Hedge Funds and Prime Brokers

• The lecture covers the role of prime brokers in hedge funds and key investment strategies that hedge funds implement.

Prime Brokers

• Prime brokers play a crucial role in hedge funds, serving as the banks that offer services to them.
• Although hedge funds may not be heavily regulated they answer to their prime brokers.
• A hedge fund chooses a bank as its prime broker, which handles:
• Hedge fund's trades, borrows securities for short positions, provides cash management and portfolio reporting, risk management and consulting, introduces the fund to potential investors, makes loans, and determines the collateral the hedge fund must provide daily.
• Prime brokerage services are also offered to Non-bank financial intermediaries.
• Prime brokers are a main source of borrowing and understand the hedge funds portfolio and how much leverage to offer.
• Hedge funds post securities with PB as collateral for its loans, and post more collateral when it loses money.
• As a hedge fund grows it is likely to use more than one prime broker.
• This means no one bank sees all the hedge fund's trades or has complete understanding of its portfolio.
• Prime brokers want to transact business of hedge funds, giving the hedge funds negotiating power to reduce fees.
• Hedge funds mostly rely on global systemically important banks as prime brokers, with the largest ones serving more than 1,000 funds.
• When a fund chooses a prime broker it takes on Prime Broker Insolvency risk.
• When Lehman Brothers went bankrupt in 2008 hedge funds that chose them as their prime broker could not access assets they had placed with them as collateral.

Risks for Prime Brokers

• Wrong-Way Risk (WWR) the prime broker's exposure to the hedge fund increases at the same time that the hedge fund is more likely to default.
• For example if a hedge fund is heavily exposed to the same asset class that is causing market stress, the value of their collateral decrease while their chances of default increase.
• Poor risk management on the bank's or the hedge fund's side is a risk. Examples are failing to monitor leverage, not stress-testing exposures, or weak margining practices.
• Risk builds up silently, and when a shock hits the system, losses can spiral quickly, even for what was assumed to be a "low-risk" lending relationship.
• Opaqueness of Funds positions, prime brokers do not have necessary visibility into funds positions, especially if booked in different entities and assets do not have verifiable market values.
• The risk exposure only becomes apparent when the fund is facing difficulties. By the time the prime broker realizes how risky the fund's positions are, it may be too late to unwind positions safely.

Hedge Fund Strategies

• Hedge funds employ various strategies categorized as: Macro funds, event-driven hedge funds, relative value hedge funds, equity hedge funds, and fund of hedge funds.
• Strategies may involve discretionary or systematic/black-box model trading.
• Discretionary trading: Hedge Fund manager identifies and selects the investments.
• Systematic / black-box model trading: Using mathematical models executed by software, with limited human involvement.

Global Macro Funds

• Global macro funds are based on forecasts of global macroeconomic variables and geopolitical trends and bets around an outcome of a specific event.
• Macro political and economic events can disproportionately impact the energy, commodity, and currency markets.
• Main risk: event outcome may differ from that forecast.
• 'Big picture' focus contrasts with event-driven and relative value strategies that focus on inefficiencies at the security level.
• This offers diversification as global financial events tend to drag down both stock and bond markets.
• For example, hedge funds bet on the outcome that Britain would vote to leave the Eurozone in 2016 and went long in safe haven assets like gold and short positions in British and European stocks and the British pound.
• An Example of a global macro fund is George Soros Quantum Fund.
• Soros believed the British pound was overvalued in 1992 and the Bank of England wouldn't be able to keep it within the ERM limits.
• The UK had high inflation and low competitiveness, and defending the pound required very high interest rates, which hurt the economy.
• The Quantum Fund shorted more than $10 billion worth of GBP using leverage.
• When the Bank of England capitulated and withdrew from the ERM on 16 September 1992, the pound plunged, and Quantum Funds made an estimated $1 billion profit in one day.

Event-Driven Funds

• Special events mean that market prices may not fully reflect all information which provides an opportunity to capture a return premium.
• Corporate events are exposed to uncertainty thus some returns from an event strategy may be driven by systematic risk or mispricing.

Merger Arbitrage

• Merger arbitrage involves buying shares of a target firm and short selling shares of acquirer with simultaneous long and short positions hedging with the ratio of shares driven by the shares in the stock offer. Short position is used to fund the Long position through leverage.
• This is based on the belief that the target firm is undervalued.
• Hedge funds buy shares from the target firm's shareholders seeking profit who want to avoid event risk but this exposes the hedge fund to the risk that the merger will fail.
• The strategy captures the differences between the ratio-adjusted spreads of the current market prices of the merger partners and the spreads upon the successful completion of the merger.
• Example: after an announcement, Mountain's price falls to R100 while Hill's jumps to R25, a HF will short sell Mountain shares and buy Hill shares.

Distressed Securities

• Hedge funds invest in securities of a company in bankruptcy or likely to fall into bankruptcy. Several strategies:
• Short selling shares on the firms in expectations that they will be able to buy shares at a lower price when firm deteriorates before bankruptcy, this is unhedged and has substantial risk if fortune changes.
• Buying undervalued securities and receiving payout from the bankruptcy process
• Capital structure arbitrage: the hedge fund enters offsetting positions within a firm's capital structure to be long relatively underpriced (senior claims) and short overpriced securities (junior claims) and being hedged against risk.
• These hedge funds are also known as "Vulture Funds".

Activist Investment Strategies

• Hedge funds use rights as shareholders, such as voting rights, to influence corporate governance to their financial benefit.
• The strategy rests on the belief that managers are not maximizing share holder wealth (agency theory).
• The actions may involve replacing management, capital structure & dividend policy changes, streamline operations or mergers and divestitures.
• The hedge fund creates it's own catalyst by winning ownership influence and persuading others to enact changes.
• Activists achieved an average of 20.2% return last year, but in 2022 activists lost an average 16%.
• Shareholder activism may be driven by social rather than financial objectives, hedge funds will principally adopt activist approaches for financial objectives.
• A study by Clifford (2008) examined effects of shareholder activism by hedge funds finding that firms targeted by hedge funds for active purposes earn larger excess stock returns and increases in ROA and that funds are more likely to have longer lock-ups and withdrawal notification periods.

Relative Value Hedge Funds

• A relative value hedge fund profits by identifying mispricings between two or more rated securities and betting prices will converge taking offsetting long and short positions so the overall exposure to market directions is small.
• Combined positions have close to zero net market risk with profits coming from short positions and overvalued securities and long positions in undervalued.
• Since returns are usually small managers employ substantial leverage to generate acceptable returns.

Convertible Bond Arbitrage

• Purchase undervalued convertible bonds and hedge risk using a short position in underlying equity done in anticipation of the price of the bombs raising in price for the shares falling or both. It is based on the belief that either the implied volatility in the option portion of the bone is too low or decrease in interest rates will increase the price of the bond more than it increase price of the share.
• Volatility arbitrage earns a riskless profit based on prices that explicitly depend on volatility, fixed income arbitrage is simultaneous long and short positioning and fixed income securities.

Equity Hedge Funds

• Equity hedge funds primarily invest in stocks but use hedging techniques to manage risk to amplify returns to generate alpha while hedging market exposures to reduce volatility.
• There are three types:
• Goes long on undervalued stocks and short on overvalued stocks creating positive risk exposure from taking net long position.
• Hedge fund has a net short exposure when short positions are greater than long positions.
• Focus is on identifying overvalued shares

Market Neutral Funds

• The hedge fund attempts to balance short and long positions by matching the data exposures and leaving the fund relatively insensitive to the stock market in order to be market neutral (beta=0).
• One example is pairs trading where funds track the recent price spread or ratio of prices if abnormally wide, Funds short sell recently outperforming stock and long recently underperforming stock on the assumption that the spread will mean-revert.
• The graph provided ratio of prices of Tesla to General Motors including bollinger bands used to visualize volatility and identify when to buy or short.
• If the ratio touches lower Bollinger Band it means that Tesla is been falling and GM has been rising and therefore you should buy Tesla and shortsell GM.

Fund of Hedge Funds

• A feeder fund invests in several other hedge funds with diversification and undertake due diligence in screening for investment worthiness providing liquidity.

Fund of Hedge Funds Cons

• They have a double layer fees and diversification may be misleading if the HF invest in similar HFs.
• They typically operate with considerable leverage in incentive fees are not netted to each underlying HF that is profitable regardless of the performance of the overall portfolio.
• Denvir and Hutson (2006) find that Fund of Hedge Funds underperform the hedge fund index on a risk-adjusted basis however returns do not suffer from negative skewness and have lower correlations with stock indices.
• For example, a feeder fund is established with $1 million invested in each of three hedge funds with no hurdle rate in the hedge funds charge an incentive fee of 20% and a fund of hedge fund charges an incentive fee of 10%.