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Handbook of Hedge Funds
“With the Handbook of Hedge Funds, François-Serge Lhabitant has created the fundamental guide to hedge fund investments. It covers a lot of ground and can truly serves as an encyclopaedia for both the entry level investors as well as to those to would like do delve a little deeper into specific themes. It also includes information on legal environments as well as operational aspects, which other recent publications are clearly lacking.” —Barbara Rupf Bee, Chief Executive Officer, HSBC Republic Investments Limited “Everybody talks about hedge funds these days, but not many people seem to know too much about them. François Lhabitant is the exception. His first book was great, this one is even better. It provides an excellent and unique introduction to the subject; straightforward, objective and with lots of insightful examples. For anyone looking for a serious introduction to hedge funds, this is the book to read.” —Harry M. Kat, PhD, Professor of Risk Management and Director Alternative Investment Research Centre,
François-Serge Lhabitant (Author)
9780470026632, Wiley
Hardback, published 8 December 2006
656 pages
24.6 x 17.8 x 3.8 cm, 1.261 kg
"...Das 'Handbook of Hedge Funds'deckt ein breites Spektrum zum Thema Hedgefonds ab und ist für Praktiker und Akademiker geeignet, die sich einen umfassenden Überblick zu dieser Asset-Klasse verschaffen wollen bzw. vertiefende Kenntnisse anstreben. Ein wichtiges Standardwerk..."
Absolut report Nr 36 Feb/März 2007
A comprehensive guide to the burgeoning hedge fund industry Intended as a comprehensive reference for investors and fund and portfolio managers, Handbook of Hedge Funds combines new material with updated information from Francois-Serge L’habitant’s two other successful hedge fund books. This book features up-to-date regulatory and historical information, new case studies and trade examples, detailed analyses of investment strategies, discussions of hedge fund indices and databases, and tips on portfolio construction. Francois-Serge L’habitant (Geneva, Switzerland) is the Head of Investment Research at Kedge Capital. He is Professor of Finance at the University of Lausanne and at EDHEC Business School, as well as the author of five books, including Hedge Funds: Quantitative Insights (0-470-85667-X) and Hedge Funds: Myths & Limits (0-470-84477-9), both from Wiley.
Foreword by Mark Anson xv 1 Introduction 1 PART I HEDGE FUND OVERVIEW 2 History Revisited 7 2.1 The very early years: The 1930s 7 2.2 The formative years (1949–1968) 8 2.3 The dark ages (1969–1974) 11 2.4 The renaissance (1975–1997) 12 2.5 The Asian and Russian crises (1997–1998) 15 2.6 The equity bubble years 18 2.7 Hedge funds today 19 2.8 The key characteristics of modern hedge funds 24 2.9 The future 35 3 Legal Environment 37 3.1 The situation in the US 39 3.1.1 The Securities Act (1933) 39 3.1.2 Securities Exchange Act (1934) 44 3.1.3 Investment Company Act 46 3.1.4 Investment Advisers Act (1940) 48 3.1.5 Blue-sky laws 55 3.1.6 National Securities Markets Improvement Act (1996) 55 3.1.7 Employee Retirement Income Security Act (1974) 56 3.1.8 Other regulations 56 3.1.9 The Commodity Futures Trading Commission 57 3.2 The situation in Europe 59 3.2.1 The UCITS directives and mutual fund regulation 59 3.2.2 The case of European hedge funds 62 3.2.3 Germany 63 3.2.4 France 69 3.2.5 Italy 75 3.2.6 Switzerland 76 3.2.7 Ireland 78 3.2.8 Spain 80 3.3 The situation in Asia 81 3.4 Internet and the global village 81 4 Operational and Organizational Structures 85 4.1 Legal structures for stand-alone funds 85 4.1.1 In the United States (“onshore”) 85 4.1.2 Outside the United States (“offshore”) 87 4.2 A network of service providers 90 4.2.1 The sponsor and the investors 91 4.2.2 The board of directors 91 4.2.3 The investment adviser 92 4.2.4 The investment manager or management company 92 4.2.5 The brokers 93 4.2.6 The fund administrator 99 4.2.7 The custodian/trustee 103 4.2.8 The legal counsel(s) 103 4.2.9 The auditors 105 4.2.10 The registrar and transfer agent 106 4.2.11 The distributors 106 4.2.12 The listing sponsor 107 4.3 Specific investment structures 108 4.3.1 Mirror funds 108 4.3.2 Master/feeder structures 109 4.3.3 Managed accounts 112 4.3.4 Umbrella funds 114 4.3.5 Multi-class/multi-series funds 115 4.3.6 Side pockets 116 4.3.7 Structured products 117 4.4 Disclosure and documents 118 4.4.1 Private placement memorandum (PPM) 118 4.4.2 Memorandum and articles of association 118 4.4.3 ADV form 118 4.4.4 Limited partnership agreements 119 4.4.5 Side letters 119 5 Understanding the Tools Used by Hedge Funds 121 5.1 Buying and selling using a cash account 121 5.2 Buying on margin 122 5.2.1 Mechanics 122 5.2.2 Buying on margin: an example 124 5.3 Short selling and securities lending 126 5.3.1 Mechanics of short selling 127 5.3.2 A detailed example 134 5.3.3 Restrictions on short selling 135 5.3.4 Potential benefits of short selling 139 5.3.5 Alternatives to securities lending: repos and buys/sell backs 140 5.4 Derivatives 142 5.4.1 Terminology 144 5.4.2 Basic derivatives contracts 144 5.4.3 Credit derivatives 146 5.4.4 Benefits and uses of derivatives 149 5.5 Leverage 151 PART II HEDGE FUND STRATEGIES AND TRADE EXAMPLES 6 Introduction 159 7 Long/Short Equity Strategies 163 7.1 The mechanics of long/short equity investing 163 7.1.1 A single position 163 7.1.2 Sources of return and feasible portfolios 165 7.1.3 Disadvantages of long/short equity investing 169 7.2 Investment approaches 170 7.2.1 The valuation-based approach 170 7.2.2 Sector specialist hedge funds 174 7.2.3 Quantitative approaches 175 7.2.4 Equity non-hedge hedge funds 175 7.2.5 Activist strategies 176 7.3 Historical performance 181 8 Dedicated Short 187 8.1 The pros and cons of dedicated short selling 187 8.2 Typical target companies and reactions 188 8.3 Historical performance 193 9 Equity Market Neutral 197 9.1 Definitions of market neutrality 197 9.1.1 Dollar neutrality 197 9.1.2 Beta neutrality 198 9.1.3 Sector neutrality 200 9.1.4 Factor neutrality 200 9.1.5 A double alpha strategy 202 9.2 Examples of equity market neutral strategies and trades 203 9.2.1 Pairs trading 203 9.2.2 Statistical arbitrage 207 9.2.3 Very-high-frequency trading 208 9.2.4 Other strategies 211 9.3 Historical performance 211 10 Distressed Securities 215 10.1 Distressed securities markets 215 10.1.1 The origins: railways 215 10.1.2 From high yield to distressed securities 216 10.1.3 The distressed securities market today 219 10.2 Distressed securities investing 226 10.2.1 Why distressed securities? 226 10.2.2 Legal framework 227 10.2.3 Valuation 228 10.2.4 Active versus passive 230 10.2.5 Risks 232 10.3 Examples of distressed trades 233 10.3.1 Kmart 233 10.3.2 Failed leveraged buyouts 234 10.3.3 Direct lending 235 10.3.4 The case of airlines 236 10.4 Historical performance 239 11 Merger Arbitrage 243 11.1 Mergers and acquisitions: a historical perspective 243 11.2 Implementing merger arbitrage: basic principles 246 11.2.1 Arbitraging a cash tender offer 247 11.2.2 Arbitraging a stock-for-stock offer (fixed exchange rate) 250 11.2.3 Arbitraging more complex offers 252 11.3 The risks inherent in merger arbitrage 254 11.4 Historical performance 263 12 Convertible Arbitrage 269 12.1 The terminology of convertible bonds 269 12.2 Valuation of convertible bonds 272 12.2.1 Valuation from an academic perspective 272 12.2.2 Valuation from a practitioner perspective (the component approach) 273 12.2.3 Risk measurement and the Greek alphabet 277 12.3 Convertible arbitrage: the basic delta hedge strategy 279 12.4 Convertible Arbitrage in practice: stripping and swapping 285 12.5 The strategy evolution 287 12.6 Historical performance 293 13 Fixed Income Arbitrage 297 13.1 The basic tools of fixed income arbitrage 297 13.2 Examples of sub-strategies 299 13.2.1 Treasuries stripping 299 13.2.2 Carry trades 301 13.2.3 On-the-run versus off-the-run Treasuries 301 13.2.4 Yield-curve arbitrage 303 13.2.5 Swap-spread arbitrage 304 13.2.6 The Treasury–Eurodollar spread (TED) 305 13.3 Historical performance 306 14 Emerging Markets 311 14.1 The case for emerging market hedge funds 311 14.2 Examples of strategies 314 14.2.1 Equity strategies 314 14.2.2 Fixed income strategies 319 14.3 Historical performance 323 15 Global Macro 327 15.1 Global macro investment approaches 327 15.2 Examples of global macro trades 328 15.2.1 The ERM crisis (1992) 329 15.2.2 The ECU arbitrage 332 15.2.3 The Asian crisis (1997) 333 15.2.4 The euro convergence (1995–1997) 337 15.2.5 Carry trades 340 15.2.6 The twin deficits 344 15.2.7 Risk management and portfolio construction 345 15.3 Historical performance 346 16 Managed Futures and Commodity Trading Advisors (CTAs) 351 16.1 The various styles of managed futures 352 16.1.1 Trading approach: discretionary versus systematic 352 16.1.2 Type of analysis: fundamental versus technical 354 16.1.3 Source of returns: trend followers and non trend followers 354 16.1.4 Timeframe for trades 355 16.2 Examples of systematic trading rules 355 16.2.1 Moving Average Convergence/Divergence (MACD) 355 16.2.2 Examples of trading ranges signals 361 16.2.3 Portfolio construction 363 16.2.4 Transparency or regulated black boxes? 363 16.2.5 Investment vehicles 365 16.2.6 Back-testing and calibration 365 16.3 Historical Performance 366 16.4 The future of managed futures 370 17 A Smorgasbord of Other Strategies 373 17.1 Capital structure arbitrage and credit strategies 373 17.2 Weather derivatives, weather insurance and catastrophe bonds 381 17.3 Mutual Fund Arbitrage 382 17.3.1 The forward pricing mechanism 383 17.3.2 The loopholes in forward pricing 384 17.3.3 Unethical, but persistent 386 17.3.4 A brutal ending 387 17.4 Arbitraging between NAVs and quoted price: Altin AG 388 17.5 Split strike conversion 390 17.6 Event-Driven Special Situations 392 17.7 Cross-listing and dual-listing arbitrage 393 17.7.1 Cross-listed companies and ADRs 393 17.7.2 Dual-listed companies 394 17.8 From public to private equity 395 17.9 Regulation D and PIPEs funds 397 17.10 IPO Lock-up Expirations 398 PART III MEASURING RETURNS, RISKS AND PERFORMANCE 18 Measuring Net Asset Values and Returns 403 18.1 The difficulties of obtaining information 404 18.2 Equalization, crystallization and multiple share classes 406 18.3 The inequitable allocation of incentive fees 406 18.4 The free-ride syndrome 407 18.5 Onshore versus Offshore Funds 408 18.6 The multiple share approach 409 18.7 The equalization factor/depreciation deposit approach 410 18.8 Simple Equalization 414 18.9 Consequences for performance calculation 414 18.10 The holding period return 415 18.11 Annualizing 417 18.12 Multiple hedge fund aggregation 418 18.13 Continuous compounding 419 19 Return Statistics and Risk 423 19.1 Calculating return statistics 423 19.1.1 Central tendency statistics 426 19.1.2 Gains versus losses 428 19.2 Measuring risk 429 19.2.1 What is risk? 430 19.2.2 Range, quartiles and percentiles 430 19.2.3 Variance and volatility (standard deviation) 431 19.2.4 Back to histograms, return distributions and z-scores 434 19.3 Downside risk measures 439 19.3.1 From volatility to downside risk 439 19.3.2 Semi-variance and semi-deviation 440 19.3.3 The shortfall risk measures 443 19.3.4 Value at risk 443 19.3.5 Drawdown statistics 446 19.4 Benchmark-related statistics 447 19.4.1 Intuitive benchmark-related statistics 447 19.4.2 Beta and market risk 448 19.4.3 Tracking error 449 20 Risk-Adjusted Performance Measures 451 20.1 The Sharpe ratio 455 20.1.1 Definition and interpretation 455 20.1.2 The Sharpe ratio as a long/short position 457 20.1.3 The statistics of Sharpe ratios 457 20.2 The Treynor ratio and Jensen alpha 460 20.2.1 The CAPM 460 20.2.2 The market model 462 20.2.3 The Jensen alpha 463 20.2.4 The Treynor (1965) ratio 465 20.2.5 Statistical significance 466 20.2.6 Comparing Sharpe, Treynor and Jensen 466 20.2.7 Generalizing the Jensen alpha and the Treynor ratio 467 20.3 M2, M3 and Graham–Harvey 468 20.3.1 The M2 performance measure 468 20.3.2 GH1 and GH2 470 20.4 Performance measures based on downside risk 472 20.4.1 The Sortino ratio 472 20.4.2 The upside potential ratio 473 20.4.3 The Sterling and Burke ratios 474 20.4.4 Return on VaR (RoVaR) 475 20.5 Conclusions 476 21 Databases, Indices and Benchmarks 479 21.1 Hedge fund databases 479 21.2 The various biases in hedge fund databases 479 21.2.1 Self-selection bias 480 21.2.2 Database/sample selection bias 482 21.2.3 Survivorship bias 482 21.2.4 Backfill or instant history bias 484 21.2.5 Infrequent pricing and illiquidity bias 485 21.3 From databases to indices 487 21.3.1 Index construction 487 21.3.2 The various indices available and their differences 490 21.3.3 Different indices – different returns 503 21.3.4 Towards pure hedge fund indices 505 21.4 From indices to benchmarks 508 21.4.1 Absolute benchmarks and peer groups 509 21.4.2 The need for true benchmarks 510 PART IV INVESTING IN HEDGE FUNDS 22 Introduction 515 23 Revisiting the Benefits and Risks of Hedge Fund Investing 517 23.1 The benefits of hedge funds 518 23.1.1 Superior historical risk/reward trade-off 518 23.1.2 Low correlation to traditional assets 520 23.1.3 Negative vs positive market environments 523 23.2 The benefits of individual hedge fund strategies 527 23.3 Caveats of hedge fund investing 534 24 Asset Allocation and Hedge Funds 537 24.1 Diversification and portfolio construction: an overview 537 24.1.1 Diversification 538 24.1.2 Portfolio construction 539 24.1.3 Asset allocation 541 24.2 Strategic asset allocation without hedge funds 543 24.2.1 Identifying the investor’s financial profile: the concept of utility functions 543 24.2.2 Establishing the strategic asset allocation 546 24.3 Introducing hedge funds in the asset allocation 547 24.3.1 Hedge funds as a separate asset class 547 24.3.2 Hedge funds vs traditional asset classes 548 24.3.3 Hedge funds as traditional asset class substitutes 549 24.4 How much should be allocated to hedge funds? 551 24.4.1 An informal approach 552 24.4.2 The optimizers’ answer: 100% in hedge funds 553 24.4.3 Static versus dynamic allocations 554 24.4.4 Dealing with “return management” 555 24.4.5 Optimizer’s inputs and the GIGO syndrome 556 24.4.6 Non-standard efficient frontiers 560 24.4.7 How much should we allocate to hedge funds? 561 24.5 Hedge funds as portable alpha overlays 561 24.6 Hedge funds as sources of alternative risk exposure 564 24.7 Risk budgeting and the separation of alpha from beta 565 25 Hedge Fund Selection: A Route Through the Maze 569 25.1 Stating objectives 569 25.2 Filtering the universe 570 25.3 Quantitative Analysis 571 25.4 Qualitative Analysis 572 25.5 Due Diligence: between art and science 573 25.5.1 The strategy 573 25.5.2 The fund itself 574 25.5.3 The management team 575 25.5.4 The infrastructure 575 25.5.5 The process 576 25.6 Ongoing monitoring 576 25.7 Common mistakes in the selection process 577 26 Funds of Hedge Funds 579 26.1 What are funds of hedge funds? 579 26.2 Advantages of funds of funds 579 26.2.1 Efficient Risk Diversification 580 26.2.2 Affordability and Accessibility 582 26.2.3 Professional management and built-in asset allocation 583 26.2.4 Access to closed funds 583 26.2.5 Better internal and external transparency 584 26.3 The dark side of funds of funds 584 26.3.1 Yet another layer of fees! 584 26.3.2 Extra liquidity 585 26.3.3 Lack of control, overdiversification and duplication 587 26.4 Selecting a fund of funds 587 26.5 Fund allocation: A look inside the “black box” 588 26.5.1 Qualitative approaches 588 26.5.2 Quantitative approaches 589 26.6 The future of funds of funds 589 27 Structured Products on Hedge Funds 591 27.1 Total return swaps linked to hedge funds 591 27.2 Call options on hedge funds 592 27.3 Basic notes and certificates 593 27.4 Capital protected notes 594 27.4.1 The financial engineering process of capital protected notes 595 27.4.2 The first generation: the naive approach 595 27.5 The second generation: The option-based approach 598 27.6 The third generation: the dynamic trading approach 602 27.7 The fourth generation: options on CPPI 608 27.8 The flies in the ointment 608 27.9 The future of capital guaranteed products 610 27.10 Collateralized hedge fund obligations 610 28 Conclusions 615 Bibliography 617 Index 625
Subject Areas: Finance & accounting [KF]
