WCM Educational Recap #7: Intro to Hedge Funds

Recapped by Morgan Tannis

This week, we discussed the investment strategies utilized by hedge funds and asset management firms.

Hedge Funds

Hedging is the process of limiting potential downside through investments in related securities

Overview

• Large pools of capital managed by a single group of investors
• Different funds specialize in different asset classes and investment strategies

Limited Partners

• Fund capital contributed by limited partners (LPs)
• LPs are not managers, only investors
• Requirements for becoming an LP are strict and difficult to obtain

The rationale for Hedge Fund Investing

• Reduced portfolio volatility
• Access to unique return streams, skilled management, and large transactions

Key Fund Tasks

• Design: Developing proprietary research tools to maintain a competitive edge and attract LPs
• Valuations: Performing financial and industry analysis, similar to a stock pitch
• Due Diligence: Studying businesses and the viability of investment ideas
• Portfolio Management: Monitoring and strategically updating positions

Common Strategies

• Equities (Long/Short): Betting on stock to perform well (long) and/or betting on a stock to perform poorly (short)
• Relative Value Arbitrage: Buying a security and shorting a related security which usually exhibit correlated price action but have irrationally diverged in price and are likely to converge again in the future
• Macro: Long and short positions in stocks, bonds, futures, options, and currencies based on major economic and political events
• Distressed: Investments in cheap debt of a company that is, or is likely to be, bankrupt, with the conviction that the debt will be repaid before liquidation is complete

Long/Short Equities

• Long Position: Requires fundamental analysis to support conviction that the company will significantly increase in value in the long term. Maintainable competitive advantages, competent management, market leadership, favorable industry dynamics, and efficient operations are indicators of future business success
• Short Position: Requires fundamental analysis to support conviction that the company will decline in value in the long term. Obsolete business models, slowing industry growth, increasing competition, and unsustainable debt loads are indicators of poor future performance
• While many funds utilize long or short only positions, others utilize both.

Investment Process

• Idea Generation: Investment team generates ideas by meetings with management and expert contacts, and conducting industry research and fundamental screening. Fundamental analysis conducted on most promising ideas
• Position Review: Portfolio Manager (PM) evaluates ideas and considers potential hedging and position size. PM continually challenges ideas to lead the due diligence process
• Implementation & Management: Analysis scope increased to consider fund liquidity, macro sentiment, and volatility

Career Pathway

Common Career Path

• IB & Equity Research, 1–3 years
• Hedge Fund Analyst, 2–3 years
• Senior Analyst (Sector Head), 1–3 years
• Portfolio Manager, undefined

Roles and Responsibilities

• Early Career: Fundamental analysis, building models, developing research tools, attending calls
• Mid-Career: Becoming a value-add, developing a network, conducting independent analysis
• Late Career: Generating own investment ideas, adding value to other sectors

Involvement in University

• 2nd year: Burgundy Asset Management, Cidel, Anson Funds
• 3rd year: DE Shaw & Co, Polar Asset Management Partners, Point72

Markets, Institutions, & Banks

• Institutions buy and sell securities, or issue debt or equity on capital markets
• Institutions buy research, investment banking, and trading services from banks

Activist Hedge Funds

• Buying a large equity stake in a company with misaligned management and shareholder incentives, and advocating for organizational change to realign incentives and unlock value

Types of Activism Investments

• Capital Structure: Recapitalizations, dividend distributions, stock buybacks
• Corporate Governance: Electing directors, removing company management or board members
• Asset Sale: Pushing for a company to sell itself or business units
• Financing/Bankruptcy: Providing financing for distressed companies

Market Structure

Stock Exchange Fundamentals

• Stocks are traded on physical or virtual exchanges
• Investors submit buy/sell orders through a broker or online

Purchasing Shares

• Investor orders are routed to a brokerage system
• Orders are internalized, filed in a dark pool, or sent to an exchange
• Shares are traded with the market maker with the highest/lowest bid/ask and delivered to the investors’ account

Types of Markets

• Auction Markets (i.e., NYSE): Buyers and sellers submit competitive bids and offers and are matched by the exchange
• Dealer Markets (i.e., NASDAQ): Dealers post buy/sell prices for specific securities and buyers can choose to engage

Types of Trades

• Flow Trading: Trading financial instruments with clients’ funds
• Agency Trading: Brokerage finds a counterparty to customers’ trade who agrees on the price
• Electronic Trading: Buyers and sellers use, and are matched through an online marketplace
• Prop Trading: Financial firm investing proprietary, rather than client, funds

Order Types

Limit Order

• An order to buy/sell at a set price or better
• Guarantees the price, but not the order

Market Order

• An order to buy/sell at the current market price
• Guarantees the order, but not the price

Pricing Strategies

Options

• Right buy/sell an asset at a set price and date
• “Call” is the right to buy; “put”, to sell

Key Terms

• Strike Price: Price at which you can call or put
• Premium: Fee to buy the option
• In-the-Money (ITM): Market price has crossed the strike price
• Out-of-the-Money (OTM): Market price has not crossed the strike price

Example

November 24: Gabby’s Cakes is trading at $67 with a premium of $3.15 for a December 70 call

• Total contract price if contracts are traded per 100 shares
• 100 shares x $3.15 = $315 + commissions
• Strike price: $70
• Breakeven price
• $70 + $3.15 = $73.15

December 24: Gabby’s Cakes is now trading for $78; the value of the options contract is now $8.25

• Profit if position is exited now
• $8.25 — $3.15 = $5.10
• $5.10 x 100 shares = $510 profit
• Profit if initial amount ($315) was initially invested in shares instead
• $315 / $67 = 4.7 shares
• 4.7 shares x $78 = $367 exit value
• $367 — $315 = $52

There is ~10x difference from the $510 options profit!

Key Takeaways

• Hedge funds are popular alternative investment vehicles for select LPs
• Common hedge fund strategies include long/short, relative value arbitrage, macro, and distressed
• Options are contracts that give the owner the right to purchase an asset at a set price and date