P1:JYS fm JWBK289-Jaeger August4,2008 14:18 Printer:Yettocome Alternative Beta Strategies and Hedge Fund Replication Lars Jaeger with Jeffrey Pease i P1:JYS fm JWBK289-Jaeger August4,2008 14:18 Printer:Yettocome i P1:JYS fm JWBK289-Jaeger August4,2008 14:18 Printer:Yettocome Alternative Beta Strategies and Hedge Fund Replication i P1:JYS fm JWBK289-Jaeger August4,2008 14:18 Printer:Yettocome Alternative Beta Strategies and Hedge Fund Replication Lars Jaeger with Jeffrey Pease i P1:JYS fm JWBK289-Jaeger August4,2008 14:18 Printer:Yettocome Copyright(cid:1)C 2008 JohnWiley&SonsLtd,TheAtrium,SouthernGate,Chichester, WestSussexPO198SQ,England Telephone (+44)1243779777 Email(forordersandcustomerserviceenquiries):[email protected] VisitourHomePageonwww.wiley.com AllRightsReserved.Nopartofthispublicationmaybereproduced,storedinaretrievalsystemortransmittedin anyformorbyanymeans,electronic,mechanical,photocopying,recording,scanningorotherwise,exceptunderthe termsoftheCopyright,DesignsandPatentsAct1988orunderthetermsofalicenceissuedbytheCopyright LicensingAgencyLtd,90TottenhamCourtRoad,LondonW1T4LP,UK,withoutthepermissioninwritingofthe Publisher.RequeststothePublishershouldbeaddressedtothePermissionsDepartment,JohnWiley&SonsLtd, TheAtrium,SouthernGate,Chichester,WestSussexPO198SQ,England,[email protected],or faxedto(+44)1243770620. 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OtherWileyEditorialOffices JohnWiley&SonsInc.,111RiverStreet,Hoboken,NJ07030,USA Jossey-Bass,989MarketStreet,SanFrancisco,CA94103-1741,USA Wiley-VCHVerlagGmbH,Boschstr.12,D-69469Weinheim,Germany JohnWiley&SonsAustraliaLtd,42McDougallStreet,Milton,Queensland4064,Australia JohnWiley&Sons(Asia)PteLtd,2ClementiLoop#02-01,JinXingDistripark,Singapore129809 JohnWiley&SonsCanadaLtd,6045FreemontBlvd,Mississauga,Ontario,L5R4J3Canada Wileyalsopublishesitsbooksinavarietyofelectronicformats.Somecontentthatappearsinprintmaynotbe availableinelectronicbooks. LibraryofCongressCataloging-in-PublicationData Jaeger,Lars. Alternativebetastrategiesandhedgefundreplication/LarsJaeger. p.cm. Includesbibliographicalreferencesandindex. ISBN978-0-470-75446-7(cloth:alk.paper) 1.Hedgefunds. I.Title. HG4530.J3272008 332.64(cid:2)524–dc22 2008022826 BritishLibraryCataloguinginPublicationData AcataloguerecordforthisbookisavailablefromtheBritishLibrary ISBN978-0-470-75446-7 Typesetin10/12ptTimesbyAptaraInc.,NewDelhi,India PrintedandboundinGreatBritainbyCPIAntonyRowe,Chippenham,Wiltshire ii P1:JYS fm JWBK289-Jaeger August4,2008 14:18 Printer:Yettocome Tomychildren,AnikaMai,KiraAnh,andTaliaLinh iii P1:JYS fm JWBK289-Jaeger August4,2008 14:18 Printer:Yettocome ForothertitlesintheWileyFinanceSeries pleaseseewww.wiley.com/finance iv P1:JYS fm JWBK289-Jaeger August4,2008 14:18 Printer:Yettocome Contents Preface ix 1 BreakingtheBlackBox 1 1.1 Newpopularity,oldconfusion 1 1.2 Thechallengesofunderstandinghedgefunds 2 1.3 LeavingAlphaville 3 1.4 Thebeautyofbeta 4 1.5 Alternativeversustraditionalbeta 4 1.6 Thereplicationrevolution 5 1.7 Fulldisclosure 6 2 WhatAreHedgeFunds,WhereDidTheyComeFrom,andWhereAreThey Going? 7 2.1 Characteristicsofhedgefunds 7 2.2 Hedgefundsasanassetclass 11 2.3 Taxonomyofhedgefunds 11 2.4 Myths,misperceptions,andrealitiesabouthedgefunds 15 2.5 Ashorthistoryofhedgefunds 22 2.6 Thehedgefundindustrytoday 26 2.7 Thefutureofhedgefunds–opportunitiesandchallenges 30 3 TheIndividualHedgeFundStrategies’Characteristics 37 3.1 EquityHedged–Long/ShortEquity 37 3.2 EquityHedged–EquityMarketNeutral 41 3.3 EquityHedged–ShortSelling 44 3.4 RelativeValue–general 45 3.5 RelativeValue–FixedIncomeArbitrage 46 3.6 RelativeValue–ConvertibleArbitrage 51 3.7 RelativeValue–VolatilityArbitrage 58 3.8 RelativeValue–CapitalStructureArbitrage 60 3.9 EventDriven–general 62 3.10 EventDriven–MergerArbitrage 64 3.11 EventDriven–DistressedSecurities 67 v P1:JYS fm JWBK289-Jaeger August4,2008 14:18 Printer:Yettocome vi Contents 3.12 EventDriven–RegulationD 69 3.13 Opportunistic–GlobalMacro 70 3.14 ManagedFutures 75 3.15 ManagedFutures–Systematic 76 3.16 ManagedFutures–Discretionary 79 3.17 Conclusionofthechapter 81 4 EmpiricalReturnandRiskPropertiesofHedgeFunds 83 4.1 WhentheSharperatioisnotsharpenough 83 4.2 Challenges of hedge fund performance measurement – the issue with hedgefundindices 84 4.3 Sourcesofempiricaldata 89 4.4 Riskandreturnpropertiesofhedgefundstrategies 90 4.5 Comparisonwithequitiesandbonds 93 4.6 Deviationfromnormaldistribution 94 4.7 Unconditionalcorrelationproperties 94 4.8 Conditionalreturnsandcorrelations 98 4.9 Hedgefundbehaviorinextrememarketsituations 105 4.10 Benefitsofhedgefundsinatraditionalportfolio 107 4.11 Quantitativeportfoliooptimizationforhedgefundsrevisited 109 4.12 Summaryofempiricalproperties 112 4.13 Appendix:Dataprovidersforpasthedgefundperformance 113 5 TheDriversofHedgeFundReturns 117 5.1 Alphaversusbeta 117 5.2 Theenigmaofhedgefundreturns 119 5.3 Hedgefundreturns:howmuchisalpha? 121 5.4 Theefficientmarkethypothesis 123 5.5 Questioningtheefficientmarkethypothesis:behavioralfinance 125 5.6 The theoretical framework of modern finance: asset pricing models and theinterpretationsofalpha 128 5.7 Systematicriskpremia:theprevalenceofbetaintheglobalcapitalmarkets 131 5.8 Riskpremiaandeconomicfunctions 138 5.9 Marketinefficiencies:the‘searchforalpha’ 140 5.10 Anillustrationofthenatureofhedgefundreturns 143 5.11 Thedecreaseofalpha 145 5.12 Thebeautyofalternativebeta 147 5.13 Thefutureofhedgefundcapacity 149 5.14 Momentumandvalue 150 5.15 Activestrategiesandoption-likereturns 152 5.16 Whymanagerskillmatters 154 5.17 Buyerbeware:somefinalwordsofcautionabouthedgefundreturns 155 6 AFirstApproachtoHedgeFundReplication–LinearFactorModelsand TimeSeriesReplicationModels 157 6.1 RevisitingSharpe’sapproach 157 6.2 Understandinglinearfactoranalysis:criteriaforthefactormodelapproach 158