THE BUSINESS What Hedge Funds Really Do R Economics Collection O EXPERT PRESS M DIGITAL LIBRARIES An Introduction to Portfolio ER Philip J. Romero and Jeffrey A. Edwards, Editors O Management (cid:127) EBOOKS FOR B A BUSINESS STUDENTS Philip J. Romero (cid:127) Tucker Balch L C Curriculum-oriented, born- H When I managed a hedge fund in the late 1990s, computer- digital books for advanced What Hedge based trading was a mysterious technique only available to the business students, written largest hedge funds and institutional trading desks. We’ve come by academic thought leaders who translate real- a long way since then. With this book, Drs. Romero and Balch lift world business experience the veil from many of these once-opaque concepts in high-tech Funds into course readings and fi nance. We can all benefi t from learning how the cooperation reference materials for between wetware and software creates fi tter models. This book students expecting to tackle does a fantastic job describing how the latest advances in fi nan- Really Do management and leadership cial modeling and data science help today’s portfolio managers challenges during their solve these greater riddles. —Michael Himmel, Managing professional careers. Partner, Essex Asset Management An Introduction POLICIES BUILT BY LIBRARIANS I applaud Phil Romero’s willingness to write about the hedge (cid:127) Unlimited simultaneous fund world, an industry that is very private, often fl amboyant, W to Portfolio usage and easily misunderstood. As with every sector of the invest- H A (cid:127) Unrestricted downloading ment landscape, the hedge fund industry varies dramatically T and printing from quantitative “black box” technology, to fundamental re- H Management (cid:127) Perpetual access for a E search and old-fashioned stock picking. This book helps inves- D one-time fee G tors distinguish between these diverse opposites and understand (cid:127) No platform or E maintenance fees their place in the new evolving world of fi nance. —Mick Elfers, F U (cid:127) Free MARC records Founder and Chief Investment Strategist, Irvington Capital N (cid:127) No license to execute D Dr. Philip J. Romero is an economist, policy analyst, band S The Digital Libraries are a R applied mathematician, and former California chief comprehensive, cost-eff ective E Philip J. Romero A economist. He has been Dean and is currently Professor way to deliver practical L treatments of important of Business Administration at the University of Oregon’s LY Tucker Balch business issues to every Lundquist College of Business. D O student and faculty member. Dr. Tucker Balch is a former F-15 pilot, Associate Professor of Interactive Computing at Georgia Tech, and co-founder of Lucena Research, Inc., an investment research fi rm. For further information, a Dr. Balch was one of the fi rst to bring instruction on quan- free trial, or to order, contact:  titative analysis to a worldwide audience via his Massive Online Open Course. [email protected] www.businessexpertpress.com/librarians Economics Collection Philip J. Romero and Jeffrey A. Edwards, Editors ISBN: 978-1-63157-089-6 What Hedge Funds Really Do What Hedge Funds Really Do An Introduction to Portfolio Management Philip J. Romero and Tucker Balch What Hedge Funds Really Do: An Introduction to Portfolio Management Copyright © Business Expert Press, LLC, 2014. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means—electronic, mechanical, photocopy, recording, or any other except for brief quotations, not to exceed 400 words, without the prior permission of the publisher. First published in 2014 by Business Expert Press, LLC 222 East 46th Street, New York, NY 10017 www.businessexpertpress.com ISBN-13: 978-1-63157-089-6 (paperback) ISBN-13: 978-1-63157-090-2 (e-book) Business Expert Press Economics Collection Collection ISSN: 2163-761X (print) Collection ISSN: 2163-7628 (electronic) Cover and interior design by Exeter Premedia Services Private Ltd., Chennai, India First edition: 2014 10 9 8 7 6 5 4 3 2 1 Printed in the United States of America. Abstract What do hedge funds really do? These lightly regulated funds continu- ally innovate new investing and trading strategies to take advantage of temporary mispricing of assets (when their market price deviates from their intrinsic value). These techniques are shrouded in mystery, which permits hedge fund managers to charge exceptionally high fees. While the details of each fund’s approach are carefully guarded trade secrets, this book draws the curtain back on the core building blocks of many hedge fund strategies. As an instructional text, it will assist two types of students: • Economics and finance students interested in understanding what “quants” do, and • Software specialists interested in applying their skills to pro- gramming trading systems. What Hedge Funds Really Do provides a needed complement to journal- istic accounts of the hedge fund industry, to deepen the understanding of nonspecialist readers such as policy makers, journalists, and individual investors. The book is organized in modules to allow different readers to focus on the elements of this topic that most interest them. Its authors include a fund practitioner and a computer scientist (Balch), in collabo- ration with a public policy economist and finance academic (Romero). Keywords absolute return, active investment management, arbitrage, capital asset pricing model, CAPM, derivatives, exchange traded funds, ETF, fat tails, finance, hedge funds, hedging, high-frequency trading, HFT, investing, investment management, long/short, modern portfolio theory, MPT, optimization, quant, quantitative trading strategies, portfolio construc- tion, portfolio management, portfolio optimization, trading, trading strategies, Wall Street Contents Part I The Basics ������������������������������������������������������������������1 Chapter 1 Introduction ..................................................................3 Chapter 2 So You Want to Be a Hedge Fund Manager ...................9 Chapter 3 An Illustrative Hedge Fund Strategy: Arbitrage ............21 Chapter 4 Market-Making Mechanics ..........................................25 Chapter 5 Introduction to Company Valuation ............................31 Part II Investing Fundamentals: CAPM and EMH �������������41 Chapter 6 How Valuation Is Used by Hedge Funds ......................43 Chapter 7 Framework for Investing: The Capital Asset Pricing Model (CAPM) ................................................47 Chapter 8 The Efficient Market Hypothesis (EMH)—Its Three Versions ..............................................................55 Chapter 9 The Fundamental Law of Active Portfolio Management ................................................................59 Part III Market Simulation and Portfolio Construction �������69 Chapter 10 Modern Portfolio Theory: The Efficient Frontier and Portfolio Optimization ..........................................71 Chapter 11 Event Studies ...............................................................81 Chapter 12 Overcoming Data Quirks to Design Trading Strategies .........................................................87 Chapter 13 Data Sources ................................................................93 Chapter 14 Back Testing Strategies .................................................97 Part IV Case Study and Issues ��������������������������������������������103 Chapter 15 Hedge Fund Case Study: Long Term Capital Management (LTCM) ...................................105 Chapter 16 Opportunities and Challenges for Hedge Funds .........111 viii CoNtENtS Teaching Cases ������������������������������������������������������������������������������������119 Glossary ���������������������������������������������������������������������������������������������121 Summary �������������������������������������������������������������������������������������������131 Index �������������������������������������������������������������������������������������������������133 PART I The Basics