Hedge Fund Analysis

An In-Depth Guide to Evaluating Return Potential and Assessing Risks

Frank J. Travers

• Publisher: Wiley
• Year: 2015
• ISBN:
  9781118237564
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Investitionen & Wertpapiere

A detailed, step-by-step book covering the entire hedge fund evaluation process

Investing in hedge funds is different from investing in other asset classes. There is much less publicly available information about hedge funds performance than there is about mutual funds or individual stocks. Consequently, investing in this class requires more sophisticated investment knowledge, greater due diligence, and, in many cases, a better-developed ability to evaluate investment managers.

Hedge Fund Analysis provides a broad framework of how to approach this endeavor, from initial screening to analytical techniques, interviewing skills, and legal and contract negotiations. Along the way, it demonstrates a variety of mechanisms for monitoring and tracking hedge funds and the underlying hedge fund portfolios—explaining each stage of the process in minute detail and providing specific examples which fully explain the opportunities and challenges you'll face each step of the way.

• Provides a detailed look at how to source hedge funds, screen through them, and rank their strengths and weaknesses
• Lays out a thorough process for evaluating funds, from initial interviews to performance analysis to onsite meetings
• Reveals what questions to ask by strategy in order to understand the underlying risk factors associated with each
• Highlights non-investment analysis, including operational due diligence and risk management, as integral elements in the process

Written by a financial professional with over twenty years of experience conducting investment manager due diligence, this book will put you in a position to make more informed decisions when investing in hedge funds.

Part One

Background

Chapter 1

Hedge Fund History

“History doesn't repeat itself, but it does rhyme.”

Mark Twain

I recently read an article printed in the financial press that questioned the viability of hedge funds as an asset class. Following the bear market decline and the corresponding volatile market environment, the article suggested that investors had begun to question whether or not hedge funds actually hedge and whether or not the asset class was doomed. Managers responded that it had become too hard to find profitable shorts, as all the best shorts quickly become crowded trades—which can lead to short squeezes.

The author of the article suggested that many hedge fund managers had become overconfident going into the market decline and had begun to invest outside of their core mandates and, even worse, did not do a good job of matching the liquidity of their fund's underlying investments with that of their underlying investors. As a result, some hedge fund investors are still waiting to receive redemption proceeds.

Additionally, the article highlighted that the SEC is tracking hedge funds more closely and that they are currently determining how to best regulate them.

What is most striking about the article (titled “Hard Times Come to the Hedge Funds”) is that it was written by Carol Loomis and was published by Fortune magazine in June 1970.¹ The bear market referred to in the article occurred the previous year and had a disastrous impact on the hedge fund industry. Many hedge funds shut down and the asset class went into a dark period that lasted nearly two decades. I suggest that readers interested in hedge fund history read this article in its entirety because it provides perspective on hedge fund history and clearly shows that no matter how much things change and progress, history is likely to repeat itself (or at least rhyme).

So Who Invented the Hedge Fund?

The hedge fund industry is generally linked historically to Alfred Winslow Jones, who created the basic format for the hedge fund—which still exists to this day. However, a number of other early pioneers had invested with an absolute return methodology long before Jones entered the investment business.

The Samurai

It has been suggested² that the world's first commodity trading advisor (CTA) or macro fund was created and managed to great success in the mid- to late 1700s in Japan. During the Tokugawa shogunate (1615 to 1867) Japan changed from many separate provinces to a single unified country. This had a positive impact on commerce and the nation's official marketplace for rice, which effectively was the currency in Japan, formed in Osaka due to its favorable location near the sea. The Dojima Rice Exchange was officially set up in the late 1600s and initially dealt only in the physical purchase and sale of rice. However, as rice became big business, more and more rice farmers and merchants began to sell “coupons” against the future delivery of rice. These coupons became actively traded because they provided buyers and sellers the ability to effectively go long or short various grades of rice at different delivery dates in the future. This market is generally considered to be the world's first futures exchange.

Munehisa Honma was born in 1724 into a wealthy merchant family in Sakata. He took over the family business in 1750, and his talent and skill as a trader has since become the stuff of legend. His first innovation was to study years' worth of price, weather, and crop data (it is rumored that he analyzed hundreds of years' worth of data) and to make forecasts of rice production and quality based on changes in weather and other seasonal effects. By reviewing the historical price movements and plotting them against other factors, he was able to anticipate when rice harvests would be strong and when they would be weak—and trade using that information. This combination of historical technical data combined with fundamental information gave him a genuine edge over his trading competition. This is a concept that we now take for granted, but back then no one else had thought to do it.

In addition, he devised a system of early price discovery. As most rice trading was done in Osaka and he was situated in Sakata (a considerable distance away), he developed an ingenious signaling system by positioning people on rooftops at regular intervals across the distance between the two cities. Once the official price was determined in Osaka, the first team member would signal the next team member using flags. This person would then signal the next in line until the message was received back home; not quite real-time quotes, but this innovation allowed for quicker price discovery. With this information in hand long before other traders in Sakata had access to it, Honma was able to gain a significant advantage over his peers (what we would today refer to as “low latency” trading).

Honma did not run a hedge fund as we define them today, but he certainly embraced the spirit of absolute return investing. He looked to make money by investing both long and short and developed ingenious methods that gave him a clear edge over his competition.

He was so successful as a trader he eventually became a financial consultant to the Japanese government and later was given the honorary title of samurai. He authored a book colorfully titled Fountain of Gold: The Three Monkey Record of Money.³ This work is credited with being one of the first investment books that focused on market and investor psychology. In his book, Honma posited that there was a clear link between supply and demand (in rice markets) but determined that investor perception and sentiment could cause temporary dislocations that an astute trader could take advantage of. He is also credited with developing many of the principles of what we now refer to as contrarian investing and reversion to the mean. In his book, he suggests that when markets are oversold there may exist a buying opportunity and vice versa. He also employed a more philosophical approach to investing, describing the rotation of the markets as yin (a bear market) and yang (a bull market).

Many of his technical and charting techniques became the basis for what is now referred to as Japanese candlestick charting, which is still used to this day (largely in Japan).

Monehisa Honma's Innovations:

Using past p...

Table of contents

• Cover
• Series Page
• Title Page
• Copyright
• Dedication
• Introduction
• Part One: Background
• Part Two: Hedge Fund Due Diligence
• About the Author
• Index