7.4 / 28 - Hedge Funds: Directional Strategies

Question 1

LO 28.1: Demonstrate knowledge of the financial economics of directional strategies.

Answer 1

• Compare and contrast equity long/short strategies, global macro strategies, and quantitative hedge fund strategies. • Discuss the effect of informational market efficiency on directional hedge fund strategies. • Describe behavioral finance, and discuss how behavioral biases affect investor behavior.

Question 2

Discretionary (Directional) Strategies vs. Quantitative Strategies

Answer 2

Discretionary strategies involve fewer bets, larger position sizes, and considerably concentrated positions compared to quantitative strategies. The two discretionary directional strategies to be discussed are equity long/short and global macro.

Quantitative strategies are generally more systematic and involve almost no discretion.

The discretionary strategies involve much more research and analysis, which does not make it feasible to hold too many positions. On the other hand, quantitative strategies use algorithms and computerized processes, which allow for substantially more positions and smaller position sizes.

Question 3

Two Discretionary Strategies

Answer 3

• equity long/short tends to focus on value and fundamentals with thorough due diligence performed on their investments, all in the style of Warren Buffett’s approach
• Global macro, on the other hand, is less detailed oriented but would hold strong opinions on international interest rates, equity prices, and commodity price, for example.
• Both strategies generate returns that are highly volatile, so significant gains or losses are likely.

Question 4

3 versions of Informational Market Efficiency (Eugene Fama)

Answer 4

1. Weak form efficiency. The weak form of the EMH states that current security prices fully reflect all currently available security market data. Therefore, past price and volume (market) information will have no predictive power about the future direction of security prices because price changes will be independent from one period to the next.

2. Semistrong form efficiency. The semistrong form of the EMH holds that security prices rapidly adjust without bias to the arrival of all new public information. As such, current security prices reflect all publicly available information. All security prices include all past security market information and nonmarket information available to the public. The implication is that an investor cannot achieve positive risk-adjusted returns on average by using fundamental analysis. In practice, semistrong form efficiency does not exist completely given the existence of many successful equity long/ short fundamental strategies.

3. Strong form efficiency. The strong form of the EMH states that security prices fully reflect all information from both public and private sources. It includes all types of information: past security market information, public, and private (inside) information.

Question 5

What is a value trap

Answer 5

A value trap can be described as when an undervalued security remains that way for an extended period due to strong competition or weak management, for example.

Question 6

What is a short squeeze?

Answer 6

short squeeze can be described as an overvalued security that does not fall in value, but actually rises rapidly in value in the short term. The result is that the short sellers incur losses to cover their short positions.

Question 7

What is Behavioral Finance

Answer 7

Behavioral finance questions the assumptions of the EMH that investors act rationally and objectively consider all relevant information in valuing securities. addresses:

1. limits to arbitrage, which refers to rational investors being challenged to overcome dislocations resulting from irrational investors, and
2. cognitive psychology, which can be described as the study of how people make investment decisions and how they fail to demonstrate complete rationality in the investment process when emotions are considered.

Question 8

WHat are the 6 behavioral biases to consider ipacting investor behavior?

Answer 8

(1) leverage aversion/restriction,
(2) sentiment sensitivity,
(3) overconfidence,
(4) anchoring effects,
(5) confirmation bias, and
(6) loss aversion/disposition effect.

Question 9

Behavioral biase 1) Leverage aversion

Answer 9

Leverage aversion theory suggests that investors who are unable or limited in ability to use leverage would drive up the prices of high-beta assets with the end result being negative alphas. High-beta assets are equivalent to average-beta assets that are levered up.

Betting against beta (BAB) is a strategy whereby an investor holds a long position in low-beta assets and a short position in high-beta assets. The empirical evidence supports BAB’s effectiveness in that BAB generated 0.7% per month between January 1926 and March 2012 in a variety of different asset classes.

high-quality assets - those that are safe, profitable, growing, and well managed. study suggests that a strategy of a long position in high-quality assets and a short position in low-quality assets earns substantial risk-adjusted returns. Importantly, both the BAB strategy and the high-quality strategy were found to also hold in many non-U.S. markets.

Question 10

Behavioral Biase 2) Sentiment Sensitivity

Answer 10

Sentiment can be described as beliefs regarding future cash flows and risks that are not backed up with sufficient research and facts. The aggregate level of stock prices is a function of sentiment and it is the riskier stocks that are most exposed to investor sentiment. Betting against investor sentiment is potentially a losing strategy due to the limits of arbitrage;

A sentiment index is created to demonstrate a strong correlation between index returns and the returns of riskier stocks. The existence of greater transaction costs and risks makes those stocks more difficult to arbitrage and to value. The sentiment index uses six underlying elements: : discounts on closed-end funds; turnover of NYSE shares; number of IPOs; average first-day returns on IPOs; equity share in new issues; and the dividend premium, which can be described as the difference between the average market-to-book-value ratios of dividend paying firms and non-dividend paying firms.

. Accruals refer to the level of net income versus cash flow, so a low-accrual stock has lower net income than cash flow. The capital asset pricing model (CAPM) suggests that high-beta socks will outperform low-beta stocks and high-accrual stocks will underperform low-accrual stocks.

Question 11

Behavioral Bias 3) Overconfidence

Answer 11

Overconfidence occurs when investors overestimate their own intuitive ability or reasoning. It may result in underestimating risk and overestimating return as demonstrated by a study by Fischoff, Slovic, and Lichtenstein (1977)5 whereby they found that events that individuals thought were 100% likely to occur actually occurred only 80% of the time. Overconfidence tends to result in excessive portfolio turnover and transaction costs, resulting in lower returns.

Question 12

Behavioral Bias 4) Anchoring Effects

Answer 12

Anchoring effects can occur when investors rationally form an initial view, but then fail to change that view as new information becomes available.

An analyst who ignores the forecasted information is falling subject to anchoring effect

Question 13

Behavioral Bias 5) Confirmation bias

Answer 13

Confirmation bias occurs when investors look for new information or distort new
information to support an existing view. Duong, Pescetto, and Santamaria (2010)6 studied confirmation bias in the U.K. by studying value investing and glamour investing using fundamentals. Value stocks have a high book-to-market ratio, earnings-to-price ratio, and cash-flow-to-price ratio whereas glamour stocks have the opposite characteristics.

Question 14

Behavioral Bias 6) Loss aversion/disposition effect

Answer 14

Loss aversion/disposition effect arises from investors feeling more pain from a loss than pleasure from an equal gain. Prospect theory results in making choices that favor certain outcomes versus probable outcomes.

Question 15

LO 28.2: Demonstrate knowledge of the background of the equity long/short hedge fund strategies

Answer 15

• Describe the equity long/short investment strategy.
• Recognize the potential equity long/short investment opportunity set.
• Discuss the value, growth, and blend approaches to equity long/short investing.
• Describe and compare the bottom-up approach and the top-down approach to fundamental analysis.
• Describe Gordon’s growth model and the enterprise valuation model for fundamental equity valuation, and use these models to calculate valuations for a given investment.
• Describe the sector-specific approach and the activist approach to equity long/ short investment.
• Discuss the steps involved in the process of executing a long/short hedge fund strategy (i.e., idea generation, optimal idea expression, position sizing, and trade execution).
• Recognize the risks associated with equity long/short investing, and describe how they may be managed.
• Describe the issues of managerial expertise, sources of return, and return attribution as they apply to the analysis of equity long/short strategies, and calculate the return on a given long/short investment.
• Discuss the procedures involved in the investment process for a fundamental equity long/short manager.

Question 16

Describe Fundamental Equity Long/Short strategy

Answer 16

Fundamental equity long/short, or simply equity long/short, is a combination strategy in which the investment manager buys equities expected to rise in value and sells equities expected to fall in value. Stock-picking ability is a key measure of the strategy’s success. The various strategies vary in terms of the extent of discretionary processes (i.e., fundamental analysis, qualitative) versus systematic processes (i.e., technical analysis, quantitative) used.

Compared with market-neutral and statistical arbitrage managers, long/short managers tend to have much longer holding periods (e.g., 3–5 years) and more concentrated portfolios consisting of 3–10 core positions with an additional 20–40 smaller satellite positions.

Question 17

Threee approaches that EQuity Long/Short managers apply to investing

Answer 17

• *• Value long/short managers** use a contrarian approach, as the focus is on firms currently out of favor. Ratio analysis may also be used, with a focus on price-to-earnings (P/E), book-to-market, dividend yield, and P/E to earnings growth rate (PEG) ratios.
• *• The growth approach** focuses on firms with superior top-line (i.e., revenue) growth potential, using the growth at a reasonable price (GARP) approach. Small high-tech companies are often included in the approach. Managers are willing to overlook negative current earnings if the firm has high growth potential.
• *• The blended approach** is a combination of the value and growth approaches. For example, the value approach may be used in falling markets and the growth approach may be used in rising markets.

Question 18

bottom-up fundamental analysis

Answer 18

Most equity long/short managers use bottom-up fundamental analysis. Those managers may use an approach using strengths, weaknesses, opportunities, and threats (i.e., SWOT analysis).

• Since portfolios are more concentrated and focused on specific stock selection, long/short managers spend a significant amount of time doing field research trying to discern information not necessarily reported in public financial documents.
• Focuse on firm’s prospects, competity advantages, industry factors, political or regulatory risks
• assemble a range of forecasts regarding a company’s future performance (e.g., sales, expenses) to lead to estimated cash flows upon which a discount rate is applied to estimate the company’s value.

Question 19

top-down fundamental analysis

Answer 19

Managers who use top-down fundamental analysis are not as concerned with firm-specific information as they are with overall economic drivers. Those managers focus on macroeconomic factors, market timing, and industry performance. As well, they have specific views on business cycle stage, inflationary expectations, and monetary and fiscal policies.

Question 20

Gordon’s growth model (GGM)

Answer 20

A simplified equation assumes that the dividends will grow at a constant rate of g in each period. Therefore, the equation is as follows:

V0 = div1 / k - g

Question 21

enterprise valuation (EV) model

Answer 21

The enterprise valuation (EV) model computes the total value of the company and then derives the equity value as follows:

EV = market value of equity + market value of debt – cash

market value of equity = EV + cash – market value of debt

The EV is the market value of the operating assets. It can also be computed using the free cash flow to the firm (FCFF) formula:

FCFF = net income + non-cash charges + [interest expense × (1 – tax rate)] – working capital investment – fixed asset investment

Question 22

Sector Specialist vs. Generalist

Answer 22

• *• Sector specialist approach.** Under this approach, a manager may go long on firms perceived to be stronger, and short on firms perceived to be weaker, all within the same sector. Common sectors include finance, health care, technology, and real estate.
• *• Generalist approach.** Under this approach, a manager invests in broad variety of company types. Often, generalist managers limit their scope to a particular geographic area, such as a particular country or a set of emerging market countries.

Question 23

activist approach

Answer 23

The activist approach is employed when the long/short manager chooses to take a very public vocal position to obtain a positive return by influencing company management to take certain actions. Depending on the position, the manager may try to cause changes that may benefit one investor group at the expense of another (e.g., bond holders vs. equity holders). It has been also found that target firms have higher payouts, better operating results, and higher CEO turnover after such activism occurs.

Question 24

execution of an equity long/short strategy can be described through a five-step process:

Answer 24

1. Idea generation - can come from different sources, but use only publicly available info
2. optimal idea expression - must determin how to profit from generated ideas
3. Size the position - confidence level
4. Execute the trade - managers are often experienced traders and may execute their own trades. strade stragies are important.
5. Risk management - Long/short managers monitor risk carefully, employing risk models and value at risk (VaR) analysis.
   
   1. pay close attention to corporage actions
   2. Scenario alnalysis - allows managers to see potential ocurrence of a company event or market event affects the value of positions.
   3. A short squeeze - occurs when a short seller is forced to close his position (i.e., purchase shares) at increasing prices. In addition, some countries use an uptick rule, whereby short stock sales can only occur when a stock price experiences a price increase.

Question 25

There are two forms of informational inefficiency, which long/short managers can use to earn excess returns.

Answer 25

• *1. Factor-based informational inefficiency.** Using models, such as the Fama-French model, equity long/short managers identify factors (e.g., size and book-to-market ratio) that indicate if a firm type is likely to underperform or overperform the market.
• *2. Firm-specific informational inefficiency.** If a market is not semistrong efficient, then long/short managers may be able to take advantage of superior information gathering and filtering at the firm level to identify mispriced securities. This approach is most likely to be successful for small companies due to the lack of market analysis.

Question 26

13F Securities

Answer 26

Long/short managers also focus on the trading activities of other market participants. Managers who have discretion over $100 million or more in 13F securities are required to file Form 13F with the Securities and Exchange Commission (SEC). Section 13F securities include most exchange-traded stocks, equity options, and shares of closed-end investment companies, as well as select convertible debt securities. However, mutual funds (i.e., open-end investment companies) and short sales are not considered 13F securities. Form 13F filings must occur within 45 days of the close of each calendar quarter.

Question 27

Equity long/short returns can be broken down as follows:

Answer 27

• • Returns/costs from long positions:
  
  • Š Price increase/decrease.
  • Š Dividends received.
  • Š Margin cost of longs (i.e., cost of margin if long positions are leveraged).
  • Š Interest earned on cash portion.
• • Returns/costs from short positions:
  
  • Š Price decrease/increase.
  • Š Short stock rebate (i.e., interest earned on short proceeds).
  • Š Borrowing (of shares) costs.
  • Š Dividend payments to purchasers of borrowed shares

Question 28

DuPont Model for measuring return on Equity (ROE)

Answer 28

ROE = net profit margin × asset turnover × leverage

or

ROE = (net income / revenue) × (revenue / assets) × (assets / book value of equity)

Question 29

P/E Ratio (Earnings refers to net income)

Answer 29

P/E = market price per share / EPS for the previous 12 months

Generally, a low P/E (“cheap”) stock is favored by value investors. However, simply looking at the P/E ratio alone is not sufficient. For example, because of increasing market efficiency, a low P/E ratio does not usually mean that it is underpriced but more likely means that it has negative attributes such as high leverage or falling sales or income levels. Also, the P/E ratio is based on prior period earnings; it is a trailing ratio, which makes it less useful.

Question 30

Investment Process Focus

Answer 30

1. Business
2. Management (of business) including comp, internal controls, corp culture
3. Financial Statements (including DuPont and other ratios)
4. Valuation (ratios like P/E)

Question 31

LO 28.3: Demonstrate knowledge of global macro hedge funds and strategies.

Answer 31

• Summarize the history of the global macro hedge fund industry.
• Describe the key characteristics of global macro strategies.
• Compare and contrast the discretionary trading approach and the systematic
trading approach.
• Compare global macro managers to commodity trading advisors (CTAs).
• Discuss various schools of thought regarding sources of returns of which global macro funds are trying to take advantage.
• Describe multistrategy global macro funds.
• Describe directional currency trades, and apply the Fisher equation.
• Discuss the possible effects of global macro funds on financial market volatility in emerging markets.
• Describe four models used for currency trading.
• Describe carry models for currency trading, and determine whether interest rate parity is satisfied in a given scenario.
• Describe trend-following and momentum models for currency trading.
• Describe value and volatility models for currency trading, and calculate the end-of-period exchange rate in a given scenario.
• Discuss risk management techniques used for global macro funds, and how they affect the portfolio construction process.

Question 32

About Global Macro Strategies

Answer 32

• Global macro hedge funds have the broadest investment universe as a result of their ability to take positions in any asset in any market. Global macro managers analyze broad macroeconomic trends (i.e., use a top-down approach) and take market bets in whatever market the manager feels offers the highest potential rewards.
• As of now, macro funds consist of less than 10% of total assets under management in the hedge fund industry and are the slowest growing of all hedge fund strategies.
  *

Question 33

Global Macro: Discretionary vs. Systematic

Answer 33

Discretionary global macro managers. These are fundamental researchers. They analyze publications from central banks, key confidence indicators, statistics on asset flows, measures of liquidity, and even comments made by politicians. Developing a network of personal contacts who are “in the know” to obtain information is an important component of this approach. The discretionary global macro manager’s goal is to understand underlying macroeconomic and asset class trends, develop likely (and unlikely) market scenarios based on these trends, and ultimately identify the best risk/reward opportunities. From there, discretionary global macro managers often use technical analysis to identify entry and exit points for individual securities. The result is a discretionary portfolio that depends greatly on the skills and subjective assessments of the individual manager.

• Systematic global macro managers. These follow a standardized, structured investment process that is objective in nature. Systematic managers rely on a consistent system of looking at economic data and using mathematical models to assess markets, identify opportunities and market signals, and establish entry/exit points for individual securities. Like discretionary managers, systematic global macro managers use technical analysis. However, systematic managers tend to use technical data to follow directional trends in markets and use tools such as moving averages, chart patterns, and breakout systems to capitalize on these trends. Some systematic managers are referred to as global trend followers, as their process leads them to longer-term macroeconomic trends.

Question 34

Global Macro Managers vs. Commodity Trading Advisors

Answer 34

While global macro strategies are similar to commodity trading advisors (CTAs) in that they both often follow trends and participate in the same markets (i.e., currency, equity, fixed-income, and commodity markets), SEVERAL key differecnes:

• CTAs wait for extablished trend in prices vs. Global Macro managers forecast price info and trade based on projections
• CTAs focus on price only, go with systematic models regardless of fundamentals vs. Global Macro considers the big picture and analyze deper when fundamentals inconsistent with trend
• CTAs follomow homo strategies, while Globla Macro use hetero strategies (dissimilar
• CTAs primarily use momentum indications vs. Macro incorporates additional market fundamentals, such as unused storage capacity in the crude oil market,

Question 35

Global Macro categorization by schools of thought:

Answer 35

• Feedback-based global macro managers. They try to understand and interpret the market’s psychology and attempt to take advantage of the irrationality that can exist due to investor behavior. Warren Buffett has been credited as wanting to “be greedy when investors are fearful and fearful when investors are greedy.”

• Information-based global macro managers. They gather information at the micro level to better understand the macro picture. The theory behind this approach is that there is a delay in publication of economic macro statistics, and that this time gap can be capitalized on by looking for pricing inefficiencies that may exist until the macro information becomes public knowledge

• Model-based global macro managers. They rely on financial modeling and underlying economic theories to assess markets, identify fiscal or monetary policy mistakes, and capitalize on disparities between unrealistic market expectations and likely real outcomes. Types of Models/trades:

• Carry trades - invest at high interest rate, borrow at low interest rate
• Yield Curve Relative value trades - invest at a high yielding part of curve, borrow at lower yielding part of curve
• Purchasing POwer Parity (PPP) models - when looking at relative values between currencies
• Valuation Models - such as dividend discount model, applied at company level, results are aggregated and applied to market
• Option pricing models - used to derive market’s expectation of future vol

Multi Strategy Funds

Question 36

What is the Fisher Effect?

Answer 36

Directional currency trading focuses on the relative values of currencies, so the Fisher effect is a fundamental concept to discuss. The Fisher equation is stated as follows:

(1 + n) = (1 + r) × (1 + i)

or

n ≈ r + i

where:
n = nominal interest rate
r = real interest rate
i = expected inflation rate

Question 37

European Monetary System (EMS)

Answer 37

• established in 1979 between several countries in Europe under guidelines set up by the Exchange Rate Mechanism (ERM) agreement.
• It was a pegged system allowing exchange rates to float within prespecified bands ranging from 2.25% for most countries to 6.% for large countries such as Italy and the United Kingdom.
• A pegged exchange rate system involves a commitment from a country to use fiscal and monetary policy to maintain the country’s exchange rate within a narrow band relative to another (usually stronger) currency, or to a bundle of currencies.
• In 1992, the United Kingdom was in recession with unemployment in excess of 10%. Typically, the U.K. central bank would have tried to use expansionary monetary policy to get the economy to grow, but cutting interest rates would have devalued the British pound beyond the exchange rate bands specified in the ERM agreement.
• Most market participants thought it was impossible to force British authorities to abandon the ERM bands, but Soros placed a massive bet by shorting British pounds.
• The Bank of England (BOE) tried to defend the band by buying pounds and raising its base lending rate. However, the BOE depleted its foreign currency reserves, and downward pressure was so great on the pound that interest rate hikes were ineffective. Ultimately, the BOE was forced to suspend participation in the ERM, resulting in a sharp devaluation in the pound, and Soros’ Quantum Fund made a profit of more than $1 billion in making the directional bet against the British pound.

Question 38

The balance of payments equation (Governments economics)

Answer 38

current account balance + capital account balance + official reserve account balance = 0

• The current account includes the exchange of goods, services, investment income, and unilateral transfers (net foreign aid and other gifts).
• The capital account includes payments for securities, direct investment, and bank deposits.
• Official reserve account transactions are those made from the reserves held by the official monetary authorities.

Question 39

Four Models for Currency Trading

Answer 39

1. Carry. The carry trade involves borrowing in a low interest rate currency and investing in a high interest rate currency in an effort to capture the interest differential between the two currencies.
2. Trend-following and momentum. Trend-following involves taking long positions in currencies that are appreciating (trending up) and taking short positions in currencies that are depreciating (trending down).
3. Value. A value approach involves buying undervalued currencies and selling overvalued currencies based on purchasing power parity (PPP).
4. Volatility. Managers using a volatility-based approach to trade currencies take positions based more on the volatility of a currency’s price movements than the direction of those price movements.

Question 40

Carry Models for Currency Trading

Answer 40

A basic carry trade involves borrowing in a currency with a low interest rate (e.g., Japanese yen) and lending in a currency with a high interest rate (e.g., Australian dollar) to profit from the interest rate differential between the two currencies.

• The primary risk to a basic carry trade is exchange rate risk, or the risk that a currency may appreciate or depreciate relative to another currency.

Question 41

forward currency premium

Answer 41

defined as the premium (or discount) resulting from a forward contract executed in the future at a forward rate. To capitalize on a forward currency premium (or discount), the strategies used by global macro hedge fund managers include:

• If the forward exchange rate is higher than the spot rate, this implies a forward premium: sell the foreign currency forward or buy the domestic currency forward.
• If the forward exchange rate is lower than the spot rate, this implies a forward discount: buy the foreign currency forward or sell the domestic currency forward.

Question 42

covered interest rate parity

Answer 42

According to covered interest rate parity, the forward premium of one currency relative to another is equal to the interest rate differential between the two currencies. The implication is that currencies with a low interest rate typically trade at a forward premium, while currencies with a high interest rate typically trade at a forward discount.

Question 43

uncovered interest rate parity (UIP)

Answer 43

states that the interest differential between two countries should be equal to the projected change in exchange rate between the respective currencies. In other words, if UIP holds, a carry trade should have a loss on the currency side which exactly offsets any gain on the interest rate side.

Question 44

Trend-Following and Momentum Models

Answer 44

Unlike carry trades, momentum trades rely on historical relationships between currencies. Trend-following is one of the most common strategies employed by professional currency managers. The concept is simple: the manager will invest in (go long) a currency that is appreciating, or trending up, and sell when the manager’s definition of the trend changes.

Managers can define a trend in a variety of different ways, but the most common approach uses a moving average of some specific time frame.

Question 45

Three forms of purchasing power parity (PPP)

Answer 45

1. The Law of one Price
2. absolute PPP
3. relative PPP

Question 46

law of one price (PPP)

Answer 46

Under the law of one price, the ratio between domestic and foreign price levels should be equal to the equilibrium exchange rate (i.e., the rate at which demand is equal to a currency’s supply in that particular economy) between domestic and foreign currencies. In other words, exchange rates between countries should allow the same goods to be purchased for the same price when adjusted for exchange rates. This theory does not account for transaction costs

• Each year, The Economist magazine publishes the Big Mac Index to determine how much it costs to purchase a McDonald’s Big Mac sandwich in various currencies around the world according to PPP
  *

Question 47

absolute purchasing power parity (PPP)

Answer 47

absolute purchasing power parity (absolute PPP) compares the average price of a representative basket of consumption goods between countries. Absolute PPP only requires that the law of one price is correct on average for a like basket of goods in each country. In practice, even if the law of one price held for every good in two economies, absolute PPP might not hold because the weights (consumption patterns) of the various goods in the two economies may not be the same (e.g., people eat more potatoes in Russia, more rice in Japan).

Question 48

Relative purchasing power parity (relative PPP)

Answer 48

Relative purchasing power parity (relative PPP) is based on the idea that even if absolute PPP does not hold, there may still be a relationship between exchange rate movements and differences in inflation rates between two countries. Simply put, if (over a one-year period) country A has a 6% inflation rate and country B has a 4% inflation rate, then A’s currency should depreciate by approximately 2% relative to B’s currency over the period.

Relative PPP Formula:

Question 49

Global Macro Risk Management and Portfolio Construction

Answer 49

Global macro funds in their infancy were high-risk strategies, placing huge highly-levered directional bets with few risk controls. High volatility and leverage levels resulted in frequent large gains and losses. For example, George Soros’s Quantum Fund gained $1 billion against the British pound in 1992, but lost $2 billion in 1998 during the Russian crisis.

Global macro hedge funds matured throughout the 1990s and today take a more disciplined, risk-adjusted approach with an emphasis on diversification rather than concentrated trading positions.

• In terms of risk controls, global macro managers commonly use value at risk (VaR) measures to create risk budgets and allocate risk capital throughout the form as well as stop-loss orders to exit losing trades before small losses become large losses.

Question 50

LO 28.4: Demonstrate knowledge of the historical performance of directional strategies.

Answer 50

• Analyze historical performance of equity long/short and global macro hedge fund strategies.

Question 51

• Analyze historical performance of equity long/short and global macro hedge fund strategies.

Answer 51

Between December 1989 and December 2014, the CISDM Equity Long/Short Index had an annual return of 10.7% and standard deviation of 7.8%. For the same period, the CISDM Global Macro Index had an annual return of 9% and standard deviation of 5.5%.
The monthly returns had a correlation of 0.56 so some diversification benefits could be earned. An equally weighted portfolio containing both indices would result in an annual return of 9.8% and standard deviation of 5.9%. Assuming a 3% risk-free rate, the equally weighted portfolio would have a Sharpe ratio of 1.15, while the Equity Long/Short Index and Global Macro Index would have Sharpe ratios of 0.99 and 1.09, respectively.