ZZBU8701: Project 1 Determining Hedge Fund NAV

Assessment Task

You are tasked with calculating annual NAV over a period of 5 years for a conviction-based Hedge Fund based on the specified assumptions, long-short trading strategy and fund fee structure outlined below.

NOTE: Read Submission details on last page to avoid any substantial penalties.

Portfolio

Conviction Hedge Fund has raised $100million. It has decided to allocate its funds as follows:

• $70 million will be allocated to its Long Portfolio
• $10 million will be allocated for equity to the Long on Margin Portfolio
• $5 million will be allocated for equity to Short on Margin Portfolio
• $15 million will be allocated for cash to cover margin calls or other future cash payouts (such as management fees)

Long Portfolio

You will be allocated 10 stocks which the Conviction Hedge Fund research team believe meet its investment criteria. (Note that these stocks are unique to you and each student will have a different combination of stocks. Your allocated stocks will be posted on Moodle in the Project 1 Stock Allocation Lookup.xls excel file in the Project 1 assessment tab.

Conviction Hedge Fund’s allocation policy for its long-only portfolio is straight forward – it allocates $7 million to purchase each stock (including transaction costs – see below). The stocks are purchased on 31 December 2019 (using closing prices derived from Factset – see below) and then are held for the full 5-year analysis period (that is, after the initial purchase, no stock is sold or bought thereafter).

Long on Margin Portfolio

The Conviction Hedge Fund research team have identified 3 stocks which they believe meet its investment criteria. The three stocks are:

• AAPL-US
• DIS-US
• T-US

Conviction Hedge Fund’s allocation policy for its long on margin portfolio is straight forward – it allocates one third of its $10 million allocation for the initial margin in each stock (including transaction costs – see below). The stocks are purchased on 31 December 2019 (using closing prices derived from Factset – see below) and then are held for the full 5-year analysis period (that is, after the initial purchase, no stock is sold or bought thereafter).

In your long on margin portfolio, you will need to consider transaction costs on the initial purchase and dividend income (see below). You will also need to calculate on an annual basis your share portfolio value, margin loan balance, equity/margin %, and the amount of margin/collateral required to be posted to satisfy a margin call (if any). This will assist in calculating margin loan interest costs.

Short on Margin Portfolio

The Conviction Hedge Fund research team have identified 3 stocks which they believe meet its investment criteria for shorting. The three stocks are:

• CHTR-US
• INTC-US
• NKE-US

Conviction Hedge Fund’s allocation policy for its short on margin portfolio is straight forward – it allocates one third of its $5million allocation for the initial margin in each stock. The stocks are purchased on 31 December 2019 (using closing prices derived from Factset – see below) and then are held for the full 5-year analysis period (that is, after the initial short sale, no stock is short sold or covered thereafter).

In your short on margin portfolio, you will need to pay dividends to the stock lenders. You will also need to calculate – on an annual basis – your share portfolio value, initial sale proceeds, initial account balance, equity/margin %, and the amount deposited for the short – which is the initial margin plus the amount of margin/collateral required to be posted to satisfy a margin call (if any). Calculating the initial sale proceeds and netting off the amount deposited will assist in calculating margin borrow costs.

Transaction Costs

Regarding brokerage and commissions assume they are only payable on the long portfolio and the long on margin portfolio. For the short on margin portfolio assume that all transaction costs are rolled into the borrow costs, and trades are therefore executed at the 31 December 2019 closing prices with no spread and no commission (Note: this is to avoid circular references and simplify the analysis).

For the long portfolio and long on margin portfolio, assume the trades occur at a 0.1% spread above the 31/12/19 closing and that a brokerage commission of 0.25% is charged on this post-spread price.

Assessment Summary

Assessment Objective:
Students are required to calculate the annual Net Asset Value (NAV) of a conviction-based Hedge Fund over a 5-year period. The assessment tests understanding of portfolio allocation, long-short trading strategies, margin accounting, transaction costs, dividends, and fund fee structures.

Key Pointers to Be Covered:

1. Portfolio Allocation:
   • Long Portfolio ($70M) across 10 allocated stocks.
   • Long on Margin Portfolio ($10M) across 3 stocks with margin considerations.
   • Short on Margin Portfolio ($5M) across 3 stocks with borrow costs and dividend payments.
   • Cash Reserve ($15M) for margin calls and fees.
2. Transaction Costs & Spread:
   • Brokerage and commissions applied to long and long-on-margin portfolios (0.25% commission on 0.1% spread).
   • Short portfolio costs included in borrow fees.
3. Annual Calculations:
   • Portfolio values, margin balances, equity/margin %, margin calls.
   • Dividend income (for long on margin) and dividend payments (for short on margin).
   • Margin loan interest costs and borrow costs for shorts.
4. NAV Computation:
   • Combine long, long-on-margin, short-on-margin, and cash to calculate annual NAV for 5 years.
5. Compliance with Submission Requirements:
   • Correct use of stock allocations from the provided Excel file.
   • Accurate calculation of annual NAV using Factset closing prices and provided assumptions.

Academic Mentor’s Step-by-Step Guidance Approach

Step 1: Understanding the Hedge Fund Structure

• The mentor first explained the overall structure of the fund, including allocations to long, long-on-margin, short-on-margin portfolios, and cash reserves.

• Students were guided to note individual stock allocations and the difference between portfolios with and without margin.

Step 2: Calculation of Long Portfolio NAV

• Students were instructed to calculate the initial investment in each stock including the spread and brokerage costs.
• Annual valuation involved multiplying the number of shares by year-end stock prices from Factset.
• The mentor emphasized tracking dividends separately if applicable.

Step 3: Long-on-Margin Portfolio

• Guidance included calculating initial margin allocations for each stock.
• Students learned to determine equity/margin percentages, calculate margin loan interest, and assess margin calls.
• Annual updates were performed to monitor portfolio value versus margin obligations.

Step 4: Short-on-Margin Portfolio

• Mentor explained how to compute proceeds from short sale and the initial margin requirement.
• Students calculated annual stock values, borrow costs, and dividend payments to lenders.
• The mentor highlighted the importance of tracking equity/margin ratios to prevent breaches.

Step 5: Transaction Costs & Spreads

• Mentor clarified that only long and long-on-margin trades incur commissions and spreads, whereas short positions integrate borrow costs.
• Students were shown how to apply the 0.1% spread and 0.25% brokerage correctly to each transaction.

Step 6: NAV Aggregation and Analysis

• Students were guided to combine all portfolios and cash reserves to calculate annual NAV for each of the 5 years.
• Mentor emphasized accuracy in summarizing margin positions, dividends, and fees to reflect true NAV.

Step 7: Verification and Error-Checking

• Mentor recommended cross-checking calculations at each step.

• Students were instructed to validate results using Excel formulas to ensure all transactions, margins, and fees were accurately incorporated.

Outcome Achieved

• The final output was a 5-year annual NAV report for the conviction-based Hedge Fund, detailing long, long-on-margin, and short-on-margin portfolios with all fees, margins, dividends, and equity ratios accounted for.

• Students gained hands-on experience in real-world hedge fund accounting, portfolio tracking, and risk management.

Learning Objectives Covered

1. Portfolio Management: Understanding allocation across multiple portfolios and applying margin requirements.
2. Financial Calculations: Computing annual NAV, incorporating fees, spreads, interest, and dividends.
3. Risk Assessment: Monitoring equity/margin ratios and preparing for margin calls.
4. Analytical Skills: Aggregating portfolio performance to derive NAV and assess investment outcomes.
5. Practical Application: Using real stock data and fund assumptions to simulate hedge fund operations over multiple years.

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