Applied Trading

Strategies

Equity Hedge Fund Strategies

Prof. Alexander Arapoglou

1
 All Hedge Index

Hedge Fund Strategies 2

 ALL Hedge VS SPX

Hedge Fund Strategies 3

 Applied Derivatives

In addition to textbook, for a very good source for market

jargon…..

Bloomberg

Google: Interactive Brokers Traders Glossary

Hedge Fund Strategies 4

 SPX

Hedge Fund Strategies 5

Hedge Fund Strategies 6
 Equity Hedge Fund Strategies

• Long/Short Equity
 Traditional “Jones Model”
 Sector/Regional Specialists
 Short-Biased
• Market-Neutral
• Merger Arbitrage
• Activist

7
 What is the Idea?
• Profit from both undervalued and overvalued equities
 Provide substantial freedom in asset selection and market
timing
 Typically maintain positive market exposure since equities trend
up in the long-run.
• Alpha makes total return comparable to 100% long but with lower
risk.

• Recipe:
 Buy stocks that you believe will outperform and short those that
you expect to underperform.
 Manage net, gross, delta, and beta exposures and leverage
(explicit and implicit) to optimally capture return opportunities.
 Carefully manage risk to avoid scenarios with large losses.

8
 Traditional “Jones Model”
• A.W.Jones 150%-long/100%-short formula is a
foundation for the broader “hedge fund” philosophy

• Typically, emphasis is on securities selection rather

then market timing

• Single sector/industry/style specialization driven by

proprietary bottom-up research
 Risk mitigation via hedging and relatively low net exposures
allows less diversified portfolios

9
 Historical Performance
• By far the most populated strategy among hedge
funds
• Example: Ray Dalio’s Bridgewater Fund

• During volatile markets, correlations among stocks

increase
 This is widely regarded as tough environment for the strategy
 In fact, fund return correlations increase by more than
individual correlations
• Is correlation risk an underappreciated source of market risk?

10
 Long-Short Equity
Long-Short Equity 1990-2013 Risk Factor Model
Annual Return (CAGR) 13.5%
Annual Volatility 9.1% Monthly Alpha 0.53%
Sharpe Ratio 1.14 Equity Market Beta 0.452
Bond Market Beta -0.117
Best Month 10.9% Commodity Market Beta 0.077
Worst Month -9.5% Annual Alpha 6.70%
Adjusted R^2 69.0%

Public Market Risk Equivalent

Skewness -0.26 T-Bills 39.2%
Excess Kurtosis 1.89 Equity 57.6%
Max Drawdown 30.6% Bond -5.6%
Return Autocorrelation 0.24 Commodity 8.8%
Annual Return 7.5%
Long-Short Equity
Long-Short Equity
Long-Short Equity
 AQR Long Short

Hedge Fund Strategies 15

 AQR VS SPX

Hedge Fund Strategies 16

 Research Insights
Do Hot Hands Persist Among Hedge Fund
Managers?
-- Jagannathan & Novikov, 2010, Journal of Finance 65(1),
217-255

 Study 3,200 funds from 1996-2005.

 Carefully control for database biases and serial correlation
 Focus is on relative performance within styles
 Good performance over a 3-year period is followed by good
performance of the subsequent 3-year period
• Persistence is only for top managers
• Persistence/alpha erodes over time (consistent with theory)

17
 Emerging Markets L/S

• Emerging Markets are popular for specialization

• Examples: Templeton, Hermes, Congest
 Regional specialization is also common across industries within
developed markets (i.e. European Banks, Japanese REITs)

• Front row access is a selling point for many countries

 Information flow deficiencies / corporate governance issues /
etc.
 Access to small caps overlooked by large multi-country funds
for liquidity and transparency reasons

• However, hedging can be a problem with specialized and emerging

market strategies
 Regulatory and institutional features constrains short selling,
hard to trade securities, macro/country/sector risk are greater 18
 Emerging Markets
Emerging Markets 1990-2013 Risk Factor Model
Annual Return (CAGR) 12.8%
Annual Volatility 14.0% Monthly Alpha 0.46%
Sharpe Ratio 0.69 Equity Market Beta 0.570
Bond Market Beta -0.101
Best Month 14.8% Commodity Market Beta 0.207
Worst Month -21.0% Annual Alpha 5.26%
Adjusted R^2 48.0%

Public Market Risk Equivalent

Skewness -0.84 T-Bills -6.5%
Excess Kurtosis 3.74 Equity 85.2%
Max Drawdown 43.4% Bond -8.2%
Return Autocorrelation 0.33 Commodity 29.5%
Annual Return 9.0%
Emerging Markets
Emerging Markets
Emerging Markets
 Xtrackers MSCI

Hedge Fund Strategies 23

 MSCI Emerging Markets

Hedge Fund Strategies 24

 Research Insights
Asset Fire Sales and Purchases and the
International Transmission of Financial Shocks?
-- Jotikasthira, Lundblad, and Ramadorai, 2011, UNC/Cambridge working
paper.

 Study 1,500 hedge and mutual funds from 1996-2008.

 Investors flows cause significant changes in portfolio allocations
 These trades significantly but temporarily affect equity prices
and correlations with developed markets
 Effects are mainly related to return chasing behavior rather
than country specific information  the cumulative return effect
reverts fully over 3 months
 Regional hedge funds with longer investment horizon are
naturally positioned to benefit from these reversals!

25
 “Short-biased”
• Accent on security selection and relative performance, could be
many longs but net short almost permanently

• Eaxmples: Bill Ackman’s Pershing Square, Jim Chanos’ Kynikos &

Ursus funds.

• It is a relatively small space with lots of turnover. Hard to make a

living even with high alpha...
 Assume b=-1.0 and alpha = 5% per year, what is approximate
E[R]?

• Some funds are run by “perma-bears” that take more of a

macro/systemic risk flavor

• Credit specialists have been attracting lots of attention recently

26
 Historical Performance

• Short-bias funds lose money on average if alpha is low

 So, they should not be compared on an absolute return basis

• Provide a lot of diversification bang-for-the-buck if

alpha is positive

• During the 2008 crisis

 Great nominal performance
 Terrible risk-adjusted performance
 Why?

27
 Short-Bias
Short Bias 1990-2013 Risk Factor Model
Annual Return (CAGR) -1.7%
Annual Volatility 18.4% Monthly Alpha 0.33%
Sharpe Ratio -0.26 Equity Market Beta -0.976
Bond Market Beta 0.178
Best Month 22.8% Commodity Market Beta 0.157
Worst Month -21.2% Annual Alpha 3.49%
Adjusted R^2 64.1%

Public Market Risk Equivalent

Skewness 0.25 T-Bills 158.2%
Excess Kurtosis 2.36 Equity -96.4%
Max Drawdown 59.6% Bond 22.8%
Return Autocorrelation 0.10 Commodity 15.4%
Annual Return -4.7%
Short-Bias
Short-Bias
Short-Bias
 Short Biased

Hedge Fund Strategies 32

 Short Bias

Hedge Fund Strategies 33

 Research Insights
Dedicated Short Bias Hedge Funds: Just a One Trick
Pony?
-- Connolly & Hutchinson, 2010, Journal of Alternative Investments.

 An equal-weighted short-bias portfolio was shown to deliver

statistically significant alpha
• Portfolio also has positive skewness
• Results hold even when 2007-08 crises is excluded from the
sample

 Diversification benefits from short-bias are the largest of any

strategy

 What else could you reasonably wish from a hedge?

34
 Equity Market-Neutral

• The idea is to deliver small but persistent returns regardless

of market environment
 Lowers the effect of volatility on compounding

• Should be an asset allocator’s dream

 Get desired level of Beta via index futures or total-return swaps
at ~zero cost

• The reality: often neither alpha nor degree of neutrality is

constant

Examples:
 Some long-short managers, for instance AQR
 High frequency trading
35
 Equity Market Neutral
Equity Market Neutral 1990-2013 Risk Factor Model
Annual Return (CAGR) 7.0%
Annual Volatility 3.2% Monthly Alpha 0.26%
Sharpe Ratio 1.21 Equity Market Beta 0.053
Bond Market Beta 0.008
Best Month 3.6% Commodity Market Beta 0.025
Worst Month -2.9% Annual Alpha 3.17%
Adjusted R^2 39.1%

Public Market Risk Equivalent

Skewness -0.26 T-Bills 64.2%
Excess Kurtosis 1.65 Equity 19.8%
Max Drawdown 9.2% Bond 10.2%
Return Autocorrelation 0.18 Commodity 5.9%
Annual Return 5.2%

36
Equity Market Neutral

37
Equity Market Neutral

38
Equity Market Neutral

39
 Equity Market Neutral

Hedge Fund Strategies 40

 Equity MKT Neutral

Hedge Fund Strategies 41

 Research Insights
Are “Market Neutral” Hedge Funds Really Market
Neutral?
-- Patton, 2009, The Review of Financial Studies 22(7), p2495-
2530.

 Using a public database over 1993-2003 about 20-30% of

“Market Neutral” hedge funds have significant market
exposure.

 However, 2008 seems to have revealed significant market

exposure for more funds.

42
 Event-Driven Equity
Strategies
• Infrequent corporate events are more likely to be
mispriced by investors
 May offer excess profit opportunities
 Funds include Kite Lake, Everett Capital, Melqart Asset
Management

• Recipe:
 Identify notable corporate events, such as takeovers,
restructurings, capital structure changes, regulatory actions,
governance abuses, …
 Exploit price inefficiencies that are tradable and have a
resolution trigger and/or mechanism

• Example:
 Traditional equity managers may not want to hold stocks of companies
43
that have announced that will acquire other firms – could lead to
 Event Driven Strategies
Event Driven 1990-2013 Risk Factor Model
Annual Return (CAGR) 12.4%
Annual Volatility 6.7% Monthly Alpha 0.52%
Sharpe Ratio 1.37 Equity Market Beta 0.312
Bond Market Beta -0.112
Best Month 5.1% Commodity Market Beta 0.096
Worst Month -8.9% Annual Alpha 6.74%
Adjusted R^2 66.3%

Public Market Risk Equivalent

Skewness -1.31 T-Bills 52.3%
Excess Kurtosis 4.15 Equity 41.6%
Max Drawdown 24.8% Bond -5.3%
Return Autocorrelation 0.38 Commodity 11.3%
Annual Return 6.3%
Event Driven Strategies
Event Driven Strategies
Event Driven Strategies
 Event Driven

Hedge Fund Strategies 48

 Event Driven

Hedge Fund Strategies 49

 Merger Arbitrage
• Examples: Paulson&Co, Arrowgrass, Shane Finmore’s Manikay

• Canonic trade:
 Buy the target’s stock if it trades at attractive discount to what
the acquirer has offered, sell acquirer’s stock to hedge market
risk
• Bets on deal failures are done too, as well as on competing bids,
etc.
• Also called “Risk Arbitrage”:
 A major violation of the arbitrage theoretical definition
we discussed last time
 However, point is that failures happen for deal-specific reasons
and, hence, are largely uncorrelated
 a diversified portfolio can make money even when unlucky in a few
deals
 …but is this really true? 50
 Merger Arbitrage

Hedge Fund Strategies 51

 HFR Merger Arbitrage

Hedge Fund Strategies 52

 Historical Performance
• Prior to 2008, the average MA fund delivered equity-
like returns with bond-like volatility
 2008 saw large drawdowns, high equity market correlation,
and higher volatility
 Systematic risk became evident as many deals disintegrated
at the same time

• Rough times followed good times

 E.g., when new money poured in
 Deal supply-demand balance as an important external factor
• M&A activity is very cyclical!

53
 Research Insights
Limited Arbitrage in Mergers and Acquisitions
-- Baker & Savasoglu, 2002, Journal of Financial Economics 64, 91-
115.

 MA funds modeled as insurance providers to investors who do

not want to bear completion risk.
 But MA funds face capital constraints (and there are only a few
funds)
 Model is tested on 4,135 mergers from 1981-1996.
 Consistent with the model, MA’s expected profit is documented
to
• increase in deal completion risk, selling pressure (=insured’s risk
aversion), target size, and
• decrease in supply in arbitrage capital.
 Overall alpha is in the range of 7-10% depending on risk model.
54
 Research Insights
Characteristics of Risk and Return in Risk
Arbitrage,
-- Mitchell & Pulvino, 2001, Journal of Finance 56(6), 2135-2175

 Study 4,750 mergers from 1963-1998.

 Make value-weighted portfolio of all announced deals correcting for
commissions and market impact.
 MA returns are positively correlated with market returns (b~0.5) in
severely depreciating markets (<-4%) but uncorrelated in flat and
appreciating markets.
• Hence, the payoff profile is similar to that of selling uncovered index puts
• Doesn’t mean that MA is not a good strategy but does suggest a proper
discount rate that incorporates nonlinearities
• Overall alpha estimated to be 3.5% per year
 Still, MA is appropriate only for investors that are willing to tolerate
significant drawdowns that coincide with market downturns.

55
 Activist Funds
• Examples: Pershing Square, Nelson Peltz’s Trian LLC , Daniel Loeb’s
Third Point Partners,Paul Singer’s Elliot Management

• If fund managers can reduce agency costs and improve

operational efficiency this can be a source of value creation
 … same premise is behind private equity

• Corporate management often opposes activist hedge funds,

accuses them of distracting, blackmailing, etc.

• Some concerns are around potential (sometimes undisclosed)

conflicts of interests.
 Decoupling control from economic exposure via hedging with
derivatives (“empty voting”)
 Short-termism (although the evidence of it is sketchy)
56
 Activist

Hedge Fund Strategies 57

 Activist

Hedge Fund Strategies 58

 Research Insights
Hedge Fund Activism, Corporate Governance, & Firm
Performance
-- Brav, Jiang, Partnoy, & Thomas, 2008, Journal of Finance 63(4), 1729-
1775.

 Study actions by 236 hedge funds related to 882 targets from

2001-6.
 Funds target small- and mid-cap “value” firms with stable cash
flows, takeover defenses, and overpaid managers.
 Activist funds propose strategic, operational, and financial
remedies
• Funds succeed in all activism efforts in two thirds of the cases.
• Funds seldom seek control and in most cases are
nonconfrontational
 The abnormal return around the announcement of activism is
approximately 7% (No reversal during the subsequent year)
 Target firms experience increases in payout, operating 59