29 results back to index
Andrei Shleifer, asset allocation, capital asset pricing model, correlation coefficient, cross-subsidies, Daniel Kahneman / Amos Tversky, diversified portfolio, endowment effect, index arbitrage, index fund, locking in a profit, Long Term Capital Management, loss aversion, margin call, market friction, market microstructure, mental accounting, merger arbitrage, new economy, prediction markets, price stability, profit motive, random walk, Richard Thaler, risk-adjusted returns, risk/return, Sharpe ratio, short selling, transaction costs, Vanguard fund
First, December 2000 was a particularly bad month for merger arbitrage. Due to deteriorating market conditions, the chance of merger failure was much greater than normal. Moreover, fewer mergers during that period meant that more arbitrage money was available for merger arbitrage driving down the speculation spreads. Second, it is possible and even desirable to close positions prior to merger completion so that they generate higher annualized returns due to the shorter holding period. Third, not all of the mergers listed would make good candidates for merger arbitrage. Merger Arbitrage Strategy Implementation The following section evaluates several deals and provides a stepby-step execution of merger arbitrage for one deal. CHOOSING DEALS FOR MERGER ARBITRAGE It is useful to consider each deal individually to determine whether it would be desirable to take a position.
*Ceased to exist in 2002. Beyond the Random Walk Table 9.5 Merger Arbitrage Although the four funds invest primarily in merger arbitrage, they may (and do) follow many related strategies. Thus, the returns of these funds may be contaminated by other arbitrage activity. For example, the Merger Fund routinely picks stocks that may be potential targets or firms that were the subject of an unsuccessful takeover attempt. The Gabelli ABC fund can engage in any kind of arbitrage activity, though it concentrates on merger arbitrage. The Enterprise Mergers and Acquisitions Fund also looks for firms that are likely to be acquired. To make sure the mutual funds are representative of pure merger arbitrage, they are compared with the Hedge Fund Research’s Merger Arbitrage Index until 2002 (available at www.hfr.com). The returns are reported in the last column of Table 9.5.
Merger activity in 2000 was in excess of 10 percent of the entire market capitalization—clearly, such a large amount of capital cannot be earmarked for merger arbitrage. • Investors can use mutual funds to capture returns from merger arbitrage or engage in merger arbitrage on their own using 227 228 Beyond the Random Walk stocks. The Merger Fund has generated an average annual abnormal return of 4.0 percent over the last decade. Hedge Fund Research’s Merger Arbitrage Index suggests an annual abnormal return of 6.4 percent without accounting for management expenses. • An ad hoc sample of mergers from December 2000 generates an annualized raw return of 13.2 percent. Since the risk premium during 2001 was negative, the abnormal return could be higher. • Not all announced deals are candidates for merger arbitrage. If only the recommended deals are accepted, the annualized raw return increases to more than 16 percent.
Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen
algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Black-Scholes formula, Brownian motion, buy low sell high, capital asset pricing model, commodity trading advisor, conceptual framework, corporate governance, credit crunch, Credit Default Swap, currency peg, David Ricardo: comparative advantage, declining real wages, discounted cash flows, diversification, diversified portfolio, Emanuel Derman, equity premium, Eugene Fama: efficient market hypothesis, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, Gordon Gekko, implied volatility, index arbitrage, index fund, interest rate swap, late capitalism, law of one price, Long Term Capital Management, margin call, market clearing, market design, market friction, merger arbitrage, mortgage debt, New Journalism, paper trading, passive investing, price discovery process, price stability, purchasing power parity, quantitative easing, quantitative trading / quantitative ﬁnance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, systematic trading, technology bubble, time value of money, total factor productivity, transaction costs, value at risk, Vanguard fund, yield curve, zero-coupon bond
The non-linear market exposure means that the standard capital asset pricing model (CAPM) model is not appropriate to evaluate the performance of merger arbitrage. The merger arbitrage payoff resembles a risk-free bond plus idiosyncratic noise and less a short put option on the market. Hence, when computing the alpha of merger arbitrage returns, we need to take into account that simply selling put options on the market earns a risk premium. To do this, one can regress the merger arbitrage excess return on both the excess return of the stock market index and the excess return of shorting put options: This regression shows a statistically significant loading on put options and a significant positive alpha. This implies that merger arbitrage has delivered positive excess returns even accounting for the non-linear market exposure. Hence, merger arbitrage managers earn a premium for providing liquidity to market participants who sell merger deals, essentially providing “insurance” against deal risk.
While new natural owners of the company will arrive after the merger is resolved (one way or the other), the market temporarily faces a significant demand for liquidity. The merger arbitrage traders buy the target when other investors sell. Hence, they provide liquidity to all those who want to get out of the stock to avoid deal risk. Said differently, the merger arbitrage traders are providing insurance against the deal risk, and their average profit is the insurance return or the compensation for liquidity provision. How do merger arbitrage managers handle deal risk? They diversify across many deals, trying to make sure that no one deal failure will be detrimental for their overall portfolio. The deal spread reaches an efficiently inefficient level where merger arbitrage managers are compensated for their liquidity provision. At times when the total number and risk of merger deals is large relative to the merger arbitrage capital, the expected return increases.
To consider a more extreme case, consider an investment of 10% of the assets in a deal, leading to a 50% drop in the target price (relative to a potential hedge in a stock deal)—this implies a 5% loss of the overall capital. While such losses are painful, the merger arbitrage manager can nevertheless still hope to be up for the year. Some managers find the potential loss of 5% of capital on a single deal to be too large, whereas others may want to take a significant bet on deals where they have strong conviction of completion. If the maximum position size is set more conservatively to 3%, then the merger arbitrage manager needs to invest in a wide variety of merger deals, covering a large fraction of all deals that take place, and this is in fact a typical behavior among merger arbitrage managers. As we will see in the historical return numbers below, the return to a diversified portfolio of merger arbitrage deals has been very good. That is, merger arbitrage managers have done well simply earning the deal-risk liquidity premium, even without special information regarding particular deals.
Money Mavericks: Confessions of a Hedge Fund Manager by Lars Kroijer
Bernie Madoff, capital asset pricing model, diversification, diversified portfolio, family office, fixed income, forensic accounting, Gordon Gekko, hiring and firing, implied volatility, index fund, Jeff Bezos, Just-in-time delivery, Long Term Capital Management, merger arbitrage, new economy, Ponzi scheme, risk-adjusted returns, risk/return, shareholder value, Silicon Valley, six sigma, statistical arbitrage, Vanguard fund, zero-coupon bond
When an agreement was finally announced, hedge funds made billions as the spread closed to zero. Happy days all round. Since the deal coincided with the very large and complex bank transaction in the UK in which Royal Bank of Scotland bought NatWest, any fund without a European merger arbitrage presence scrambled to get one, and massive amounts of capital flowed to the strategy and region. With the internet bubble popping in 2000/01 and a subsequent slowdown in business combinations, a lot of new merger-arbitrage analysts had to look elsewhere to make money. Good merger-arbitrage analysts are often not good value investors and don’t have a lot of experience at valuing companies in the typical investment-banking fashion. This was where I thought I could provide an angle to make some money for HBK and myself. From my time at Lazard and SC Fundamental I had experience with fundamental value analysis and could use this skill now.
A week later I was back in good health and thrilled when HBK offered me a job to start as an investment professional. Over the past seven days I had lost any hope of becoming a scuba-diver, but gained a job in merger arbitrage and special situations investing. London beckoned … and I was eager to follow my new calling. 2 * * * Taking the plunge Joining ‘The Firm’ HBK was founded in the early 1990s as a convertible arbitrage shop. Harlan Korenvaes had used his connections from heading the convertibles group at Merrill Lynch to raise money for his own venture. Since inception, the returns had been excellent. After the early days of focusing on one area, the firm had quickly expanded into others such as fixed-income arbitrage, merger arbitrage, emerging-markets fixed-income, and special situations. When I joined in July 1999 the firm was managing around $1.5 billion in assets, on its way to managing double-digit billions five years later.
We took a small position in Superfos, perhaps partly to keep me interested, and one morning we arrived at work to the news that Ashford did indeed increase their bid to 59 and had received full board approval from Superfos. I remember thinking ‘Cool’ and counting the performance fee we would make on the profits, but felt a bit unexcited about it all. Sam congratulated me on the deal and told me jokingly to keep up my 100 per cent record of successful deals. If only … 1999 and 2000 were very busy years for merger arbitrage in Europe. The transaction where British mobile company Vodafone bought the German Mannesmann in a $200-billion share deal was the peak of European and perhaps world merger arbitrage. This deal had it all: regulatory complexity, currency angle, unclear merger ratio, hostile takeover, massive downside if the deal broke, and virtually unlimited liquidity. Many of the larger US hedge funds had $100-million positions, where they were long Mannesmann and short Vodafone to lock in the spread on the transaction (the difference between the Mannesmann share price and the consideration you would receive in Vodafone shares if the deal went through).
Commodity Trading Advisors: Risk, Performance Analysis, and Selection by Greg N. Gregoriou, Vassilios Karavas, François-Serge Lhabitant, Fabrice Douglas Rouah
Asian financial crisis, asset allocation, backtesting, capital asset pricing model, collateralized debt obligation, commodity trading advisor, compound rate of return, constrained optimization, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, discrete time, distributed generation, diversification, diversified portfolio, dividend-yielding stocks, fixed income, high net worth, implied volatility, index arbitrage, index fund, interest rate swap, iterative process, linear programming, London Interbank Offered Rate, Long Term Capital Management, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, p-value, Ponzi scheme, quantitative trading / quantitative ﬁnance, random walk, risk-adjusted returns, risk/return, Sharpe ratio, short selling, stochastic process, systematic trading, technology bubble, transaction costs, value at risk
Two hedge fund styles use shortvolatility strategies: merger arbitrage and event driven. Merger arbitrage managers take a bet that the merger will be completed. They analyze antitrust regulations, consider whether the bid by the acquiring company is hostile or friendly, and check on potential shareholder opposition to the merger. If the merger is completed, the merger arbitrage manager earns the spread that it previously locked in through its long and short stock positions. However, if the merger falls through, the merger arbitrage manager may incur a considerable loss that cannot be known in advance. Measuring the Long Volatility Strategies of Managed Futures 199 From this perspective, merger arbitrage hedge funds can be viewed as merger insurance agents. If the merger is completed successfully, the merger arbitrage manager will collect a known premium (the spread it previously locked in).
To prove that managed futures are an excellent diversifying agent for other hedge fund strategies, we construct a portfolio that is 50 percent managed futures and 50 percent merger arbitrage. Table 9.3 presents the Monte Carlo VaR for merger arbitrage alone and for the combined portfolio of merger arbitrage/managed futures. We note first that the VaR for merger arbitrage alone are significantly larger (in absolute value) than that for the combined portfolio. This is consistent with a short put option position— being on the hook for potential losses in a market downturn. 5See Anson and Ho (2003) for an examination of the nature of short volatility strategies. Merger Arbitrage Excess Returns 200 RISK AND MANAGED FUTURES INVESTING 4.00% 2.00% 0.00% –2.00% –4.00% –6.00% –8.00% –20.00% –15.00% –10.00% –5.00% 0.00% 5.00% 10.00% 15.00% S&P 100 Excess Returns Merger Arb Regression Line Coefficient Threshold alow blow ahigh bhigh S.E.
Merger Arbitrage Excess Returns 200 RISK AND MANAGED FUTURES INVESTING 4.00% 2.00% 0.00% –2.00% –4.00% –6.00% –8.00% –20.00% –15.00% –10.00% –5.00% 0.00% 5.00% 10.00% 15.00% S&P 100 Excess Returns Merger Arb Regression Line Coefficient Threshold alow blow ahigh bhigh S.E. Regression Adj. R-Squared FIGURE 9.13 −0.0451 0.0265 0.4769 0.0069 0.0410 0.0112 0.2692 t-statistic 5.67 6.10 1.50 Merger Arbitrage We also can see that the VaR at the 1 percent level and 5 percent for the combined portfolio as well as the maximum loss are approximately onehalf of that for merger arbitrage alone. These results demonstrate the complementary behavior of managed futures with merger arbitrage. The combination of managed futures with merger arbitrage greatly reduces the risk of loss compared to merger arbitrage as a stand-alone investment. Our work supports that of Kat (2002) for blending managed futures with other hedge fund styles to minimize and manage volatility risk. 201 Measuring the Long Volatility Strategies of Managed Futures TABLE 9.3 Monte Carlo Value at Risk 1 Month VaR @ 1% Confidence Level 1 Month VaR @ 5% Confidence Level Maximum Loss Number of Simulations Merger Arbitrage Merger Arbitrage and Managed Futures −6.04000% −3.1500% −3.1400% −10.7400% −1.7340% −5.5210% 10,000 10,000 Finally, in Figure 9.15, we present the distribution of returns associated with our combined portfolio managed futures and merger arbitrage.
Market Sense and Nonsense by Jack D. Schwager
asset allocation, Bernie Madoff, Brownian motion, collateralized debt obligation, commodity trading advisor, conceptual framework, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index arbitrage, index fund, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, market fundamentalism, merger arbitrage, pattern recognition, performance metric, pets.com, Ponzi scheme, quantitative trading / quantitative ﬁnance, random walk, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sharpe ratio, short selling, statistical arbitrage, statistical model, transaction costs, two-sided market, value at risk, yield curve
Merger arbitrage funds will profit from the closing of the discount if the deal is completed and will minimize losses to the extent they are able to avoid deals that break. Merger arbitrage funds are highly dependent on the level of merger activity and the level of discounts. When there is a sharp expansion in merger activity, such as occurred in 1999–2000 and 2006, merger arbitrage funds will do well. However, periods of depressed merger activity, such as 2001 to 2005, will be accompanied by low or negative returns. The level of returns of any merger arbitrage fund is more likely to be a reflection of the level of past merger activity than of manager skill, and there is no reason to assume that past merger conditions will have any predictive value for the level of future merger activity. On the contrary, the cyclical tendency in mergers may even suggest that the conditions in recent years—and by implication the level of merger arbitrage returns in recent years—are an inverse indicator.
We now look at two hedge fund strategies to illustrate the impact of strategy category on performance: Merger arbitrage. When a merger deal is announced, the target company’s stock price will jump to some level below the announced acquisition price. The discount exists because there is some uncertainty whether the deal will be completed. This discount will diminish over time as the likelihood of a successful transaction increases, and will approach zero if the merger is successfully completed. Merger arbitrage funds seek to profit by buying shares in the target company (and hedging with sales of the acquiring company if the merger deal is a stock exchange at a specified ratio rather than cash acquisition). Merger arbitrage funds will profit from the closing of the discount if the deal is completed and will minimize losses to the extent they are able to avoid deals that break.
Merger arbitrage funds will seek to profit by buying the acquired company’s stock in a cash acquisition or buying the acquired company’s stock and selling the acquiring company’s stock in the appropriate ratio in a stock exchange deal and earning the discount. Since a large majority of announced mergers are completed, most such trades will be profitable. The risk in the strategy is that if the deal breaks, the resulting loss can be many multiples of the discount that would have been earned. To be successful, merger arbitrage managers need to have the expertise and skill to select those mergers that will end up being completed. Some merger arbitrage managers will also occasionally seek to profit by doing a reverse merger arbitrage trade on announced mergers they believe will fail to be successfully concluded. Convertible arbitrage. Convertible bonds are corporate bonds that pay a fixed interest payment but also include a built-in option to exchange the bond into a fixed number of shares before maturity. A rising stock price would push up the convertible bond price by increasing the bond’s conversion value.
The New Science of Asset Allocation: Risk Management in a Multi-Asset World by Thomas Schneeweis, Garry B. Crowder, Hossein Kazemi
asset allocation, backtesting, Bernie Madoff, Black Swan, capital asset pricing model, collateralized debt obligation, commodity trading advisor, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index fund, interest rate swap, invisible hand, market microstructure, merger arbitrage, moral hazard, passive investing, Richard Feynman, Richard Feynman, Richard Feynman: Challenger O-ring, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, short selling, statistical model, systematic trading, technology bubble, the market place, Thomas Kuhn: the structure of scientific revolutions, transaction costs, value at risk, yield curve
These trading managers invest in events such as liquidations, spin-offs, industry consolidations, reorganizations, bankruptcies, mergers and acquisitions, recapitalizations, share buybacks, and other corporate transactions. CASAM/CISDM Merger Arbitrage Index (CISDM Merger Arbitrage): The median performance of merger arbitrage managers reporting to the CASAM/CISDM Hedge Fund Database. Merger arbitrage represents strategies that concentrate on companies that are the subject of a merger, tender offer, or exchange offer. While there are a number of different trading based approaches, merger arbitrage strategies often take a long position in the acquired company and a short position in the acquiring company. CASAM/CISDM Emerging Markets Index (CISDM Emerging Markets): The median performance of emerging market managers reporting to the CASAM/ CISDM Hedge Fund Database.
Currently several noninvestable as well as investable manager based CTA indices are available. 144 0.39 1.00 0.78 0.80 0.73 0.50 0.74 0.53 0.12 0.39 0.45 0.54 0.68 0.61 0.65 0.76 0.57 Fixed Income Arbitrage 1.00 Equity Market Neutral 0.24 0.53 0.69 0.56 0.71 0.79 1.00 0.78 0.45 Convertible Arbitrage 0.36 0.75 0.83 0.68 0.90 1.00 0.79 0.80 0.54 Distressed Securities CISDM Hedge Fund Strategy Correlations (2001–2008) CISDM Equity Market Neutral CISDM Fixed Income Arbitrage CISDM Convertible Arbitrage CISDM Distressed Securities CISDM Event Driven Multi-Strategy CISDM Merger Arbitrage CISDM Emerging Markets CISDM Equity Long/Short CISDM Global Macro EXHIBIT 7.7 0.47 0.89 0.86 0.82 1.00 0.90 0.71 0.73 0.68 Event Driven Multi-Strategy 0.45 0.79 0.65 1.00 0.82 0.68 0.56 0.50 0.61 Merger Arbitrage 0.47 0.83 1.00 0.65 0.86 0.83 0.69 0.74 0.65 Emerging Markets 0.60 1.00 0.83 0.79 0.89 0.75 0.53 0.53 0.76 Equity Long/Short 1.00 0.60 0.47 0.45 0.47 0.36 0.24 0.12 0.57 Global Macro 145 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% – 1.00% – 2.00% – 3.00% – 4.00% – 5.00% – 6.00% EXHIBIT 7.8 Average Monthly Return CISDM Distressed Securities CISDM Emerging Markets CISDM Convertible Arbitrage CISDM Merger Arbitrage CISDM Hedge Fund Strategy Returns Ranked by S&P 500 (2001–2008) CISDM Global Macro CISDM Equity Market Neutral Middle 32 Months S&P 500 Worst 32 Months CISDM Equity Long/Short CISDM Event Driven Multi-Strategy CISDM Fixed Income Arbitrage Best 32 Months 146 THE NEW SCIENCE OF ASSET ALLOCATION Sources of Managed Futures Return The sources of return to managed futures are uniquely different from traditional stocks, bonds, or even hedge funds.
Exhibit 8.11 emphasizes the relationships between noninvestable CISDM hedge fund indices and the investable Hedge Fund Research (HFRX) 186 EXHIBIT 8.10 THE NEW SCIENCE OF ASSET ALLOCATION Performance of Alternative Hedge Fund Indices (2001–2008) Barclays Hedge Fund Index CISDM Equal Weighted Hedge Fund Index CSFB/Tremont Hedge Fund Index HFRI Fund Weighted Composite Index Barclays Equity Market Neutral CISDM Equity Market Neutral CSFB/Tremont Equity Market Neutral HFRI Equity Market Neutral Barclays Fixed Income Arbitrage CISDM Fixed Income Arbitrage CSFB/Tremont Fixed Income Arbitrage Barclays Hedge Convertible Arbitrage CISDM Convertible Arbitrage CSFB/Tremont Convertible Arbitrage HFRI Convertible Arbitrage Barclays Event Driven CISDM Event Driven Multi-Strategy CSFB/Tremont Event Driven HFRI Event Driven Barclays Merger Arbitrage CISDM Merger Arbitrage CSFB/Tremont Risk Arbitrage HFRI Merger Arbitrage Barclays Distressed Securities CISDM Distressed Securities CSFB/Tremont Distressed HFRI Distressed Securities Barclays Equity Long Short CISDM Equity Long/Short CSFB/Tremont Long/Short Equity HFRI Equity Hedge Barclays Global Macro CISDM Global Macro CSFB/Tremont Global Macro HFRI Macro Barclays Emerging Markets CISDM Emerging Markets CSFB/Tremont Emerging Markets Annualized Return Standard Deviation 5.1% 5.6% 5.4% 5.0% 4.1% 5.6% 0.4% 3.3% 1.3% 3.6% 0.8% 1.7% 3.3% 1.2% 0.7% 6.6% 5.6% 7.6% 6.0% 5.7% 4.8% 4.1% 4.3% 6.6% 7.6% 8.5% 7.7% 4.8% 4.4% 4.5% 2.8% 7.7% 6.4% 11.6% 8.8% 9.7% 7.9% 8.7% 6.6% 6.6% 5.6% 6.4% 3.1% 2.0% 14.7% 2.9% 6.4% 4.8% 7.1% 7.5% 6.2% 7.9% 8.2% 6.3% 6.3% 5.6% 7.1% 3.8% 3.4% 3.9% 3.7% 7.3% 6.0% 6.1% 6.6% 5.4% 6.0% 7.2% 8.2% 5.2% 3.3% 5.5% 5.1% 12.6% 10.5% 10.3% Return and Risk Differences among Similar Asset Class Benchmarks 187 Correlation Information Ratio Maximum Drawdown 0.78 0.84 0.97 0.78 1.34 2.84 0.03 1.16 0.20 0.74 0.11 0.23 0.53 0.15 0.08 1.05 0.90 1.36 0.85 1.50 1.43 1.04 1.16 0.91 1.26 1.40 1.18 0.89 0.73 0.62 0.34 1.47 1.93 2.10 1.71 0.77 0.75 0.84 −23.1% −21.1% −19.7% −20.5% −6.1% −2.8% −42.7% −8.3% −28.6% −19.3% −29.0% −31.5% −22.5% −32.9% −35.3% −19.6% −20.2% −18.9% −23.9% −7.2% −5.7% −8.2% −8.1% −34.3% −21.2% −21.5% −26.9% −14.0% −17.0% −21.6% −28.5% −6.4% −2.6% −14.9% −4.9% −40.1% −35.3% −30.9% S&P 500 BarCap US Aggregate CISDM HF Strategy Index 0.78 0.79 0.62 0.80 −0.13 0.44 0.21 0.02 0.50 0.56 0.44 0.48 0.46 0.45 0.49 0.72 0.76 0.62 0.77 0.62 0.66 0.56 0.66 0.58 0.65 0.58 0.58 0.77 0.77 0.68 0.81 0.30 0.30 0.21 0.13 0.75 0.69 0.69 0.01 0.00 0.05 −0.03 −0.03 0.00 −0.22 −0.07 0.11 0.11 0.19 0.25 0.32 0.21 0.26 −0.08 0.00 −0.04 −0.04 0.06 0.05 0.14 0.06 −0.02 0.10 −0.07 −0.01 −0.11 −0.10 0.04 −0.07 0.12 0.11 0.30 0.12 0.05 0.09 0.10 0.99 1.00 0.91 0.99 0.57 1.00 0.07 0.59 0.85 1.00 0.89 0.97 1.00 0.93 0.97 0.94 1.00 0.92 0.96 0.86 1.00 0.67 0.90 0.87 1.00 0.83 0.91 0.98 1.00 0.91 0.96 0.81 1.00 0.45 0.76 0.98 1.00 0.95 188 CISDM Equal Weighted Hedge Fund Index HFRX Equal Weighted Strategies Index CISDM Equity Market Neutral HFRX Equity Market Neutral CISDM Convertible Arbitrage HFRX Convertible Arbitrage CISDM Distressed Securities HFRX Distressed Securities CISDM Event Driven Multi-Strategy HFRX Event Driven CISDM Merger Arbitrage HFRX Merger Arbitrage CISDM Equity Long/Short HFRX Equity Hedge 7.2% 6.6% 2.2% 3.4% 7.4% 18.2% 6.8% 8.2% 6.9% 7.3% 3.8% 3.8% 6.3% 8.6% −1.7% .3% 1.4% −0.9% −15.7% 4.2% −2.7% 3.3% −0.2% 5.4% 5.1% 4.1% −2.2% Standard Deviation 3.8% Annualized Return 0.48 (0.03) 1.43 1.35 0.65 (0.26) 0.62 (0.33) (0.86) (0.12) 0.42 2.45 (0.25) 0.53 Information Ratio 0.29 −6.0% 0.88 1.00 0.80 1.00 0.96 1.00 0.83 1.00 0.91 −60.4% −21.2% −31.8% −20.2% −25.8% −5.7% −3.4% −17.0% −28.5% 1.00 1.00 −2.8% −22.5% 0.93 1.00 CISDM Strategy Index −23.6% −21.1% Maximum Drawdown Comparison on Noninvestable and Investable Indices (2004−2008) Performance and Correlations 2004–2008 EXHIBIT 8.11 0.87 0.86 0.77 0.55 0.77 0.83 0.82 0.61 0.75 0.69 0.05 0.49 0.80 0.82 S&P 500 0.05 0.04 0.10 0.28 0.03 0.06 0.11 −0.11 0.19 0.37 −0.24 0.06 0.12 0.12 BarCap US Aggregate Correlation 0.76 0.71 0.63 0.47 0.60 0.70 0.81 0.54 0.80 0.80 −0.11 0.37 0.75 0.74 BarCap US Corporate High-Yield Return and Risk Differences among Similar Asset Class Benchmarks 189 indices over the period 2004 to 2008.1 The HFRX indices are based on a set of managers that provide daily transparency and follow a set of selection rules (e.g., size, years since inception) that are typically demanded by large institutional investors.
Investment: A History by Norton Reamer, Jesse Downing
Albert Einstein, algorithmic trading, asset allocation, backtesting, banking crisis, Berlin Wall, Bernie Madoff, Brownian motion, buttonwood tree, California gold rush, capital asset pricing model, Carmen Reinhart, carried interest, colonial rule, credit crunch, Credit Default Swap, Daniel Kahneman / Amos Tversky, debt deflation, discounted cash flows, diversified portfolio, equity premium, estate planning, Eugene Fama: efficient market hypothesis, Fall of the Berlin Wall, family office, Fellow of the Royal Society, financial innovation, fixed income, Gordon Gekko, Henri Poincaré, high net worth, index fund, interest rate swap, invention of the telegraph, James Hargreaves, James Watt: steam engine, joint-stock company, Kenneth Rogoff, labor-force participation, land tenure, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, margin call, means of production, Menlo Park, merger arbitrage, moral hazard, mortgage debt, Network effects, new economy, Nick Leeson, Own Your Own Home, pension reform, Ponzi scheme, price mechanism, principal–agent problem, profit maximization, quantitative easing, RAND corporation, random walk, Renaissance Technologies, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sand Hill Road, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spinning jenny, statistical arbitrage, technology bubble, The Wealth of Nations by Adam Smith, time value of money, too big to fail, transaction costs, underbanked, Vanguard fund, working poor, yield curve
He was soon taking a limousine to work, living in a tenbedroom home in Westchester County, New York, on 200 acres, and spending lavishly. Even more than lead an opulent lifestyle, Boesky also tried to cultivate an aura of great ﬁnancial sophistication. He liked to claim that his success was due to mastery of strategies like merger arbitrage, a concept about which he had heard from a former classmate. Later Boesky even published a book entitled Merger Mania with a subtitle of Arbitrage: Wall Street’s Best Kept Money-Making Secret.131 The strategy itself was relatively simple. In the basic form of merger arbitrage, investors purchase debt or equity in a corporation that might soon be the target of a merger or acquisition. The investors do this in anticipation of a spread between the offer price announced in the deal and the price at which the target’s securities were trading before the announcement.
ASSETS UNDER MANAGEMENT IN 2014 Hedge Funds $2508.4 Billion Funds of Funds $455.3 Billion sectors: Convertible Arbitrage Distressed Securities Emerging Markets Equity Long Bias Equity Long/Short Equity Long-Only Equity Market Neutral Event Driven Fixed Income Macro Merger Arbitrage Multi-Strategy Other Sector Speciﬁc $29.5 Billion $184.9 Billion $277.6 Billion $203.8 Billion $202.3 Billion $132.5 Billion $42.6 Billion $291.2 Billion $396.7 Billion $204.0 Billion $30.4 Billion $273.8 Billion $96.6 Billion $142.5 Billion Source: “Hedge Fund Industry—Assets Under Management,” BarclayHedge Alternative Investment Databases, accessed 2015, http://www.barclayhedge.com/research/indices/ghs/mum/HF_Money_Under_Management .html. More New Investment Forms 265 Today Jones’s true market neutral, long/short style makes up only a fraction of hedge fund assets under management.21 A closer look at some of the strategies can help illuminate the full range that hedge funds currently cover. Merger arbitrage involves going long the equity of a ﬁrm that is the target of an acquisition attempt (and typically going short the acquirer as well if the acquisition is done for stock).
“secret-sauce,” alpha-generating strategies that previously required great specialization to achieve. For instance, merger arbitrage or momentum investing strategies were relatively rare before the late twentieth century, when hedge fund managers and others identiﬁed the alpha-generating potential of such methods. Now, after the turn of the twenty-ﬁrst century, more capital ﬂows into such investment strategies as a direct result of their success in creating value for investors. As a result, generalist portfolio managers are able to create funds around such special, historically successful strategies and capitalize on their mass-market potential. Also, multiproduct ﬁrms sell exposure to such strategies at lower fees than the standard 2-and20 arrangement. Indeed, in recent years, merger arbitrage mutual funds have emerged, again attesting to the cheaper delivery of a once rare, sophisticated strategy.
The Little Book of Hedge Funds by Anthony Scaramucci
Andrei Shleifer, asset allocation, Bernie Madoff, business process, carried interest, Credit Default Swap, diversification, diversified portfolio, Donald Trump, Eugene Fama: efficient market hypothesis, fear of failure, fixed income, follow your passion, Gordon Gekko, high net worth, index fund, Long Term Capital Management, mail merge, margin call, merger arbitrage, NetJets, Ponzi scheme, profit motive, quantitative trading / quantitative ﬁnance, random walk, Renaissance Technologies, risk-adjusted returns, risk/return, Ronald Reagan, Saturday Night Live, Sharpe ratio, short selling, Silicon Valley, too big to fail, transaction costs, Vanguard fund, Y2K, Yogi Berra
Event Driven—One Man’s Loss Is Another Man’s Gain As the name implies, event-driven strategies attempt to capitalize on opportunities that occur within a company and exploit pricing anomalies that result from a specific event. Oftentimes, these strategies occur before or after a merger or acquisition (hence the name merger arbitrage), bankruptcy, buyout, or spin-off. In this instance, a hedge fund manager takes a significant position in a limited number of companies with special situations—and by special I mean unusual situations that provide money-making opportunities. Event-driven strategies can be further subdivided into the following: Merger Arbitrage Distressed Securities In 1985, Tom Steyer—a former Goldman Sachs compatriot who escaped the hustle and bustle of Wall Street in favor of San Francisco—started Farallon and created the event-driven fund. Just as he practiced at his alma mater, Steyer’s day began by studying the merger and acquisition action taking place across the continent so that he could pounce on the stock’s initial price offering before it skyrocketed after the takeover bid was announced.
For starters, hedge fund managers may take advantage of micro inefficiencies in markets where small mispricings are apparent. Two simple examples of taking advantage of micro inefficiencies would occur in the following strategies: 1. Long/Short Equity: The manager believes a certain stock is too cheap in comparison to a competitor or the broader market. In order to profit from this mispricing, the manager would go long the stock and short the market or the competitor. 2. Merger Arbitrage Strategy: If a company is acquiring a smaller competitor in an all-share deal, the manager would short the acquiring company’s stock and go long the company to be acquired to capture the spread between completed acquisition prices and current prices. Oftentimes, however, hedge funds take advantage of larger macro inefficiencies. A classic example of managers exploiting macro inefficiencies occurred in 2007 when managers took long volatility positions.
The government, antitrust regulators, a shareholder revolution, a possible new buyer, a relentless company—all the players that make up the nightmares of our typical event-driven manager. You get the picture. These are factors that most hedge fund managers cannot control. Although event-driven strategies use very little leverage and historically provided alpha, their moment in the spotlight has surely faded. Why? Event-driven strategies—specifically merger arbitrage—tend to have a higher correlation to the overall market than other hedge fund strategies. Think about it—this is strategy that earns its bread and butter based on mergers and acquisitions, which tend to happen more successfully in a thriving economy. It’s no wonder that this strategy has been underperforming since the 2007 to 2009 economic crisis. Moreover, many mergers and acquisitions do not go as planned.
bank run, barriers to entry, bash_history, Bernie Madoff, Flash crash, housing crisis, index fund, locking in a profit, London Whale, market microstructure, merger arbitrage, prediction markets, price discovery process, Sergey Aleynikov, Spread Networks laid a new fibre optics cable between New York and Chicago, transaction costs, zero day
In fact, there is an entire slice of the hedge fund world called “merger arbitrage” that places bets on whether or not such mergers or acquisitions happen. If the hedge fund thinks that the acquisition will definitely happen, it will buy any shares available if they are below the acquisition price. Conversely, if it thinks that the acquisition will not happen, it is willing to sell shares – and even sell them for less than the acquisition price, since the share price often collapses catastrophically when an acquisition attempt fails. The fact that merger arbitrage is a large and profitable business indicates that the prices of merger targets are far from stable. That is why the stock of an acquisition target trades in a narrow range, but is incredibly fragile: if there is a big sale, some merger arbitrage hedge fund immediately worries that another hedge fund has learned that the acquisition has fallen apart, and the stock is about to collapse.
Lewis’ synopsis of the report sounds so absurd that one wonders how the SEC could have come to this conclusion. It didn’t. Briefly, the SEC-CFTC report listed a cascade of events, starting with a highly volatile market that was already in the midst of the biggest one-day drop of that year. The downdraft was then exacerbated by an unusually aggressive series of orders to sell $4.1 billion of a benchmark futures contract. Just as Katsuyama dumping a million shares of Solectron in a jittery merger-arbitrage market caused a “minicollapse,” so did this trade. Only this trade wasn’t in a tiny tech stock, it was a market-wide product. And just as Thor smacked unlucky market-makers, dumping a lot more risk onto them than they anticipated, so did this trade. Naturally, the unlucky market-makers who had just bought billions of dollars of stock futures (in the midst of the market’s worst day all year) looked to hedge their risk.
The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds by Maneet Ahuja, Myron Scholes, Mohamed El-Erian
Asian financial crisis, asset allocation, asset-backed security, backtesting, Bernie Madoff, Bretton Woods, business process, call centre, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, en.wikipedia.org, family office, fixed income, high net worth, interest rate derivative, Isaac Newton, Long Term Capital Management, Mark Zuckerberg, merger arbitrage, NetJets, oil shock, pattern recognition, Ponzi scheme, quantitative easing, quantitative trading / quantitative ﬁnance, Renaissance Technologies, risk-adjusted returns, risk/return, rolodex, short selling, Silicon Valley, South Sea Bubble, statistical model, Steve Jobs, systematic trading
The portfolio is divided across the $6.5 billion Paulson Merger Funds, the $9.7 billion Credit Opportunities, the $3.0 billion Recovery funds, and the $1.1 billion Gold funds, and the $17.9 billion Advantage funds. Paulson & Co. specializes in three types of event arbitrage: mergers, bankruptcies, and any type of corporate restructuring, spin-off, or recap litigation that affects the value of a security. In merger arbitrage, a major focus of the firm’s proprietary research is to anticipate which deals may receive another bid, and then to weight the portfolio toward those specific deals. The goal of the Paulson funds, like any fund, is to produce above average returns with less volatility and low correlation to the broader equity markets. Their correlation with the S&P 500 since 1994 has been 0.07 percent. But finding arbitrage opportunities is not where the science kicks in.
It’s Not All Numbers When his firm started to hit its stride in the early 2000s, Paulson drew on some of the skills he’d learned in the nonfinance courses he had taken at Harvard: simple concepts like product/market segmentation. In fact, Paulson credits his marketing knowledge for some of his recent success. He says: “You know, one of the ways we grew was not by coming up with more products but by reformulating the same product.” Paulson Partners originally started out with a domestic merger arbitrage fund in 1994. “While we were not pioneers in the hedge fund space, we still were early in its evolution. By 1996, we thought it may be the right time to launch an international product.” It was the same product, just targeted to different investors. Paulson says: “It was the same portfolio; Paulson International just targeted a foreign investor base and added all the bells and whistles to appeal to international clients.”
“And ‘Paulson Enhanced’ is the same exact portfolio as the merger and international funds, only it’s twice as much leverage. These marketing terms helped me create new products for new markets and differentiate the product without more work.” Today, the Enhanced and International funds combined are 11 times the size of the original Paulson Partners Fund. Paulson & Co. launched the Advantage fund in 2003 and the Advantage Plus in 2004. These funds added to the merger arbitrage base by including bankruptcy, distressed, and other forms of event investing. Initially, Paulson & Co. grew slowly, but once it had a five-year track record and proved steady performance, making money in both 2001 and 2002, when many other funds were feeling the strain of the post-9/11 market collapse, it started grabbing investors’ attention. In 2002, Paulson was managing $300 million.
Getting a Job in Hedge Funds: An Inside Look at How Funds Hire by Adam Zoia, Aaron Finkel
backtesting, barriers to entry, collateralized debt obligation, commodity trading advisor, Credit Default Swap, credit default swaps / collateralized debt obligations, discounted cash flows, family office, fixed income, high net worth, interest rate derivative, interest rate swap, Long Term Capital Management, merger arbitrage, offshore financial centre, random walk, Renaissance Technologies, risk-adjusted returns, rolodex, short selling, side project, statistical arbitrage, systematic trading, unpaid internship, value at risk, yield curve, yield management
Note: Fixed income arbitrage is a generic description of a variety of strategies involving investments in fixed income instruments, and weighted in an attempt to eliminate or reduce exposure to changes in the yield curve. Risk Arbitrage Sometimes called merger arbitrage, this involves investment in event-driven situations such as leveraged buyouts (LBOs), mergers, and hostile takeovers. Normally, the stock c01.indd 6 1/10/08 11:00:55 AM Getting Started 7 of an acquisition target appreciates while the acquiring company’s stock decreases in value. Risk arbitrageurs invest simultaneously in long and short positions in both companies involved in a merger or acquisition. As such, they are typically long the stock of the company being acquired and short the stock of the acquirer. The principal risk is deal risk, should the deal fail to close. Merger arbitrage may hedge against market risk by purchasing Standard & Poor’s (S&P) 500 put options or put option spreads.
My interviewers knew full well that I didn’t have the relevant experience, so the questions were more an assessment of my personality traits. They wanted to know such things as whether I could think out of the box and could work well with the team that was in place. I was also asked some basic finance questions and about what I wanted to get out of the job, such as: Do you understand how options work? Do you know what merger arbitrage entails? What do you know about hedge funds? What is attractive about working at a hedge fund? For the c08.indd 106 1/10/08 11:09:08 AM Operations 107 last, I knew not to say the chance to make a lot of money. Instead, I acknowledged how rare an opportunity it is to come straight out of college and work at a buy-side shop and how I would make the most of it. I spoke about how interested I was in investing and the markets and that I enjoyed working with numbers.
1960s counterculture, banking crisis, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, financial innovation, fixed income, index fund, Isaac Newton, Long Term Capital Management, margin call, Mark Zuckerberg, Menlo Park, merger arbitrage, mortgage debt, mortgage tax deduction, Ponzi scheme, Renaissance Technologies, rent control, Robert Shiller, Robert Shiller, rolodex, short selling, Silicon Valley, statistical arbitrage, Steve Ballmer, Steve Wozniak, technology bubble
They long ago figured that Paulson at some point would want to launch a career making investments of his own. Gruss & Co. specialized in merger-arbitrage, taking a position on whether or not a merger would take place and investing in shares of companies being acquired. The firm hadn’'t undertaken buyouts on its own, but the Anderson experience convinced the firm’'s founder, Marty Gruss, to test the waters more deeply. He asked Paulson to lead a new effort to do similar buyout deals, hoping to potentially rival firms like KKR. Gruss was so eager to hire Paulson that he agreed to make Paulson a general partner and give the young banker a cut of profits racked up by other groups at the firm. Watching Gruss and his father, Joseph, up close, Paulson quickly picked up the merger-arbitrage business. By buying shares of companies being acquired, and selling short companies making acquisitions, Gruss was able to generate profits that largely were shielded from stock-market fluctuations.
He paid a $350 fine for the lesser infraction of driving while impaired. But by 1994, the life of leisure was getting a bit tiresome to Paulson. He still dreamed of earning great wealth. It was time, he realized, to go back to work. “"Time was getting on; I realized I needed to focus,”" Paulson says. The surest path to genuine wealth seemed to be investing for himself. So he started a hedge fund, Paulson & Co., to focus on merger-arbitrage, the specialty he had picked up from Gruss. Paulson reached out to everyone he knew, mailing more than five hundred announcements about his firm’'s launch. But he didn’'t get a single response, even after waiving his initial $1 million minimum investment. Paulson never had managed money on his own, didn’'t have much of a track record as an investor, and wasn’'t known to most potential clients.
“"If you hadn’'t been such a jerk, you would have gotten a job earlier.”" “"If I came off as a jerk, I didn’'t mean to,”" Pellegrini responded, quietly. Paulson agreed to give Pellegrini a chance. His employees didn’'t like him very much, but Paulson viewed Pellegrini as a smart gamble, a bright, well-educated analyst who might yet become an asset. He told Pellegrini it would take him a year or so to learn the merger-arbitrage business, and welcomed him aboard. Pellegrini was forty-seven, a year younger than his new boss and thrilled at the opportunity to show he wasn’'t washed up. HIS EARLY MONTHS at Paulson & Co. were tough on Pellegrini. Worried about being overwhelmed by the details of his job, as he had been at Lazard, Pellegrini arrived at the office before 6:30 a.m. each morning, among the first to arrive.
A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation by Richard Bookstaber
affirmative action, Albert Einstein, asset allocation, backtesting, Black Swan, Black-Scholes formula, Bonfire of the Vanities, butterfly effect, commodity trading advisor, computer age, disintermediation, diversification, double entry bookkeeping, Edward Lorenz: Chaos theory, family office, financial innovation, fixed income, frictionless, frictionless market, George Akerlof, implied volatility, index arbitrage, Jeff Bezos, London Interbank Offered Rate, Long Term Capital Management, loose coupling, margin call, market bubble, market design, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, new economy, Nick Leeson, oil shock, quantitative trading / quantitative ﬁnance, random walk, Renaissance Technologies, risk tolerance, risk/return, Robert Shiller, Robert Shiller, rolodex, Saturday Night Live, shareholder value, short selling, Silicon Valley, statistical arbitrage, The Market for Lemons, time value of money, too big to fail, transaction costs, tulip mania, uranium enrichment, yield curve, zero-coupon bond
More often than not, crises aren’t the result of sudden economic downturns or natural disasters. Virtually all mishaps over the past decades had their roots in the complex structure of the financial markets themselves. Just look at the environment that has precipitated these major meltdowns. For the crash of 1987, it was hard to see anything out of the ordinary. There were a few negative statements coming out of Washington and some difficulties with merger arbitrage transactions—traders who play the market by guessing about future corporate takeovers. What else is new? The trigger for the LTCM crisis was something as remote as a Russian default, a default we all saw coming at that. Compare these with the market 2 ccc_demon_001-006_ch01.qxd 2/13/07 1:44 PM Page 3 I N T R O D U C T I O N : T H E PA R A D O X OF MARKET RISK reaction to events that shook the nation.
The most common approach to classifying hedge funds, one used by Hedge Fund Review, CSFB/Tremont, and Standard & Poor’s, is to organize them based on trading styles. For example, the Standard & Poor’s Hedge Fund Index has three styles: arbitrage, event-driven, and directional/tactical. Each of these styles has three strategic subsets. Arbitrage consists of equity market neutral, fixed income arbitrage, and convertible arbitrage; event-driven has merger arbitrage, distressed, and special situations; directional/tactical has long/short equity, managed futures, and macro. The problem with this sort of classification, based as it is strictly on the trading style or strategy type, is that it has to be revised over time as new strategies emerge and existing ones fail. An alternative classification matrix, which I developed in 2001, attempts to overcome this problem, but in so doing reveals the existential issue for hedge funds.1 This approach classifies hedge funds by five characteristics: 1.
Another category for direction that is useful is event, which depicts strategies that usually have low correlation with the market, but on occasion the correlation can be very high (e.g., during a liquidity or credit crisis). 3. Investment type. This provides more information about the specifics of the investment process or strategy. For example, in the neutral classification there is relative value and statistical arbitrage; the event classification would include merger arbitrage, credit arbitrage, and distressed debt. Investment type is the one component of the analysis that will vary over time with the introduction of new investment strategies. 4. Geographic region. Where is the fund trading? Differentiation may be limited to G-10 and emerging markets, or the region can be broken out in more detail. 5. Liquidity. Some funds trade short-term and in instruments that can be traded easily.
More Money Than God: Hedge Funds and the Making of a New Elite by Sebastian Mallaby
Andrei Shleifer, Asian financial crisis, asset-backed security, automated trading system, bank run, barriers to entry, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Bonfire of the Vanities, Bretton Woods, capital controls, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency manipulation / currency intervention, currency peg, Elliott wave, Eugene Fama: efficient market hypothesis, failed state, Fall of the Berlin Wall, financial deregulation, financial innovation, financial intermediation, fixed income, full employment, German hyperinflation, High speed trading, index fund, Kenneth Rogoff, Long Term Capital Management, margin call, market bubble, market clearing, market fundamentalism, merger arbitrage, moral hazard, natural language processing, Network effects, new economy, Nikolai Kondratiev, pattern recognition, pre–internet, quantitative hedge fund, quantitative trading / quantitative ﬁnance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical arbitrage, statistical model, technology bubble, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs
Its founder, Nick Maounis, was a convertible-arbitrage specialist by background, but he had hired experts in merger arbitrage, long/short equity investing, credit arbitrage, and statistical arbitrage; and in 2002, following the collapse of the corrupt energy company Enron, Maounis had snapped up several stranded employees to open an energy-trading operation. Maounis made the standard arguments for this mission creep: A blend of alpha-generating strategies would diversify away risk, and Amaranth would move capital aggressively among strategies as market conditions shifted. The fund’s energetic shape-shifting was a point of pride. In the first months after Amaranth’s launch in September 2000, nearly half of its capital had been focused on merger arbitrage. A year later, that strategy had been cut to practically zero, and more than half of Amaranth’s capital was focused on convertible arbitrage.
He was motivated partly by a desire to escape Wall Street for a life on the West Coast and partly by that sense of justice. As a young analyst at Morgan Stanley, he had been upset to discover that investment-bank advisers can be paid for being wrong; sounding convincing mattered more than actually being right, since the objective was simply to extract fees from the clients. After a stint at Stanford’s business school, Steyer had worked at Goldman Sachs for the merger-arbitrage unit run by Robert Rubin, the future Treasury secretary. This suited him better: Goldman got paid in this business only when Goldman was right, though the distribution of the profits among employees sometimes generated arguments. The way Steyer saw things, setting up an independent fund was the logical next step. He had begun at a firm that took no responsibility for bad investment calls. He had moved to a firm that took responsibility collectively but that did not always recognize an individual’s contribution.
But by 2005 nobody could argue that hedge funds were exceptional in any way: More than eight thousand had sprouted, and the long track records of the established funds made it hard to dismiss their enviable returns as the products of good fortune. Bit by bit, the old talk of luck and genius faded and the new lingo took its place—at hedge-fund conferences from Phoenix to Monaco, a host of consultants and gurus held forth about the scientific product they called alpha. The great thing about alpha was that it could be explained: Strategies such as Tom Steyer’s merger arbitrage or D. E. Shaw’s statistical arbitrage delivered uncorrelated, market-beating profits in a way that could be understood, replicated, and manufactured by professionals. And so the era of the manufacturer arrived. Innovation and inspiration gave way to a new sort of alpha factory. You could see this transformation all over the hedge-fund industry. By the early 2000s, there was no longer much doubt that long/short equity stock picking, as practiced by Julian Robertson’s Tiger, could deliver market-beating returns.
Money and Power: How Goldman Sachs Came to Rule the World by William D. Cohan
asset-backed security, Bernie Madoff, buttonwood tree, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversified portfolio, fear of failure, financial innovation, fixed income, Ford paid five dollars a day, Goldman Sachs: Vampire Squid, Gordon Gekko, high net worth, hiring and firing, hive mind, Hyman Minsky, interest rate swap, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, merger arbitrage, moral hazard, mortgage debt, paper trading, passive investing, Ponzi scheme, price stability, profit maximization, risk tolerance, Ronald Reagan, Saturday Night Live, South Sea Bubble, time value of money, too big to fail, traveling salesman, value at risk, yield curve, Yogi Berra
He figured either Armageddon was imminent—in which case nothing much would matter—or the United States would end up winning the war and the country would desperately need its railroads back to rebuild and supply the victorious nation. In the latter instance, railroad bonds bought at a steep discount during the war would be worth a fortune. Cy Lewis had a great influence on Gus Levy. He encouraged Levy to trade in distressed railroad bonds and in other forms of arbitrage, including so-called block trading—the buying and selling of large blocks of stock, ideally at a profit—and in so-called merger arbitrage, which as Rohatyn described was the trading in the stocks of companies involved in corporate mergers, generally after the mergers had been announced publicly. Many institutional shareholders that owned the shares of companies involved in mergers often chose to sell those shares into the market—shares would trade up to near the offer price after a merger had been announced—since the time and risk involved in waiting often many months for a merger to close to get slightly more cash or stock was not generally worth doing.
Merger arbs were willing to buy the stock being sold quite simply because they hoped to make an attractive return on the money invested. They were willing to take the chance a deal might not close, or the financial consideration might change unfavorably, in the hope of making money on their bet. There were risks, of course—if they bought the stock of a company being taken over and then the deal failed to close, such a mistake could be devastating financially. But such mishaps were rare, and experts in the art of merger arbitrage did their best to avoid them. Why Cy Lewis would give away one valuable trading idea after another to a competitor—albeit someone who was also a friend—may never be known for sure. Perhaps it was just friendship, perhaps it helped create a market for the products Lewis was selling. In 1941, with the United States on the verge of entering World War II, Levy was anxious to see action. He did not have to go to war because by then he had two children.
.” —— AS LEVY SPENT more and more of his time running the firm and managing his extracurricular activities, Tenenbaum began to take on more responsibility and more initiative in building Goldman’s arbitrage business. One way that the arbitrage business became more complex was that as the M&A business began to pick up in the 1960s, Goldman would “arb” the deals by buying and selling stock in the companies involved in a deal—usually after the deal had been announced publicly. In this new frontier of merger arbitrage—known among arbitrageurs as “event driven” arbitrage—information was power and could mean the difference between making a lot of money or losing a lot of money. The people with the information about M&A deals were, of course, the people responsible for putting the deals together in the first place—the corporate executives, the investment bankers, and the lawyers—and arbitrageurs would think nothing of “making the call”—as arbs referred to the practice—to these groups of insiders to try to glean whatever bits of information they could that would give them a trading advantage.
algorithmic trading, Benoit Mandelbrot, Chance favours the prepared mind, constrained optimization, Dava Sobel, Long Term Capital Management, Louis Pasteur, mandelbrot fractal, market clearing, market fundamentalism, merger arbitrage, pattern recognition, price discrimination, profit maximization, quantitative trading / quantitative ﬁnance, risk tolerance, Sharpe ratio, statistical arbitrage, statistical model, stochastic volatility, systematic trading, transaction costs
Did competition eliminate risk arbitrage as an investment strategy? Quite! The dearth of opportunity during 2002–2005 was not because of a greater number of practitioners or increasing assets managed in the strategy, both of which preceded the return decline, but because of the structural change in the economy. As 2005 drew to a close, anticipation was already building that merger activity would increase, resuscitating the merger arbitrage business, with just a few months of consistently positive economic news. Increased Trinity Troubles 161 participation in the business will have an impact on return as activity increases. The gains will be smaller on average; better, more experienced managers will do well if they discover and exploit the new patterns described in Chapter 11; neophytes, relying on traditional ideas, will have a more difficult time.
What is the difference between merger and statistical arbitrage such that massive structural change in the economy—caused by reactions to terrorist attacks, wars, and a series of corporate misdeeds—was accepted as temporarily interrupting the business of one but terminating it (a judgment now known to be wrong) for the other? Immensely important is an understanding of the source of the return generated by the business and the conditions under which that source pertains. The magic words ‘‘deal flow’’ echo in investor heads the moment merger arbitrage is mentioned. A visceral understanding provides a comfortable intellectual hook: When the economy improves (undefined—another internalized ‘‘understanding’’) there will be a resurgence in management interest in risk taking. Mergers and acquisitions will happen. The game will resume after an interlude. There is no convenient label for the driver of opportunities in statistical arbitrage (although some grasp at ‘‘volatility’’ in the hope of an easy anchor—and partially it may be).
Hedge Fund Market Wizards by Jack D. Schwager
asset-backed security, backtesting, banking crisis, barriers to entry, Bernie Madoff, Black-Scholes formula, British Empire, Claude Shannon: information theory, cloud computing, collateralized debt obligation, commodity trading advisor, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, diversification, diversified portfolio, family office, financial independence, fixed income, Flash crash, hindsight bias, implied volatility, index fund, James Dyson, Long Term Capital Management, margin call, market bubble, market fundamentalism, merger arbitrage, oil shock, pattern recognition, pets.com, Ponzi scheme, private sector deleveraging, quantitative easing, quantitative trading / quantitative ﬁnance, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Sharpe ratio, short selling, statistical arbitrage, Steve Jobs, systematic trading, technology bubble, transaction costs, value at risk, yield curve
Wasn’t the fact that you had no experience at all in merger arbitrage an impediment to getting the job? Well, at $22,000, they clearly weren’t willing to spend much money and weren’t looking for an experienced analyst. I hoped they were just looking for someone with potential. What year was this? I started December 1981. Ironically, you began your career right before a major bottom in the stock market. It was interesting. At that time, not many people were looking to go to Wall Street because the market hadn’t gone up for 13 years. What were your experiences in your first job? At the time, merger arbitrage was the Wild West. There were great inefficiencies and plenty of opportunities, so that even a pedestrian year might be a 60 percent to 80 percent return. Was this just doing plain vanilla merger arbitrage? We did do straight risk arbitrage, and there were wide spreads available.
See also Financial bubble of 2005–2007 Insurance Auto Auctions (IAAI) Intrinsic value Investment misconceptions Investors, pleasing James, Bill Jones, Paul Tudor Kassouf, Sheen Kellogg, Peter Kelly criterion Key3Media Keynes, John Maynard Kimmell, Emmanuel Klein, Joel Kovner, Bruce LEAPS Ledley, Charlie Lehman Brothers Lewis, Michael Liquidity vs. solvency The Little Book That Beats the Market (Greenblatt) Long, Simon Long Term Capital Management (LTCM) Long-term cycles LTCM (Long Term Capital Management) Macro outlook Madoff, Bernard Mai, Jamie Brazilian interest-rate trade investment strategy pillars subprime mortgages/bonds Manager selection Manalapan Oracle Capital Management Market behavior Marriott Mean reversion Measurement Specialties Merger arbitrage Micron Technology Milken, Michael Mistakes, learning from Mobius, Mark Monthly returns Mortgage-backed securities (MBSs). See also Subprime mortgages/bonds Moscowitz, Eva Net exposure indicator Net exposure ranges Net working capital Nevsky Fund Newberg, Bruce Newport Corporation New revenue sources News, market response to 9/11 Nomura Normal distribution assumption Obama, Barack October 1987 crash Omni Global Fund Optionality, free Options carry currencies vs.
Expected Returns: An Investor's Guide to Harvesting Market Rewards by Antti Ilmanen
Andrei Shleifer, asset allocation, asset-backed security, availability heuristic, backtesting, balance sheet recession, bank run, banking crisis, barriers to entry, Bernie Madoff, Black Swan, Bretton Woods, buy low sell high, capital asset pricing model, capital controls, Carmen Reinhart, central bank independence, collateralized debt obligation, commodity trading advisor, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, deglobalization, delta neutral, demand response, discounted cash flows, disintermediation, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, framing effect, frictionless, frictionless market, George Akerlof, global reserve currency, Google Earth, high net worth, hindsight bias, Hyman Minsky, implied volatility, income inequality, incomplete markets, index fund, inflation targeting, interest rate swap, invisible hand, Kenneth Rogoff, laissez-faire capitalism, law of one price, Long Term Capital Management, loss aversion, margin call, market bubble, market clearing, market friction, market fundamentalism, market microstructure, mental accounting, merger arbitrage, mittelstand, moral hazard, New Journalism, oil shock, p-value, passive investing, performance metric, Ponzi scheme, prediction markets, price anchoring, price stability, principal–agent problem, private sector deleveraging, purchasing power parity, quantitative easing, quantitative trading / quantitative ﬁnance, random walk, reserve currency, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Robert Shiller, Robert Shiller, savings glut, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, systematic trading, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs, tulip mania, value at risk, volatility arbitrage, volatility smile, working-age population, Y2K, yield curve, zero-coupon bond
There could be infinitely granular classifications, but the current state of the art appears to follow the three-part classification: traditional betas, alternative betas, alpha. Even here the boundaries are fuzzy, but I would say that the three premia—equity risk premium, bond risk premium, credit risk premium—accessed by static long-only holdings in traditional asset classes belong to the category of traditional betas. Examples of alternative (or HF) betas include the value, carry, momentum, and volatility strategies reviewed in this book as well as mechanical merger arbitrage or convertible arbitrage strategies. The demarcation line between alternative beta and alpha is especially blurry. I like a demarcation line that says that any static (average) exposure to a non-traditional factor is alternative beta, while any dynamic factor timing, other fine-tuning, or discretionary security selection is alpha. This definition lumps most systematic strategies into alternative beta but not all.
Dynamic risk allocation was addressed (clumsily) by regressing past 24-month HF index returns on selected factors to find current weights. Such approaches with static asset classes could only capture, in the rearview mirror, HFs’ recent average exposures. To better proxy HFs’ current exposures, some studies broadened the menu of factors to include nonlinear exposures (such as synthetic lookback options) and/or dynamic trading strategies (such as a trend-following proxy, merger arbitrage proxy, convertible arbitrage proxy). The in-sample fit to HF index and HF sector index returns can often be surprisingly good, but out-of-sample results less so. Such analyses show that, as a group, HFs often have significant risk exposures (albeit time varying) to equities, the small-cap premium, interest rates, and credits. Besides lower fees, the benefits of using replicators include better liquidity, capacity, and transparency; lesser single-manager risk; and greater flexibility and granularity, which can be useful in risk budgeting and tactical sector allocations.
Natural value indicators exist for some systematic strategies (e.g., the dispersion of valuation ratios between value and growth stocks, or the implied-vs.-realized volatility gap for volatility selling). For FX carry, the combination of carry dispersion and expected spot rate changes from value dispersion across currencies capture ex ante opportunity. Useful measures of ex ante opportunity also exist for certain hedge fund strategies, such as merger arbitrage or convertible arbitrage. However, for trend following and for general hedge fund investing there are no obvious value anchors. The relative importance of the three components varies across investments, often by construction. For example, the currency carry strategy earns nearly all of its long-run profits by being systematically long carry (buying high-yield currencies against selling low-yield currencies).
accounting loophole / creative accounting, airline deregulation, Andrei Shleifer, asset allocation, Bretton Woods, buy low sell high, capital asset pricing model, commodity trading advisor, corporate governance, discounted cash flows, diversification, diversified portfolio, fixed income, frictionless, high net worth, index fund, inflation targeting, invisible hand, law of one price, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, market bubble, merger arbitrage, new economy, passive investing, price mechanism, purchasing power parity, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, shareholder value, Sharpe ratio, short selling, statistical arbitrage, the market place, transaction costs, Y2K, yield curve
Long-Short Equity strategies invest mainly in equities and derivative instruments. The manager uses short selling, but maintains a position in the neutral stock. Equity Market Neutral strategies attempt to exploit inefficiencies in the market through balanced overvalued securities buying and selling so that either a neutral-beta (that is, risk) or a neutral-dollar (that is, amounts invested) approach is obtained. Merger Arbitrage funds invest in companies involved in the mergersand-acquisitions process. Typically, they go long on targeted companies and sell short the acquiring companies. Relative Value strategies look to take advantage of the relative price differentials between related instruments. Short Selling strategies maintain a net or simple short exposure relative to the market. Chapter 12 Keeping the Wheels on the Hedge-Fund ATV 227 The potential downside of hedge-fund strategies is, if misapplied, they can bring disastrous results.
Alpha Strategies 1997 1998 1999 2000 2001 2002 Convertible Arbitrage 14.81% 3.11% CTA Global 12.27% 14.30% 1.82% Distressed Securities 16.70% –2.26% 19.75% 4.81% 14.65% 5.86% 27.34% Emerging Markets 22.57% –26.66% 44.62% –3.82% 12.52% 5.76% Equity Market Neutral 15.43% 10.58% 13.15% 15.35% 8.18% 4.71% Event Driven 20.98% 1.00% 22.72% 9.04% 9.32% –1.08% 20.48% Fixed-Income Arbitrage 12.43% –8.04% 12.63% 5.70% 7.81% 7.56% Long/Short Equity 21.35% 14.59% 31.40% 12.01% –1.20% –6.38% 19.31% 16.08% 17.77% 13.78% 8.60% 7.32% 3.52% 2003 2004 Average Return Standard Deviation Sharpe Ratio 10.61% 6.09% 1.08 8.73% 5.01% 0.94 17.89% 12.73% 9.58% 0.91 31.27% 14.30% 10.56% 21.82% 0.30 6.29% 4.71% 4.49% 1.27 12.43% 11.54% 9.07% 0.83 6.26% 6.41% 6.45% 0.37 8.62% 11.87% 12.22% 0.64 10.80% 1.10% 14.57% 11.64% 8.35% 5.17% 9.72% Alpha Strategies 1997 1998 1999 2000 2001 Merger Arbitrage 17.44% 7.77% 17.97% 18.10% 2.87% Relative Value 16.51% 5.27% 17.15% 13.35% 8.63% Short Selling 3.07% 2002 2003 2004 Average Return Standard Deviation Sharpe Ratio –0.90% 8.34% 4.83% 9.33% 7.44% 0.72 2.77% 5.71% 10.08% 5.40% 1.13 20.76% –0.05 12.15% 27.07% –22.55% 22.80% 10.20% 27.27% –23.87% –4.66% 3.01% Chapter 14 Every Strategy Has Its Day Average Return 15.78% 4.25% 15.88% 11.13% 8.21% 6.25% 12.01% 6.94% 9.98% 4.36% 1.37 Funds of Funds 17.39% 4.20% 28.50% 7.84% 3.52% 1.26% 11.45% 7.08% 9.85% 8.98% 0.65 Hurdle Rate* 9.30% 10.44% 7.72% 5.76% 5.20% 5.54% 7.88% 9.67% 9.55% * The hurdle rate is defined as the average of one month LIBOR plus 400 basis points.
The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal by Ludwig B. Chincarini
affirmative action, asset-backed security, automated trading system, bank run, banking crisis, Basel III, Bernie Madoff, Black-Scholes formula, buttonwood tree, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, diversification, diversified portfolio, family office, financial innovation, financial intermediation, fixed income, Flash crash, full employment, Gini coefficient, high net worth, hindsight bias, housing crisis, implied volatility, income inequality, interest rate derivative, interest rate swap, labour mobility, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low skilled workers, margin call, market design, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, mortgage debt, Northern Rock, Occupy movement, oil shock, price stability, quantitative easing, quantitative hedge fund, quantitative trading / quantitative ﬁnance, Ralph Waldo Emerson, regulatory arbitrage, Renaissance Technologies, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Sharpe ratio, short selling, sovereign wealth fund, speech recognition, statistical arbitrage, statistical model, systematic trading, The Great Moderation, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond
The S&P 500’s historical volatility turned out to be about 22%. The options that LTCM thought were cheap in 1998 were actually fairly priced. Even if LTCM had survived, the trade would not have made money for them, though their losses would have been much more manageable.30 The 1998 risk models didn’t include crowd interconnectedness or the price of liquidity during a crisis. Risk Arbitrage Trades Risk arbitrage, also known as merger arbitrage, is a trading strategy used by many hedge funds. In this strategy a trader invests in companies going through a merger, spinoff, acquisition, or similar event. The most typical trade begins when two companies announce their merger (or similar event). Risk arbitrage attempts to profit from the merger’s completion or failure. Risk arbitrage funds may also take speculative positions in companies that traders think might be bought out or become the subject of a bidding war, but these transactions are the minority.
It is hard to know how much was attributable to the Salomon arbitrage group shutdown, how much to Russia’s indirect effects, and how much to other factors. LTCM’s portfolio was down 2.11%, or about $78 million, on the day that Russia defaulted. LTCM’s historical profit-and-loss volatility on any given day was about $38 million, so this was a big dip. The next few days brought a string of smaller losses. Extreme losses began on Friday, August 21, when LTCM lost $552 million, $160 million of that on a merger arbitrage play—the Ciena Tellabs merger—that fell short. On the following Monday, the firm lost another $220 million. On Tuesday, it shed $129 million. LTCM’s losses seemed to be a symptom, one caused by crowds of other traders unwinding positions similar to the firm’s favored investments. LTCM lost money on 14 of 18 business days from July 22, 1998, to August 14, 1998. How many losses did the exodus cause, and how many were the fault of a general panic about problems in Russia and Asia?
See Long-term Capital Management Mack, John Madoff Securities Market prices, as endogenous Market risk Mark-to-market accounting Marron, Donald Matched-book funding Matthews, Paul Mattone, Vinny Maturity transformation Maughan, Deryck Maxwell, David Mayer, Jeff MBS (mortgage-backed securities) McCarthy, Lawrence McCulley, Paul McDade, Herbert (Bart) McDonald, Lawrence McDonough, William McEntee, James McGee McHale, Sharon Measuring risk Media and housing bubble Mellon Bank Merger arbitrage trades Meriwether, John: career of on crowding on financial insurance as financial pioneer JWM Partners and letter by at LTCM on post-Lehman period at Salomon Brothers on 2008 Merrill Lynch: Bank of America and Bear Stearns and liquidity stress test results real estate exposure Merton, Robert Metallgesellschaft, collapse of Meyer, William MF Global Min, Euoo Sung Modest, David Molinaro, Samuel Money market products Moody’s Investors Service, Inc.
The Quants by Scott Patterson
Albert Einstein, asset allocation, automated trading system, Benoit Mandelbrot, Bernie Madoff, Bernie Sanders, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Brownian motion, buttonwood tree, buy low sell high, capital asset pricing model, centralized clearinghouse, Claude Shannon: information theory, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, Doomsday Clock, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, Gordon Gekko, greed is good, Haight Ashbury, index fund, invention of the telegraph, invisible hand, Isaac Newton, job automation, John Nash: game theory, law of one price, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, merger arbitrage, NetJets, new economy, offshore financial centre, Paul Lévy, Ponzi scheme, quantitative hedge fund, quantitative trading / quantitative ﬁnance, race to the bottom, random walk, Renaissance Technologies, risk-adjusted returns, Rod Stewart played at Stephen Schwarzman birthday party, Ronald Reagan, Sergey Aleynikov, short selling, South Sea Bubble, speech recognition, statistical arbitrage, The Chicago School, The Great Moderation, The Predators' Ball, too big to fail, transaction costs, value at risk, volatility smile, yield curve, éminence grise
As other hedge funds sold indiscriminately in a broad, brutal deleveraging, Citadel snapped up bargains. Its Kensington fund gained 31 percent that year. By then, Citadel had more than $1 billion under management. The fund was diving into nearly every trading strategy known to man. In the early 1990s, it had thrived on convertible bonds and a boom in Japanese warrants. In 1994, it launched a “merger arbitrage” group that made bets on the shares of companies in merger deals. The same year, encouraged by Ed Thorp’s success at Ridgeline Partners, the statistical arbitrage fund he’d started up after shutting down Princeton/Newport, it launched its own stat arb fund. Citadel started dabbling in mortgage-backed securities in 1999, and plunged into the reinsurance business a few years later. Griffin created an internal market–making operation for stocks that would let it enter trades that flew below Wall Street’s radar, always a bonus to the secrecy-obsessed fund manager.
It posted a gain of 25 percent in 1998, 40 percent in 1999, 46 percent in 2000, and 19 percent in 2001, when the dot-com bubble burst, proving it could earn money in good markets and bad. Ken Griffin, clearly, had alpha. By then, Griffin’s fund was sitting on top of a cool $6 billion, ranking it among the six largest hedge funds in the world. Among his top lieutenants were Alec Litowitz, who ran the firm’s merger arbitrage desk, and David Bunning, head of global credit. In a few years, both Litowitz and Bunning would leave the fund. In 2005, Litowitz launched a $2 billion hedge fund called Magnetar Capital that would play a starring role in the global credit crisis several years later. A magnetar is a neutron star with a strong magnetic field, and Litowitz’s hedge fund turned out to have a strong attraction for a fast-growing crop of subprime mortgages.
algorithmic trading, Berlin Wall, bonus culture, BRICs, business process, collapse of Lehman Brothers, collateralized debt obligation, complexity theory, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, disintermediation, diversification, Emanuel Derman, financial innovation, fixed income, friendly fire, Goldman Sachs: Vampire Squid, high net worth, housing crisis, London Whale, Long Term Capital Management, merger arbitrage, new economy, passive investing, performance metric, risk tolerance, Ronald Reagan, Saturday Night Live, shareholder value, short selling, sovereign wealth fund, The Nature of the Firm, too big to fail, value at risk
What Goldman was better at than any other bank was working to maximize the revenue from the transaction or flow—finding and managing “multiple roles in a particular transaction.” For example, if it were a cross-border M&A deal, then Goldman would provide M&A advice as well as involve its foreign exchange desk to handle the currency exchange for the purchase price. If Goldman missed the deal—meaning our bankers were not involved—then proprietary trading might possibly be involved in merger arbitrage (oftentimes, Goldman would make more money in proprietary merger arbitrage than if it had been hired to advise on the deal). Goldman ensured that we looked at each transaction and each flow and had some way to make money from it. The more roles we played in a transaction, the more opportunities we had to make money on a cost base that was essentially fixed, and thus the transaction would be much more profitable for us than if we had played only one role.
How I Became a Quant: Insights From 25 of Wall Street's Elite by Richard R. Lindsey, Barry Schachter
Albert Einstein, algorithmic trading, Andrew Wiles, Antoine Gombaud: Chevalier de Méré, asset allocation, asset-backed security, backtesting, bank run, banking crisis, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, business process, buy low sell high, capital asset pricing model, centre right, collateralized debt obligation, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, discounted cash flows, disintermediation, diversification, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, full employment, George Akerlof, Gordon Gekko, hiring and firing, implied volatility, index fund, interest rate derivative, interest rate swap, John von Neumann, linear programming, Loma Prieta earthquake, Long Term Capital Management, margin call, market friction, market microstructure, martingale, merger arbitrage, Nick Leeson, P = NP, pattern recognition, pensions crisis, performance metric, prediction markets, profit maximization, purchasing power parity, quantitative trading / quantitative ﬁnance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Richard Feynman, Richard Feynman, Richard Stallman, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, sorting algorithm, statistical arbitrage, statistical model, stem cell, Steven Levy, stochastic process, systematic trading, technology bubble, The Great Moderation, the scientific method, too big to fail, trade route, transaction costs, transfer pricing, value at risk, volatility smile, Wiener process, yield curve, young professional
In “A Tale of Two Hedge Funds,” Ken and I describe in detail how the supposedly low-risk strategies of LTCM and another infamous hedge fund, Granite, came apart in spectacular fashion when they had exhausted the market’s liquidity. “A Tale of Two Hedge Funds” appears in our edited volume, Market Neutral Strategies ( 2005), which brought together some of the industry’s most successful practitioners to discuss longshort equity strategies, convertible bond hedging, and merger arbitrage, as well as sovereign fixed income and mortgage arbitrage. It serves as a cautionary reminder of how such strategies, when not managed carefully, can blow up, threatening the very markets in which they operate. I had taken the liberty of sending a draft of Capital Ideas and Market Realities to Nobel laureate Harry Markowitz, who not only liked the work, but offered to write the foreword to the book.
He received an MBA and a PhD in finance from the University of Chicago. Tanya Styblo Beder has built three businesses during her 20-year career in the global capital markets. Beginning in 2004, Ms. Beder designed and built as its CEO Tribeca Global Management LLC, Citigroup’s multistrategy hedge. As CEO, she also was responsible for several other institutional fund offerings including convertibles, distressed debt, merger arbitrage, and credit. Beginning in 1999, she built the Strategic Quantitative Investment Division (SQID) of Caxton Associates LLC. Before her roles in the hedge fund industry, Ms. Beder founded two consulting firms specializing in risk measurement, risk oversight, capital markets and derivatives—Capital Market Risk Advisors in 1994 and SB Consulting Corp. in 1987. Before this, she was a vice president of The First Boston Corporation, where she started her career in mergers and acquisitions and was a consultant in the financial institutions practice at McKinsey & Company.
The Handbook of Personal Wealth Management by Reuvid, Jonathan.
asset allocation, banking crisis, BRICs, collapse of Lehman Brothers, correlation coefficient, credit crunch, cross-subsidies, diversification, diversified portfolio, estate planning, financial deregulation, fixed income, high net worth, income per capita, index fund, interest rate swap, laissez-faire capitalism, land tenure, market bubble, merger arbitrage, new economy, Northern Rock, pattern recognition, Ponzi scheme, prediction markets, risk tolerance, risk-adjusted returns, risk/return, short selling, side project, sovereign wealth fund, statistical arbitrage, systematic trading, transaction costs, yield curve
Due to the volatile environment, managers reduced their trade sizes, believing that this would not have a negative impact on returns as dispersion was so high. Indiscriminate selling is not conducive to this approach. Table 1.3.1 Performance of hedge fund indices in 2008 Strategy Net of fees year to date returns to 31 Oct 08 (USD) HFRI Fund Weighted Composite Index HFRI Equity Hedge (Total) Index HFRI EH: Equity Market Neutral Index HFRI EH: Quantitative Directional HFRI EH: Short Bias Index HFRI Event-Driven (Total) Index HFRI ED: Merger Arbitrage Index HFRI Macro (Total) Index HFRI Relative Value (Total) Index HFRI RV: Fixed Income–Asset Backed HFRI RV: Fixed Income–Convertible Arbitrage Index HFRI RV: Fixed Income–Corporate Index HFRI RV: Multi–Strategy Index –15.48 –22.49 –3.78 –19.04 21.18 –16.66 –5.37 5.55 –17.11 0.07 –35.06 –18.32 –20.69 ________________________________________________ HEDGE FUND STRATEGIES 33 ឣ Discretionary macro Discretionary macro is one of the few strategies that has posted positive performance in the year to date (end October 2008).
Extreme Money: Masters of the Universe and the Cult of Risk by Satyajit Das
affirmative action, Albert Einstein, algorithmic trading, Andy Kessler, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Basel III, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, BRICs, British Empire, capital asset pricing model, Carmen Reinhart, carried interest, Celtic Tiger, clean water, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, debt deflation, Deng Xiaoping, deskilling, discrete time, diversification, diversified portfolio, Doomsday Clock, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, eurozone crisis, Fall of the Berlin Wall, financial independence, financial innovation, fixed income, full employment, global reserve currency, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, happiness index / gross national happiness, haute cuisine, high net worth, Hyman Minsky, index fund, interest rate swap, invention of the wheel, invisible hand, Isaac Newton, job automation, Johann Wolfgang von Goethe, joint-stock company, Joseph Schumpeter, Kenneth Rogoff, Kevin Kelly, labour market flexibility, laissez-faire capitalism, load shedding, locking in a profit, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, Martin Wolf, merger arbitrage, Mikhail Gorbachev, Milgram experiment, Mont Pelerin Society, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, Naomi Klein, Network effects, new economy, Nick Leeson, Nixon shock, Northern Rock, nuclear winter, oil shock, Own Your Own Home, pets.com, Plutocrats, plutocrats, Ponzi scheme, price anchoring, price stability, profit maximization, quantitative easing, quantitative trading / quantitative ﬁnance, Ralph Nader, RAND corporation, random walk, Ray Kurzweil, regulatory arbitrage, rent control, rent-seeking, reserve currency, Richard Feynman, Richard Feynman, Richard Thaler, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, Rod Stewart played at Stephen Schwarzman birthday party, rolodex, Ronald Reagan, Ronald Reagan: Tear down this wall, savings glut, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, Slavoj Žižek, South Sea Bubble, special economic zone, statistical model, Stephen Hawking, Steve Jobs, The Chicago School, The Great Moderation, the market place, the medium is the message, The Myth of the Rational Market, The Nature of the Firm, The Predators' Ball, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, trickle-down economics, Turing test, Upton Sinclair, value at risk, Yogi Berra, zero-coupon bond
To be alternative, there must be a majority; the alternative cannot be the majority. Inflow of money into successful hedge funds eroded returns. Louis Bacon (of Moore Capital) observed: “Size matters. It is the bane of the successful money manager.”5 Size forces style drift. LTCM drifted from its métier, relative value trading in fixed income, into volatility trading, credit spread trading, and merger arbitrage. In 2006, when market neutral hedge funds losses mirrored the fall in the market, hedge fund managers explained: “Everything in the market was a compelling buy. We could find nothing to short.” The market changed. Banks cloned hedge funds, replicating returns by using simple instruments, with lower fees and less risk of an Amaranth or LTCM.6 Investors were looking for grand masters at knock-off prices.
In a weakening economic environment, hedge funds believed that VW shares were overvalued and bet that the share price would fall. As Porsche’s share purchases and option activity pushed up VW’s share price, hedge funds sold VW shares short, looking to buy them back when the price fell. Some funds sold VW shares and bought the shares of other car companies to capture the correction in relative prices. Merger arbitrage funds sold VW shares and bought Porsche shares, betting that the prices would converge. Others shorted VW ordinary shares and bought the preference shares trading at a 50 percent discount to ordinary shares, betting that the spread would decrease. Around September 2009, Porsche announced it intended to lift its shareholding to 75 percent, allowing it to enter into a domination agreement, giving it effective control of VW.
accounting loophole / creative accounting, Albert Einstein, Asian financial crisis, asset-backed security, Black Swan, Black-Scholes formula, Bretton Woods, BRICs, Brownian motion, business process, buy low sell high, call centre, capital asset pricing model, collateralized debt obligation, complexity theory, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, currency peg, disintermediation, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, Haight Ashbury, high net worth, implied volatility, index arbitrage, index card, index fund, interest rate derivative, interest rate swap, Isaac Newton, job satisfaction, locking in a profit, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, Marshall McLuhan, mass affluent, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, mutually assured destruction, new economy, New Journalism, Nick Leeson, offshore financial centre, oil shock, Parkinson's law, placebo effect, Ponzi scheme, purchasing power parity, quantitative trading / quantitative ﬁnance, random walk, regulatory arbitrage, risk-adjusted returns, risk/return, shareholder value, short selling, South Sea Bubble, statistical model, technology bubble, the medium is the message, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, volatility smile, yield curve, Yogi Berra, zero-coupon bond
Astute investors noticed liquidity, hedge funds that after you adjusted for risk and the returned less than absence of liquidity, hedge funds returned traditional assets. less than traditional assets. DAS_Z01.QXP 8/11/06 310 2:10 PM Page 310 Tr a d e r s , G u n s & M o n e y The absence of opportunities created ‘style drift’: hedge funds with certain areas of expertise began to trade in other markets. LTCM, too, had drifted from their metier – relative value trading in fixed income – into volatility trading, credit spread trading and merger arbitrage. Hedge funds are not noted for their transparency. Lack of disclosure means that you don’t know how far the ship is off course until it is on the rocks. Cases of fraud and other common crimes also began to surface. There was every sign that the hedge fund universe was overheated. At the suggestion that there was a ‘bubble’, one manager bristled that hedge funds weren’t an ‘asset class’, therefore there was no ‘bubble’ to burst.
The Snowball: Warren Buffett and the Business of Life by Alice Schroeder
affirmative action, Albert Einstein, anti-communist, Ayatollah Khomeini, barriers to entry, Bonfire of the Vanities, Brownian motion, capital asset pricing model, card file, centralized clearinghouse, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, desegregation, Donald Trump, Eugene Fama: efficient market hypothesis, global village, Golden Gate Park, Haight Ashbury, haute cuisine, Honoré de Balzac, If something cannot go on forever, it will stop, In Cold Blood by Truman Capote, index fund, indoor plumbing, interest rate swap, invisible hand, Isaac Newton, Jeff Bezos, joint-stock company, joint-stock limited liability company, Long Term Capital Management, Louis Bachelier, margin call, market bubble, Marshall McLuhan, medical malpractice, merger arbitrage, Mikhail Gorbachev, moral hazard, NetJets, new economy, New Journalism, North Sea oil, paper trading, passive investing, pets.com, Plutocrats, plutocrats, Ponzi scheme, Ralph Nader, random walk, Ronald Reagan, Scientific racism, shareholder value, short selling, side project, Silicon Valley, Steve Ballmer, Steve Jobs, supply-chain management, telemarketer, The Predators' Ball, The Wealth of Nations by Adam Smith, Thomas Malthus, too big to fail, transcontinental railway, Upton Sinclair, War on Poverty, Works Progress Administration, Y2K, zero-coupon bond
I picked up the phone, and it was Eric Rosenfeld at Long-Term.” The boyish Rosenfeld, forty-five years old and one of Meriwether’s key lieutenants, was the person who had had the brain-numbing job of going through thousands of Mozer’s trades at Salomon and reconstructing what went wrong. Buffett liked Rosenfeld. Now he had been deputized by Meriwether to cut back the portfolio’s size by selling the firm’s merger arbitrage positions. “I hadn’t heard from him for years. With fear in his voice, Eric started to talk about me taking out their whole big stock arbitrage position, six billion dollars’ worth. They thought stock arbitrage was mathematical.”22 Responding reflexively, Warren Buffetted Rosenfeld. “I just said to Eric, I would take certain ones but not all of them.” By a few days later, the market’s gyrations had cost Long-Term half its capital.
In When Genius Failed, Lowenstein drew this conclusion after extensive interviews with Meriwether’s former team. 20. Roger Lowenstein, When Genius Failed. Shorting it as a collection of stocks would not work because of a basis mismatch between Berkshire and the offsetting hedgeable positions. Berkshire was a collection of wholly owned businesses fueled by an insurance company that also owned some stocks, not a quasi-mutual fund. 21. Roger Lowenstein, When Genius Failed. 22. Stock or merger arbitrage is a bet on whether a merger will close. Merger-arb specialists talk to lawyers and investment bankers and specialize in scuttlebutt. Their bets are based partly on knowledge about a deal, not just statistics about how typical deals have done. 23. Interview with Eric Rosenfeld; Lowenstein, When Genius Failed. 24. Michael Siconolfi, Anita Raghavan, and Mitchell Pacelle, “All Bets Are Off: How Salesmanship and Brainpower Failed at Long-Term Capital,” Wall Street Journal, November 16, 1998. 25.
Bernie Madoff, the Wizard of Lies: Inside the Infamous $65 Billion Swindle by Diana B. Henriques
accounting loophole / creative accounting, airport security, Albert Einstein, banking crisis, Bernie Madoff, British Empire, centralized clearinghouse, collapse of Lehman Brothers, diversified portfolio, Donald Trump, dumpster diving, financial deregulation, forensic accounting, Gordon Gekko, index fund, locking in a profit, mail merge, merger arbitrage, Plutocrats, plutocrats, Ponzi scheme, Potemkin village, random walk, Renaissance Technologies, riskless arbitrage, Ronald Reagan, short selling, Small Order Execution System, sovereign wealth fund, too big to fail, transaction costs, traveling salesman
It could be as simple as ordering cartons of cigarettes by telephone from a vendor in a low-cost state and simultaneously selling them over the phone at a higher price in states where they are more expensive, thereby locking in a profit. Or it could be as complex as using computer software to instantly detect a tiny price differential for a stock trading in two different currencies and execute the trades without human intervention—again, locking in the profit. What distinguished riskless arbitrage from the more familiar “merger arbitrage” of the 1980s—which involved speculating in the securities of stocks involved in possible takeovers—was that a profit could be captured the moment it was perceived, if the trade could be executed quickly enough. A conventional trader would buy a security in hopes of selling it later at a profit; if he guessed wrong, he lost money. By contrast, an arbitrage trader would not buy a security at all unless he could almost instantly sell it, or its equivalent, at a profit; if he had to guess about whether he’d make a profit, he didn’t do the trade.
The Intelligent Investor (Collins Business Essentials) by Benjamin Graham, Jason Zweig
accounting loophole / creative accounting, air freight, Andrei Shleifer, asset allocation, buy low sell high, capital asset pricing model, corporate governance, Daniel Kahneman / Amos Tversky, diversified portfolio, Eugene Fama: efficient market hypothesis, hiring and firing, index fund, Isaac Newton, Long Term Capital Management, market bubble, merger arbitrage, new economy, passive investing, price stability, Ralph Waldo Emerson, Richard Thaler, risk tolerance, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, sharing economy, short selling, Silicon Valley, South Sea Bubble, Steve Jobs, the market place, transaction costs, tulip mania, VA Linux, Vanguard fund, Y2K, Yogi Berra
Here, however, Graham means “net working-capital value,” or the per-share value of current assets minus total liabilities. * Le coeur a ses raisons que la raison ne connaît point. This poetic passage is one of the concluding arguments in the great French theologian’s discussion of what has come to be known as “Pascal’s wager” (see commentary on Chapter 20). * As discussed in the commentary on Chapter 7, merger arbitrage is wholly inappropriate for most individual investors. 1 Patricia Dreyfus, “Investment Analysis in Two Easy Lessons” (interview with Graham), Money, July, 1976, p. 36. 2 See the commentary on Chapter 11. 3 There are also many newsletters dedicated to analyzing professional portfolios, but most of them are a waste of time and money for even the most enterprising investor. A shining exception for people who can spare the cash is Outstanding Investor Digest (www.oid.com). 1 As a brief example of how convertible bonds work in practice, consider the 4.75% convertible subordinated notes issued by DoubleClick Inc. in 1999.