Hedge Fund Investing. Mirabile Kevin R.

fund that raises $50 million in assets and buys $100 million in securities needs to borrow $50 million from a broker or bank. It has $100 million in long market value and $50 million of AUM. It will also have a negative finance balance in its margin account or from borrowing in the repo market.

      The fund will receive income on $100 million of securities appreciation or depreciation in value and any coupons or dividends. It will also pay interest expense on any funds borrowed from its broker or bank related to the purchase of securities.

      Illustration 2

       Cash Account

       Annual Financing Activity

      • Annual financing expense at a 5 percent interest rate would equal $2.5 million per year.

      • Dividend or coupon income or expense based on a 4 percent dividend yield or coupon payment would generate a positive $4 million per year.

      The fund has an ending cash balance of negative $50 million. Accounts with a negative cash balance have to borrow money from their broker or bank to pay for the purchase of securities. Borrowing cash to buy shares normally occurs automatically in a securities margin account for amounts that are within a fund’s borrowing limit. In the United States, borrowing limits for specific types of securities are set forth under U.S. Federal Reserve Regulation T. Fixed-income–oriented investments will generally be funded via the repo market on a security by security basis. The fund will have a net profit from its financing activity of $1.5 million, given the excess income from dividends or coupons over the amount of interest paid to carry the position.

      Assuming the fund had a trading gain of 10 percent on its $100 million portfolio, its gross return on investment before any fees would be 23.0 percent. The fund return is simply the trading profit of $10 million plus the net financing and dividends of positive $1.5 million divided by the beginning-of-the-year AUM of $50 million. The use of leverage has transformed a market gain of 10 percent plus a dividend yield or coupon payment of 4 percent into an investor return of 23.0 percent. The return from leverage in this case is a positive 9 percent.

      • Fund return on investment is 23 percent.

      • Return on assets plus dividends yield is 14 percent.

      • Return from leverage is 9 percent, which equals the return on an incremental $50 million of assets of 10 percent plus the dividend of 4 percent less the 5 percent cost of carrying the position.

      If the portfolio had lost 10 percent, the effects of leverage would have generated a significant loss. The loss of $10 million, however, would be reduced by the positive carry of $1.5 million, resulting in an $8.5 million loss on a $50 million fund or negative 17 percent. The loss without leverage would have been only negative 6 percent. The additional loss due to the use of leverage is negative 11 percent.

      An Example of a Leveraged Short-Sale Position in a Margin Account or via a Repo Transaction

      A fund that raises $50 million and sells short $100 million in securities will generate $100 million in cash, but also needs to borrow $100 million in securities from a broker or bank via a stock borrow or repo transaction. The fund has $100 million in short market value and $50 million of AUM. It will also have a credit balance in the margin account related to its short sale proceeds or will have an overnight cash investment in a repo market transaction.

      The fund will receive income on $100 million of securities appreciation or depreciation in value and must pay any coupons or dividends that occur to the entity from which it borrowed the stock or bonds, usually a broker or bank.

      A fund that enters into a short sale must also pay a fee to borrow or rent securities from its broker or bank to make a delivery against the short sale.

      Illustration 3

       Cash Account

       Annual Financing Activity

      • Annual interest income at a 4 percent rate would equal $6 million per year.

      • Dividend or coupon income or expense based on a 1 percent dividend yield or coupon would generate a negative $1 million per year.

      • 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