alternative investment management

8/3/2019 Alternative Investment Management

http://slidepdf.com/reader/full/alternative-investment-management 1/17

Alternative Investment

ManagementHedge Fund Strategy Report



Executive SummaryWith a primary aim to preserve capital, and further yield a positive return, our fund implemented two

main strategies after consideration of a wider universe.

Through the f irst strategy, ADR mispricing trading, no opportunities were found over the trading

period due to large bid-asks spreads and unclear foreign exchange rates as provided by the trading

platform. These elements eroded the potential value of the trades, sometimes halving the premium

identif ied when the trade was placed.

Market timing, the funds second strategy, underperformed expectations due to insuff icient macro-

economic knowledge and unexpected volatility due to world eventsaffectingequitymarkets.

Overall, management employed sound strategies. Recommendations for further management of the

fund are to take steps to reduce spreads, by ut ilising a better platform, for ADR mispricing trades,

which would signif icantly increase prof its. Moreover the market timing strategy requires further and

deeper macroeconomic research, to which time constraints were an impediment.

We understand the importance for the management of the fund to conf irm all details before entering

into a trade, as mistakes weremade with dividend dates, and prefer longer dated options longer as in

som

e cases the share prices would have had t

ime to rebound post d

ividend

if the exp

iry had beenlonger out.

We also f ind through our trading that when an investment decision has been made and an effective

stop-loss in place it is not advisable to reverse the play on market reaction, as you do not g ive the

market time to turn in the direction you initially called.



Structure of Report

Introduction

Trading Rules and Limitations

Strategy

Options

Application Expected Results

Conclusion



IntroductionIn January 2011 the Hedge Fund Strategy group was created to formulate investment plans and

evaluate performance over a small window period of early 2011. Contained within this report is an

evaluation of three trading strategies, reasoning behind the f inal choice, and evaluation of expected

market performance.

In undertaking the task three strategies are discussed and evaluated; ADR Arbitrage and derivations,

Technical Indicator Trading and Market Timing. Within these strategies an evaluation of the model is

made alongside practical considerations giventhe limitations of the trading platform, outlined below.

The primary aim of the fund in these turbulent times is to preserve capital, and as such a smaller

prof it return is targetedbut a strong emphasis placed on preserving the initial investment.

Limitations of the Trading Platform

The trading platform through Stocktrak was used as the basis of evaluation which leads to signif icant

restrictions.

The only stocks with any degree of price series information are US stocks, and as the authors of

this report are based in the UK this provides an obstacle as the majority of prior market knowledge

is UK based.

There are limitations to the trades that can be executed; free access is not granted to foreign

exchange trades which excludes any currency hedging.

Very limited access to commodity markets is allowed through few futures contracts which l imits

the ability to tailor commodity holdings to specif ic requirements.

Observances of the platform also note that the bid ask spread on some securities and derivatives is

comparativelyhighwhich creates signif icantprof it erosion.

The platform also performed inconsistently; some trade requests were lost after submission and did

not make their way to the market, and there were various points at which the platform either refused

admission to the trading site or refused to accept a trade for reasons unknown.

LimitationsOutside of the Platform

Further to the platform limitations there have been other limitations felt over the evaluation period,

notably the time restraints in place as a direct result of the authors various other commitments

taking precedence over the period. Given the disadvantage this has on the effectiveness of anystrategy the models have been looked at in an ideal-world scenario to give an idea of the likely

returns should the appropriate time have been allowed for completion of the project.



ADR ArbitrageTraditional ADR Arbitrage takes advantage of opportunities created when US banks hold foreign

assets and issue American Depositary Receipts which are traded on US exchanges. These stocks are

essentially a claim on (a multiple of) the foreign stocks, and the ADR Arbitrage process requires the

ability to convert them back into the original foreign stocks.

From the point of view of an American Investor the process for an ADR Arbitrage is as follows

1. US Investor acquires ADR at the ask price (with USD)

2. ADR is converted into the underlying foreign stock

3. Foreign stock is sold in foreignmarket at the bid price (in foreign currency)

4. Foreign currency received is then converted into USD at the ask exchange rate

The impact of fees, taxes and spreads are present at each stage, along w ith issues relating to liquidity

issues and any restrictions. With regards the last two items, if we discount countries with highly

illiquid ADR markets then the volume of trade should provide suff icient illiquidity, and there should

not be any restrictions on trade, such as there being no two-way fungibility in the Indian ADR market

pre 2001 (Amary & Ottonio, 2005). This limitation to the more liquid markets discounts the choice of

ADRs with which to arbitrage. If we consider the average premium by country as in Table 1 then we

see the premiums present for the UK are small on average, but with the variance of premiums there

should still be some opportunity for prof it.

Table 1: ADR Premiums by Country

Number of ADRs Average Premium Std Dev Min Max

Japan 88 0.34 1.1 -3.05 3.03

United Kingdom 82 0.06 3.93 -29.86 10.95

Brazil 51 2.51 23.2 -8.59 164.28

Hong Kong 51 -1.32 3.85 -18.37 3.87

Australia 37 -0.36 4.92 -13.39 11.5

France 37 0.55 3.89 -11.9 17.57

Germany 29 -3.77 18.22 -98.34 1.54

Netherlands 28 -3.33 16.89 -89.42 0.9

Mexico 26 0.53 2.96 -4.97 9.72

South Africa 20 0.27 4.34 -5.7 11.15

Chile 18 -0.34 2.41 -9.48 1.63

Russia 18 -1.16 6.36 -20.56 14.89

Switzerland 14 0.07 0.36 -0.73 0.57

China 12 -0.18 1.26 -3.3 1.35

Ireland 12 -1.41 7.19 -8.9 16.84

Argentina 11 -7.83 27.34 -90.18 1.89

India 11 4.63 23.41 -62.56 20.62

Italy 11 -0.39 1.45 -4.54 0.77South Korea 11 1.7 4.52 -3.54 12.89

Israel 10 -0.46 1.64 -2.52 2.51

Other Countries 92 -1.13 -50.71 12.57



ADR ArbitrageDrawbacksof ADR Arbitrage

Using Brazil as an example Alves & Morey (2003) found that there are almost no arbitrage

opportunities for the individual investor, though there will be for institutions with lower transaction

costs, or f inancial institutions with no broker fees (if they operate as broker in both markets). Under

these conditions, and assuming only opportunities at the larger end of the premium spread are

considered, there should still be room to prof it from this activity.

PracticalConsiderations

ADR Arbitraging requires the ability to transform shares not present in Stocktrak, and absent is the

opportunity to convert the foreign currency back into USD at a transparent predetermined rate in

order to settle the trade fully. As such, whilst the strategy provides room to prof it under the right

conditions, a strategy involving direct ADR Arbitrage cannot be considered for this fund.

Though we are unable to transact the traditional ADR arbitrage, the possibility remains to extract

some value from the relative mispricing of ADRs and their underlying securities, which are explored inthe following section.



ADR Relative MispricingWe could employ a relative pricing strategy when we f ind ADRs with premiums over the foreign

underlying stocks and trade against each other. The process would be as follows (for an arbitrage

where US is undervaluedagainst the underlying UK stock):

1. UK security is sold in the UKmarket for GBP at the bid price

2. FX is sold for the amount of the UK sale and the GBP is converted into USD

3. U.S. investoracquires ADR at the ask price with USD

The prices are subsequently expected to align through either natural market movements or by other

participants exploiting the ADR arbitrage opportunity present. Either the ADR will increase in line

with the UK security or the value of the UK security will fall to that of the ADR. Under both conditions

the investor will makemoney as they will be able to settle the trade in the market on one side; selling

their ADRs for a prof it, before using the proceeds (after the reverse FX transaction) to buy the UK

stocks and settle the short position in the underlying stock. In the example of the UK this should

present no practical problems in terms of going short, though there will be some costs incurred in

borrowing the stocks (unless it is a naked hedge).

This trade should hedge out all market risk as the securities are expected to move together in line

with any shocks in the market, and the trade should only be act ive until the two align and the relativedifferential narrows. There is however evidence to suggest that the two do not always move in

tandem, and in instances where the underlying markets move separately the ADR moves with the US

market and not with the underlying security in some cases. In these cases the spread between the

two would actually widen, and the ADR premium increase contrary to the theory behind the trade.

Though this would not be expected to be a permanent change there have been periods of sustained

spreads between ADRs and the underlying assets in times of crisis, such as in Argentina in the 2001

period of social unrest (Amary & Ottonio, 2005).

If trades can be found with large premiums (either positive or negative) then this could provide a

good source of revenue in the short to medium term, though we recognise that in times of crisis, asthere are at present, the trade may take longer than usual to return a prof it as spreadsmay widen or

at least remain over the short term. Despite the risks these trades should generate returns with low

volatility.



Technical Indicator TradingPrevious work by the authors has explored the area of Technical Analysis, and creating a rules based

trading system based on technical indicators. A study was carried out using a large-cap high-volume

equity from the USmarket: Google, over the period of January 2008 to September 2010.

Four trading strategies were evaluated, optimized over a test period and then evaluated over a test

period. Of the four strategies three were simple one-factor models, and the f inal was a more

advanced two-factor model. Over the test period the models were optimized and three then

produceda prof it over the evaluationperiod, the results of which are summarized in Table 2.

Table 2: Technical Indicator Trading Rules

Despite the success of the trading rule system the inputs in terms of time were too steep to

contemplate on the scale needed for success within the conf ines of the trading period, with between

15 and 20 hours needed to perform the necessary steps to evaluate just the one equity. Furthermore

the intermittency of the trades meant that even if successful strategies could be evaluated over a test

period there is no guarantee the trading rules would trigger a clear trading s ignal over the trading

period in early 2011. Table 2 also highlights the issue faced in as such that if the incorrect trading

strategy is chosen the full investment may be lost under any technical indicator trading system. As

the primary concern of the fund is capital preservation Technical Indicator Trading is discounted as a

viable strategy.

Annualised Prof it Trade Eff iciency

Moving Average Crossover 210% 50%

+DI -DI Crossover 72% 50%

Relative Strength Index Closed Out 0%

ADX and DI Crossover 804% 100%



Market TimingMarket Timing is either the easiest or most diff icult strategy of the three depending on how it is

viewed. In essence the fund manager can trade entirely at their discretion, which requires an

understanding of the market and an appreciation of drivers and news-flows. Return volatility under

this strategy is expected to be very high, and as such steps are necessary to reduce potent ial losses

and provide some downside protection.

Instead of investing directly in the underlying assets with protection only afforded by the stop losses

in place derivatives are used to provide access to upside with f ixed downside protection. As a tradeoff for the benef it gained the option price is sacrif iced, as observed in Figure 1. Investments are

made at the discretion of the managers as and when opportunities present themselves.

Call Option Put Option

Figure 1: Payoff from Call and Put Options

Stop Loss

A stop loss is inbuilt to the trade in the form of the option price itself, however a more sophisticated

moving stop loss is desired. To this end a system is put in place where the option stop loss will be

moved to breakevenwhen the option value doubles, as shown in Figure 2.

Payoff When Option Value < x2 Payoff When Option Value Doubles

Figure 2: Option Payoff with Moving Stop Loss



Investing StrategyAfter consideration of several options a multi-strategy method is employed utilising ADR mispricing

and market timing. Where possible ADR arbitrage opportunities are observed a trade will be

executed to take advantage of the expected realignment. In addition to this trades will be executed in

a discretionary fashion based on market news.

So as to preserve capital a maximum value is prescribed for each type of trade; for ADR mispricing,

due to the hedged nature of the trades a limit of 10% of the original capital can be traded, meaning

each trade can be $200000 when leverage is taken into account. For the options trades, as themaximum loss is equal to the initial outlay the maximum trade allowed is 3% of the initial capital, or

$30000 per trade.

Alternative Strategies Not Pursued

Other strategies which were considered but not chosen due to insuff icient knowledge of the market

are as follows:

Aggressive Growth

Distressed Securities

Emerging Markets

Fund of Funds

Income Generating

Macro

Market Neutral Arbitrage

Market Neutral Securities HedgingOpportunistic

Short Selling

Special Situations

Value Deep Discount etc.

(Magnum Funds, 2011)



ADR Mispricing TradingDuring the course of the trading period several trading opportunities were identif ied, primarily within

the f inancial sector where UK Banks showed signif icantly different underlying local security values

than the ADR counterparts. At this point the trade was investigated and if signif icant prof it

opportunity found the trade would be executed.

In practice no opportunities were found over the trading period due to a combination of factors;

1) Non-transparencyof foreign exchange rates

2) LargeBid-Ask spreads

The expected prof it from each trade can be shown as in Figure 3, where the original mispricing is

shown as the difference between market values of the underlying price and the ADR price (when

converted into a common currency).

Figure 3: ADR Mispricing prof it opportunity

The value in the trade is eroded however by the spreads on the securities; in each of the nine

opportunities identif ied the Bid spread on the stock being sold (UK or US depending on the direction

of the premium) plus the Ask spread on the stock be ing bought eroded over half of the premium

found. On top of this, though the trading fees are low ($25) the combination of fees contribute in

part to an erosion of prof it. Given that in every mispricing found over half the premium is eroded in

the f irst round of trading then, even if the prices aligned perfectly, when a similar bid-ask spread is

taken into account for the second round of trading to settle the initial trades all opportunity for prof it

is eroded fully.

On top of this the exchange rate is not always clear in the Stocktrak system, so it is not guaranteed

the trade would yield the correct amount of one currency or another, as the FX trade is not processed

by themanager, but completed automatically by the system.

On the next page we take a closer look at one of the poss ible trades highlighted in which there were

potential prof it opportunities identif ied.



Barclays ADR MispricingThe share price movement of Barclays is shown in Figure 4, where both the UK listed stock

(LON:BARC) and the US ADR (NYSE:BCS) are shown. The Implied Market Cap is calculated as the share

prices are not direct 1:1 and so would move in tandem but not on the same scale]. So as to present a

clear picture the Close price of the UK stock is listed, alongside the open price of the ADR, so the

timeframe looked at is consistent. The average exchange rate over the day is applied to transform the

prices. As observed there are three opportunities highlighted (as we chose a minimum premium

differential of 2.5%) on the 10th Feb and the 10th and 16th March. Unfortunately the combined bid-ask

spreads (bid on short and ask on purchase) represented 52%, 55% and 64% of the premium in each

case, and as such the trades were not executed as it was almost certain that the second round of

spreads would have eroded all of the prof it gained.

In looking at the range of premiums a viable trade would have been to buy in on the 10th Feb and sell

out on the 10th March, which would have resulted in a margin on the trade of 2.6% after fees. This

trade is hand-picked from the premiums with the benef it of hindsight though, and not foreseen

during the actual trading time. If steps could be taken to reduce spreads (poss ibly by utilising a better

platform) then the ADR mispricing trades could have been executed. Of the three trades identif ied

for Barclays a halving of spreadwould have led to prof itable trades in all three cases.

Figure 4: Barclays Share Price Movements, and ADR Premiums

50

55

60

65

70

27 Jan 10 Feb 24 Feb 10 Mar 24 Mar 07 Apr I m p l i e d M a r k e t C a p ( $ b n ) Barclays (BCS v BARC)

ADR OPEN UK CLOSE

-3.00%

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%

27 Jan 10 Feb 24 Feb 10 Mar 24 Mar 07 Apr

%

D i f f e r e n t i a l ( A D R P r e m i u m ) Barclays (BCS v BARC)

ADR Premium



Market TimingThe decision was made early on to trade in US stocks for twomain reasons;

1) Price history and graphing was available only for the US stocks

2) There was little transparency in the FX rates used on the s ite, and the account was administered

in dollars

This restriction is particularly costly, as the managers of the fund are both more conversant with the

UKmarket that the US, and so a deal of market knowledge was discounted.

Civil Unrest

Over the start of the trading period there were fairly benign sideways market conditions, but as the

unrest in Tunisia spread across the Arab states the conditions became more volatile. Without in

depth macro knowledge the managers decided not to invest in companies affected directly by the

unrest, and due to reasons explained further on the decision was made not to invest directly in oil.

This decision turned out to be quite costly; oil prices were approximately $100 per barrel (for Brent

Crude) and by the end of the trading period had risen to approximately $120. If the investment had

been made at the f irst signs of unrest in Tunisia we could have locked in gains of 20% over the two

month period, an annualised gain of nearly 200% when compounded. Despite the signs indicatingtrading we were unwilling to enter into the tradedue to three reasons:

1) There were no options available on oil contracts, which was decided upon as the desired

investment strategy due to the downside protection

2) This downside protection was especially important due to the volatility of oil prices over the

medium term; oil lost 70% of its value in the crisis of 2008 and we were valuing capital

preservation highly

3) News suggested demand was being fuelled by speculators not economic demand, and as the

world economy was in a contracting, or at least only slowly-growing phase then we were unsure

how long the demand would persist for before possibly declining sharply

The volatility expected in oil related companies was due in part to the uncertainty over oil prices and

in part the unknown effect the unrest would have on world equitymarkets.

Trades Executed

Barclays

Throughout February Barclays ADR was trading consistently under the underlying (see Figure 4) and

the f inanc

ial accounts were due to be announced. On the 16

th

February, with results due on the daythe managers felt the results would beat market expectations, and as such bought Barclays short

dated call options expiring March, at strikes of 21 and 22, which were the options immediately

surrounding the share price. In the short term the share price didmove upwards, and the options



Market Timinggained in value by one third. Themanagers failed to foresee that the shares at that po int were not

ex-div, as had been thought, but in fact two days after holding the options the ex-div date passed.

Due to this the value of the options fell sharply, and as the options did not reach double their initial

value (3% of the portfolio - $30k) the stop loss was not moved from the basic option price and the

options continuedto fall in value until the expiry date in March.

Lessons learned

Conf irmand reconf irm ex-div dates before entering trades

Theta is felt more in short-dated options. The value of the portfolio would not have been impacted

by the full $30k if the options had been longer dated as the share pr ice would have had time to

reboundpost dividend if the expiry had been longer out.

Google

On the same day; 16th February a mispricing was noticed in far out of the money Google options. The

February 2012 call options were higher priced at a strike of 700 than 670 (and the share price at the

time was around 620). The managers decided to trade on this anomaly as it was expected to correctand reverse; that is the price of nearer to the money options should cost more. As such a trade was

constructed whereby the 700 were sold short in themarket and the 670 bought with the proceeds, so

the only cost was the initial fee and the stock borrowing costs. The bid-ask spread on the two

cancelled out most of the potential gain if we expected the options to equalise, but as we thought the

prices would reverse relative to each other there would still be suff icient room for prof it. Market

orders were placed during London trading hours, to be f illed at the start of the US market.

Due to the illiquidity of the market for the 670 options that side of the trade could not be f illed at US

trade start. The trade was sent in good faith and it was not realised until early on the 19th Feb, when

the short position was coveredand closed out.

Lessons learned

Acceptance of trade does not constitute a guarantee the trade will go through it is not safe to

assume so

Markets,and especially open positions need to be checked on a regular basis

Apple

Whilst researching the release of the upcoming iPhone and iPad 2 (which has since been released) inlate February the managers noted concerns there would be delays in the launch date over those

already expected, which had not hit the major news outlets. As such apple puts were bought in



Market Timingexpectation of a fall in Apple share prices when the news hit the market. Added to this was the

recent poor performance in the stock price, having fallen from 365 to 340 in roughly a week.

Despite beating the news to the market the share prices rallied over the next week or so, picking up

most of the losses they had shed, back up to 360 on 3rd March. At this point the managers took the

view that the market had reversed and Apple would cont inue to trend upwards. The put positions

were closed out at a loss of approximately 35%, and opposing call positions bought. The market

reversed again and fell to 330, further than when the original put options bought. If the original

options had been reta

ined th

is pos

ition would have shown a prof

it over the trad

ing per

iod.

Lessons learned

It is good to have the willpower to close a losing position and reverse it if the market is heading in

a different way, but that doesnt always mean you wont just make a bad decision the second time,

andsticking with your originalfeelingmay be the best bet.

HSBC

The managers took a directional bet on HSBC shares, learning from previous issues with very shortoption periods, and bought June expiry calls at a strike of 60, when the shares were at 56.

Unfortunately the share price subsequently fell to 50 in March before rallying back to 54 in April.

These options were the only open positions left at the end of the trading period and lost 80% of their

value by the end of the trading period.

Trading Performance

Over the trading period the S&P gained 0.5% and the portfolio lost 7.31%. Though the managers

managed to p

ick the wrong s

ideinm

ost trades the downside was l

imited to the opt

ion values and assuch losses were limited. If large positions were taken in the underlying stocks the losses could have

beeneven greater.

If the managers had more time to devote to the active trading without other commitments, which

posed the greatest barrier to prof it of any of the restrictions, then we have no doubt the errors would

have been spotted and rectif ied prior to causing any problems. If the trading period was extended we

feel the loss could have been reversed and the 7.3% loss would not be indicative of annual

performance.



Improvements to StrategyWhatwe would do differently if faced with the same task again?

Try to apportion more time to the project; as other deadlines are now complete a repeat project

would leaveus withmore time to devote to this project

Utilise different platforms as Stocktrak does not offer the full functionality desired. If needing real

time information, and the option to perform quick technical analysis on securities from all

countries then utilising Bloomberg alongside the trading platformwould be ideal

Conf irm all details before entering into a trade, specif ically from the mistakes made the dividenddates, but any other details. Also conf irm a trade has been executed as in low volume markets

sometimes trades are accepted as a market order but there is nomarket to be counterparty for the

trade. This can leavehedging strategies un-hedged.

Respect the Greeks when option trading take into account the likely movement of share price

over the short term if trading very short options, if the term is too small then there is signif icant

erosion of value caused by Theta; the effect of time on option value

Once an investment decision has been made and an effective stop-loss in place it is not advisable

to reverse the play on market reaction as you do not give the market time to turn in the direction

you initially called

How would we get around any issues faced?

Use a computerised system to keep track of ADR mispricing over all available ADRs, possibly

expandto GDRs too, which would highlight opportunities to utilise the desired strategymore often

Seek to f ind a broker with lower bid-ask spreads as this is the primary eroder of value we faced,

and with different prices we could have entered intomore prof itable trades

Automate Technical Analysis for stocks under managers rules, possibly invest in a programme like

Metastock or an Excel based tool which can f

ilter share pr

ices for those

meet

ing spec

if icpredef ined investment criteria

Do we need better strategies?

The strategies we looked to employ were sound; if we could eliminate some of the bid-ask spread

and widen the rangeof ADRs we look at there is signif icantpotential for prof it on the trades

Market-timing should only be done when you know a lot more about the market that the common

investor, and unfortunately with the time constraints in place we were unable to get a s ignif icant

edgei

n them

arket.I

f we were to repeat the task we would look to speci

ali

sei

n one or two areasand devote a great deal of time to investigating and understanding the market more fully before

entering into any trades



ConclusionThe fund performed poorly over the trading period, losing 7.31%, which is an annualised loss of

approximately 37% (as with reduction in capital the 3% rules get progressively smaller) and

underperformedthemodest 0.5% gain in the S&P500 signif icantly.

We feel, however that the full year results would not fall into loss as we would take the steps outlined

to improve the eff iciency of the trading, and being able to devotemore time to the task, in terms of

technical analysis for example, would improve the performance and turn a prof it. As the ultimate aim

is capital preservation, we would target a modest 10% gain over the year under these strategies, and

would look to increasingly orient our trading on an ADR mispricing strategy rather than market timing,

the latter producing volatile results.

This exerc

ise has

made clear the need for full knowledge about a

market before trad

ingin relat

ion toevents, as the news is likely to already be encompassed in the price giveneff icientmarkets.

alternative investment management

Documents