Efficiently Inefficient describes the key trading strategies used by hedge funds and demystifies the secret world of active investing. Leading financial economist Lasse Heje Pedersen combines the latest research with real-world examples and interviews with top hedge fund managers to show how certain trading strategies make money--and why they sometimes don't.
Pedersen views markets as neither perfectly efficient nor completely inefficient. Rather, they are inefficient enough that money managers can be compensated for their costs through the profits of their trading strategies and efficient enough that the profits after costs do not encourage additional active investing. Understanding how to trade in this efficiently inefficient market provides a new, engaging way to learn finance. Pedersen analyzes how the market price of stocks and bonds can differ from the model price, leading to new perspectives on the relationship between trading results and finance theory. He explores several different areas in depth--fundamental tools for investment management, equity strategies, macro strategies, and arbitrage strategies--and he looks at such diverse topics as portfolio choice, risk management, equity valuation, and yield curve logic. The book's strategies are illuminated further by interviews with leading hedge fund managers: Lee Ainslie, Cliff Asness, Jim Chanos, Ken Griffin, David Harding, John Paulson, Myron Scholes, and George Soros.
Efficiently Inefficient effectively demonstrates how financial markets really work.
Free problem sets are available online at www.lhpedersen.com
|Publisher:||Princeton University Press|
|Edition description:||New Edition|
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About the Author
Lasse Heje Pedersen is a finance professor at Copenhagen Business School and New York University's Stern School of Business, and a principal at AQR Capital Management. A distinguished financial economist, he has won a number of awards, notably the Bernácer Prize, awarded to European economists under forty who have made outstanding contributions in macroeconomics and finance.
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How Smart Money Invests and Market Prices are Determined
By Lasse Heje Pedersen
PRINCETON UNIVERSITY PRESSCopyright © 2015 Princeton University Press
All rights reserved.
Understanding Hedge Funds and Other Smart Money
There are many types of active investors who make markets efficiently inefficient. These investors include large sophisticated pension funds with in-house trading operations, endowments, dealers and proprietary traders at investment banks, trading arms at commodity producing firms, mutual funds, proprietary trading firms, and hedge funds. In each case, the traders have slightly different contracts or profit-sharing agreements and face different political and firm-specific pressures and concerns. Since the focus of this book is the trading strategies, not the players, it would take us too far astray to discuss each of these trading set-ups in detail. However, to relate the trading strategies to real-life investors, it is worthwhile to understand the most pure-play bet on beating the market, namely hedge funds.
It is notoriously difficult to define what hedge funds are. Said simply, they are investment vehicles pursuing a variety of complex trading strategies to make money. The word hedge refers to reducing market risk by investing in both long and short positions, and the word fund refers to a pool of money contributed by the manager and investors. Asness has provided a tongue-in-cheek definition:
Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years they deliver a one-in-a-hundred year flood. They are generally run for rich people in Geneva, Switzerland, by rich people in Greenwich, Connecticut. —Cliff Asness (2004)
Hedge funds are exempt from much of the regulation that applies to other investment companies, such as mutual funds. Hedge funds have a lot of freedom in the trading that they do, as well as limited disclosure requirements, but in exchange for this freedom, they are restricted in how they can raise money. In terms of freedom, hedge funds can use leverage, short-selling, derivatives, and incentive fees. In terms of restrictions, hedge fund investors must be "accredited investors," meaning that they need a certain amount of financial wealth and/or financial knowledge to be allowed to invest (to protect smaller, presumably less sophisticated, investors from the complexities encompassed in hedge fund strategies and risks that they may not understand). Also, hedge funds have historically been subject to a non-solicitation requirement, meaning that they cannot advertise or actively approach people for investments (although the regulation is being tightened in certain ways and loosened in others, e.g., in connection with the recent JOBS (Jumpstart Our Business Startups) Act in the United States).
Active investment has been around as long as markets have, and hedge funds have existed for more than half a century. The first formal hedge fund is believed to have been a fund created by Alfred Winslow Jones in 1949. Jones took long and short positions in stocks and reportedly earned a phenomenal 670% return from 1955 to 1965. While short-selling had been widely used long before Jones, he had the insight that, by balancing long and short positions, he would be relatively immune to overall market moves but profit from the relative outperformance of his long positions relative to his short positions. After Fortune magazine published Jones's results in 1966, interest in hedge funds started to grow, and in 1968 the U.S. Securities and Exchange Commission (SEC) counted 140 hedge funds. In the 1990s, the hedge fund industry saw a dramatically increased interest as institutional investors began to embrace hedge funds. In the 2000s, hedge funds with billions of dollars under management became commonplace, with total assets in the hedge fund industry reaching a peak of about $2 trillion before the global financial crisis, falling during the crisis, and since reaching a new peak.
Because of hedge fund leverage, their aggregate positions are much larger than their assets under management and, given their high turnover, their trading volume is a much larger part of the aggregate trading volume than their relative position sizes, so hedge fund trading is now a significant proportion of all trading. In an efficiently inefficient market, the amount of capital allocated to hedge funds cannot keep growing since, given a limited demand for liquidity, there is a limited amount of profit to be made and a limited need for active investment.
1.1. OBJECTIVES AND FEES
The objective of asset managers is to add value to their investors by making money relative to a benchmark. Mutual funds typically have a market index as a benchmark and try to outperform the market, whereas hedge funds typically have a cash benchmark (also called an "absolute return benchmark"). Hedge funds are not trying to beat the stock market but, rather, trying to make money in any environment. This is where the "hedge" part comes in. In contrast, mutual fund returns are usually benchmarked to a stock market (or bond market) index such as the Standard & Poor's 500 (S&P 500). Hence, if the S&P 500 is down 10% and a mutual fund is down 8%, it is outperforming its benchmark and applauded by its investors, whereas a hedge fund down 8% would be punished by its investors for the loss since its bets should not depend on market moves. Conversely, if the S&P 500 is up 20%, investors in a mutual fund that is up 16% will complain that it picked stocks that underperformed. Investors in a hedge fund that is truly market neutral (many are not) are satisfied that the hedged bets paid off in absolute terms. A hedge fund with returns that are independent of the market has the potential to be very diversifying to investors.
Asset managers charge fees for their investment service. Mutual funds charge a management fee (a fixed proportion of the assets), and hedge funds often also charge a performance fee. The management fee is meant to cover the manager's fixed expenses, and the performance fee is meant to strengthen the manager's incentive to perform well. The performance fee also enables the hedge fund to pay performance-based bonuses to its employees.
While fees vary greatly across funds, the classic hedge fund fee structure has been "2 and 20," meaning a 2% management fee paid regardless of returns, and a 20% performance fee. For instance, if the hedge fund has a return of 12%, then the return is 10% after the management fee. The performance fee is then 20% of the 10%, that is, 2%, leaving 8% for the investors. Sometimes the performance fee is subject to a hurdle rate, such as the Treasury Bill rate, meaning that the hedge fund only earns performance fees on the return that exceeds the hurdle rate. However, performance fees typically do not depend on whether the fund beats the stock market return.
A hedge fund's performance fee is often subject to a high water mark (HWM). This means that, if the hedge fund loses money, it only starts to charge performance fees when the losses have been recovered. Just as you can see how high the water has reached by looking at the marks on the piers supporting a dock, a hedge fund keeps track of its cumulative performance and only charges performance fees when it reaches new highs. Note, however, that the HWM is investor specific. If a hedge fund gets a new investor just after suffering losses, the hedge fund can charge performance fees from the new investor as soon as it makes money (since the new investor has not incurred any losses that need to be made up).
While fees are income for asset managers, they are costs for investors. Investors should be aware of the fees they pay since fees in money management are very large, both in terms of the total amount of money paid, the fraction of the value added by the manager, and the effect of the long-term investment performance. There exist managers who track an index (explicitly or implicitly) while charging high fees, resulting in performance that underperforms the index by the fee each year, significantly hurting the long-run returns.
The fee should be viewed in relation to the amount of effective money management that the manager provides and the quality of this management. The amount of effective management can be measured as the "active risk," i.e., the volatility of the deviation from the benchmark (or tracking error). Hence, if a manager does not deviate from the benchmark, the fee should be very small. Similarly, a hedge fund manager who runs a high-risk and low-risk version of the same hedge fund typically charges a larger fee for the high-risk fund. This measure of the amount of effective management helps explain why hedge funds charge larger fees than mutual funds, namely because hedge funds effectively deliver more asset management services (since a large part of mutual fund returns is just delivering the benchmark).
To understand the importance of costs in the financial sector, consider how costs build up for a household saving for retirement. The retirement savings are managed in a pension fund with costs to pay its staff. The pension fund may hire investment consultants who charge fees to help pick the asset managers, and the asset managers charge another layer of fees. If the pension fund invests in a fund-of-funds, that adds yet another layer of fees. A final layer of costs comes from the transaction costs incurred through the turnover of the active manager (and earned by dealers and banks). Unless the fees in each layer are very competitive relative to the costs of passive management, the asset manager must add a lot of value through his trading. For an end investor to beat the market, a "double inefficiency" must exist: First, the security market must be inefficient enough that active managers can outperform, and second, the money management market must be inefficient enough that the end investor can find a money manager whose fee is below the expected outperformance.
A number of famous hedge fund managers have produced spectacular returns, but these managers represent the best performers, not the typical hedge fund returns. Does more rigorous evidence for skill in money management exist?
This question is surprisingly hard to answer for several reasons, especially for hedge funds. First, the data on hedge fund returns are rather poor as they are available only over a limited time period and subject to important biases. To understand why, note that hedge fund databases consist of the returns of hedge funds that choose to report to the database provider. There is no comprehensive source of hedge fund returns, since their only reporting requirement is to their investors and hedge funds are often highly secretive. Hedge funds report their returns to promote themselves (remember that they are not allowed to advertise but can hope that investors will approach them if they see their track record in a database). This situation leads to several biases in the databases. First, when a hedge fund starts to report to a database, the fund reports all past returns, which are "backfilled" in the database. Since funds are more likely to start reporting after having experienced good performance, this leads to a "backfill bias": Funds that have poor performance from the beginning never make it into the database, while better performing funds are more likely to start reporting. Some databases and researchers account for this by only including returns from a certain time period after the hedge funds started reporting, disregarding the biased backfilled data. Another effect is that some hedge funds stop reporting when they experience poor performance, leading to a "survivorship bias." A bias pulling in the opposite direction arises from the fact that the most successful hedge funds often do not report to the databases. These funds value their privacy and do not need any additional exposure to clients; they may in fact be closed to new investments due to limited capacity. Hence, the databases exclude some of the most impressive track records, such as that of Renaissance Technologies.
When all these biases are taken into account, the evidence suggests that trading skill does exist among the best hedge funds and the best mutual funds, especially when considering performance before fees. Furthermore, some researchers find evidence of performance persistence, meaning that the top managers continue to be the top managers more often than not, but the persistence is not strong, and asset allocators should be careful of chasing performance, pulling money out at the bottom and investing at the peak rather than focusing on the manager's long-term record, process, and team.
The evidence also suggests that the biases in many estimates of hedge fund returns are very large—beware!—these biases are not just "rounding error" but rather effects that change the perception of average returns by several percentage points. Furthermore, hedge fund returns are on average far from market neutral. Hedge fund indices have large correlations to equity markets, and the correlation has been growing over time. Also, hedge funds often have negative skewness and excess kurtosis, meaning that they sometimes have extreme returns, especially on the downside. Indeed, hedge funds, especially the small ones, have a high attrition rate, and the industry has been marked by some large blowups, including the failures of Long-Term Capital Management (LTCM), Bear Stearns' credit funds, and Amaranth.
Rather than looking at the performance of actual hedge funds, we can circumvent some of the issues discussed above by cutting to the chase and studying the actual trading strategies that hedge funds pursue as we do in this book. As we will see, the core strategies have worked more often than not over long time periods and worked for economic reasons of efficiently inefficient markets.
1.3. ORGANIZATION OF HEDGE FUNDS
Hedge funds are contractually organized in a number of different ways, but the typical master–feeder structure used by major hedge funds is illustrated in figure 1.1.
This structure is not as complicated as it first looks. The main point of the diagram is that, contractually, there is a distinction between the "fund," where the money is, and the "management company," where the traders and other employees work, even though the entire structure (or the relevant part) is often called the hedge fund for short.
An investor in a hedge fund invests in a feeder fund, whose sole purpose in life is to invest in the master fund, where the actual trades take place. (Investors in some, typically smaller, hedge funds invest directly into the master fund.) The master–feeder structure is useful since it allows the manager to focus on running a single master fund while at the same time creating different investment products (the feeder funds) tailored to the needs of the different investors. Typically, U.S. taxable investors prefer a feeder fund that is registered in the United States, while foreign investors and tax-exempt U.S. investors prefer an offshore feeder fund, established in an international financial center, such as the Cayman Islands. In addition to these tax-driven differences in where the various feeder funds are registered, feeder funds can also be used to tailor performance characteristics to different groups of investors. For instance, one can have several feeder funds denominated in different currencies, even though the underlying investments are the same. In this case, the foreign-currency-denominated feeder funds have a currency hedge in addition to their investment into the master fund. Another use of this structure is to have feeder funds at different risk levels. If the master fund has a volatility of 20% per year, one feeder fund might have the same volatility while another has half the volatility. The lower-risk feeder simply invests half its capital in a money market fund and the other half into the master fund, thus realizing half the risk.
The master fund has a pool of money, and this is where all the trades are carried out. It has an investment management agreement (IMA) with the management company to provide investment services, including strategy development, implementation, and trading. Hence, the management company is where all the employees work—including the traders, research analysts, operations staff, business development people, compliance, and legal personnel—and the management company is owned by the hedge fund managers. The management company trades on behalf of the fund, while the fund, and ultimately the investors, own the capital (and the hedge fund managers are typically themselves investors). The master fund is typically organized as a partnership, where the feeder funds are the limited partners, and the general partner is a company owned by the management company.
Excerpted from Efficiently Inefficient by Lasse Heje Pedersen. Copyright © 2015 Princeton University Press. Excerpted by permission of PRINCETON UNIVERSITY PRESS.
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Table of Contents
The Main Themes in Three Simple Tables vii
Who Should Read the Book? xiv
About the Author xvii
i. Efficiently Inefficient Markets 3
ii. Global Trading Strategies: Overview of the Book 7
iii. Investment Styles and Factor Investing 14
Part I Active Investment 17
Chapter 1 Understanding Hedge Funds and Other Smart Money 19
Chapter 2 Evaluating Trading Strategies: Performance Measures 27
Chapter 3 Finding and Backtesting Strategies: Profiting in
Efficiently Inefficient Markets 39
Chapter 4 Portfolio Construction and Risk Management 54
Chapter 5 Trading and Financing a Strategy: Market and Funding Liquidity 63
Part II Equity Strategies 85
Chapter 6 Introduction to Equity Valuation and Investing 87
Chapter 7 Discretionary Equity Investing 95
Interview with Lee S. Ainslie III of Maverick Capital 108
Chapter 8 Dedicated Short Bias 115
Interview with James Chanos of Kynikos Associates 127
Chapter 9 Quantitative Equity Investing 133
Interview with Cliff Asness of AQR Capital Management 158
Part III Asset Allocation and Macro Strategies 165
Chapter 10 Introduction to Asset Allocation: The Returns to the Major Asset Classes 167
Chapter 11 Global Macro Investing 184
Interview with George Soros of Soros Fund Management 204
Chapter 12 Managed Futures: Trend-Following Investing 208
Interview with David Harding of Winton Capital Management 225
Part IV Arbitrage Strategies 231
Chapter 13 Introduction to Arbitrage Pricing and Trading 233
Chapter 14 Fixed-Income Arbitrage 241
Interview with Nobel Laureate Myron Scholes 262
Chapter 15 Convertible Bond Arbitrage 269
Interview with Ken Griffin of Citadel 286
Chapter 16 Event-Driven Investments 291
Interview with John A. Paulson of Paulson & Co. 313
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