A page number followed by f refers to a figure and a page number followed by t indicates a table.
3Com/Palm carve-out, 310, 310f
13D filing, 107
60/40 portfolio, 167, 169–70, 211
144a securities, 270
absolute return benchmark, 21
accounting practices: dedicated short bias managers and, 115; quality of reported earnings and, 101–2
accredited investors, 20
accruals, 101
acquisitions. See mergers and acquisitions
active investment: basic concept of, vii; limited need for, 20, 20n; long history of, 20; producing market efficiency, 3; transaction costs of, 63–64; types of investors involved in, 19. See also hedge funds
active investment strategies. See hedge fund strategies
active risk, 22
activist investing, 102, 106–7; distressed firms and, 291, 311
Adam Harding and Lueck (AHL), 225
administrator of hedge fund, 26
aggregate demand, 193f, 194; shocks to, 195–96, 195f, 195t
aggregate supply, 192–93, 193f; shocks to, 195–96, 195t
AIG, 78
Ainslie, Lee S., III, viii, 1, 11, 15t, 16; interview with, 108–14; resizing positions and, 55
alpha, 27–29; in convertible bond arbitrage, 281–82; risk-adjusted, 30; in three-factor regression model, 29
alpha-to-margin (AM) ratio, 31
Amaranth, 24
American depositary receipts (ADRs), 151, 152f
Apple Computer, 314
AQR Capital Management, xi–xii, xiii, 158
arbitrage: defined, 233; as disproof of frictionless efficient markets, 3n2; general framework for, 234–35; Law of One Price and, 6, 7t; limits of, 41–42; option pricing and, 235–40; overview of strategies for, 8, 13–14. See also capital structure
arbitrage; convertible bond arbitrage; fixed-income arbitrage; merger arbitrage; relative-value trades; statistical arbitrage
Arthur Andersen, and Enron failure, 124
ask price, 63. See also bid–ask spreads
Asness, Cliff, viii, 1, 1n, 14–15, 15t, 16; on good quant investment managers, 133; interview with, 158–64; on nature of hedge funds, 19; portfolio optimization and, 56, 133
asset allocation: Harding on, 229; introduction to, 167–68; by large institutional investors, 168–69; strategic, 167, 168–72, 211; tactical, 167, 175–76, 185 (see also market timing). See also portfolio construction
assets under management (AUM), 74–75
AT&T, 319
auditors, 26
BAB. See betting against beta (BAB)
backfill bias, 23
backtests of strategies, 2, 38, 47–50; adjusting for trading costs, 50, 69; Asness on, 163; biases affecting, 48–50; in fixed-income arbitrage, 252; for market timing, 174–75, 174t; out-of-sample performance in, 175; procedure for, 47–48; in quantitative equity investing, 133, 134t, 135
balance sheet of hedge fund, 74–76, 76f
Balassa–Samuelson effect, 197n
Baldwin United, 127
banking system, Soros on evolution of, 205
bank loans or credit lines, as leverage, 76
Bank of England, Soros’s famous trade involving, viii, 1, 187, 204, 320
bankruptcy investing, 291, 311–12, 314; Paulson on, 319–20
bank stocks, concerns about short-selling of, 123–24
bargain-hunting investors, 99, 103–4, 103f
Baruch, Bernard, 123
basis points (bps), 70
basis trades, 264
bear or bull markets, time series momentum strategies in, 209, 220–21, 220f
Bear Stearns: failure of, 24, 78; risk arbitrage at, 313, 314
beating the market, 3–4, 5, 19, 21, 22. See also alpha
behavioral biases: Asness on successful strategies and, 164; demand pressures created by, 46; overcome by quantitative modeling, 133; pushing prices away from fundamentals, 3, 41; systematic portfolio construction and, 57; trend-following strategies and, 209. See also overreaction/underreaction
benchmark, 21; information ratio and, 30
benchmark portfolio, 167, 168. See also strategic asset allocation
Berkshire Hathaway, 104–6, 160. See also Buffett, Warren
Bernanke, Ben, 191
beta, 27–29; benchmark and, 30; capital asset pricing model and, 140–41, 140f. See also betting against beta (BAB); market exposure (beta risk)
betting against beta (BAB), ix, 16, 140–44, 142f, 143f
bid–ask spreads: defined, 63; effective cost and, 68; market makers’ profits due to, 154; optimal trading and, 64, 65, 67
bid price, 63
binomial option pricing, 236–38, 237f, 237n; in convertible bond valuation, 272
BlackBerry, 115
Black–Scholes–Merton formula, 7t, 238–40; convertible bond valuation using, 272; foreshadowed by Thorp and Kassouf, 270; Griffin on his early use of, 288; Nobel Prize for, 262; Scholes’s interest in fixed-income arbitrage and, 263
Blackstone Group, 320
Boesky, Ivan, 233
bond carry, defined, 255
bond carry trades, 16, 187, 188t, 255–56, 257
bond futures, 241, 262; for government
bonds, 209; hedging interest-rate risk with, 283; Scholes on, 264–65; in time series momentum strategy, 213, 214–17f, 220
bond returns, 179–80, 179n, 243–44, 245f; carry and, 255–56, 256f; convexity and, 246–47; on leveraged bond, 246, 248, 249, 249n. See also bond yields
bonds: central bank actions and, 190; economic environment and, 191–92, 191t; leveraged, 241, 244–46, 248–49, 249n; on-the-run versus off-the-run, 241, 257, 258f, 259; prices of, 242, 243, 244, 246; specialness of, 245–46, 245f; strategic asset allocation and, 168. See also convertible bonds; corporate bonds; fixed-income arbitrage; government bonds
bond value trade, global, 197, 198, 198f
bond yields, 179–80, 242–43, 243f; determinants of, 248–49; earnings yield compared to, 179; on leveraged bonds, 244–46, 245f, 248; real, 197. See also bond returns; yield curve
bonuses, performance-based, 21
book-to-market ratio (B/M), 29, 136, 137
boom/bust cycles: Soros on, 15, 15t, 200–204, 202f, 205–6, 207. See also bubbles
break-even inflation trading, 262
break-even rates (forward rates), 247–48; bond carry as, 255n6
breakout, 48
broker/dealers, 25
bubbles: greater fool theory and, 107, 120; mitigated by short-selling, 121; Paulson on subprime mortgage securities and, 321; riding rather than trading against, 41–42, 107; Soros and, 15, 41, 201–4, 202f, 205–6, 207. See also conglomerate boom of late 1960s; Internet bubble of late 1990s; subprime credit crisis
Buffett, Warren: on arbitrage, 233; on diversification in arbitrage, 292; on holding periods, 105–6, 111; on intrinsic value, 87, 88, 89, 90; leverage used by, 105; leveraging safer securities, 6, 141; on merger arbitrage, 298–300, 304; Sharpe ratio achieved by, 104–5, 160; as value and quality investor, 9, 99, 104–5
busted convertible bonds, 282–83, 282f, 284, 285f
butterfly trades, 241, 251–55, 252f, 253f, 254f
buy in, 118
callable convertible bonds, 269, 272
call options: convertible bonds and, 13, 269, 272; defined, 235; Merton’s Rule and, 6, 7t. See also options
call protection, 269
capacity: of hedge fund, 72, 73f; of trading strategy, 72, 73f
CAPE (cyclically adjusted price earnings) ratio, 179
capital: aggregate supply and, 192–93; supply shocks arising from changes in, 196
capital asset pricing model (CAPM): liquidity-adjusted, 43–44; margin requirement and, 45; market portfolio and, 169; merger arbitrage and, 306; predicting alpha equal to zero, 28, 29; required rate of return and, 90; security market line and, 140–41, 140f; statement of, 6, 7t, 140
capital flows, 199
capital structure: in efficiently inefficient markets, 7t; in neoclassical finance, 7t; Scholes on fixed-income arbitrage and, 268
capital structure arbitrage, 14, 261, 291, 312
capital structure changes, arbitrage related to, 291, 312
carry, defined, 187
carry-trade unwinds, 186
carry trading, ix, 16, 185–88; of bonds, 16, 187, 188t, 255–56, 257; of currencies, 12, 16, 185–87, 186f, 188t; exposure of macro traders to, 12; performance across global markets, 188, 188t
carve-outs, 291, 307–8, 308f; trading on, 308–11, 310t, 310f
catalysts, 106–7; Asness on, 162; starting a trend, 210, 210f
CDSs. See credit default swaps (CDSs)
Centerbridge Partners, 320
central banks: bond yields and, 248–49; carry trades and, 186–87; economic environment and, 191–92; Federal Reserve, 189–91, 205, 206; general collateral repo rate and, 245; macro traders’ monitoring of, 189–91, 250; trend-following strategies and, 209, 211. See also exchange rates; interest rates; monetary policy; Taylor rule
CFTC (Commodities and Futures Trading Commission), 156–57
Chanos, James, viii, 1, 15t, 16; on Enron, 124–27, 128, 129; interview with, 127–32; on Murphy’s Law, 115; position limits of, 55
China: Harding’s agnostic view of, 229; trading themes involving, 12, 200
clean surplus accounting relation, 92, 178
Clear Wireless, 319
closed-end funds: event opportunities related to, 313; statistical arbitrage involving, 153
Cohen, Abby, 160
collar stock deals, 293, 301–3, 302f
collateral: as cash provided by short seller, 116, 118; in efficiently inefficient markets, 7t; in financing by prime brokers or repo lenders, 26, 76, 80; on hedge fund balance sheet, 76. See also margin requirements
Commodities and Futures Trading Commission (CFTC), 156–57
commodity carry trade, 187–88, 188t
commodity futures: carry of, 16, 187–88; in time series momentum strategies, 209, 213, 214, 214–17f, 218t
commodity markets: demand pressures in, 46; stagflation and, 192
commodity trading advisors (CTAs), 208; Adam Harding and Lueck as, 225; diversification from investing with, 228; fees of, 223; tail hedging and, 228; trading rules of, 48. See also managed futures investing
commodity value trade, 197–98, 198f
computer models. See quantitative equity investing
confirmation bias, 212
conglomerate boom of late 1960s, 201–2, 203
constant rebalanced asset allocation, 169–70. See also rebalancing of portfolio
contrarian trading strategies: providing liquidity to demand pressure, 45–46; value investing as, 9
convergence time, natural, 235
convergence trades, 13. See also fixed-income arbitrage
conversion price, 269
convertible bond arbitrage, viii, 13–14, 233; Griffin on, 286–90; hedge ratio in, 275, 275f, 283; life of a trade in, 270–72, 271f; liquidity crises and, 283–85, 284f, 285f, 286f; profits and losses in, 277–82, 278f, 279t, 280f, 281f
convertible bonds: basic features of, 13–14, 269–70; hedgeable and unhedgeable risks for portfolio of, 283–86; hedging of, 270, 275, 275f; leveraged with prime brokers, 80, 284, 284f; liquidity discount of, 281–82, 281f; liquidity risk of, 14, 43, 270, 271, 281, 283–85; Merton’s Rule and, 6, 7t; types of, 282–83, 282f; valuation of, 13–14, 272–73, 273f, 274f; when to convert, 275–76, 276n. See also convertible bond arbitrage
convexity trading, 247, 277, 279; in mortgage markets, 265–66; Scholes on, 263, 264, 265–66; takeovers and, 285
corporate bonds: arbitrage trades involving, 260–61 (see also capital structure arbitrage); bankruptcy and, 319; with embedded options, 180n; hedging interest-rate risk with, 283; loss rate in case of default on, 260, 260n; market for, 241; in overheated economy, 191; returns on, 179–81; strategic asset allocation and, 168. See also bonds; convertible bonds
corporate events: risk to convertible bonds from, 283. See also event-driven investment
corporate hedging activity, in line with trends, 212
correlations across assets: liquidity spirals and, 82; in portfolio construction, 55, 57; portfolio volatility and, 58
costs of implementing a strategy, 63–64. See also funding costs; transaction costs
coupons: bond prices and, 242; bond returns and, 180, 243; of convertible bonds, 269, 270, 271, 277, 283, 287, 288; inflation and, 179; reinvestment of, 179n
crash risk, 31–32; implied volatility and, 239; liquidity spiral and, 82; volatility and, 58
credit carry trades, 188
credit default swap index, 283
credit default swaps (CDSs), 241; capital structure arbitrage with, 312; credit return and, 180; fixed income arbitrage involving, 13, 260–61; to hedge convertible bond default risk, 283; in overheated economy, 191
credit risk, 260; of convertible bonds, 283; of credit carry strategy, 188; in event-driven investment, 292; Scholes on, 264
credit spread, 180–81, 260; of distressed firms, 311; in overheated economy, 191
crises. See global financial crisis of 2007–2009; liquidity crises
cross-margining, 80
cross-sectional regression, and security selection, 51, 52–53
CTAs. See commodity trading advisors (CTAs)
currency carry trades, 11–12, 16, 185–87, 186f, 188t
currency crisis, of 1992 in U.K., 187, 204
currency forwards: macro traders using, 187; in time series momentum strategies, 209, 212–13, 214, 214–17f, 218t
currency markets: arbitrage opportunities in, 6; central bank activities in, 190, 211; Soros on fixed currency system and, 206–7; Soros on reflexivity in, 203. See also foreign exchange markets
currency value trade, 197, 198, 198f
curve trades, Scholes on, 264–65
cyclically adjusted price earnings (CAPE) ratio, 179
databases listing hedge funds, 23
data mining biases, 49
data vendors, 26
DD. See drawdown (DD)
deal risk, 233; in merger arbitrage, 294–96, 304–5, 308
deal spread in merger arbitrage, 294–96, 297, 300, 304; for failed deals versus successful deals, 297–98, 298f; Paulson on, 316
dedicated short bias hedge funds, viii, 9–10, 87–88, 115–24; basic focus of, 115–16; controversy about benefits of, 122–24; difficulties of, 117–18; how short-selling works for, 116–17; overvaluation of companies and, 119–21. See also Chanos, James; Enron; short-selling
defensive equity investing, 16
delta. See hedge ratio (delta, Δ)
demand pressure: bond yields and, 252; derivative prices and, 7t; need to identify source of, 266; option prices and, 46, 240; providing liquidity to, 45–46
demand shift, as catalyst of trend, 210
demand shocks, 5, 194–96, 195f, 195t
derivatives: binomial model for value of, 236–38, 237f, 237n; Black–Scholes–Merton formula for value of, 7t, 238–40, 262, 263, 270, 272, 288; defined, 235; in efficiently inefficient markets, 7t; exchange-traded, 80; key markets for, 241; leverage achieved with, 74, 76, 80; in neoclassical finance, 7t; over-the-counter (OTC), 80; prime brokerage of, 80; volatility trades with, 262. See also futures; options; subprime credit crisis; swaps
derivatives clearing merchants, 26
directional volatility trades, 262
discounted cash flow model. See dividend
discount model discount rate, 89–90, 100, 102
discretionary equity investing, viii, 9, 10, 11, 87–88, 95–108; Asness on quantitative investing versus, 162–63. See also Ainslie, Lee S., III; dedicated short bias hedge funds; fundamental analysis; quality investing; value investing
discretionary macro hedge funds, 185
Dish Network, 318
disposition effect, 106
distressed convertible bonds, 282f, 283
distressed investments, 14, 291, 311–12; Paulson on, 319–20
diversification: beta risk and, 28; of carry trades, 188, 188t; of convertible bond portfolio, 283; CTA investments as source of, 228; in event-driven investment, 292; as form of risk management, 59; hedge funds as source of, 26; by market neutral hedge fund, 21, 28; in merger arbitrage, 295, 303–4, 306, 317–18; portfolio optimization and, 55, 57; in quantitative equity investing, 133, 134, 144, 162; of time series momentum strategy, 209
dividend discount model, 89–92; fundamental analysis using, 97; margin of safety and, 98; quality and, 100; residual income model derived from, 92
dividend growth, 176, 177, 178
dividends: book value and, 92; early conversion of bond and, 276; in merger arbitrage, 296; recapitalization and, 314; on short equity position in convertible bond arbitrage, 277. See also dividend discount model
dividend yield, 176–77, 176n; as carry of an equity, 188; historical average, 178; market timing based on, 172–75, 174f, 174t
DJCS Managed Futures Index, 221, 222t
Donchian, Richard, 208
downside risk, 32
drawdown control, 54, 59, 60–62; by managed futures managers, 225
Drexel Burnham Lambert, 129
Druckenmiller, Stanley, 11
dual-listed stocks, 149–50, 149f, 151, 152f, 235
duration, 244; modified, 180, 181, 244, 246, 251, 253, 254, 255
Dutch disease, 199
dynamic hedging strategy, 234, 235, 237–38, 240
earnings, as net income, 92, 178–79
earnings manipulation, 121
earnings restatements, 121
economic capital, 32
economic environments, 191–92, 191t; shocks leading to, 195t, 196
efficiency of markets: enhanced by hedge funds, 26; enhanced by short-selling, 123; enhanced by value investors, 89; Scholes on fixed-income arbitrage and, 263
efficiently inefficient markets: arbitrage in, 151, 233, 235, 241; for convertible bonds, 271; defined, vii; dynamics of, 3–6; equity markets as, 88–89; information in, 40–41; limited amount of profit for active investment in, 20; liquidity risk in, 42; merger arbitrage and, 295; for money management, 3n3; versus neoclassical finance and economics, 6, 7t; option prices in, 240; price discrepancies between bonds in, 241; Scholes on, 265; short-selling and, 119
efficient market hypothesis, vii, 3; Harding on, 227, 228; liquidity spiral theory versus, xiii; paradox of, 3n3; Soros on, 201, 203; tests of, 3, 3n2
“Egyptian” collar deal, 302, 302f
Einhorn, David, 122
embedded options: convertible bonds with, 281; corporate bonds with, 180n; Scholes on, 263
emerging markets: bonds in, 262; global macro traders and, 12; Soros on, 205, 207
e-mini S&P 500 futures, and flash crash of 2010, 155–57, 156f
enter–exit trading rule, 48
equalization agreement, 149
equity capital in a hedge fund, 74–75, 76f; daily change in, 78
equity index futures: e-mini S&P 500 futures, 155–57, 156f; in time series momentum strategies, 209, 213, 214, 214–17f, 218t
equity market neutral investing. See fundamental quantitative investing
equity returns, 176–79; historical, 178, 179
equity risk premium, 42, 89, 177–78, 178n5; short-selling against headwind of, 10, 124; strategic asset allocation and, 168
equity strategies, 8, 9–11, 87–88. See also dedicated short bias; discretionary equity investing; quantitative equity investing; value investing
equity valuation, 89–94; Ainslie on, 109, 110. See also intrinsic value
ES (expected shortfall), 59
ETFs. See exchange traded funds (ETFs)
European Central Bank, 190
European options, 235, 236, 239–40. See also options
event-driven investment, viii, 2, 13, 14, 233; classes of, 291–92; demand pressure and, 46; portfolio construction in, 292. See also capital structure arbitrage; capital structure changes; merger arbitrage; Paulson, John A.
exchange rates: global trade and, 199; pegged, 190; Soros on, 203, 206–7; volatility of, 190, 211. See also central banks
exchange-traded derivatives, 80
exchange traded funds (ETFs), 28; event opportunities related to, 313
expectations hypothesis, 249, 256
expected excess return, 29
expected returns. See performance measures
expected shortfall (ES), 59
factor investing, 14–16; Asness on, 163. See also investment styles; momentum investing; value investing
Fama–French three-factor model, 29, 159; HML factor in, 29, 137, 137n
Fama–MacBeth method, 52
far-from-equilibrium conditions, 15t, 203–4, 206, 207
FDI (foreign direct investment), 196
Federal Open Market Committee (FOMC), 191
Federal Reserve, 189–91; Soros on, 205, 206
Fed model, 179
feedback: in liquidity spiral, 81; Scholes on fixed-income arbitrage and, 15t, 16, 264, 266, 267; Soros on, 201, 203
feedback trading, extending a trend, 211–12
fees of hedge funds, 21–22, 38; managed futures, 223
financial crises. See global financial crisis of 2007–2009; liquidity crises
financing for hedge funds. See “funding” entries; leverage
fire sale: avoiding redemptions and, 75; in fixed-income arbitrage, 241; funding liquidity risk and, 63; liquidity spiral and, 82, 83f
First Executive, 129
fixed exchange ratio stock deal, 293, 300, 301f, 303
fixed-income arbitrage, viii, 13, 233, 241–42; basic concepts of, 241; fundamental bond concepts underlying, 242–48; leverage in, 241, 244–46, 248–49, 249n; liquidity risk premiums earned by, 44; with on-the-run versus off-the-run Treasuries, 13, 257, 258f, 259; Scholes on, 15t, 16, 263–68; trading on dimensions of the term structure, 250–55; typical trades in, 13, 241 (see also specific trades)
fixed-income futures, in time series momentum strategies, 214, 214–17f, 218t
fixed-income markets, 241; central bank activities in, 211; low-risk investing in, 16. See also bonds; derivatives
flash crash of 2010, 155–57, 156f
floating exchange ratio stock deal, 293, 301, 302f, 303
FOMC (Federal Open Market Committee), 191
foreign direct investment (FDI), 196
foreign exchange markets: central bank intervention in, 190; forward contracts in, 187. See also currency markets
forward-interest-rate markets, 190
forward rates, 247–48; bond carry as, 255n6
forwards. See currency forwards
fraud: of Baldwin United, 127; by companies hostile to short-selling, 123; Enron and, 129; investigating possibility of, 115; spreading false stories about a company as, 132; uncovered by short sellers, 132. See also insider trading
French, Kenneth: Asness as student of, 158, 159. See also Fama–French three-factor model
frictions: in arbitrage trading, 235; carry trading and, ix; demand pressures created by, 46; early conversion of bond and, 276; funding frictions, 7t; market frictions, 5; short sales and, 119–21; supply shocks arising from, 196; trend-following strategies and, 209, 211
front-running, 107
fundamental analysis, 41, 88, 97–98; Ainslie’s orientation toward, 110, 111; dedicated short bias managers using, 115; fundamental quant and, 134
fundamental quantitative investing, 11, 134, 134t, 135–49; Ainslie on incorporation of approaches from, 110; betting against beta (BAB) in, ix, 16, 140–44, 142f, 143f; factors considered in, 135–36; momentum investing in, 138–39, 138f, 144, 146, 148, 149; portfolio construction in, 144–45; quality investing in, 139–40; quant event of 2007 and, 144, 145–49; value investing in, 136–38, 137f, 144, 145–46, 146f, 147–48
fundamental risk: in arbitrage, 41; in value investing, 89
fundamentals, Soros on, 201
fundamental value, 89; from arbitrage pricing, 234, 235; Harding on, 228. See also intrinsic value
funding liquidity risk, 45, 63, 80–81; of convertible bonds, 281, 283; to short seller, 118. See also liquidity risk
funding of a portfolio, 74, 77–79. See also leverage
funds of funds, and quant event of 2007, 145
futures: demand pressures associated with expiration of, 46; interest rate futures, 190; leverage through, 80; market exposure of, 28; mortgage-backed securities and, 261; statistical arbitrage involving, 153; in time series momentum strategies, 213, 214, 214–17f, 218t. See also bond futures; commodity futures; equity index futures; managed futures investing
futures commission merchants (FCMs), 26, 80, 225
gain-on-sale accounting, 124–25
GARP (growth at a reasonable price) investing, 104
gates, 75
GDP (gross domestic product), 192–93; output gap and, 189
general collateral (GC) repo rate, 245, 245f
GlaxoSmithKline, 290
global bond value trade, 197, 198, 198f
global equity index value trade, 197, 198, 198f
global financial crisis of 2007–2009: banned short-selling of financial stocks during, 117; as challenge to neoclassical economics, 6; convertible bond markets in, 284; falling bond yields in, 192; on-the-run/off-the-run spread during, 257, 258f; Soros on, 203, 204, 205; spreading from subprime market to other markets, 83, 84f; yield curve during, 257, 258f. See also subprime credit crisis
global macro investing, viii, 11–12, 184–85; carry trades in, 185–88, 188t (see also bond carry trades; currency carry trades); central bank monitoring in, 189–91, 250; economic developments affecting, 191–96, 191t, 195f, 195t; key trades of, 196–200, 198f; Paulson’s “greatest trade ever” classified as, 292; Scholes on futures contracts and, 264–65; Scholes on segmented views of yield curve and, 263; thematic, 200. See also Soros, George
global tactical asset allocation (GTAA), 176, 185
global trade flows, 199
global warming, 200
Goldilocks economy, 191t, 192, 196
Goldman, Sachs & Co.: Asness at, 158, 159, 161; Long-Term Capital Management and, 84; risk arbitrage at, 313–14
gold prices, 11–12, 48, 192, 200
Gordon’s growth model, 90–91, 100
government bonds: market for, 241; repo rate for, 245; short-selling, 260, 261; spread trades involving, 264; strategic asset allocation and, 168. See also bonds; Treasury bonds
Graham and Dodd, 95, 96, 98, 139
“greatest trade ever,” 2, 292, 313, 320–22
Great Recession. See global financial crisis of 2007–2009
Greenlight Capital, 122
Greenspan, Alan, 190–91, 203, 206
Griffin, Kenneth C., viii, 2, 15t, 16; interview with, 286–90
gross domestic product (GDP), 192–93; output gap and, 189
gross leverage, 74
growth: bad forms of, 101, 102; economic environment and, 191–92, 191t; factors affecting, 193; quality investing and, 100–102, 103–4; supply or demand shocks and, 195t; trading on direction of interest rates and, 250
growth at a reasonable price (GARP) investing, 104
growth banks, 205
Gruss Partners, 313
GTAA (global tactical asset allocation), 176, 185
haircut, 77, 80. See also margin requirements
Hansen, Lars, 3
Harding, David W., viii, 1–2, 15t, 16; interview with, 225–29
Harvard Management, 43
hedge fund managers, viii, 1–2. See also specific managers
hedge funds: balance sheet of, 74–76, 76f; capacity of, 72, 73f; defined, 19; fees of, 21–22, 38; high attrition rate of, 24; history of, 20; limited need for, 20; limited regulation of, 20, 23; objectives of, 21; organization of, 24–26, 25f; performance measures of, 27–38; performance of, 22–24; role in the economy, 26; total assets under management by, 20; withdrawals from, 75
hedge fund strategies, viii, 7–14, 8f; asset pricing theories and, 2–3; capacity of, 72, 73f; performance measures of, 27–38; predictive regressions of, 50–53; profit sources of, 39–46, 40f. See also backtests of strategies; investment styles; specific strategies
hedge ratio (delta, Δ): in binomial option pricing model, 237; in convertible bond arbitrage, 275, 275f, 283; to make a strategy market neutral, 28; in slope trade, 251
hedging: as benefit of short-selling, 123; of convertible bonds versus straight bonds, 270; defined, 19; dynamic, 234, 235, 237–38, 240; in fixed-income arbitrage, 241; Scholes on broker-dealers and, 267; tail hedging, 59, 228
Heisenberg uncertainty principle of finance, 135
high-conviction trades: going for the jugular with, 12, 321; portfolio construction and, 55, 57
high-frequency trading (HFT), 10, 134, 134t, 135, 153–57; flash crash of 2010 and, 156–57; as market making, 44–45, 153–55
high-minus-low (HML) factor, 29, 137, 137n
high-moneyness convertible bonds, 282, 282f, 284, 284f
high water mark (HWM), 21–22, 35, 36f
holding periods, 105–6; at Maverick Capital, 111–12
hurdle rate, 21
Huygens, Christiaan, 81
hybrid convertible bonds, 282, 282f
idiosyncratic risk, 27–28; in information ratio, 30; washed out in quant investing, 144
illiquid assets, in asset allocation, 168, 170
illiquidity premium, 43
illiquid securities, defined, 63
IMA (investment management agreement), 25
implementation costs, 63–64. See also funding costs; transaction costs
implementation shortfall (IS), 70–72, 73f
implied cost of capital, 93
implied expected returns, 93
index arbitrage, 153
index funds, 28
index options: demand pressure for, 46; implied volatilities of, 239
index weightings, Maverick’s indifference to, 111
industry-neutral portfolio construction, 144; quant event of 2007 and, 146
industry rotation, 98
inefficient markets: Asness on successful strategies and, 164; defined, vii. See also efficiently inefficient markets
inflation: aggregate demand and, 193f, 194; aggregate supply and, 193, 193f; bond returns and, 180; central bank policies and, 189–90; currency returns and, 182–83; economic environment and, 191–92, 191t; employment and, 193; equity returns and, 178–79; Federal Reserve policy and, 189–90; interest rates and, 189–90, 194, 250; supply or demand shocks and, 195t
inflation risk premium, 196
information: efficient market hypothesis and, 201, 227; short sellers as providers of, 132; as source of profits, 39, 40–42, 40f
information ratio (IR), 30, 31; adjusted for stale prices, 37
insider trading, 9, 40–41, 294, 318
Integrated Resources, 129
interest rate futures, 190
interest-rate risk: in convertible bond arbitrage, 283; in event-driven investment, 292
interest rates: aggregate demand and, 194; in efficiently inefficient markets, 7t; inflation and, 189–90, 194, 250; in neoclassical finance, 7t; option instruments related to, 262; overnight, central banks and, 248–49. See also central banks; risk-free interest rate; Taylor rule; term structure of interest rates
interest-rate swaps, 259–60; in convexity trading, 266; in curve trading, 265; in hedging portfolio of convertibles, 283; margin requirements for, 80; market for, 241; in mortgage trading, 261; in spread trades, 264, 265; swaptions and, 241, 262; in volatility trading, 262
Internet bubble of late 1990s: Asness on, 161–62; carve-outs during, 309–10, 310f; greater fool theory and, 107; low dividend yield during, 174; Soros and, 41, 203, 206
Internet stocks, demand pressures for, 46
intrinsic value: Ainslie on, 109; Buffett on, 87, 88, 89, 90; dividend discount model and, 89–92, 97, 98, 100; fundamental analysis and, 97; quality characteristics and, 100; residual income model and, 92–93, 92n, 97; value investing and, 88–89, 96, 97, 98–99, 98f; value investor versus growth investor and, 103–4, 103f. See also fundamental value; value investing
investment banks: prime brokerage service of, 80; risk arbitrage and, 314
investment management agreement (IMA), 25
investment–saving (IS) curve, 194, 194n
investment styles, ix, 2, 14–16. See also specific styles
iPhone, 115
IR. See information ratio (IR)
irrational exuberance, 203
IS (implementation shortfall), 70–72, 73f
IS-MP model, 194n
iTraxx, 283
JOBS (Jumpstart Our Business Startups) Act, 20
Jones, Alfred Winslow, 20
Jones, Paul Tudor, 184
junk bond companies, 129
Kabiller, David, 161
Keynes, John Maynard, 13, 119, 137, 204
Keynesian Beauty Contest, 119–20
Kohlberg, Kravis, Roberts & Co. (KKR), 298–99
Krail, Bob, 161
Krispy Kreme, 46
Kynikos Associates, 15t, 127; Kynikos Opportunity Fund, 131. See also Chanos, James
LBO. See leveraged buyout (LBO) investors
Leap Wireless, 319
Leasco Systems and Research Corporation, 202
legal advisors, 26
Lehman Brothers, failure of: convertible bond market and, 284, 285; liquidity crisis unfolding around, 149; management’s efforts to distract from, 122; recession following, 319; stress tests and, 59; as sudden event, not in models, 11; unable to fund their positions, 78
leverage: alpha-to-margin (AM) ratio and, 31; betting against beta and, ix, 16, 141; bubbles based on, 203; Buffett’s use of, 105; in convertible bond arbitrage, 271, 277, 284, 284f; defined, 74; embedded in derivatives, 80; embedded in options, 236, 240; in fixed-income arbitrage, 241, 244–46, 248–49, 249n; funding costs and, 63–64; market timing with, 174–75; measures of, 74; overall economics of, 77–80; preference for risky securities instead of, ix, 45, 141; provided by prime brokers, 26; quant event of 2007 and, 145, 148; reactive risk management and, 61; riding out a drawdown and, 54; in risk parity investing, 171–72; Scholes on, 268; Soros on, 201, 203; sources of, 74–76, 76f. See also margin requirements
leveraged buyout (LBO) investors: acquisitions by, 293; applying leverage to safer stocks, 141; failure rate of, 304; KKR deal for Arcata Corp., 298–300; quant event of 2007 and, 145
leverage risk premium, ix
LIBOR rate, interest-rate swaps and, 259–60
Liew, John, 161
limit orders, 135, 154, 155; flash crash of 2010 and, 155, 157
Lipper/Tass database, managed futures funds in, 221, 222t
liquidity: enhanced by short-selling, 123; Keynes on preference for, 204; limited demand for, 20; on-the-run/off-the-run spread and, 257, 259
liquidity-based asset allocation, 170
liquidity crises: in convertible bond markets, 283–85; in flash crash of 2010, 157; neoclassical economics and, 6; on-the-run/off-the-run spread during, 257, 259; risks associated with, 44; systemic, in September 2008, 149. See also liquidity spirals
liquidity management, 59
liquidity provision, ix, 4; by high-frequency traders, 153, 154, 155, 156, 157; as investment style, 16; by market makers, 123, 153–54; useful for the economy, 26
liquidity risk: arbitrage and, 42, 151, 233; capital asset pricing model and, 6, 7t, 43–44; compensation for, 39, 40f, 42–46; components of, 42–46, 63; of convertible bonds, 14, 43, 270, 271, 281, 283–85; defined, 5; funding crisis and, 80–81; to funding of short seller, 118; of mortgage-backed securities, 261; in value investing, 89
liquidity risk premium, 42, 44; asset allocation and, 168, 170; convertible bond arbitrage and, 270, 281; investment style based on, ix, 16
liquidity spirals, 7t, 81–83, 82f, 83f; alternatives for dealing with, 148; buying securities during, 44; in carry-trade unwinds, 186; cause of, xi; in convertible bond market, 283; drawdown policy for dealing with, 61; in quant event of 2007, xii–xiii, 144, 147, 148; stress tests and, 59. See also liquidity crises
liquid securities, defined, 63
Livermore, Jesse, 208
loan fee, 117, 118; decision not to lend shares and, 124; stock valuation and, 121
lock-up provisions, 75
London Financial Futures Exchange, 225
long–short equity funds, 95–96
Long-Term Capital Management (LTCM): among other troubled hedge funds in 1998, 161; bailout of 1998 for, 205; convertible bond market and, 285; counterparties’ behavior toward, 84; failure of, 24; on-the-run/off-the-run spread and, 257; Scholes at, 262, 268; stress tests using, 59
loss, time horizon for observing, 33t, 34–35
lost decade, 191t, 192; demand shocks and, 196
low-risk investing, ix, 16, 140–44, 142f, 143f
Lynch, Peter, 106
macroeconomics, 191–96, 191t, 195t
macro strategies, 8, 11–13; asset allocation for, 167–68. See also global macro investing; managed futures investing
MADD (maximum acceptable drawdown), 60–61
managed futures indices, 221, 222t, 223
managed futures investing, viii, 11, 12–13, 208–10; explaining the returns of, 221, 222t, 223; implementation of, 224–25; Scholes on, 264–65; surprises and, 227–28. See also commodity trading advisors (CTAs); Harding, David W.; time series momentum strategies; trend-following investing
managed futures quants, 13
management departures, 127, 128
management quality, 102, 104; Ainslie on, 108, 110, 112, 113
Man Group, 225
Manufacturers Hanover Trust Company, 202
MAR (minimum acceptable return), 32
margin calls, 79, 118; liquidity spiral and, 148
margin of safety, in value investing, 89, 98–99, 98f
margin requirements, 77–80; alpha-to-margin ratio and, 31; in arbitrage trading, 233; in convertible bond trading, 281, 284; defined, 77; on hedge fund balance sheet, 75–76, 76f; liquidity spiral and, 82, 148; in managed futures strategies, 225; in options trading, 238; for short seller, 116, 118; for swaps, 259; for time series momentum strategy, 225. See also collateral
Market Break of May 1962, 157
market dislocations, event opportunities in, 313
market exposure (beta risk), 28, 29, 42; of merger arbitrage portfolio, 305–7; quality and, 102; quant portfolio construction and, 144
market impact, market makers’ profits due to, 154
market impact costs, 63, 64–65, 66f; effective cost and, 68
market liquidity risk, 42–45, 63; of convertible bonds, 281, 283. See also liquidity risk
market makers, 44–45; basic economics of, 153–55; failure of liquidity provision by, 157; liquidity provision by, 123, 153–54
market-neutral excess return, 28
market-neutral hedge funds, 21, 28; asset allocation by, 167, 169; quantitative equity investing by, 133, 135, 144
market portfolio, 169
market price: discrepancy between theoretical value and, 2–3; versus intrinsic value, 89, 98–99, 98f; Soros on distortions of, 200–201
market timing strategy, 51–52, 53, 167, 172–75
mark to market profit and loss, 78
master–feeder hedge fund structure, 24–26, 25f
Maverick Capital Management, 11, 15t, 108. See also Ainslie, Lee S., III
maximum acceptable drawdown (MADD), 60–61
maximum drawdown (MDD), 35, 36f
McDonough, Bill, 205
mean-reverting trades, 16, 99, 187, 251, 263–64, 266–67
mean–variance portfolio optimization, 56–57
Mendillo, Jane, 43
merger, early conversion of bond prior to, 276
merger arbitrage, 14, 291, 292–307; acquirers talking up their stock price and, 303; basic concept of, 294–96; demand pressure and, 46; determining the hedge in, 300–303, 301f, 302f; historical return of, 295, 305–7, 306f; life of a trade in, 296–300, 297f, 298f; Paulson on, 2, 15t, 16, 296, 314–16; portfolio construction and, 303–4; portfolio-level hedges for, 307–8; risk in, 304–5; types of deals involved in, 292–94, 293f
mergers and acquisitions: available universe of, 303; bad growth involving, 101, 102; convertible bonds and, 285; failure rate of, 304; types of, 293–94, 293f. See also merger arbitrage
Merton model, and corporate default, 261
MetroPCS, 319
Meyer, Frank, 290
minimum acceptable return (MAR), 32
mispricing: exploited by high-frequency traders, 155; in flash crash of 2010, 157; persistence of, 41–42; statistical arbitrage and, 134, 135. See also arbitrage
modified duration, 180, 181, 244, 246, 251, 253, 254, 255
Modigliani, Franco, 263
Modigliani–Miller Theorem, 6, 7t
momentum investing, 14–16, 138–39; Asness on, 15t, 158–59, 161, 162; initial underreaction/delayed overreaction and, 41, 139; quant portfolio construction and, 144; Scholes on, 266–67; value performance compared to, 138, 138f, 158. See also time series momentum strategies; trend-following investing
momentum/value investing, 139; Asness on, 161, 162; global, 196–99, 198f; quant equity performance during 2008, 149; quant event of 2007 and, 146, 146f, 148
momentum/value/quality investing, 140
monetary policy, 6, 7t. See also central banks; exchange rates; interest rates
monetary transmission mechanism, 248
money management, market for, 3n3, 4–5
mortgage-backed securities, 261; commercial, 261; credit returns of, 180n. See also subprime credit crisis
mortgage basis trade, 261
mortgage bonds, market for, 241
mortgage refinancing waves, 265–66
mortgage servicers, 266
mortgage trading, 13, 241, 261; Scholes on, 265–66
municipal bond spreads, 262
mutual funds: active, discretionary equity investing by, 96; difference between hedge funds and, 8; hardly beating the market, 4; management fees of, 21; market index as benchmark of, 21, 22; required to report geometric averages, 32n; trading skill in, 23
NASDAQ, crises affecting, 157
natural convergence time, 235
natural rate of unemployment (NAIRU), 189n
neoclassical finance and economics, 6, 7t
NeoStar, 113
net asset value (NAV), 74–75, 76f
net income (NI), 92; earnings yield and, 178–79, 178n6
net leverage, 74
no-arbitrage condition, 234
Nokia, 115
non-solicitation requirement, for hedge funds, 20
Norges Bank Investment Management, 167
Ogden Corporation, 202
Okun’s law, 189n
on-the-run versus off-the-run Treasuries, 13, 241, 257, 258f, 259
opportunity cost, of trading pattern, 71–72
options: American-type, 235, 237n, 276; arbitrage pricing of, 235–40; basic concept of, 235–36; binomial model of, 236–38, 237f, 237n; Black–Scholes–Merton formula for, 7t, 238–40, 262, 263, 270, 272, 288; on bond futures, 262; convertible bond pricing and, 270, 272; demand-based pricing of, 46, 240; embedded, 180n, 263, 281; exchange-traded, 80; interest-rate related, 241, 262; in-the-money versus out-of-the-money, 58, 235–36, 239; leverage embedded in, 236, 240; markets for, 241; risk associated with, 236. See also derivatives
order flow, trading on, 107
out-of-sample backtests, 50, 53
output of a country, 192–93, 193f
overheated economy, 191, 191t; demand shocks and, 196
overreaction/underreaction, ix, 41, 139, 209, 210–12, 210f
overstated earnings, 115
over-the-counter (OTC) markets: dealers in, 25; derivatives in, 80; market makers’ withdrawal during crises affecting, 157; transaction costs in, 65, 66f, 67
overvaluation of stock prices, 119–21. See also bubbles
pairs trading, 152
parity conversion value, 269
par value, of convertible bond, 269
passive asset allocation, 169
Paulson, John A., viii; “greatest trade ever,” 2, 292, 313, 320–22; interview with, 313–22; on merger arbitrage, 2, 15t, 16, 296, 314–16; Soros’s influence on, 206, 320, 321
Paulson & Co. Inc., 313
payout ratio, and quality investing, 100, 104
PBs. See prime brokers (PBs)
pegged currencies, 186–87, 190
pension funds: asset allocation by, 168, 169–70; demand pressure on bonds due to, 249, 252, 255; discretionary equity investing by, 96; Scholes on, 263, 265
performance attribution, 37–38
performance measures, 27–38; adjusting for illiquidity and stale prices, 36–37; annualizing, 33–34; estimating, 32–33; gross versus net of transaction costs and fees, 38; introduction to, 27–29; risk–reward ratios, 29–32; time horizons and, 33–35, 33t. See also return; Sharpe ratio (SR)
performance of hedge funds, 22–24
Phillips curve, 193
PIPEs (private investments in public equity), 291, 313
P&L. See profits and losses (P&L)
Platinum Grove Asset Management, 262, 268
policy portfolio, 167, 168. See also strategic asset allocation
political events: global macro developments and, 199–200; Soros on importance of, 204
portfolio, replicating, 234–35, 237, 239–40
portfolio construction, 54–57; Ainslie on, 110; Asness on, 133, 160; Chanos on, 131; components of, 167; in event-driven investment, 292; in fundamental quantitative investing, 144–45; industry-neutral, 144; in merger arbitrage, 303–4; in quantitative investing, 133. See also asset allocation
portfolio insurance, trends and, 212
portfolio optimization, 56–57; Asness on, 164; Harding on, 229
portfolio rebalance rule, 47–48, 50. See also rebalancing of portfolio
portfolio sort, as predictive regression, 51–53
post–earnings-announcement drift, 41
PPP. See purchasing power parity (PPP)
preferred habitat theory, 249
present value model. See dividend discount model
price. See market price
price surplus, 178, 178n6, 179
price-to-book (P/B) value, 99, 104, 139; for overall market, 197
pricing period, of floating exchange ratio stock deal, 301, 302f
prime brokers (PBs), 25f, 26; of cash instruments, 80; hedge fund balance sheet and, 76; margin call from, 79; of OTC derivatives, 80; predatory trading by, 84; profit earned by, 78–79
Prince, Chuck, 201
private equity, 293; illiquidity of investments in, 170. See also leveraged buyout (LBO) investors
private investments in public equity (PIPEs), 291, 313
production function, 192
profitability: measures of, 101; quality investing and, 100, 101–2, 104
profits and losses (P&L): mark to market, 78; time horizon for observing, 33t, 34–35
profit sources, from trading strategies, 39–46, 40f
proportional transaction costs, 65
“pump and dump” schemes, 107–8, 123
purchasing power parity (PPP), 182–83; trading based on, 197, 197n
put options, 235–36; demand pressure for, 46, 240; implied volatilities of, 239. See also options
qualified institutional buyers (QIBs), 270
quality at a reasonable price (QARP) investing, 100, 104, 140
quality investing, ix, 16, 100–104; Ainslie on, 108–9; value investing combined with, 16, 100, 103–5, 139–40
quant event of 2007, xii–xiii, 144, 145–49, 146f
quantitative easing, 189
quantitative equity investing, viii, 10–11, 88, 133–35; advantages and disadvantages of, 133–34; Ainslie on incorporation of approaches from, 11, 110; Asness on, 162–64; types of, 134–35, 134t. See also fundamental quantitative investing; high-frequency trading; statistical arbitrage
quantitative global macro investing, 185
random walk hypothesis, 173
RAROC (risk-adjusted return on capital), 31–32
reactive risk management. See drawdown control
real assets, in strategic asset allocation, 168, 171
real bond yield, 197
real business cycles, 7t
real estate boom, 203
real estate investment trusts (REITs), 261
realized average return, 32
reallocation. See tactical asset allocation
rebalancing of portfolio, 169–70; in managed futures strategy, 224, 224f, 225; in time series momentum strategy, 213; trading against trends, 211. See also portfolio rebalance rule
recovery rate in case of default, 260, 260n
redemption notice periods, 75
reflexivity, Soros on, 200–204, 202f, 206
regressions: estimating, 32–33; predictive, 50–53
Regulation FD (Fair Disclosure), 129
relative valuation, 93
relative-value trades, 8; across asset classes, 261; on cross-country interest rate differences, 250; Griffin on, 287; mortgage-related, 261; on volatility, 262. See also arbitrage
Renaissance Technologies, 23
replicating portfolio, 234–35, 237, 239–40
repo (repurchase agreement), 80
repo lenders, 76
repo rate, 80, 245–46, 245f, 248; general collateral (GC), 245, 245f; interest-rate swaps and, 259–60
required rate of return (discount rate), 89–90, 100, 102
residual income model, 92–93, 92n, 97
residual reversal strategies, 153
return, 27–29; Chanos on shorting opportunities and, 128; of highly shorted stocks, 121; of major asset classes, 176–83. See also performance measures
return drivers of investment styles, ix
returns of hedge funds, 22–24. See also performance measures
reversal strategies, 152–53; Asness on, 158, 159
Ricardian equivalence, 7t
Ricardo, David, 208
risk: measurement of, 57–59; Soros on, 204, 206–7. See also liquidity risk; market exposure (beta risk); value-at-risk (VaR); volatility
risk-adjusted alpha, 30
risk-adjusted return, 29–31. See also Sharpe ratio (SR)
risk-adjusted return on capital (RAROC), 31–32
risk arbitrage, 14, 314. See also merger arbitrage
risk aversion coefficient, 56, 171
risk-based asset allocation, 170–71
risk-free interest rate: bond prices and, 241; bond yields and, 248–49; return of a trading strategy and, 27–28
risk management, 54; drawdown control in, 54, 59, 60–62, 225; in line with trends, 212; in managed futures investing, 225; versus predatory trading, 84; prospective, 59–60; trader’s emotions and, 61
risk neutral probability, 238
risk parity investing, 16, 45, 171
risk premium: Asness on successful strategies and, 164; bond yield and, 248–49; carry trading and, ix; corporate credit and, 168, 260; inflation and, 196; leverage and, ix; liquidity-adjusted CAPM and, 43; option value and, 238; strategic asset allocation and, 168; value investing and, ix. See also equity risk premium; liquidity risk premium
risk–reward ratios, 29–32; Soros on, 206–7
roll-down return, 180, 255–56, 256f
Sabre Fund Management, 226
safety: margin of, in value investing, 89, 98–99, 98f; quality investing and, 100, 102, 104
Salomon Brothers, 262, 263, 268
Scholes, Myron, viii, 2, 15t, 16; interview with, 262–68
sector rotation, 98
Securities and Exchange Commission (SEC): convertible bonds and, 270; count of hedge funds in 1968, 20; Enron and, 125; firms having enforcement actions by, 121, 122–23; flash crash of 2010 and, 156–57; Market Break of May 1962 and, 157
securities lender (sec-lender), 79
security market line (SML), 140–41, 140f, 141n
security selection, 167–68; cross-sectional regression strategy for, 51, 52–53; global tactical asset allocation and, 176
self-financing trading strategy. See dynamic hedging strategy
sell-side quants, 88n
share buybacks or issuances, 312
share classes, arbitrage trading on, 150–51, 150f
shareholder lawsuits, short interest in firms having, 121
shareholder value, 102; Ainslie on, 108. See also dividends
Sharpe ratio (SR), 29, 30–31; annualizing, 34; of betting against beta portfolios, 141–42, 142f, 143f, 144; of carry trades, 188, 188t; of global value and momentum trades, 198, 198f; of high-minus-low (HML) factor, 137; in low-risk investing, 141, 142, 142f, 143f; of managed futures funds and indices, 221, 222t; market timing strategy and, 175; of merger arbitrage, 305; portfolio risk and, 171; rebalancing a portfolio according to, 48; of security selection strategy, 52–53; of short-term bonds, 249n; Sortino ratio compared to, 32; time horizon and, 33, 33t, 34; of time series momentum strategies, 209, 214, 214–17f, 218, 218t, 219, 223, 224; of Warren Buffett, 104–5, 160
shocks: to capital flows and trade flows, 199; Scholes on, 268; supply and demand, 5, 194–96, 195f, 195t
short-selling: Ainslie on, 109–10; banned for financial stocks during some crises, 117, 123–24; basic concept of, 10; benefits of, 123–24; in convertible bond arbitrage, 270, 277, 283; creating a catalyst for, 106; criticisms of, 26, 122–24, 131–32; in fixed-income arbitrage, 241, 250–55, 260; frictions associated with, 119–21; management actions to discourage, 122; of options, 239–40; overvaluation of stocks and, 119–21; overview of, 116–18; in quality investing versus value investing, 139; of stocks “on special,” 277. See also dedicated short bias hedge funds
short squeeze, 118; predatory trading and, 84
Siamese twin stocks, 6, 149–50, 149f
side pockets, 75
size risk, 29
Skilling, Jeff, 127
small-minus-big (SMB) factor, 29
smile, of time series momentum, 220–21, 220f
smirk, of implied volatility, 239
SML (security market line), 140–41, 140f, 141n
Soros, George, viii, 1, 11, 13, 15–16, 15t; famous trade by, shorting the pound, viii, 1, 187, 204, 320; on going for the jugular, 11–12, 321; Internet bubble and, 41, 203, 206; interview with, 204–7; Paulson’s learning from, 206, 320, 321; Scholes on, 264; theory developed by, 15t, 200–204
Soros Fund Management, 204
Sortino ratio, 32
sovereign bonds, 260
sovereign credit risk, 200
sovereign wealth funds, 96, 167
special purpose acquisition companies (SPACs), 313
special security structures, 313
spin-offs, 14, 291, 307–9, 308f; Paulson on, 314, 316
spreads: widening during periods of stress, 267–68. See also bid–ask
spreads; credit spread; deal spread in merger arbitrage spread trades, Scholes on, 264, 265
SR. See Sharpe ratio (SR)
stagflation, 191t, 192; supply shocks and, 196
standard deviation (σ): annualized, 34; estimating, 33; of excess return (volatility), 30, 57–58; in risk–reward ratios, 29–32. See also volatility
Standard & Poor’s 500 (S&P 500): flash crash of 2010 and, 155, 156f, 157; mutual funds benchmarked to, 21; versus time series momentum strategy, 219, 219f, 220, 220f; trades related to inclusion in or exclusion from, 292
Standard & Poor’s GSCI index, 46; versus time series momentum strategy, 220
statistical arbitrage (stat arb), 10, 16, 134, 134t, 135, 149–53; Asness on, 158; quant event of 2007 and, 146
stock indices: commodity trading advisors trading in, 228; excess demand for put options on, 240; price change around inclusion or deletion date and, 313. See also Standard & Poor’s 500 (S&P 500)
stock market crash of 1987: Griffin on, 288; withdrawal of market makers during, 157
stocks: arbitrage trading on share classes, 150–51, 150f; capital structure arbitrage and, 261, 312; economic environment and, 191–92; leverage for, 80; Soros on rebound after crisis abates, 204; twin stocks, 6, 149–50, 149f, 151, 152f, 235. See also “equity” entries
stock selection strategies. See equity strategies
stop-loss orders: predatory trading and, 84; trends and, 212
strategic asset allocation, 167, 168–72; trading against trends, 211
strategic risk target, 60
strategies of hedge funds. See hedge fund strategies
stress loss, 59
stress tests, 32, 59; margin requirements and, 77
structured credit, 262
styles of investment, ix, 2, 14–16. See also specific styles
subprime credit crisis, xii; “greatest trade ever” in, 2, 292, 313, 320–22; ripple effects on banks and hedge funds, 145; spreading to other markets, 83, 84f. See also global financial crisis of 2007–2009
subsidiaries. See carve-outs; spin-offs; split-offs
supply shocks, 5, 194–96, 195t; as catalyst of trend, 210
survivorship bias, 23
suspending redemptions, 75
swap contracts, margin requirements for, 80
swap rate, 259
swaps. See credit default
swaps (CDSs); interest-rate
swaps swap spreads, 13, 241, 259–60 swap spread tightener, 259–60
systematic global tactical asset allocation funds, 185
systematic macro hedge funds, 185
systematic risk. See beta
tactical asset allocation, 167, 175–76; global macro funds using, 176, 185. See also market timing strategy
tactical risk target, 60
tail hedging: commodity trading advisors and, 228; via options, 59
takeovers, 14; convertible bonds and, 283, 285–86. See also merger arbitrage
Taylor principle, 189
Taylor rule, 7t, 189–90, 189n, 191, 194; monetary easing and, 195
tech bubble. See Internet bubble of late 1990s
terminal value of a stock, 91
term loan, 118
terms of trade, 199
term structure of interest rates, 242–43, 243f, 250; trading on the curvature of, 251–55, 252f, 253f, 254f; trading on the level of, 250; trading on the slope of, 250–51. See also yield curve
TFP (total factor productivity), 192
thematic global macro traders, 12, 200
Tiger Cub funds, 108
Tiger Management Corporation, 1, 108
time decay, in convertible bond arbitrage, 280, 280f
time lags, in backtesting, 47
time series momentum strategies, 209–10; margin requirements for, 225; position sizing in, 213, 213n, 214, 219–20, 225; single-assets example (1985 to 2012), 212–14, 214–17f. See also managed futures investing
time series momentum strategies, diversified: example of (1985 to 2012), 214, 218–19, 218t; explanation of returns from, 219–21, 220f; hypothetical fee for, 223, 224; managed futures fund returns and, 221, 222t, 223; versus S&P 500, 219, 219f, 220, 220f
time series regression, 51–52, 53
TIPS (Treasury inflation-protected securities), 192
T-Mobile, 319
total factor productivity (TFP), 192
tracking error risk, 30
track record of hedge fund, 38
trading rules: broad classes of, 47–48; defined, 47; implementation costs and, 64
trading signals, 47; multivariate regression on, 51, 53
trading strategies. See hedge fund strategies
transaction costs, 63–64; adjusting backtests for, 50; of arbitrage trades, 235; Asness on, 160, 163; estimating expected values of, 69–70; implementation shortfall and, 70–72; liquidity of securities and, 63; of managed futures strategies, 224–25; market liquidity risk and, 42–45, 63; as market makers’ profit, 154; measuring, 67–69; optimal trading in light of, 64–67, 66f; in portfolio optimization, 57; reduced by short-selling, 123; sources of, 63
“Travolta” collar deal, 302, 302f
Treasury bonds: hedging interest-rate risk with, 283; on-the-run versus off-the-run, 13, 241, 257, 258f, 259; swaps and, 259, 260. See also government bonds
Treasury inflation-protected securities (TIPS), 192
trend-following investing, ix, 12–13, 15t, 16, 208–10; Harding on, 226, 227–28, 229; initial underreaction/delayed overreaction and, ix, 41, 209, 210–12, 210f; rationale underlying, 210–12, 210f; Scholes on, 266, 267. See also commodity trading advisors (CTAs); managed futures investing; time series momentum strategies
t-statistic: of alpha estimate, 28–29; of alpha for time series momentum strategies, 218t, 219; security selection strategy and, 52–53
twin stocks, 6, 149–50, 149f, 151, 152f, 235
Two-Fund Separation Theorem, 6, 7t
uncovered interest rate parity (UIP), 182n, 185
underlying of a derivative, 235
underreaction/overreaction, ix, 41, 139, 209, 210–12, 210f
unemployment: aggregate supply and, 193; Federal Reserve policy and, 189–90; natural rate of (NAIRU), 189n; supply shocks and, 196
Unilever, 149–50, 149f, 151, 152f, 235
valuation. See arbitrage pricing; convertible bonds: valuation of; equity valuation; intrinsic value
value-at-risk (VaR), 58–59; drawdown control and, 60–61; economic capital and, 32; margin requirements and, 77
value investing, ix, 9, 14–16, 15t, 88–89, 96–99; Asness on, 15t, 158, 161, 162, 163; deep value investors and, 99, 103; efficiently inefficient equity market and, 88–89; fundamental analysis in, 97–98; in global markets, 196–99, 198f; holding periods in, 105–6, 111–12; margin of safety in, 89, 98–99, 98f; negative-feedback trading as form of, 16; quality investing combined with, 16, 100, 103–5, 139–40; quant event of 2007 and, 145–46, 146f, 147–48; quantitative, 136–38, 137f, 144; 60/40 portfolio and, 169–70. See also Buffett, Warren; intrinsic value; momentum/value investing
value risk, 29
value trap, 99
variance: annualized, 34; estimation of, 33
Verizon, 319
volatility: of Berkshire Hathaway, 105; of bond yields, 251; of deviation from benchmark, 22; directional trades on, 262; implied, 239, 262; option prices and, 239; position sizes in time series momentum strategies and, 213, 213n, 214, 219–20, 225; quality and, 102; relative-value trades on, 262; as risk measure, 57–58, 59; Soros on, 204; of stock price underlying convertible bonds, 280–81, 282; strategic risk target measured as, 60. See also standard deviation (σ)
volatility trades, fixed-income, 241, 262
Volcker, Paul, 206
Volcker Rule, 314
volume-weighted average price (VWAP), 67, 68–69
Waddell & Reed Financial, Inc., 155, 156f
warrant, 269
Weil, Jonathan, 124
Whitehead, John, 313
Winton Capital Management, 225
Wood Mackenzie, 225
yield curve, 242–43, 243f; bond returns and, 245f (see also bond returns); hedging the risk of parallel moves in, 246; in overheated economy, 191; preferred habitat theory of, 249; Scholes on segmented clienteles concerned with, 263; speculating on the slope of, 190. See also bond yields; term structure of interest rates
yield-curve carry trade, 187
yield curve trading, 13, 241, 264–65
yield to maturity (YTM), 179–80, 242, 243f; of corporate bond, 260; determinants of, 248–49; of swap, 259. See also yield curve