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FIN3102 Investment Analysis and Portfolio Management

Case 1- The Dynamis Fund: An Energy Hedge Fund

Section C4 Group 1C

Group Members

Chen Zu Qing (U098258E)

Kwan Kin Weng (U090381H)

Low Siao Chi (U098260J)

Sim Wan Lin (U098374Y)

Yong Jun Kang Eric (U098357R)

Yong Lin Lin (U098312Y)

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1. Why would a regional brokerage offer such instruments

Compared to individual portfolios, such funds woo investors by offering several advantages namely:

professional asset/money management, liquidity and more diversification than most individuals can

create or afford in a personal portfolio.

The brokerage’s motivation in recommending energy investments can be explained by the high

commission that could be earned. Hedge funds charge a fee for assets under management and incentive

fees based on a certain percentage of the profits earned. With good stock picking, the brokerage would

be able to earn profits in both up and down markets.

A regional broker would want to offer hedge funds because they are only lightly regulated and thus the

fund managers can use more advanced investment strategies such as a leveraged and derivatives

positions. It is stated in their selling memorandum that their mission is to exploit investment

opportunities in publicly traded companies in the energy sector. Hence, the fund seeks to generate above

average returns relative to both S&P Energy composite and the broader market through a variety of

investment instruments.

Also, the fund's use of various strategies will be designed to minimize risk while maximizing potential

return, again increasing the commission that could be paid to the hedge fund managers. This potentially

high level of compensation helps the brokerage retain talented brokers and specialists, raising the

reputation of the firm.

Furthermore, investing in energy funds serves as a diversification tool. This is because from historical

records, energy prices have had a high correlation with inflation. In times of rising inflation, energy

funds have been found to perform better than the market. Thus, they are able to act as a source of risk

diversification. This explains the presence of a market for such energy funds.

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In addition, energy funds have been a very popular fund with investors. The high dependence on oil in

all parts of the world has made energy stocks a hedge for emerging market portfolios. With a demand

for such energy stocks, a regional brokerage will want to cash in on this opportunity and offer energy

funds. In order to cater to a larger crowd of investors, the brokerage firm will offer energy hedge funds

to sophisticated investors and energy mutual fund to general public who will like to invest in energy

fund, but are unable to do so given their smaller amount of capital.

Investing in energy funds is often complicated and risky, given the volatility of such

commodities. Brokerage firms have a fiduciary responsibility to research on such funds before

recommending them to their clients. They have to ascertain if the investments are suitable for the clients

based on their age, investment experience and tolerance for risk. In view of this, investors prefer a firm

that can provide them with personalized services suited to their needs and risk tolerances. To be able to

get these services, most of these investors go to regional brokerage firms. Such regional brokerages can

deliver the attention to their clients due to their small size. Thus, with such demand in energy funds,

regional brokerage firms would be able to make a profit out of offering such instruments. It will allow

them to better position themselves in the market.

2. Why did S&S start a hedge fund in addition to its energy portfolio

The Energy portfolio is essentially a long equity fund for investors to buy stocks. It is stated that in their

selling memorandum that the Energy Portfolio will seek to earn above average returns by investing in

smaller and medium-size companies that are growing earnings and cash flow in a dramatic way.

Therefore, it can only stand to gain when the market goes up.

On the other hand, the introduction of the hedge fund will provide benefits to both its investors and the

fund manager in the following ways:

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For the investors, the hedge fund acts as a better investment for reaping returns in both bull and bear

markets by having both long and short positions. Also, hedge funds are lightly regulated as compared to

mutual funds and thus the fund managers can pursue more advanced and a wider range of strategies

including leverages, derivatives, short sales, options and futures contracts. The flexibility in managing

the hedge funds allows fund managers to exploit opportunities within the energy sector. The potentially

higher returns attract investors with higher risk tolerance.

Hedge funds cater to sophisticated investors who earn a minimum amount of money annually and have a

certain amount of net worth, along with investment knowledge. It helps to cater to the needs of the

sophisticated investors and target a substantially different market from the mutual funds. This is in line

with S&S’s corporate strategy of providing the best possible service to its retail customers and

continuing to grow the asset management business.

As for the fund managers, a hedge fund provides a radically different incentive package than the typical

mutual fund. The fees paid by investors are higher as compared to that for mutual funds, including

additional fees that mutual funds do not charge. There are no restrictions on the fees a hedge fund

manager can charge, as compared to mutual fund fees which are regulated and transparent. The energy

hedge fund charges a 1% management fee, which is for the same service that the management fee covers

in mutual funds. This fee alone may form a substantial part of the fund manager’s profit, thus making

the management of the hedge fund attractive to the fund manager.

In addition to the management fee, incentive fees are charged based on 20% of the fund’s profits. It

serves to reward the fund manager for the stock picking ability and for good performance. The

potentially high returns that hedge fund offers from the wider range of investment strategies also

increases the potential incentives that the fund manager gets, explaining the main reason for starting the

Energy Hedge Fund.

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3. Does the fee structure for the Dynamis hedge fund make sense?

Comment on the differences in the compensation between the energy

portfolio and the Dynamis fund.

The fee structure of the Dynamis Fund includes management fees as well as performance fees.

Management fee is equivalent to 1% of assets under management while performance fee is equivalent to

20% of profits earned by the hedge fund. The performance incentive will only be allocated unless any

previous losses have been recouped, implying the existence of a high-water mark. Also, there exist a

hurdle rate of 10% and the full 20% profit incentive to be allocated to the fund manager begins only at

12.5% return.

The main difference between the fee structure of hedge funds and mutual funds would be the

implementation of the performance fee. Hedge funds are more actively managed than mutual funds and

this performance fees can be seen as additional compensation to the fund managers for the additional

efforts involved. Hedge funds have higher flexibility than mutual funds and hedge fund managers are

allowed the use of short selling, leverage as well as derivatives, from plain vanilla options to very exotic

instruments.1 Also, the incentive fees act as an attraction to lure talented managers so as to deliver high

returns to the clients.2 In a research paper

3, it was also found that incentive fee provides managers with

strong incentive schemes: the higher the incentive fee, the better the fund performance. In fact, a 1%

increase in incentive fee will increase the average monthly return by 1.3%.

It is necessary to determine if this fee structure can indeed help deliver superior profits that are

demanded. In theory, the fee structure helps align investors’ goal to that of the fund manager since the

fund managers’ income is tied to the profits of the fund. Also, the high-water mark ensures that investors

1 Past present and future, Rene M Stulz, 2007

2 Are hedge funds fees too high?, Francois-Serge Lhabitant, 2007

3 On the Performance of Hedge Fund, Bing Liang, 1998

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do not lose out since any losses have to be recouped before the performance fees can be charged. It also

ensures that managers engage in limited risky activities. Without the high-water mark, the managers

gain from the upside but do not suffer from the downside and this does not lead to goal congruence.

However, in the case of huge losses, goal alignment will be out since fund manager can simply abandon

the fund and start another fund since the high-water mark will prevent the manager from earning the

incentive fees in the coming periods. Furthermore, towards the end of an evaluation period, managers

have incentives to increase the variance of the portfolio and take on more risks when the asset value of

the fund is not far below the high water mark, in order to receive the performance fees4. The cyclical

nature and volatility in the energy sector also makes the usage of high water marks an unfair means of

compensation to the investment managers of energy hedge fund.

By capping the fund managers’ compensation to the profits will prevent managers from simply

increasing the portfolio and assets under management so as to increase management fees. To determine

if the fee structure has been useful to investors, we look at the returns of the hedge funds over a period

of time to determine its performance. The Hennessee Hedge Fund Index actually outperformed other

indexes such as the S&P500, NASDAQ and Dow Jones Industrial Average. A thousand dollars invested

in the hedge fund index would have grown to USD19, 647 as compared to $5,299 if invested in the

S&P500.5 Apart from its superior returns, the annualized standard deviation of the Hennessee Hedge

Fund Index is lower than most of the indexes other than the Barclays Aggregate Bond Index. This would

indicate that hedge funds are good value for money since investors are getting the most from their

investments. Also, it is indicative that hedge funds are able to minimize the investment risk as well.

4 High-Water Marks and Hedge funds management contracts, Gotetzmann, Ingersoll, Ross, 2003

5 http://www.hennesseegroup.com/indices/returns/dollargrowth.html

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Evidently, in times of bearish market, empirical data has shown that while hedge funds did suffer

negative returns, they fared far better than the S&P500.6

Since the performance fees compensate the managers of hedge funds for their efforts and form a

substantial portion of their income, would the management fees be excessive as a result? For mutual

funds, the management fees cover the advertising and administrative costs as well as the managers’

compensation and thus easily justified. However, reducing the management fees for hedge funds would

be unfair for hedge fund managers since there will be advertising and administrative costs involved in

the operations of the fund. In order for the management fees to be able to cover the operating costs, the

hedge fund would need to have at least $500million worth of assets under management, according to a

survey done by KPMG. 7 In view of the increasing operational expenses due to investors’ need for

pertinent risk controls, efficient operational systems and studious compliance, we propose the following

scheme of compensation:

1) If the assets under management have a total value of $500million and below, it would be a better

and fairer strategy to charge a management fee of 2 % in order for the fund manager to

completely cover its operating costs, including costs for facilities, infrastructure and information

technology, business support, marketing and public relations fees.

2) For assets under management above $500million, management fees will remain at 1% of assets

under management.

3) Lastly, the use of hedge fund stock options to compensate the managers helps provide fair

rewards and proper incentives. It works by giving the hedge fund manager an option to purchase

a fixed number of shares of common stock at a price that is equivalent to the fair value of the

shares on the date that the share option was granted. When the fund manager chooses to exercise

6 http://www.hennesseegroup.com/indices/returns/downmarketanalysis.html

7 http://www.securitiestechnologymonitor.com/issues/19_78/22897-1.html

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y = 0.7827x + 0.013 R² = 0.1082

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Energy Portfolio v S&P 500

the option, he will realise a gain that is equal to the spread of the difference in the stock price on

the date of grant and on the exercise date 8

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4a. Which index would you recommend as a benchmark for the

performance of the energy portfolio? What, if any shortcomings does

the index you recommended have?

Diagram 4a-1 on the left is a scatter plot of

energy portfolio against the current benchmark,

S&P500. From the diagram, it appears that the

S&P500 is not a very good benchmark for

Energy Portfolio as the points were scattered

randomly. Table 4a.1 shown below also shows

that the r-square value and correlation coefficient

are the lowest among all other indexes. In

addition, its tracking error, which is used observe how the portfolio has diverge from the benchmark, is

the second highest among all other indexes. All these evidences imply that S&P500 is not an adequate

benchmark to measure the performance of the Energy Portfolio fairly.

S&P 500 Russell Oil Comp Wells Drillers Prod Crude

SPOILC SPOILW SPOILD SPOILP

RSQ 10.82% 27.88% 40.31% 59.43% 59.33% 58.64% 17.09%

Correl 0.3289 0.528 0.6349 0.7709 0.7702 0.7657 0.4134

Tracking Error 7.0200% 6.2900% 5.8400% 4.7200% 6.1100% 4.8000% 7.5300% Table 4a-1

8 Compensating Hedge Fund Managers with Stock Options: A new path of alignment of interests with investors, Earle,2010

Diagram 4a-1

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Also, from Table 4a-1, we observed that

SPOILW has the highest r-square value. Thus, if

we were to plot the Energy Portfolio return

against index return, we will able to get a more

clustered plot (diagram 4a-2), but it is still not

good enough as the r-square values of SPOILD

and SPOILP in respect to energy portfolio are

also close to the r-square value of SPOILW and

excluding the SPOILD and SPOILP indexes might result in the loss of important indicative factors.

Regression on Multiple Indexes By running a multiple regression of the energy portfolio’s returns on the SPOILW, SPOILD and

SPOILP indexes, it is possible to get a relation to see how the three indexes explain the returns of the

energy portfolio.

Regressing the S&S Energy Portfolio returns on the three indexes would yield the following equation.

The right hand side of the equation can be used as the multi index benchmark to measure the

performance of the portfolio manager. By substituting the various returns of the SPOILW, SPOILD and

SPOILP indexes over the time period into the equation, we would get a list of returns for this new

benchmark. Further regression of the original energy portfolio returns on this new list of returns for the

new benchmark would yield the following result.

Multi Index Benchmark SPOILW SPOILD SPOILP

R, Correlation 0.88513 0.7709 0.7702 0.7657

R square 0.78342 0.5943 0.5933 0.5864 Table 4a-2

y = 0.9547x + 0.009 R² = 0.5943

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Wells v S&S Energy Portfolio

Diagram 4a-2

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As shown in table 4a-2 above, this new multi index benchmark will serve as a better benchmark since it

has a higher R and R square value. A larger portion of the energy portfolio returns has been explained by

this new benchmark.

Problems of Multi-Index Benchmark The returns of the three indexes used above are correlated and hence the model might not be that

accurate. In fact, given that the SPOILW, SPOILD and SPOILP are indexes that track the performance

of oil-related companies, it is highly possible that returns are highly correlated. Numerically, the

correlation between the SPOILW and the SPOILD index is 0.7761 that of the SPOILW and SPOILP is

0.5892. Given this high correlation, the multi index benchmark will not be an accurate predictor for

future hedge fund results. To create a more accurate benchmark, the variables have to be non-correlated

and independent. This leads to the next benchmark that will be proposed, the multi factor benchmark.

Multi-Factors Regression The multi-factor regression model we used are stated below,

The indexes selection process are as follows:

1. We examine the major qualitative similarity

S&S Energy

Portfolio S&P 500 Russell

Oil Comp

(SPOILC)

Wells

(SPOILW)

Drillers

(SPOILD) Prod (SPOILP) Crude

Small-Mid Cap Large Cap Small Cap

Oil Benchmark

Services &

Supplies

Intergrated

Service Co. Oil Services

Intergrated

Service Co.

Offshore

Drilling

Offshore Rig Construction

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Capital

Equipment Oil Equipment

Exploration

Exploration

Exploration Exploration

Production

Production

Production Production

Table 4a-3

As observed from Table 4a-3, the Energy Portfolio shares some similar characteristics with SPOILC,

SPOILW, SPOILD and SPOILP.

2. Then we compare their quantitative characteristic,

S&P 500 Russell Oil Comp Wells Drillers Prod Crude

SPOILC SPOILW SPOILD SPOILP

RSQ 10.82% 27.88% 40.31% 59.43% 59.33% 58.64% 17.09%

Correl 0.3289 0.528 0.6349 0.7709 0.7702 0.7657 0.4134 Table 4a-4

From Table 4a-4, although SPOILC, SPOILW, SPOILD and SPOILP share similar characteristics with

the energy portfolio, only the R-squared values of SPOILW, SPOILP & SPOILD are high and close

enough. Hence, after taking into consideration of both the quantitative and qualitative factors, it appears

that these 3 indices mentioned above can be used as the major factors in the new benchmark.

Thereafter, we process the data with procedures as follows: (1) The SPOILW is used as the main proxy

for the hidden factor due to its superior R square value. It is important to note that there will be other

hidden factors present in the other two indexes given their high correlation with the portfolio’s returns.

(2) Find the factor that is present within the SPOILD index but not explained by the SPOILW. To do

that, we regress SPOILD on SPOILW so as to get the residual values (ResDonW). (3) Regress SPOILP

on SPOILD and SPOILW so as to find the residual values of SPOILP that cannot be explained by both

the SPOILD and SPOILW (ResPonWD). (4) Regress the Energy Portfolio Return with SPOILW,

ResDonW, ResPonWD and obtain the regression model as below:

The resulting graphs and statistics are shown in diagram 4a-3 and 4a-4.

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y = 0.7827x + 0.013 R² = 0.1082

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S&S Energy Portfolio v S&P

Energy Portfolio v RSQ Correl Slope

Tracking

Error

M2

Measures

Jensen

Alpha

S&P 500 10.82% 0.3289 0.7827 7.02% 0.02% 1.30%

New Benchmark 78.34% 0.8851 1.0000 3.44% -0.21% 0.90% Table 4a-5

From diagram 4a-4 and table 4a-5, we can observe that the r-square value and correlation coefficient

have significantly improved by 7 times and 2.7 times respectively, from the original measurement using

the S&P 500 as the benchmark. The proposed benchmark is a superior way in measuring and predicting

Energy Portfolio returns compared to standalone indexes.

Pros and Cons of Proposed Benchmark The strengths of the benchmark are (1) it is more indicative of the portfolio performance, thus allowing

the investors to know how well is the fund manager performance. (2) It allows the company to have a

better gauge of fund manager performance, thereby rewarding them in a fairer manner. However, there

are also shortcomings of the model, which are (1) investors, the general public, might not fully

understand the highly sophisticated model, thereby rendering the model valueless. (2) Fund managers

might feel exploited as the company measures their performance with a different benchmark when their

job is only to “beat the market”, which is the S&P500. In addition, when the fund was started, investors

y = x - 2E-17 R² = 0.7834

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New Benchmark

Diagram 4a-3 Diagram 4a-4

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might have been told that its purpose was to outperform the general market, symbolised by the S&P500.

Changing to a different benchmark thereafter would not make sense.

Looking at these factors, the S&P500 is recommended as the benchmark for public reporting purpose

because it is simple to understand, especially since the ultimate motive of the public to invest in the

Energy Portfolio is to get a better return than the market.

However, for internal purposes, when the company measures the performance of the managers, they can

still use the new benchmark to measure the performance because the risk adjusted return would be more

indicative of the manager performance in term of their timing, asset allocation and stock picking skills.

4b. Which index would you recommend as a benchmark for the

performance of the Dynamis hedge fund? What, if any shortcomings

does the index you recommended have?

S&P Russell OSX Crude SPOILD SPOILP SPOILW Bonds

R 0.402676 0.59564 0.91738 0.261659 0.852843 0.720669 0.832547 0.198899

R2 0.162148 0.354787 0.841587 0.068466 0.727342 0.519364 0.693135 0.039561

Beta 0.916135 1.767116 0.867105 0.377185 0.748641 1.257605 0.913691 -2.18323 Table 4b-1

In selecting a suitable benchmark to evaluate the performance of the fund manager, it is important to

select a benchmark which has a high correlation to the returns of the fund. Regression of the returns of

the hedge fund on the various indexes will yield the results as shown above.

From table 4b-1, It can be seen that the OSX, SPOILD and SPOILW indexes are highly correlated with

the hedge fund’s returns. The R-square values of 0.842, 0.727 and 0.693 of the OSX, SPOILD and

SPOILW indexes indicate that 84%, 73% and 69% of the hedge fund returns can be explained by the

indexes respectively.

At this instance, if a single index benchmark has to be chosen among the various indexes, it would have

to be the OSX index due to its higher correlation and R square value. However, given that indexes like

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the SPOILD and SPOILW also have rather high correlation values with the hedge fund’s returns, it

would be better if these indexes can be taken into account as the new benchmark is created.

Multi-Factor Benchmark An accurate benchmark that can be used would be a multi factor benchmark. It is assumed that returns

and patterns in the various indexes are caused by separate factors. The OSX, SPOILD and SPOILW

indexes will be used as proxies for these hidden factors that can be used to explain the hedge fund’s

returns.

The OSX index is used as the main proxy for the hidden factor due to its superior R square value. It is

assumed that there will be other factors present in the other two indexes given their high correlation with

the hedge fund’s returns. Moving on to find the factor that is present within the SPOILD index but not

explained by the OSX index, we regress SPOILD on OSX so as to get the residual values

(ResSPOILDonOSX). Following that, we would need to regress SPOILW on SPOILD and OSX so as to

find the residual values of SPOILW index that cannot be explained by both the SPOILD and OSX

indexes (ResSPOILWonOSX, SPOILD).

Given that the returns of the OSX index, the residuals of the regression of SPOILD on OSX as well as

the residuals of the regression of SPOILW on OSX and SPOILD are now available, we can regress the

returns of the S&S hedge fund on these 3 variables and we will get the following equation.

a = OSX = factor explained by OSX index,

b = ResSPOILDonOSX = factor explained by SPOILD but not OSX index,

c = ResSPOILWonOSX,SPOILD = factor explained by SPOILW but not the SPOILD and OSX indexes

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y = x + 5E-18 R² = 0.8485

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S&S vs Multi Factor Benchmark

Substituting the relevant values back into the equation would give the following graph.

As seen in figure 4b-1, the new multi factor

benchmark will have a R-square value of 0.8485,

similar to that of the multi index benchmark used

earlier. However, this multi factor benchmark is more

accurate because the variables are not correlated and

as a result, the equation in the multi factor benchmark

better predicts returns. Thus, in performance evaluation, the multi factor benchmark should be used.

5a. How have Energy Portfolio performed?

In measuring how has energy portfolio performed, we employed several tools, namely sharpe ratio,

measures and Jensen measures. The definition of those tools are defined as follows:

S&P 500

Benchmark

Energy

Energy

Portfolio

Sharpe Measure 36.31% 33.39% 29.56% Table 5a-1

And from Table 5a-1, we can observe that the reward-to-risk ratio of energy portfolio is well below both

benchmarks, meaning that for the same amount of risk borne by a particular investor, investing in S&P

would be more worthwhile as it generate more return for per unit of risk borne.

Figure 4b-1

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M2 Measures Jensen Alpha

Energy Portfolio v S&P 500 0.02% 1.30%

Energy Portfolio v New Benchmark -0.21% 0.90% Table 5a-2

Further, from Table 5a-2, we are able to observe that the M2

measures and Jensen alpha appears to be

better when the portfolio is measured against S&P 500. However, when we use the new benchmark to

measure the performance of Energy Portfolio, the M2

measures and Jensen alpha is lower than what we

obtained using the S&P500 as benchmark, meaning that the fund manager did not “beat the market”.

The 0.90% of alpha might simply due to liquidity premium.

Hence, we are able to conclude that, even though the energy portfolio did give a higher return to its

investors, but, in fact, the fund manager neither not “beaten the market” as its M2 measure is negative,

nor justified for the additional risk borne as the sharpe ratio is lower than the sharpe ratio of S&P 500.

5b. How have Dynamis Hedge Fund performed?

OSX SPOILD SPOILW S&P

Multi

factor

benchmark

Dynamis

fund

Sharpe ratio 2.80% 0.32% 2.73% 8.32% 3.57% 3.28%

M2 Measure 0.01% 0.09% 0.02% -0.05% -0.01% -

Table 5a-3

As seen in table 5a-3, from the Sharpe ratios, it is clear that the hedge fund did not perform better than

the S&P500 index. However, it outperformed the oil-related indexes such as the OSX and SPOILD

indexes. In general, oil-related indexes did not outperform the S&P500 and noting that the hedge fund is

invested in the oil sector, it might explain the fund’s poor performance.

The Dynamis hedge fund has a M2 measure of 0.01% and 0.09% when adjusted to the same risk of the

OSX and SPOILD index respectively. It further proves that the hedge fund outperform the oil indexes

even though it underperforms the S&P500 index as seen by the negative M2 measure value.