9: Manager selection, DD, Regulation

Question 1

Moneyness

Answer 1

Moneyness = NAV / high watermark

If less than 1, the manager’s option is out of the money.

Question 2

Traits of funds likely to liquidate

Answer 2

1. Young
2. Poor Performance
3. Low AUM
4. Short lock up
5. Short redemption notice
6. No high watermark

Question 3

Method to construct contingency tables (to test for persistence)

Answer 3

1. calculate median performance variable
2. categorize each manager as W or L (vs. median)
3. count # of times W in P1 is W in P2 etc.
4. compute cross product ratio (no persistence if CPR=1)
5. test CPR for statistical significance

Question 4

Results of Test for Persistence

Answer 4

• no performance persistence

- strong persistence found in risk (except for merger arb)

Question 5

Omega ratio

Answer 5

• used for monitoring

- high omega preferred

Question 6

Hurst exponent

Answer 6

• measure of persistence
• high H preferred
• 0 < H < 0.5: mean reverting
• 0.5 < H < 1: persistent performance
• 0.5: random returns

Question 7

D-statistic

Answer 7

• measure of downside risk
• D = 0: no downside risk
• D = 1: no positive returns
• low D preferred

Question 8

Calmar Ratio

Answer 8

Ratio of returns to drawdown

Question 9

Carpenter (2000)

Answer 9

• managers increase risk as fund value drops
• managers increase risk below hurdle rate
• assumes fund liquidation @ value = 0

Question 10

Goetzmann, Ingersoll and Ross (2003)

Answer 10

• managers reduce risk as fund value drops
• emphasis on avoiding liquidation
• assumes fund liquidation is possible before value = 0

Question 11

Panageas and Westerfield (2009)

Answer 11

• no adjustments when returns are higher or lower

- managers compensated with incentive fee and HWM keep a constant proportion in the risky asset,

Question 12

Hodder & Jackwerth (2007)

Answer 12

• managers increase risk when returns are low, then decrease as fund grows
• find a liquidation barrier and having managers invested inhibits excessive risk taking as fund value decreases
• slight changes to the compensation structure can have significant effects on the risk-taking behavior of managers

Question 13

Tournament Behavior

Answer 13

• funds with below-median returns in 1H have increased volatility in 2H
• Found to be true in mutual funds and hedge funds

Question 14

Empirical findings (risk behavior) based on relative performance

Answer 14

1. Managers with poor performance increased risk (to improve rankings)
2. Managers with strong performance decreased risk (to maintain rankings)

Question 15

Empirical findings (risk behavior) based on absolute performance

Answer 15

1. ITM - reduce risk (‘locking in’ behavior)
2. ATM - increase risk
3. OTM - reduce risk (do not ‘put it all on black’)

Question 16

UCITS Eligible Instruments

Answer 16

1. Permitted: stocks & bonds, s & b derivatives
2. Permitted in many regions: investing in indices based on non-eligible assets
3. Not permitted in most regions: physical commodities or associated certificates
4. Not permitted anywhere: HFs, PE, RE
5. Luxembourg: can invest in closed end REIT funds and closed-end HFs

Question 17

Trash Ratio

Answer 17

10% of portfolio can be in non-eligible assets

Question 18

Issues with using VaR as risk management tool

Answer 18

1. does not account for extreme events

2. depends on normal returns

Question 19

Non-sophisticated UCITS funds

Answer 19

long only funds, may use derivatives for hedging

Question 20

Sophisticated UCITS funds

Answer 20

use derivatives for investing; more risk management

Question 21

Alternative UCITS funds vs HFs

Answer 21

1. Performance comparable to HFs
2. Outperform investable HF indices
3. Less risk than HFs (due to leverage limits)
4. Less exposure to illiquid assets than HFs

Question 22

Relationship with HF size, age, survival and risk taking?

Answer 22

size: no
age of fund: no

Weak evidence that smaller and young funds are more likely to engage in “locking in” behavior following relatively poor performance or when significantly below HWM. Makes sense given that liquidation concerns are more of a concern for this group

Question 23

Qualification criteria for UCITS

Answer 23

open ended
liquid
well-diversified
invest only in eligible assets
use limited leverage

Question 24

UCITS key points

Answer 24

• PE, HF, and RE are not permitted
• 10% trash ratio: this is for ineligible assets
• Short positions can only be constructed synthetically using derivatives
• In UCITS FoFS, individual investments cannot exceed 20% of NAV or 30% in non-UCITS funds
• must allow 20% of NAV to be redeemed at any time
• must value investments 2x a month
• must offer min. 2 redemptions per month to clients
• must provide NAV to authorities 2x a week
• must publish NAV 2X a month to investors
  -no selection, survivorship or instant history bias
• when identifying leverage levels:
  Un-Sophisticated UCITS use commitment approach, 200% leverage on NAV (via derivatives)
  Sophisticated UCITS use VaR approach
• can hold illiquid instruments (up to 10% of NAV) as long as they can meet the expected redemption requests from investors