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The multistrategy hedge fund produces a nominal return

The multistrategy hedge fund produces a nominal return of 3.45 percent after fees. The arithmetic and geometric averages both equal 1.14 percent per month, which compounds to 14.53 percent.

3.12 The average return calculated under question 3.10 reflects no incentive or management fees. The fees on the fund of funds reflect both the management and incentive fees charged by the individual hedge funds plus the additional fees charged by the fund of funds manager. However, in some months, some individual hedge fund managers charged incentive fees while other funds lost money. The incentive fees did not reflect this netting of performance in a particular month. In contrast, the multistrategy hedge fund netted the gains from one strategy and the losses from another before calculating incentive fees. Because fund B and fund C are below their high-water marks, some of the future returns from those individual funds will not be subject to incentive fees black box, implying that employees do not subjectively override investment or valuation decisions made by the model. However, fundamental models can also be used to construct rules used to build and maintain trading positions.

4.2 This is not a merger arbitrage trade because the hedge fund did not sell the acquiring company. Although the hedge fund will profit if the deal is announced, the position remains exposed to changes in value for stocks generally. If the hedge fund also sold short shares of Company X, then the position is at least roughly insulated from changes in equity prices.

4.3 The answer depends on the particulars of the situation. Many times, the merger doesnt take place according to the first set of terms announced. Another buyer of Company Y may emerge. Company X may be required to raise the bidding price for Company Y, either to entice shareholders to sell or to outbid competing buyers. The merger arbitrage trader should sell Company X only if doing so reduces the risk of carrying shares of Company Y.

4.4 Although a gain of $5 does represent a 5 percent gain on a $100 investment, the return to the merger arbitrage fund may be considerably higher. For example, if the $5 gain could be achieved in four months, this strategy could produce annualized returns of 15 percent (or more if the midyear gains are reinvested). Further, if the manager borrows, the return on the money invested could be considerably higher. Finally, although the best-case gain of $5 does not look attractive if the worst case is a $10 loss, it might be that the gain is very likely and the loss is unlikely.

.5 It works the other way. XYZ will likely sell short the acquirer and must make substitute payments to the lender of the shares of the acquirer company. Also, XYZ will own shares in the target company, so would prefer to receive higher dividends, all other things being equal. However, the amount of the dividends and the cost of borrowing are usually fairly unimportant factors in the profitability of a deal.

4.6 The hedge fund is a limited liability structure that assures that investors can generally lose no more than their original investment. Buying companies that may risk bankruptcy or are already in bankruptcy creates a situation where hedge fund investors can earn leveraged returns with limited downside. The incentive structure motivates managers to take risks that are likely to offer rewards. The traditional asset management framework, in contrast, often leads to an environment where managers invest in only low-risk assets.

4.7 Pairs trading produces a relatively low-risk and low-return pattern of performance. Because the returns tend not to be highly correlated with stock and bond returns, it is a good strategy to add to a traditional portfolio. Whether it is a good companion to other hedge fund strategies hinges mostly on the nature of the pairs strategy. The definition of pairs trading ranges from very narrowly defined arbitrage trades to relationships based on no more support than the previous behavior of the two stocks. Although the answer depends on the nature of the pairs strategy, it is possible that this strategy is correlated with other types of trades in the multistrategy hedge fund.

4.8 Endowments and foundations pay no income tax on most investment returns. As a result, neither would care whether the trading produced income or capital gains. In general, the strategy is sensible for a taxexempt account because the tax rate of the marginal trader prices the ex-dividend price change at a level at which tax-exempt investors should make money.

Endowments and foundations must be careful to avoid incurring interest expenses from leveraged trading. Interest expense can trigger a tax called unrelated business income tax (UBITsee Chapter 10). These tax-exempt organizations must be careful to avoid a hedge fund that regularly uses debt to increase returns to the dividend capture strategy.

4.9 The strategy requires the hedge fund to buy corporate bonds or preferred stocks on smaller, less established companies. Short sales of the common stock only imperfectly hedge changes in credit spreads. In particular, these hedges provide protection from changes in spreads on the individual company securities but may provide no protection from a general widening of spreads.

Depending on how thoroughly the hedge fund lays off risk, a convertible arbitrage position can leave the investor open to the risk that option volatility declines. The investor is also often exposed to the risk that prices trade in a narrow range and the convertible option erodes in value. The investor is at risk as well for default on the bonds the hedge fund owns. Short sales in the equity may provide imperfect protection against losses on the defaulted securities.

4.10 Even if the pattern of returns described is accurate for fixed income arbitrage, hedge fund investors may want to include the strategy in portfolios. Whether to include the strategy hinges on the pattern of return of a portfolio with and without the hedge fund strategy in question. The past performance problems occurred when traditional assets and popular hedge fund strategies were profitable. In fact, fixed income arbitrage strategies are not very correlated to traditional stocks and bonds or to most hedge fund strategies.

4.11 Not necessarily. Problems with mortgage strategies were caused in part by uncertainty when interest rates declined to rates outside the historical experience of most investors. If rates were to rise, the mortgage instruments would be exposed to market loss at an accelerated rate. Market neutral trades involving mortgage-backed securities can become unbalanced when rates decline but also when they rise. The most profitable time to own mortgage-backed assets is when interest rates stay in a narrow range for a considerable period of time.

4.12 The most popular strategies are typically the strategies that have recently been performing the best. A concentration in the strategies that are popular may make it easier to market the fund of funds. It is hard to criticize the fund of funds manager for providing the kind of portfolio that is desired by investors.

However, investing in the strategies and particular funds that have recently performed well might also create a portfolio of hedge funds that provides great returns in the future if the winners of the recent past are the winners of the near future. The fund of funds manager must believe that there is at least some persistence in performance.

Unfortunately, academic researchers have found fairly little persistence in performance of individual managers, although hedge fund styles are more persistent (see S. J. Brown, W. N. Goetzmann, and R. G. Ibbotson, Offshore Hedge Funds: Survival and Performance, 1989-1995, NBER Working Paper Series, 1997). However, researchers have also found little consistent evidence that last years stars are more likely to crash than other hedge funds and other hedge fund strategies cause it can have unlimited shareholders, there can be more than one class of shares, and the investors have no liability for losses above their committed capital. However, a C corporation must pay corporate income tax on the investment returns. When returns are distributed or the investment in a fund is eliminated, the investor is taxed a second time on this investment return. A partnership or a limited liability corporation would offer the same limitation on loss and the investment return would be taxed only once.

5.2 In locations where the hedge fund would pay no or very little tax, the C corporation is a great business model. The absence of tax at the corporate level means that investors are not taxed twice. Further, in a corporate structure many fewer calculations are necessary to calculate the taxable income of the investors.

5.3 If liabilities exceed assets, the equity shareholders would lose all their equity value. If the equity base is not large enough, the liability holders are exposed to loss.

5.4 Like the equity holders, the partners bear the loss caused by declines in the value of the companys assets. If the value of assets declines below the value of the liabilities, the general partner is liable for the difference, even if it means that the general partner must infuse additional capital into the business.

5.5 A flow-through tax entity is a partnership, an S corporation, a limited liability corporation, or a limited liability partnership. These types of businesses calculate income and expenses and report the net income to the Internal Revenue Service (in the United States). Part of the tax filing is an allocation of the taxable items to each investor as if the investor separately controlled a pro rata part of the business.

5.6 The investor who must invest as a general partner must be a business with limited capital whose owners have no liability beyond their committed investment.

5.7 A general partner has unlimited liability. By putting capital in a business that then serves as general partner, the capital can support the limited partner but the creditors are limited to the capital committed to the business that serves as the general partner. The general partner can be set up as a C corporation, an S corporation, a limited liability partnership, or other structure that relieves the owners from general liability.

5.8In the event of fraud, the law may ignore liability-limiting structuresdesigned to protect the ultimate owner.

5.9 If a hedge fund sponsors more than one hedge fund, it might set up separate business units for each fund. If one fund lost more than the paid-in capital, the creditors would have no claim on the assets supporting other hedge funds. The business unit that serves as the manager might also act as the general partner of one of the funds, but it probably doesnt make sense to set up multiple managers just because there are multiple funds.

5.10 A mirrored hedge fund structure has a domestic fund for U.S. investors and a fund located in a tax-free or low-tax domicile to accept investments from investors outside the United States. The primary objective of this structure is to avoid backup withholding on the investment returns and to prevent non-U.S. investors from having to pay U.S. taxes.

5.11 The two funds are marketed in tandem. Often, the longer track record of one fund is used to market both funds. Unless the monthly performance of the two funds is similar, it wouldnt be possible to use the earlier performance to market the second fund.

5.12 Partnership accounting and tax reporting are significantly more complicated than accounting and tax reporting for a corporation. A partnership must maintain the cost basis of each investor in each asset. Usually, a partner will have many different costs for each asset. Because a corporation is taxed as an entity, it is not necessary to preserve details for individual investors.

.13 With a master-feeder structure, it is possible to maintain one portfolio and accept investment from both U.S. and offshore investors. Only one track record is created and there is no possibility for the two groups of investors to receive significantly different returns.

5.14 Many mirrored funds were created before the master-feeder structure was created. Also, it is much easier to create a second, mirrored fund if the first fund is already operating and has a number of assets with costs already established. Finally, the cost of setting up the masterfeeder structure is higher than setting up either a U.S. or an offshore fund (although probably cheaper than setting up both a domestic and an offshore fund).

5.15 Lawyers and accountants have favored Delaware. Most states have responded by making their states very competitive as business domiciles. For many kinds of businesses, the state the business is located in would serve as a good domicile. It is important to discuss the location question with your lawyer.

5.16 It is important to locate the fund in a domicile with low or no taxes, so that investors can avoid unnecessary double taxation. Beyond that, some countries have greater protection of privacy, a stronger legal tradition, conveniences in terms of travel time to the domicile, and time zones that are more convenient to the manager and investors. In addition, it may be important to pick a domicile that has language skills matching the language of the funds investors. Finally, some domiciles are more prepared to deal with special requirements, such as religious or cultural rules.

5.17 In order for offshore investors to avoid backup withholding, the U.S. Internal Revenue Service must deem the hedge fund to be a non-U.S. business. If the fund is administered in the United States, the IRS will probably assert that the business is a U.S. entity and require the fund to withhold taxes for the offshore investors this cash as collateral, but accountants view it as a short-term loan that must be repaid. Note that the accounting records do not document that the stocks held as long positions are actually being held by a dealer because the hedge fund still represents that it owns the common (even though it doesnt currently possess or even have legal title to the shares).

The stock loan agreements that show up as assets include the money posted with other dealers to collateralize shares that the hedge fund has borrowed. Accountants treat this transaction much like a certificate of deposit: The fund has delivered cash to an arms-length counterparty, who will return the cash with interest.

The $60 million in stock loan assets represent the cash that is collateralizing $50 million of borrowed securities. The $10 million difference represents the haircut or collateral that the securities lender requires. The $30 million in stock loan liabilities represents the cash that is borrowed by the fund. These loans are secured by some of the $40 million in common stock held as long positions. The $10 million difference represents a haircut or required margin. The fund may also have excess collateral, which gives the fund some room to lose money on its positions without being thrown into liquidation. It is also possible that the fund holds some positions that cannot be financed (restricted stock, small private issues, or other nonmarginable positions).

6.2 It is possible to calculate leverage by adding the long positions to the short positions (treating both as positive values) and dividing by the capital. This result of 2.25:1 ($40 million plus $50 million $40 million) is reasonable. Frequently, the leverage will be calculated from the assets on the balance sheet and the liabilities will be ignored. Using this methodology, the leverage is 2.5:1 ($40 million + $60 million $40 million).

The $60 million serves as a proxy for the short positions, because it represents the collateral posted to borrow the stocks held short. The fund has $10 million tied up in haircuts on the short positions.

6.3 A hedge fund probably would not want to buy the asset. It would expect to lose money borrowing at 5 percent to invest in the security expected to earn 3 percent. In fact, the fund probably shouldnt buy the asset at all (without leverage) because any unused capital could earn a higher return as a short-term investment earning 5 percent. The fund might buy the asset anyway if it is part of a strategy that is expected to make money overall (a basket trade, for example). A manager might buy the asset despite the expected loss if the security improved the characteristics of the portfolio (the risk of loss, favorable cash flow, favorable tax treatment, or other factors).

The fund might want to sell the asset short, however. The fund could expect to lose 3 percent on the security held short but could invest the proceeds of the sale at 5 percent. Whether the trade was profitable would depend on the haircut required and execution costs. The manager should also assess whether a short position in the security would increase or reduce risk to the portfolio.

6.4 The first fund can be described as unlevered. This means the fund has leverage of 1:1. The second fund has leverage of 1:1 only if it can borrow the securities to cover its short without having to put up a haircut. If the fund has to post margin, the leverage of the fund containing the short positions would exceed 1:1 if the leverage ratio is calculated from the asset side of the balance sheet, as is the convention.

6.5 The leverage is 2:1. It doesnt matter that the stock is held in a margin account, but it does imply there might be margin debt (probably less than $25 million) on the liability side of the balance sheet. This margin debt does not enter into the leverage calculation.

It is possible that this hedge fund carries short positions and that some of the $100 million is assets are actually stock loan agreements positions that the fund has borrowed to make delivery on short sales. The leverage calculation does not depend on the size of the liabilities.

6.6 It is sensible to include another $50 million (or $48 million) in assets in the calculation. This fund would resemble a fund that carried only cash positions but had leverage of 3:1. However, investors and trading counterparties would not be given enough information to know what positions exist off the balance sheet. As a result, the leverage would be only 2:1.

6.7 The dealer that executes the trades will limit the size of unsettled positions. The broker is at risk if its customer gets into financial difficulty. A prudent broker will monitor intraday positions real-time. The broker will also monitor intraday realized and unrealized losses. Finally, the broker may watch for exceptions from the pattern of trading typical of the customer (position size, types of assets traded, and other considerations).

6.8 Many futures exchanges have adopted SPAN margining. At the time of this writing, stock exchanges like the New York Stock Exchange and cash options exchanges like the Chicago Board Options Exchange have not adopted SPAN margining. Span margining could apply to currency futures, but much of the trading in foreign exchange takes place over-the-counter (OTC). No regulations govern margin on OTC currency trading, and a creditworthy hedge fund may be required to post only maintenance margin but no initial margin. SPAN margin can reduce the margin required for positions held on a single futures exchange, but the fund will likely get no reduction in margin due to positions held in various futures exchanges, even if the positions are carried by the same broker. Also, the broker is not constrained to collect only the minimum SPAN margin.

6.9 Some hedge funds have registered as broker-dealers to take advantage of 15 percent margin requirements for dealers. A hedge fund can avoid initial and maintenance margin requirements completely by creating a joint back office (JBO) with a dealer. To create a JBO, a hedge fund will appear to structure itself as part of the dealer. The structure may appear to have substance yet create no real economic link between the dealer and the customer. With a JBO, a hedge fund needs to post only enough margin to satisfy the dealer. The fund can use futures and OTC derivatives to create positions subject to lower margin requirements or no margin at all. Finally, the fund may be able to sidestep U.S. margin requirements if the fund is organized offshore and books financing trades with non-U.S. broker-dealers (or offshore subsidiaries of U.S. broker-dealers).

6.10 The haircut equals $300,000, equal to $125,000 on the long position ($50 million .25%) and $175,000 on the short position ($35 million .50%). .11 The leverage equals 283.92:1 [($50,000,000 + $35,175,000)/ $300,000]. Notice that this calculation relies on the asset value of the stock loan on the short position ($35 million plus the haircut of $175,000). Of course, no hedge fund could maintain leverage hundreds of times their capital, but it might be possible to leverage a part of the position to this extent. However, financing counterparties would permit these trades only if the overall leverage of the fund was within guidelines set by the credit departments of the financing desks.

6.12 The question doesnt provide enough information to answer the question precisely. It would be necessary to know the coupons on the bonds long and short. It would be helpful, too, to know the average yield to maturity on the long portfolio versus the average yield to maturity on the short portfolio. Many fixed income funds attribute much of their net return to these factors, which we must assume net to zero.

The financing cost on the long position can be described as r% $1 billion (where r% is the average repo rate on the position). The reverse income on the short position is therefore (r% - 0.5%) $1 billion (ignoring haircuts). The net cost is therefore:

6.13 The holder of record on the ex-dividend date gets the dividend. You are not the holder because you delivered the shares to the buyer. Assuming the buyer still owns the shares, the company will pay the dividend to that holder. The company will not pay a dividend to the lender of the shares because the lender passed ownership to you. You must, therefore, make a substitute payment of $25,000 to the lender to compensate the lender for the dividend forgone. The payment reduces the dividend income you report on your fund.

6.14 The market value of the 50,000 shares after the split should approximately equal the market value of the 25,000 shares before the split. The cash collateral should therefore remain adequate. You must eventually return 50,000 shares to the lender.

6.15 The lender of the shares loses the right to vote the shares when title is passed to the borrower. Because the proxy vote is announced well before the record date, the lender can recover the right to vote by closing out the financing trade before the record date on the vote. Or, the lender could require a premium (lower rebate rate) to compensate for the lost vote. If the lender had committed to lend the shares for a fixed term prior to the proxy announcement, the borrower pays no compensation to the lender.

6.16 The security lender treats the income the same as if the payment was received from the corporation or Treasury directly. Likewise, a borrower reduces dividend income or Treasury interest by the amount of these substitution payments.

6.17 The counterparty on a futures contract is the clearing corporation, not the entity that actually bought or sold the contract on the floor of the exchange when the hedge fund established the position. The clearing corporation has several advantages in protecting itself from loss compared to a lender in the cash market for the underlying security. First, the clearing corporation has daily margin (both initial and maintenance), which may be more frequently maintained than in other markets. Second, the updated price of the asset is easy to verify because the same standardized asset trades frequently. Third, because the asset trades frequently, it is relatively easy for the clearing corporation to liquidate or buy in a trade if a customer fails to maintain margin.

6.18 The loans affect to total amount of money in the system by restricting the money multiplier. While the Fed has not used the margin regulations to affect economic activity, it is still interested in limiting the chance for shocks to the financial system caused by speculation and bubbles.

6.19 If the hedge fund deposited an additional $1 million and paid down the margin loan to $7 million, the account would be in compliance with the maintenance margin requirement. Reduce a return, it fails to distinguish between a return produced over a short period of time and an equal return produced over a longer period of time. Most investors would prefer that a gain occur over a short period of time.



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Previous Issues

200605-24Some hedge funds are designed to provide very high returns and may accept high degrees of risk to attain those returns

200605-23Hedge fund investments can be structured as notes that pay a coupon equal to the return of the underlying hedge fund assets

200605-22Hedge funds face very few restrictions on their use of derivatives in their portfolios

200605-21Marketing and Hedge Fund Regulations in the United States

200605-20Value at risk is an adaptation of classical statistics to risk measurement

200605-19Summary of Hedge Fund Risk and Return Data

200605-18Most hedge funds create an interim closing to measure partner gain or loss

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