Hedge Fund Case 1 Group 5

1. What problem is Michaud facing?

Michaud need to evaluate Fairfield Guard’s prospectus to determine whether it
is a good investment opportunity for LAAMCO. As part of the due diligence
Michaud intends to verify the historical performance of Fairfield Guard and
quantify their value-added by backtesting the collar strategy.

2. What is a fund of hedge funds?

Similar to a FoF, a fund of hedge funds is an investment vehicle whose portfolio
consists of shares in a number of hedge funds.
The fund of funds strategy can be applied to any type of investment fund, from
a mutual fund to a private equity fund, while funds of hedge funds construct
portfolio of only hedge funds. A fund of hedge funds may invest in hedge funds
using a particular management strategy only or using many different strategies
in an attempt to gain exposure to all of them.

3. Why is LAAMCO doing Due Diligence on Fairfield Guard?

In general, due diligence is an important procedure to take on investments to
evaluate the legal status, commercial potential etc of the target. In specific for
Fairfield Guards’ case, their historical return was so stellar for collar strategy
takers that extra procedure should be taken to ensure Fairfield Guard has been
transparent in their prospectus and to evaluate the fund manager’s alpha.

4. What is a collar strategy?

A collar strategy is an options strategy that limits both gains and losses by
holding an underlying stock, buying an out of the money put option, and selling
an out of the money call option for a notional amount equivalent to the value
of the securities. As stated in Fairfield Guard’s investment prospectus, they
adopted the collars strategy to hedge their long position in the underlying
asset from short-term downside risk through the put option, which is financed
by selling the call option.

5. How do you think the return of Fairfield Guard?

To run the simulated backtest, we price the options with B-S model taking
strike price K 1 of the put option and K 2 of the call option 3% below/above the
index level respectively, so as to limit the monthly return variations at approx.
3%. See Exhibit 1 for model assumptions.
The simulated strategy boosted our $1 investment at the fund’s inception to
$4.58 by end of 2007, still outperforming HFRI EH but at a lower Sharpe ratio of
0.16, implying that the strategy is still influenced by the volatile stock market
to some extent. On the other hand, the result does not outperform S&P 500
index as much, yet the volatility was well controlled below 3%. In conclusion,
collar strategy which implies that effectiveness of collar strategy is positive but
limited.
Yet Fairfield Guard still beat our simulated portfolio from all aspect – 26%
higher total absolute return, 0.07% higher monthly average return and higher
Sharpe ratio. It implies that the fund manager did very well in stock selection,
earning alpha. (See Exhibit 2&3).

6. Would you invest in Fairfield Guard?

From the results above, we can see that when we tried to replicate Fairfield
Guard’s collar strategy with S&P 500 Index adjusting on a monthly basis, we
ended up with a better Sharpe ratio than the index fund but did not
outperform peer market-neutral hedge funds in terms of risk control. Fairfield
Guard’s historical return seems very attractive and the managers’ skill has been
proven by their alpha earned.
However, further due diligence procedure should be taken before making the
final decision, e.g., has there been any changes in the fund’s management
structure or investment strategy? Does there exist any factors in the market
that might invalidate collar strategy in the foreseeable future? Has Fairfield
Guard been transparent in disclosure? Do they hold any asset that does not fit
with LAAMCO’s fund portfolio?
Exhibit 1 Backtest simulation assumptions,
1. As we used B-S model for option pricing, the below assumptions are
inherited,
1) The options are European and can only be exercised at expiration;
2) No dividend is paid out during the life of the option;
3) Markets are efficient and cannot be predicted;
4) No transaction costs are incurred when buying an option;
5) The risk-free rates are approximated by return rate on Treasury Bills
6) The returns on the underlying S&P 500 are normally distributed with
standard deviation tracked by VIX.

Exhibit 2 Fund Return Comparison

Backtest
Fairfield Guard
Simulation HFRI EH S&P 500 Index
Average annualised return 9.90% 10.84% 8.58% 10.26%
Volatility (annualised) 10.36% 2.48% 3.06% 13.37%
Sharpe ratio (annualised) 0.57 2.77 1.50 0.03

Exhibit 3 Month end values of $1 in each fund