Jai Chandani(F025)

Overview of Hedge Funds and Their Importance in Investment

Portfolios:

About Hedge Fund Key characteristics of

hedge funds include:

Hedge funds are investment funds that pool capital

Hedge funds employ a diverse range of strategies
from sophisticated investors and employ a wide range
Hedge funds often focus on active risk management
of strategies to generate returns. Unlike traditional
Hedge fund managers typically earn performance fees based on the
mutual funds, hedge funds typically have greater
fund's returns
flexibility in their investment approach, allowing them
to invest across various asset classes, use leverage,
and employ complex trading strategies
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 In the context of hedge funds, factor models seek to identify
the key drivers of hedge fund returns and quantify their
impact. These models help investors understand how
different market factors contribute to hedge fund
performance and assess the relative importance of each
factor.

Common Factors Affecting

Hedge Fund Returns:
FACTOR MODELS Market Risk
FOR HEDGE Interest Rate Risk
Credit Risk
FUNDS: Currency Risk
Liquidity Risk
Volatility
Economic Factors
 Concept of Non-Normality in Hedge Fund Returns:

Non-normality in hedge fund returns refers to the departure of return distributions

from a normal (bell-shaped) distribution. Hedge fund returns often exhibit non-normal
characteristics such as skewness (asymmetric tail risk) and excess kurtosis (fat tails),
indicating a higher likelihood of extreme positive or negative returns compared to a
normal distribution. Non-normality implies that hedge fund returns do not follow the
same statistical properties as traditional assets, posing challenges for risk assessment
and portfolio optimization.
 Alpha is an index that is used for determining the highest
possible return concerning the least amount of risk
ALPHA
Alpha Calculation (Step by CALCULATION
Step):

1. Firstly, figure out the risk-free rate, which can be determined from the average annual return of government security, say Treasury
bonds, over a substantial period.
2. Next, figure out the market return, which can be done by tracking the average annual return of a benchmark index, say the S&P 500,
over a substantial period. Consequently, the market risk premium is computed by deducting the risk-free rate of return from the
market return. Market risk premium = Market return – Risk rate of return
3. Next, the beta of a portfolio is determined by assessing the portfolio’s movement compared to the benchmark index.
4. Now, based on the risk-free rate of return (step 1), a beta of the portfolio (step 3), and market risk premium (step 2), the expected
rate of return of the portfolio is calculated as below.
5. Expected rate of return of portfolio = Risk-free rate of return + β * (Market return – Risk-free rate of return)
6. Next, the actual rate of return achieved by the portfolio is calculated based on its current value and the previous value.
7. Finally, the formula for calculation of alpha of the portfolio is done by deducting the expected rate of return of the portfolio (step 4)
from the actual rate of return of the portfolio (step 5) as above.

The formula that calculates alpha is: Alpha = R - Rf - beta (Rm - Rf).
In this formula, R represents the portfolio's return, Rf represents
the risk-free rate of return, beta represents the systematic risk of
a portfolio, and Rm represents the market return, for each
benchmark.
 Sharpe Ratio

The Sharpe ratio evaluates the risk-adjusted performance of an investment portfolio by determining the excess return
received for the extra risk/volatility associated with a riskier portfolio.

The steps to calculate the Sharpe ratio are as follows:

Step 1 → First, the formula starts by subtracting the risk-free rate from the portfolio return to isolate the excess
return.
Step 2 → Next, the excess return is divided by the portfolio’s standard deviation (i.e. the proxy for portfolio
risk).

Sharpe Ratio = (Rp − Rf) ÷ σp

Where:
Rp = Expected Portfolio Return
Rf = Risk-Free Rate
σp = Standard Deviation of Portfolio (Risk)
 Treynor Ratio

The Treynor Ratio is a measure of a portfolio’s excess return per unit of systematic risk, or the market volatility of the
portfolio.

Calculating the Treynor ratio requires three inputs:

Portfolio Return (Rp)

Risk-Free Rate (Rf)
Beta of the Portfolio (β) Treynor Ratio = (rp – rf) ÷ βp
Where:
rp = Portfolio Return
rf = Risk-Free Rate
βp = Beta of the Portfolio
 FUNDS OF FUNDS
(FOFS):

Benefits of FoFs:
Funds of Funds (FoFs) are investment vehicles that
pool capital from investors and allocate it across a
portfolio of hedge funds rather than directly investing Diversification
in individual securities or assets. In essence, FoFs Access to Multiple Hedge Funds
invest in other hedge funds, serving as a fund Professional Fund Selection
Risk Management
manager of managers. FoFs offer investors exposure
Liquidity and Transparency
to a diversified portfolio of hedge fund strategies
managed by different fund managers within a single
investment vehicle.
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