William N. Goetzmann, Yale School of Management, 2000
Martin Bagwell and Tod Sprewell are the principals in Pleiades Capital
Management in Greenwich, Connecticut. Pleiades is a British Virgin Islands
corporation which utilizes relative value arbitrage and event-driven risk
arbitrage strategies to generate excess trading profits with minimal exposure
to the U.S. equity and debt markets. The relative value arbitrage strategies
are based upon pairs trading, APT and proprietary factor-based valuation
models. The fund uses leverage, short-sales future and options.
The firm manages two hedge funds: Pleiades and Top 20. Each has a capitalization
of about $100 million of which $20 million each represents the partner's
own interest. The managers have a high water mark contract that guarantees
2% of capital each year and 15% of any appreciation in asset value of the
fund over the year. If the fund value decreases over the year, then the
loss must be made up before any 15% incentive fee is paid.
1997 and 1998 were turbulent times for hedge funds. Many funds experienced
withdrawals as a result of investor aversion to losses. At the same time,
demand for "skill-based" investing grew throughout the 1990's as SEC constraints
on the number of investors in unregulated investment companies relaxed,
and as institutional investors sought alternative asset classes to enhance
their relative performance.
Bagwell and Sprewell are interested in the possibility of increasing
assets under management in the two funds, but they are concerned about
growing too large. The larger the trade, the larger is te price impact
on the market and they are concerned about diminishing marginal returns.
If they are to grow, they will have to demonstrate the risk characteristics
of their funds to potential investors. They will have to show what the
systematic fund risks are, what the volatility of the funds is and what
the maximum draw down that might be expected. In preparation for this,
they have asked a consultant to prepare a thorough risk analysis report.
The data for the second fund is only available through 1997, due to auditing
issues related to disagreement about the method for calculating returns
Bagwell and Sprewell will not disclose anything about the securities
they trade in, but they are willing to provide monthly returns as well
as general descriptions about the funds' activities. The Pleiades fund
itself focuses strictly upon merger and acquisition arbitrage. The Top
20 fund trades equity pairs.
In preparation for your report address the following questions.
1. Do the two funds have a positive systematic risk-adjusted return
over their lifespans?
2. Do the two funds have significant exposure to systematic APT risk
factors? Check their exposure to the equity premium, the horizon premium,
default premium and the small stock premium. In addition, examine the exposure
to proxies for the Fama-French factors: small-minus-big and high-book to
market minus low-book to market. For more information on the APT and systematic
factors, see the site: Advanced
Portfolio Technologies. This site explains the used of APT in arbitrage
in expectations in general and pairs trading in particular.
3. What economic or financial logic might explain some of the estimated
4. What is the maximum monthly draw down of each fund?
5. What is the probability of a negative return n any given month?
6. If an investor wished to lever their portfolio such that the had
a 5% chance of a 2% down month, what kind of leverage could each fund take?
7. What are the long-term prospects of each strategy?
8. What factors might contribute to the positive or negative correlation
of the two strategies?
Optional work -- extra credit and maybe a job at a hedge fund:
Try your hand at developing and back-testing an APT strategy. Try to
implement one of the strategies below.
I. Download a set of five industry portfolios from the Ibbotson EnCorr
Analyzer. Divide the sample into two time periods . Estimate the alphas
and systematic risk loadings of the each portfolio. Construct a portfolio
of these industries -- possibly long-short -- that provides positive alpha
and zero exposure to systematic risk. Test whether this portfolio performed
well out of sample. What are its risk and return characteristics?
II. Try a pairs trading strategy. Go to the WRDS
system which is available through the ICF web data sets page. This
will require a password so start early. From the system, download the daily
returns from two stocks you think should make a good pair. Test to see
whether a pairs trading scheme worked for this pair. Look at the maximum
draw down and other things of interest.
III. Try a merger arbitrage position. Find a merger that was announced
sometime before 1998. Identify the announcement day through a Nexis Lexis
search. See what would happen if you had bought shares in the takeover
candidate and held them through till the merger. WRDS
has the daily stock pricing and return information for you.