve capita ital, ii) Reduce ce volatili tility ty and risk sk and iii) Deliv iver r positi itive ve returns ns under all market condi ditio tions ns Produced by Angelo De Pol Slide 4

Comparison of Hedge Funds vs Traditional Funds Tradit aditional ional Funds ds Hedge dge Funds ds Indust stry ry Size $26 trillion $2 trillion Returns rns Versus a benchmark Absolute Investme estment nt Long Only Long or Short Strate ategy gy Complexity xity Low High Correl elati ation on to Market et High Lower Leverage rage No Yes Trading ding Presence nce Lower Turnover Higher Turnover Fees Low - Based on AUM High - based on AUM and Performance Liquidi dity ty Relatively Liquid Restrictions & Lock-ups Transpare nsparency cy Relatively High Low Minimum mum Investmen stment Relatively Small Large Produced by Angelo De Pol Slide 5

Who are the Managers?  Ex bankers typically with investor contacts and trading expertise  Vary considerably in size - Top 15% control 75% of Industry Assets  Most managers based in New York, Connecticut and London  But funds typically registered in tax havens like Cayman Islands New York London Cayman Islands Produced by Angelo De Pol Slide 6

Who are the Investors?  High Net Worth individuals, Funds of Fund Managers & Institutional investors  Minimum Investment size is very high – usually at least $1million  Acceptance has grown substantially…viable alternative to traditional markets  Investors seek attractive, stable and non-market correlated returns Produced by Angelo De Pol Slide 7

Hedge Fund Strategies … help represent the hedge fund universe Breakdown as at end of 2009; Source : CS/Tremont Produced by Angelo De Pol Slide 8

Hedge Fund Strategies Statistics for 2009 Produced by Angelo De Pol Slide 9

Event Driven Strategy Exploits pricing inefficiencies caused by anticipated corporate events. Many variations… Event nt Driven Distre tressed ssed Merger er Specia ial Credit it Reg’n D Activist vist Securiti rities es Arbitra itrage ge Situ tuatio ations s Arbitra itrage ge Companies Merging Restructuring Corporate Private Active near companies Fixed Equity management bankruptcy Income and influence Securities of companies Produced by Angelo De Pol Slide 10

Managed Futures Strategy  Also called Commodity Trading Advisors (“CTAs”)  Systematic approach to investing in futures contracts in bond, equity, commodity and currency markets  Highly quantitative model based trading  No trader decisions – all model based  Use mean reversion, trend and pattern recognition models  Operate in highly liquid markets, providing flexibility  Models can break down in very volatile markets Produced by Angelo De Pol Slide 11

Funds of Hedge Funds  Invest in other Hedge Funds  Portfolio diversification main aim (strategy, manager and fund)  Important and very influential in industry  Have access to extensive resources and systems  Regularly rebalance portfolio and perform due diligence  But additional layer of fees and leverage  Suffered major blow in crisis as diversification benefit muted Produced by Angelo De Pol Slide 12

Growth of Hedge Fund Market (AUM in $ Billions) CORRELATIO REGULATION N LIQUIDIT LEVERAGE Y STABILITY TRANSPAREN CY INFLUENCE Produced by Angelo De Pol Slide 13

Hedge Fund Market Performance vs. Equities Credit Equity Bear Correlation Russia/ Crisis Market Increasing LTCM Crisis Average Annualised Volatility - Hedge Funds : 6%, Equities : 15% Produced by Angelo De Pol Slide 14

Hedge Fund Derivatives • Seller gives return on hedge fund Demand for more  basket and gets LIBOR plus spread participation and leverage Many variations…  • Simple products Total Volatility linked notes, Aries  • Appeal to broad investor base Return notes,“Best of” options, • Exposed to both upside and Enhanced calls... Swaps downside performance Delta 1 Exotics certificates Funds of Hedge Funds Leveraged CPPI notes certificates Offer leverage of up to 300% • Upside exposure to underlying fund  Poor performance may result in • Guaranteed principal (at maturity)  investor losing entire investment • Final return = combination of risky and non-risky asset Produced by Angelo De Pol Slide 15

What is CPPI?  Constant Proportion Portfolio Insurance  Helps ensure 100% of investor’s capital is protected (at maturity)  And investor also gets participation in underlying asset growth  Simple formula based hedging mechanism with set minimum “cushion”  Determines composition of investment between : 1.Risky Asset (e.g. Hedge Fund of Funds) and 2.Non- Risky Asset (Cash, Fixed Term Deposits)  Poor Performance  Deleve verage • Sell Risky Asset to buy more Non- Risky Asset • Possibly end up with no Risky Asset exposure  Good Performance  Leverage up Risky Asset exposure Produced by Angelo De Pol Slide 16

What is CPPI? The following graph illustrates how Risky Asset exposure is determined by the CPPI mechanism The Reference Portfolio’s allocation to the Risky Asset is determined by Reference Portfolio Value applying a pre-determined Multiplier to the Cushion. Cushion 100% Reference P ortfolio Value (t) - Bond Floor (t) Cushion(t) Bond Floor Reference P ortfolio Value (t) 70% The Capital is Target Exposure 100% The Bond Floor is a fixed line starting at protected on = Cushion x Multiplier 70% (for example) and reaching the level of Maturity Date protection of 100% by the Maturity Date Produced by Angelo De Pol Slide 17

Impact of the Credit Crisis…the perfect storm Gates es & Madoff ff Suspen ensi sion ons Fraud ud Redempti mption ons Lehman an Failure re Short rt Deleve verag raging ng sellin ing g ban ban  2000 00 hedge ge funds ds liquidated dated (25%), 5%), indus ustry try benc nchm hmarks arks lost 20%  Indus ustry try AU AUM down n $1.2 trillion on (42%), mass ssive ive risk k & l & lever erage age reduc uction ion  Huge ge loss s of inves estor tor confidence idence and lots of litigation ion Produced by Angelo De Pol Slide 18

Impact of the Credit Crisis…Performance vs. Equities Peak Current Drawdown -5% -20% Trough -27% -53% Hedge Funds : Credit Suisse / Tremont Hedge Fund Index Equities : MSCI World Index Produced by Angelo De Pol Slide 19

Hedge Fund Industry Outlook  Growth starting to pick up again… Industry Assets Under Management (AUM) now $2 trillion  Before Credit Crisis Growth was around 20% per year  2009 one of best performing years ever in industry   But Investors much more demanding now… More transparency and liquidity demanded  Also better controls, risk management and infrastructure  And of course lower fees   Industry consolidation… Largest managers getting bigger  Managers targeting more traditional institutional investors  Produced by Angelo De Pol Slide 20

Key Risks Lack of Transparency Operational Risks Poor Liquidity Lack of Regulation High Leverage Produced by Angelo De Pol Slide 21

Key Risks - Operational Risk Distribution of Reasons for Fund Breakdown of Operational Risk Failures Failures Source : Understanding and Mitigating Operational Risk in Hedge Fund Investments: A Capco White Paper Produced by Angelo De Pol Slide 22

Key Risks - Hedge Fund Portfolio Risks • CPPI notes have built in rebalancing mechanism • But in stressed markets this mechanism can fail… Gap Risk • Bank would make-up shortfall • Collateral has gap risk too • Hedge Fund Liquidity is poor Liquidit uidity • Hedging effectiveness is reduced Risk • In stressed markets actual liquidity may be worse • High levels of operational risk • Poor transparency in industry Conc ncentrat ntration ion • Manager, fund and strategy diversification critical Produced by Angelo De Pol Slide 23