Alternatives

Alternatives

Core Concepts

Hedge Fund Strategies

• Long/Short Equity: Combines long positions in undervalued stocks with short positions in overvalued stocks. Net exposure can range from net long to market neutral.
• Market Neutral: Targets zero beta to the market. Returns driven by stock selection alpha, not market direction.
• Global Macro: Takes positions in currencies, rates, equities, and commodities based on macroeconomic views. Highly discretionary.
• Event-Driven: Profits from corporate events — mergers (merger arbitrage), restructurings, spinoffs, bankruptcies.
• Relative Value: Exploits pricing discrepancies between related securities (convertible arbitrage, fixed income arbitrage, capital structure arbitrage).
• Managed Futures/CTA: Systematic trend-following strategies across futures markets. Historically provide positive convexity (perform well in crises).

Fee Structures

The standard hedge fund fee is "2-and-20" — 2% annual management fee on AUM plus 20% performance fee on profits.

• High-water mark: Performance fees are only charged on new profits above the previous peak NAV. Protects investors from paying fees to recover losses.
• Hurdle rate: A minimum return (often a risk-free rate) that must be exceeded before performance fees apply.
• Clawback: Mechanism to recover performance fees if subsequent losses erode earlier gains (more common in PE).

Private Equity Metrics

• IRR (Internal Rate of Return): The discount rate that sets the NPV of all cash flows (capital calls and distributions) to zero. The canonical money-weighted return — it is sensitive to the timing and size of cash flows, unlike the time-weighted returns used for public market funds.
• TVPI (Total Value to Paid-In): (Distributions + Remaining Value) / Total Capital Called. A multiple of invested capital.
• DPI (Distributions to Paid-In): Distributions / Total Capital Called. Measures realized returns only — the "cash-on-cash" multiple.
• RVPI (Residual Value to Paid-In): Remaining Value / Total Capital Called. Measures unrealized value. TVPI = DPI + RVPI.

J-Curve

Private equity funds typically show negative returns in the early years because management fees are charged on committed capital, initial investments are carried at cost or slightly written down, and returns have not yet materialized. As portfolio companies mature and are exited, returns improve. The characteristic shape — initial losses followed by gains — resembles the letter J.

Vintage Year Diversification

PE fund performance is significantly influenced by the economic environment at the time of investment. Spreading commitments across multiple vintage years reduces the risk of investing all capital at unfavorable valuations.

Illiquidity Premium

The expected excess return demanded for accepting illiquidity — the inability to sell quickly at fair value. Private equity, venture capital, and certain hedge funds impose lock-up periods (1-10+ years). The illiquidity premium is theoretically 150-400bp for PE and private credit, though estimates vary and are debated.

Lock-Up Periods, Gates, and Side Pockets

• Lock-up: Period during which investors cannot redeem (typically 1-3 years for hedge funds, 7-12 years for PE).
• Gates: Limits on the percentage of fund assets that can be redeemed in any single period (e.g., 10-25% per quarter).
• Side pockets: Illiquid or hard-to-value positions segregated from the main portfolio. Investors cannot redeem side-pocketed assets until they are realized.

Replication and Factor Exposure

Many hedge fund returns can be replicated with systematic factor exposure (equity market, size, value, momentum, credit, volatility selling). Research shows that a significant portion of hedge fund "alpha" is actually alternative beta — compensation for well-known risk factors. True alpha (manager skill net of factor exposure) is scarce and diminishing.

Due Diligence

Key areas: operational risk (back-office, custody, valuation practices), strategy capacity (can the strategy scale?), manager skill vs factor exposure, transparency and reporting, alignment of interests, and regulatory compliance.

Key Formulas