Hedge Fund Investing. Mirabile Kevin R.

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СКАЧАТЬ Annual borrow fees of 1 percent of the value of the short sale would result in $1 million of additional expense.

      The fund has an ending cash account credit balance or repo of positive $150 million. Accounts with a positive cash account or repo balance earn interest from their broker or bank at a rate that is lower than when they borrow. A fund that has a short position also owes the dividend or coupon to the broker or bank from which it borrowed the shares or bonds to execute the short sale. Borrowing shares normally occurs automatically in a securities margin account, subject to limits set forth under U.S. Federal Reserve Regulation T or the NYSE. Borrowing bonds to cover short sales normally occurs in the repo market.

      The fund will have a profit from its financing activity, given the excess interest income from margin interest of $6 million versus dividends or coupons owed and borrow fees of $2 million. In the case of a short sale, the effects of leverage are even more powerful; the fund could actually lose $4 million in trading and still break even for the year before expenses!

      Assuming the fund had a trading gain of 10 percent based on a decline in value on its $100 million short portfolio, its gross return on investment before any fees would be 28 percent. The fund return is simply the profit of $10 million on the short sale plus the net margin interest and dividends or coupons of positive $4 million ($6 million less $2 million) divided by the beginning of the year AUM of $50 million. The use of leverage and short selling has transformed a market decline of 10 percent into a positive return of 28 percent.

      • Fund return on investment is 28 percent.

      • Return on short position of 10 percent, positive carry of 2 percent, plus margin interest on initial deposit of 4 percent is 16 percent.

      • Return from leverage is 12 percent, which equals the return on an incremental $50 million of assets of 10 percent plus the positive carry on the additional short position of 2 percent.

      If the short portfolio had increased in value by 10 percent, the effects of leverage and short selling would have generated a significant loss. However, the loss of $10 million from the change in market value would be reduced by the positive carry and margin interest of $4 million, resulting in only a $6 million loss on a $50 million fund, or negative 12 percent. The additional loss due to the use of leverage is a negative 8 percent.

      Most funds use a combination of long and short positions in a single portfolio so that they can cancel out the effects of overall market changes and just capture the relative effects and profits from small changes in the value of long positions relative to the short position or relative to the market as a whole. The effects of leveraged long positions and leveraged short selling on a stand-alone basis can increase risk and generate extreme outcomes. Long and short investing allows funds to use leverage and short selling in tandem to reduce risk and lower volatility while magnifying gains.

INTRODUCTION TO PERFORMANCE AND RISK MEASUREMENT

      Hedge funds provide investors with periodic reports of their returns and their risk profile, either directly or via a third-party service provider or database. There are no standard methodologies that are mandated, and many forms of reporting and aggregation have limited value, are misleading, or are not accurate. Fund performance is generally reported on a monthly basis and is calculated net of all fees. Some of the basic values reported to an investor are those related to the fund’s returns, volatility, and fund exposure.

      Arithmetic and Geometric Mean Returns

      The average monthly return is simply the sum of all monthly returns in a reporting period divided by the number of periods. A fund generating monthly returns of 2 percent, 4 percent, 2 percent, and 1 percent would have an arithmetic mean of 2.25 percent per month and a 27 percent annualized return.

      The geometric mean or compound growth rate is the rate of return that equates the beginning value to the ending value of an investment over the number of periods of the investment. A fund generating monthly returns of 2 percent, 4 percent, 2 percent, and 1 percent would have a geometric mean that is slightly lower at 2.24 percent per month and an annualized return that is slightly higher at 31 percent.

      Funds should normally use the geometric mean or compound growth rate when reporting results to an investor; however, this may not always be the case.

      Standard Deviation, Skew, and Kurtosis

      The primary source of risk of investing in a fund is the variation of the fund’s monthly returns and the risk you will lose money or that returns will be unpredictable. This variation is commonly referred to as the fund’s volatility or standard deviation.

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