Methods, computer systems, software, and portfolio for outperforming alternative indices

In one aspect, the invention comprises a computer-implemented method comprising: (1) electronically receiving data describing a fund index and funds on which the index is based; (2) electronically receiving data describing one or more securities; (3) electronically receiving data describing returns of: (a) the fund index, (b) funds on which the index is based, and (c) the one or more securities; (4) electronically identifying a subset of funds on which the fund index is based as superior-performing funds over a period of time preceding a first time; and (5) constructing, at the first time, and based on the identified subset of funds, a first portfolio of securities whose return exceeds a return of the fund index over a first period of time. Other aspects of the invention comprise software for implementing the above aspect and embodiments thereof, as well as portfolios constructed according to the above aspect and embodiments thereof.

CROSS-REFERENCE TO RELATED APPLICATIONS

This application is related to U.S. patent application Ser. No. 12/184,122, filed Jul. 31, 2008. The entire contents of that application are incorporated herein by reference.

INTRODUCTION

Hedge fund Outperformance STrategy (HOST) baskets, which are comprised in an aspect of the present invention, are portfolios of liquid instruments geared towards providing a higher return than that of an overall universe of hedge funds. One example of an overall universe of hedge funds is the HFRI Composite Index, maintained by Hedge Fund Research, Inc., and which is currently the most widely used Index for measuring performance of the Hedge Fund market. The goal of HOST is to exploit performance persistence of the best hedge fund managers (“star” funds) to outperform the average fund in the hedge fund universe. Although the description herein focuses on hedge funds, those skilled in the art will recognize that the invention may be used in conjunction with any indexed group of funds or securities.

HOST baskets, in an embodiment, are based on a pre-determined set/portfolio of liquid instruments that span the financial markets and are rebalanced monthly. In one aspect of the invention, instruments used in embodiments of the present invention were judiciously selected following a battery of tests so that they span the investment universe of the funds: stocks, bonds, commodities, credit, currency and volatility. In one embodiment, all securities are derivatives and, thus, there is no restriction on using leverage.

In one aspect of the invention, the composition of the portfolio (i.e., the amount to invest in each instrument in the portfolio) is determined based on analyzing the historical return time-series of the hedge funds returns to be replicated. Each month, the portfolio is constructed by finding the set of “weights” (for each instrument) that would have minimized the return tracking error between the portfolio (based on the weights examined) and the hedge funds to be replicated over the analysis period.

Embodiments of the present invention are different from other products in this field in at least the respects described below. None of the products mentioned herein is conceded to be prior art to the present invention.

Other hedge fund replication related products are known: Goldman Sachs (ART—Absolute Return Tracker), Merrill Lynch Factor Index, J.P. Morgan (ABI—Alternative Beta Index), and Bear Stearns (MAST). All of these products aim to replicate the overall universe of hedge funds—i.e., to deliver returns that are similar to broad hedge fund indices. The goal of HOST is to outperform the broad hedge fund indices, not replicate them. The application utilizes performance persistence among the best fund managers. By mimicking the investment style of the best managers, HOST seeks to outperform the broad hedge fund indices which reflect the average return earned by the overall universe of hedge funds. Of course, those skilled in the art will recognize that HOST will not always outperform broad hedge fund indices. The goal of HOST is to outperform the broad hedge fund indices, but it may under-perform in a certain month, or over a certain period of time, depending on the performance of the star funds that it tracks.

In an embodiment, HOST ranks each hedge fund relative to its peers, using a “relative risk-reward ratio,” described below. The relative risk-reward ratio metric of ranking funds addresses differences in leverage across funds, as well as “return smoothing” and style misclassification.

In addition, in one embodiment, all securities are derivatives and there is thus no restriction on using leverage. Furthermore, an embodiment of the present invention uses at-the money put and call options on S&P500 Index, DAX Index, and FX basket. This enables generation of various return profiles (e.g., straddles) which hedge funds are known to employ, while controlling the level of risk.

In one aspect, the invention comprises a computer-implemented method comprising: (1) electronically receiving data describing a fund index and funds on which the index is based; (2) electronically receiving data describing one or more securities; (3) electronically receiving data describing returns of: (a) the fund index, (b) funds on which the index is based, and (c) the one or more securities; (4) electronically identifying a subset of funds on which the fund index is based as superior-performing funds over a period of time preceding a first time and (5) constructing, at the first time, and based on the identified subset of funds, a first portfolio of securities whose return exceeds a return of the fund index over a first period of time.

In various embodiments: (1) the identifying comprises, for each fund, calculating a relative risk-reward ratio; (2) the identifying comprises, for each fund, calculating an excess return over peer funds; (3) the excess return is averaged over the second period of time; (4) the identifying further comprises dividing the averaged excess return by a standard deviation of the excess return; (5) one or more of the securities are derivative securities; (6) at least one of the one or more derivative securities is a put option; (7) at least one of the one or more derivative securities is a call option; (8) the put option is an at-the-money put option; (9) the call option is an at-the-money call option; (10) at least one of the one or more derivative securities is an index swap; (11) the method further comprises, at a second time that is subsequent to the first time, constructing a second portfolio of securities whose return exceeds a return of the fund index over a second period of time; (12) the second time is approximately one month after the first time; (13) constructing the first portfolio comprises identifying a set of one or more weights, one weight for each security in the first portfolio, such that the set of weights minimizes return tracking error between the superior-performing funds and the first portfolio of securities over the first period of time; (14) the tracking error is calculated based on a sum of squared return residuals between the first portfolio and the fund index; (15) the securities in the first portfolio comprise one or more call options and one or more put options; and (16) the call options comprise one or more at-the-money call options and one or more at-the-money put options.

Other aspects of the invention comprise software for implementing the above aspects and embodiments, as well as portfolios constructed according to the above aspects and embodiments.

DETAILED DESCRIPTION

In one aspect of the invention, instruments used in embodiments of the present invention were judiciously selected following a battery of tests so that they span the investment universe of the funds: stocks, bonds, commodities, credit, currency and volatility. In an embodiment, the HOST basket comprises 13 instruments that span the breadth of the investment universe, as shown inFIGS. 1-3and listed below. As used herein, the term “factor” is interchangeable with “instrument.”

At-the-money (“ATM”) Options:1. Call on S&P 500 Index (“SPCa”)2. Put on S&P 500 Index (“SPPa”)3. Call on DAX Index (“DXCa”)4. Put on DAX Index (DXPa”)5. Call on custom FX basket (“FXCa”)6. Put on custom FX basket (“FXPa”)

Exchange Traded Fund:9. iShares MSCI Emerging Markets Index Exchange Traded Fund (“EEM”)

Total Return Swap:10. Lehman Brothers U.S. Aggregate Index (“AGG”)11. Lehman Brothers High Yield CDX Index (“HY”)12. Lehman Brothers Commodity Index Total Return (“LBCI”)

This portfolio is exemplary, and the present invention is not limited to this illustrative combination of instruments. Other instruments and combinations are contemplated to be within the scope of the present invention.

Selecting Star Hedge Funds and Return

Hedge fund data used for the construction of a HOST embodiment is based on different hedge fund return databases. In one embodiment, all the hedge funds in the HFN (Hedgefund.net) database are used, and then “star” hedge funds are selected using an objective algorithm. An exemplary algorithm is described below.

The identification of “star” funds is done once a year using the previous 12 months of data for each fund as follows: every December, hedge funds are ranked relative to the other funds in their style category. Each fund receives a score based on its relative risk-reward ratio” The relative risk-reward ratio of a fund is the excess return of the fund over that of the peer funds in its style category, averaged over the previous 12 months, divided by the standard deviation of the excess performance. Funds are then assigned into quartiles based on their relative risk-reward ratio, and the top quartile of funds is identified as the “star” funds. For convenience, the return of the star hedge funds will be denoted herein as RHF.

HOST Portfolio Weights Calculation

In one aspect of the invention, the “weight” of each instrument (i.e., the amount to invest in each instrument) in the portfolio is determined. The factor weights for all the factors (except for USD LIBOR) are calculated using a rules-based, discretion-free optimization algorithm. In one embodiment, the algorithm seeks to explain excess returns over USD LIBOR for the time-series of hedge funds returns as the weighted sum of excess returns for each of the factors. Specifically, for the exemplary portfolio ofFIGS. 1-3, the algorithm ideally wants to satisfy the equality below for each time t:
RtHF−RtLibor=ω1(RtEM−RtLibor)+ω2(RtAGG−RtLibor)+ω3(RtHY−RtLibor)
+ω4(RtSPCa−RtLibor)+ω5(RtSPPa−RtLibor)+ω6(RtDXCa−RtLibor)+ω7(RtDXPa−RtLibor)
+ω8(RtLBCI−RtLibor)+ω9(RtFXCa−RtLibor)+ω10(RtFXPa−RtLibor)+ω11RtRUT+ω12RtVIX(1)
where RtHFis the star hedge funds' return at a time t, RtLiboris LIBOR's return at a time t, RtEMis EEM's return at time t, ω1is EEM's weight in the portfolio, RtAGGis AGG's return at time t, ω2is AGG's weight in the portfolio, and so on for each of the instruments in the portfolio (except LIBOR). The abbreviations for the instruments are shown in the list of instruments above and also inFIGS. 1-3.

However, satisfying this equality in equation (1) is the ideal, and in actuality, there will most likely be some difference between the left and right sides of equation (1) at some times t. That is, the portfolio will most likely not be able to perfectly replicate the star funds' performance at all times. The difference between the left and right sides of equation (1) will be referred to herein as “residual tracking error” and will be denoted as etfor a time t. Specifically, at each time t:
et=RtHF−RtLibor−[ω1(RtEM−RtLibor)+ω2(RtAGG−RtLibor)+ω3(RtHY−RtLibor)
+ω4(RtSPCa−RtLibor)+ω5(RtSPPa−RtLibor)+ω6(RtDXCa−RtLibor)+ω7(RtDXPa−RtLibor)
+ω8(RtLBCI−RtLibor)+ω9(RtFXCa−RtLibor)+ω10(RtFXPa−RtLibor)+ω11RtRUT+ω12RtVIX]  (2)
The value of RtHFis computed as described above, and the other returns in equation (2) are publicly available as of the monthly rebalancing date. In one embodiment, each factor return is rounded to 1/100th of a basis point.

In one embodiment, the objective of the optimization algorithm is to minimize a weighted sum of squared residual tracking errors in a particular span of time by adjusting the weights ω. Specifically, the optimization algorithm adjusts the weights ω to perform:

Min⁢∑t=1T⁢Ψ⁡(t)×et2(3)
where etis provided in equation (2), and Ψ(t) is a time-based function that allocates different importance to different times t. For example, in one embodiment, the optimization algorithm allocates more importance to more recent times, and less important to earlier times. In this case, Ψ(t) can be an exponential decay function that decays as time gets earlier and earlier.

This allows HOST to quickly respond to more recent market conditions and hedge funds return realizations. The time-based function Ψ(t) will also be referred to herein as a “rebalancing weighting factor.” One skilled in the art will understand the ways to actually implement/perform the minimization operation in equation (3). In various embodiments, the algorithm includes additional constraints.

For example, in one embodiment, the optimization algorithm performs equation (3) while keeping the weight of EEM non-negative. In one embodiment, the optimization algorithm considers a span of time that runs up to one month before the rebalancing date, to reflect realistically the timing of reported returns by hedge funds. For example, factor weights for February 2008 are determined using the optimization over January 2005-December 2007 time period.

After the weight of each instrument in the portfolio (except LIBOR) is rebalanced, the weight for LIBOR (ω13) is computed as:

e13=1-∑i=110⁢ωi(4)
The model uses USD LIBOR as the funding rate, with cash being invested or borrowed at that rate. In equation (4), the weights of “RUT” and “VIX” are not included because they are already unfunded (i.e., price) returns. In one embodiment, all weights are rounded to 1/100th of a percentage point.

In an exemplary embodiment, the HOST basket is rebalanced monthly on the last Index Business Day of each month (the “monthly rebalancing date”). As used herein, “Index Business Day” means a day on which commercial banks and foreign exchange markets settle payments and are open for general business. The factor weights (ω) are computed at the beginning of each month and are held constant over the duration of that month.

The factor weights represent the composition of the HOST portfolio. A positive weight indicates an investment and a negative weight indicates, for example, a short for a future or a payout of the return in a swap contract. Since EEM is an exchange traded fund, it does not allow for any negative weights. The magnitude of the weight corresponds to the magnitude of the amount associated with the instrument. The composition of the HOST as per September 2008 was:

Embodiments of the present invention comprise computer components and computer-implemented steps that will be apparent to those skilled in the art. For example, calculations and communications can be performed electronically, and agreements can be composed, transmitted and executed electronically. An exemplary system is depicted inFIG. 4. As shown, computers100communicate via network110with a central server130. A plurality of sources of data160,170relating to, for example, hedge fund data and/or index data, also communicate via network110with a central server130, processor150, and/or other component to calculate and transmit, for example, HOST data. The server130may be coupled to one or more storage devices140, one or more processors150, and software160.

Other components and combinations of components may also be used to support processing data or other calculations described herein as will be evident to one of skill in the art. Server130may facilitate communication of data from a storage device140to and from processor150, and communications to computers100. Processor450may optionally include local or networked storage (not shown) which may be used to store temporary information. Software160can be installed locally at a computer100, processor150and/or centrally supported for facilitating calculations and applications.

For ease of exposition, not every step or element of the present invention is described herein as part of a computer system and/or software, but those skilled in the art will recognize that each step or element may have (and typically will have) a corresponding computer system or software component. Such computer system and/or software components are therefore enabled by describing their corresponding steps or elements (that is, their functionality), and are within the scope of the present invention.

Moreover, where a computer system is described or claimed as having a processor for performing a particular function, it will be understood by those skilled in the art that such usage should not be interpreted to exclude systems where a single processor, for example, performs some or all of the tasks delegated to the various processors. That is, any combination of, or all of, the processors specified in the claims could be the same processor. All such combinations are within the scope of the invention.

The present invention has been described by way of example only, and the invention is not limited by the specific embodiments described herein. As will be recognized by those skilled in the art, improvements and modifications may be made to the invention and the illustrative embodiments described herein without departing from the scope or spirit of the invention.