Southeastern Hedge Fund Competition – Department of Finance

Types of Strategies

The objective of submissions to the Southeastern Hedge Fund Competition is to propose an investment strategy that is attractive to a hedge fund. The types of investment strategies that are of interest to hedge funds are extremely wide-ranging, covering all asset classes and markets. However, participants should keep in mind that this is a hedge fund competition. Therefore, in-depth analysis of a single stock with a proposed strategy of being long (or short) that stock is unlikely to score highly.

Additionally, the proposed strategy should be able to deploy enough capital to make it of interest to a small hedge fund. For example, a strategy that earns 20 percent per year on $100,000 but cannot be scaled to deploy more than $100,000 is unlikely to score well. As a general guideline, the strategy should be able to deploy at least $10 million. Finally, the competition is particularly geared toward innovative and novel trading strategies. Participants are encouraged to be creative.

Components of a Submission

The remainder of this section provides guidance on the components of a good submission. As discussed in the rules, the submission document can have up to six pages of written text with up to an additional four pages of tables and charts. The guidance provided here is not intended to provide a strict outline for a proposal. It is merely intended to give some ideas as to the issues that a good proposal should address, along with simple (although by no means complete) examples. The hedge fund strategy used as an example is a simple pairs strategy. A simple pairs strategy is chosen as the example for two reasons. First, it is sufficient to be illustrative of the suggestions made below. Second, it is too well-known and commonly used to be considered a strong submission. That is not to say that a pairs strategy could not possibly score well. However, a well-scoring pairs strategy would need to be sufficiently different from well-known and commonly used pairs strategies such as the one discussed here to warrant a high score. It should also be noted that the examples given here are intentionally short. An actual proposal will likely want to go into more depth on several of the points discussed below. Finally, it should be noted that all numbers in the example are completely made up.

Main Idea

The proposal should clearly state the main idea behind the trading strategy.

Example: The main idea underlying our proposed trading strategy is to identify pairs of stocks whose firms are highly similar but whose stocks appear to be priced differently, and to profit from the differential pricing. Specifically, the strategy will take long positions in stocks that appear to be cheap relative to the paired stock and short positions in stocks that appear expensive relative to the paired stock. The strategy will then realize a profit when the differential pricing is corrected.

Economic Hypothesis

The proposal should state the economic hypothesis underlying the proposed investment strategy and provide economic arguments as to why the hypothesis should hold.

Example: The strategy is based on the idea that stocks of similar firms should be valued similarly. This hypothesis should hold because stocks of similar firms are likely to generate similar cash flows and have similar risk. Since cash flows and risk are the two primary determinants of the value of an investment, if two stocks are similar along these two dimensions, the stocks should be valued similarly.

Implementation

The proposal should describe in detail how the proposed investment strategy will be implemented.  This should include a discussion of how trading signals are calculated, how the securities to trade are selected, how the position sizes are determined, the timing and execution of the trades, and all other aspects relevant to the implementation of the strategy.

Example: The first step in implementing our pairs trading strategy is to identify pairs of similar firms. We define two firms to be similar if the firms are in the same industry, have similar leverage, and have a high correlation between their stocks’ returns. Specifically, at the end of each month, we look at all firms in the S&P 500 index. For each stock we calculate the leverage of the stock as the ratio of the book value of the firm’s debt divided by the market capitalization of the firm’s stock. We then examine pairs of firms that have the same 4-digit SIC and have a difference in leverage that is less than 0.1. Finally, we use daily returns over the past year to calculate the correlation between the returns of the stocks of each of the pairs of firms that satisfy the same-industry and similar-leverage criteria. We retain only pairs with correlation greater than 0.6.

Having identified the pairs of similar stocks, we then determine whether the stocks are similarly valued using the price-to-earnings ratios of each stock.  For each stock in each pair, we take the price-to-earnings ratio to be the price of the stock divided by forecast earnings over the next year. We require that there be at least a difference of 1.0 between the price-to-earnings ratios of the stocks in the pair. Pairs not satisfying this criterion are discarded.

Finally, for each remaining pair, we will take a $1 million long position in the stock with the lower price-to-earnings ratio and a $1 million short position in the stock with the higher price-to-earnings ratio. We will hold the positions for the duration of the next month, at which point the current pairs will be liquidated and we will repeat the process.

Risks

The proposal should describe in detail the risks associated with the strategy and how any unwanted risks will be mitigated.

Example: There are two main risks associated with this strategy. First, there is the possibility that the stocks that the strategy has long positions in have, on average, different betas than the set of stocks the strategy is short. This would result in the portfolio having exposure to moves in the overall market. To remove any potential exposure to moves in the overall market, we will calculate each stock’s beta with respect to the S&P 500 index using daily data over the past year. We will then take the portfolio’s beta to be the average beta of the stocks the portfolio is long minus the average beta of the stocks the portfolio is short. If the portfolio’s beta is not zero, we will hedge the portfolio’s exposure to overall moves in the market using S&P 500 index futures.

Second, it is possible that our pairs selection strategy has overlooked something about the firms chosen as pairs and that the firms are not truly similar. To mitigate the possibility that a single pair experiences a large loss, we will monitor the profits of each pair and liquidate the pair if the total losses on the long position and the short position in the pair add up to more than $100,000, or 10% of the initial long (or short) position size.

Liquidity and Capital Considerations

The proposal should discuss how liquidity may affect the implementation of the trading strategy and how much capital the trading strategy might be able to deploy.

Example: Since we will implement our trading strategy only on stocks in the S&P 500 index, the stocks we will trade are very liquid. We therefore expect that we should be able to scale up the strategy quite easily. Since almost all S&P 500 index constituent stocks have more than $100 million in dollar trading volume every day, trading $1 million in any stock should have very little price impact.  While the trading strategy as we propose it would take $1 million positions in each stock, there are many ways the proposed trading strategy could be scaled to take on more capital. Specifically, instead of only trading at the end of the month, we could initiate new positions each day, and then each day only liquidate the positions that were initiated one month prior. Assuming 20 trading days per month, this would scale the strategy from approximately $1 million in each stock to $20 million in each stock. Since each month we identify on average 50 tradable pairs, this would enable us to grow the portfolio to have total long positions of $1 billion and short positions of the same size.

Analysis of Strategy Prospects

The proposal should provide some analysis of the expected returns and risk associated with the investment strategy. In cases such as this pairs trading example, this can be done by simulating the strategy historically. However, for a wide range of strategies, it may not be possible to historically simulate the strategy. For example, the strategy may be particular to current market conditions that have not existed in the past, or the data necessary to simulate the strategy may not be available. If the strategy cannot be simulated, then alternative techniques should be used to, as best as possible, assess the risk and expected returns of the strategy. It may be a good idea to tabulate the results of your analysis. In the example, it is assumed that there is a table accompanying the text.

Example: To assess how the strategy has performed historically, we simulate the strategy during the period from 1980 through 2017. The data used for the simulation come from Bloomberg. The results of the simulations are shown in Table 1. The strategy generates an average monthly excess return of 0.4%. The standard deviation of the monthly excess returns of the strategy is 2.0%. The annualized Sharpe ratio of the strategy is therefore 0.69. The worst drawdown experienced by the strategy began in August 1994. The low point of this drawdown was realized in February 1996, at which point the strategy had lost 14% from its previous high. The drawdown ended in April 1997, at which point the strategy overcame its previous high-water mark.

Stephanie Lang, CFA

principal and chief investment officer
Stephanie joined Homrich Berg in 2005 and was named chief investment officer in 2014. Stephanie oversees a team of professionals within the investment department of HB and is responsible for all investment matters including asset allocation, the selection and monitoring of traditional and alternative investments, as well as the research efforts for HB’s internal private fund-of funds. She also chairs the firm’s investment committee.

Stephanie earned an MBA from Georgia State University’s Robinson College of Business and a bachelor’s degree in finance from the University of Georgia. Stephanie is a member of the CFA Institute, Atlanta Society of Finance and Investment Professionals and the Southern Capital Forum, and serves on the board for Atlanta Women in Alternatives.

Firm Description
Founded in 1989, Atlanta-based Homrich Berg is a national independent wealth management firm that provides unbiased, fee-only investment management and financial planning services, serving as the leader of the financial team for our clients including high-net-worth individuals, families, and not-for-profits. We have service offerings for small and large clients, from investments only up to full service comprehensive wealth management and family office. Homrich Berg manages over $4 billion for more than 1,400 family relationships nationwide with clients in 41 states. We have three local offices here in the metro Atlanta area that employ more than 80 employees including client service teams and dedicated investments staff focused on due diligence and investment strategy.

Michael W. Masters

founder and managing member, Masters Capital Management LLC

Michael W. Masters is the founder and managing member of Masters Capital Management LLC. Michael has led this Atlanta-based firm as its chief investment officer and portfolio manager since its inception in 1994.

Michael has presented expert testimony to the U.S. Congress, CFTC, Financial Crisis Inquiry Commission, and other foreign governments. Additionally, he has presented to institutions including OPEC, the Hyman P. Minsky Conference, the Energy Information Administration, Harvard Kennedy School, Massachusetts Institute of Technology and Georgia Institute of Technology.

Firm Description
Masters Capital Management LLC (the “adviser” or “firm”) is an investment management firm registered with the U.S. Securities and Exchange Commission (“SEC”) under the Investment Advisers Act of 1940. The adviser’s principal place of business is located in Atlanta, Georgia.

The adviser provides discretionary investment advisory and management services to pooled investment vehicles intended for sophisticated and institutional investors. It provides advice to the pooled investment vehicles based on specific investment objectives and strategies surrounding investments in U.S. listed equities and derivatives.

Clay McDaniel

partner and director of research, BT Wealth Management
Clay is a partner and the director of research at BT Wealth Management and is responsible for leading the research efforts for the firm. He is a member of the investment committee and works closely with the CIO and wealth advisors on asset allocation and portfolio construction.

Clay has 15+ years of experience investing globally across all asset classes and has a strong background in private and alternative investments using hedge funds, private equity, managed futures, and private REITs, among others. He has performed full investment and operational due diligence on funds across a wide variety of sizes and strategies. Most recently, he worked as director and senior research analyst for Zurich Alternative Asset Management, a wholly owned subsidiary of Zurich Insurance Company. Additionally, he has built a broad sourcing network that encompasses asset managers, banks, brokers, and family offices, among others.

Clay is a chartered financial analyst (CFA) and holds a master’s in economics and B.B.A. in finance from the Gatton School of Business & Economics at the University of Kentucky.

Jeffrey J. Vale

partner and chief investment officer, Infinity Capital Partners LLC

Jeffrey J. Vale is a partner and serves as chief investment officer at Infinity Capital Partners LLC. He is a member of the investment committee responsible for implementation of the investment policies and performing due diligence on fund managers. Prior to joining Infinity Capital Partners, Jeff was a senior analyst with Long Bow Capital Management LLC — a long/short equity hedge fund. Before joining Long Bow Capital, he served as an analyst at Wilshire Associates where he consulted with portfolio managers on risk analytics. Prior to Wilshire, he was an associate at Concord International Investments. Jeff has been active in the investment management field for more than 20 years. He holds the Chartered Alternative Investment Analyst designation. He earned a B.S. in finance and economics from New York University and an MBA from Emory University.

Firm Description
Infinity Capital Partners LLC (“Infinity”) is an independent, privately owned fund of hedge funds manager based in Atlanta, Georgia. Infinity’s primary goal is to consistently maximize returns relative to risk. Founded in 2002, Infinity is owned and managed by its principal partners. Infinity’s investors include high net worth individuals, family offices, wealth management firms, and institutional investors. The firm’s partners and professionals have significant industry experience and have amassed a track record of success managing alternative investment partnerships.

J.P. Vincent

managing director, Cowen Prime Services LLC

J.P. Vincent is a managing director at Cowen Prime Services LLC. Mr. Vincent joined Cowen as a result of Cowen’s acquisition of Convergex Global Clearing and Prime Services, at which he was the managing director of business development. Prior to his time with Cowen and Convergex, Mr. Vincent was head trader at Dorado Capital Management, a senior vice president of institutional sales at Neovest, and started his career at Bell Capital Management, an Atlanta RIA. Mr. Vincent earned a bachelor’s degree in management from Georgia Tech’s Scheller College of Business and holds multiple FINRA certifications. Mr. Vincent also serves as an advisory board member to private equity firm Buckhead Investment Partners, is a board member of the Southeastern Hedge Fund Association, and previously served on the board of Hedge Funds Care.

Firm Description
Cowen is a leading provider of integrated prime services and out-sourced trading to hedge funds, family offices, mutual funds, and registered investment advisors. The firm offers a full suite of prime brokerage services including customized, high-end execution solutions, multiple custody and clearing options, advanced pre- and post-trade analytics, enhanced reporting, access to securities lending providers and capital introduction services. Its many years of industry experience, coupled with the diverse background of the professional staff and unsurpassed customer service, give Cowen a unique perspective and expertise in the industry that continues to be a winning combination.