AL 26-27 Flashcards
hedge fund strategis
- lower regulatory and legal constraints
- flexibility to use shorting selling and derivatives
- a large investment universe
- aggressive investment exposures
- comparatively free use of leverage
- liquidity constraints for investors
- lack of transparency
- higher cost structure
- basic trade-off between the added fees and alpha
- lack of full underlying investment transparency attribution, higher cost allocations associated with the establishment and maintenance of the fund investment structures
- long lived investment commitment periods with limited redemption availability
- liquid alternative significantly underperform similar strategy, hedge fund benefit from liquidity premium phenomena that cannot be easily transported into a metal fund format.
HFR classification 6
- Equity hedge
- event driven
- FOF
- Macro
- Relative value
- Risk parity
HFRX index of equally weighted hedged fund (open/close to new investor)
IFFRX outperform HFRI
HFRI index series tracks only hedge fund open to new investors
Lipper classification 10
- dedicated short bia
- equity market neutral
- long/short equity hedge
- event driven
- convertible arbitage
- fixed income arbitrage
- global macro
- managed futures
9 FOF - Multi-strategy
MorningStar 3
Merger arbitrage
system futures
FOF (debt, equity, event drive, macro/systematic/ multi-strategy, and relative value)
Credit suisse 9
- convertible arbitrage
- EM
- equity market neutral
- event driven
- fixed income
- global macro
- long/short equity
- managed futures
- multi-strategy (weighted by fund size)
6 categories
- equity
- event driven
- relative value
- opportunistic (top-down)
- specialist
- multi manager
equity
invest primarily in equity/equity related instruments
long/short equity
dedicated short bias
equity market neutral EMN
-delta-gamma hedging delta=0 gamma=0
event driven
merger arbitrage
distressed securities
relative value
FI arbitrage
convertible
bond arbitrage
Opportunistic
global macro
managed futures
specialist
volatility strategies
reinsurance strategies
multi-manager
multi-strategy
FOF
long/short equity
aim to achieve avg return of long-only but with std that are 50% lower
goal: find more sources of idiosyncratic alpha
attractiveness: liquid, diverse, with market-to-market pricing driven by public market quotes
- added short-side exposure typically
- reduced beta risk and provides an additional source of potential alpha and reduced portfolio volatility
leverage usage:
variable: the more market neutral of quantitive the strategy approach, the more levered the strategy application tend to be to achieve a meaningful return profile
long the underpriced and short the overpriced ones
70-90% long
20-50% short
- stock selection defines manager skills for most L/S equity managers
- market timing ability is an additional but secondary consideration
- account for 30% hedge fund, the most prevalent
inv. characteristic: define of L/S equity manager
: strategy focus
- flexibility in holding long/short portion overtime
-use of average
strategy implementation of L/S equity
speclist L/S
- analyze fundamental situation from both top-down and bottom up analytical perspective
- sector speclizaation
Generalist L/S
avoid complex centers, take a more balanced and flexible (quant) approach
pm can readily reallocate capital more efficiently as opportunities emerges in different sectors
dedicated short selling
return goal less than other HF but with a negative correlation benefit
bottom up approach
use technique analysis, z score, m-score, swap and bond spread, and implied volatility put put options
short sell overpriced equities, only trade short-side exposure
60-120% short
characteristics:
- lower return goals but with a negative correlation benefit
- higher volatility given short beta exposure
- lower leverage : sufficient nature volatility
short-biased:
aim to create an uncorrelated or negatively correlated source of return to seeking out failing business models, fraudulent accounting, corporate mismanagement or other factors that may soar the market’s preselection of a given equity
volatility mitigator
short sell overpriced equity but may balance short exposure with some modest value-oriented or possibly index-oriented long exposure
30-60% net short
successful short-biased manager might not be characterized by increasingly positive returns as the market declines and the rf return when the market rise.
activist short selling
short the position and then publicly present their research backing the short thesis
EMN equity market neutral
useful during periods of non-trending or declining markets
goal: capture alpha while minimizing portfolio beta exposure
less volatile
implementation pair trading stab trading muti-class trading statistical arbitrage trading
take opposite position in similar equities that have divergent valuation while maintain a near net zero portfolio exposure to the market.
exp(beta)=0
risk factor ~=0
- typically must apply leverage
- constrained using highly quantitative methodologies
result in a less dynamic overall return, less volatile and steadier return,
Preferred replacement for FI during period when fi returns are unattractively low.
characteristics:
1. portfolio does not take big risk but do attempt to neutralize other risk factors
2. higher leverage is used
3. attack during period of market vulnerability and weakness
4. high levels of diversification and liquidity and a lower std of returns across normal market conditions
limited partnership are preferred vehicle
risk:
- general market could trend upward with no benefit to the portfolio
- the success of the strategy is sensitive to historical data
- the long position could decrease and the short position could increase in value
multi-class trading EMN equity market neutral
long and short different classes of shares of the same company, such as voting and nonvoting shares
- large # of security are traded and positions are adjusted on a daily/hoursly basis using algothrimm based models
statistical arbitrage trading
EMN equity market neutral
when time horizon of EMN shrinks to even shorter intervals and mean reversion and relative momentum characteristics of market behavior are emphasized
-use trading cost hurdle to determine if and when should rebalance portfolio
event driven
soft catalyst
investment made proactively in anticipation of an event that has yet to occur
hard-catalyst: investment are made in reaction to an already unnormal corp. event in which security prices has yet to fully converge
take position in corp. structure and derivatives that are attempting to profit from the outcome of M&A,bankrupcies, share issurances, buybacks, capital restitution, reorganization, and similar events
merger arbitrage
event driven
sell put buy riskless bond
cash for stock: acquiring company after target company a cash price/shre
stock for stock: to ear spread
characteristics:
1. relative liquid- with defined gains but occasional downside shocks when deals fall
2. have market sensitivity and left-tail risk, especially during the market stress periods
3. return profile is insurance like + a short put option
4. relatively high sharpe ratio with low double-digit returns and mid-single digit std
5. moderate high level of leverage use, typical 3-5 time leverage
6. has left tail risk associated with it
strategy implementation
. for stock for stock, short selling maybe difficult due to liquidity issue or other constraint
- in the case A’s credit quality is greater than that of Target’s, pM can benefit from improve quality of t by selling the CDs
distressed securities (long bias) event driven
take position insecurities of firms that are financial distress, including firms that are in bankruptcy or near bankruptcy
- long initial lock-up period
- valuation of such securities are subject to smoothing effect
liquidity: firm’s asset are sold off over time, based on the priority of their claim, debt and equity holders are paid off sequentially
senior secured debt - junior secured debt, unsecured bet, convertible debt, preferred stock, and common stock
inv. characteristics:
1. higher return but with more variability
2. long-biased
3. moderate to low level of leverage
4. high level of iliquidity
5. subject to security specific outcomes but still impacted by macro-economics
6. returns are lumpy and somewhat cyclical. it’s attractive in the econ recovery stage
high level of iniquity
reorganization
event driven
- a firm’s capital structure is re-organized
- the terms for correct claims are negotiate and revised current debt holders may agree to extend the maturity of their debt contracts or even to exchange their debt for equity shares
PM focus on how the firms’ financials will be restricted and an assessing the value of the business enterprise and the future value of different classes of claims
relative value
fixed income arbitrage
convertible bond arbitrage
fixed income arbitrage
- extract cheap implied volatility by buying undervalued convertible bond and short overvalue common stock.
- arbitrage arise from variations/mispricing
inve. characteristics:
1. few mispricing opportunities in the U.S due to its highly liquid treasury market
2. significant leverage used
3. high correlations across different securities
strategy implementation of fix income arbitrage
yield curve trade
pm benefit from long and sell fi securities with different maturity with expectation that the curve will steeper, flatten
the opposite position typically are from the same issuer (credit, liquidity, risks are hedged)
if not, the issues should be in the same sector
strategy implementation of fix income arbitrage cross trades (carry trade)
long lower liquidity, off -the-run T bond
short higher liquidity, duration, matched
on-the-run bond
1/R and credit risks are hedged with liquidity risk remained
Convertible bond arbitrage
relative value
= long convertible bond, short equity/ long put option
= straight debt +long equity call option
- high leverage used
- liquidity issue surface for this strategy in 2 ways:
- naturally less-liquid securities because of their relatively small issue sizes and inherent complexities
- availability and cost to borrow underlying equity for short-selling
Strategy implementation for convertible bond arbitrage
implementation: exploit the fact that the options within convertible instruments usually exhibit low implied volatilities when compared to the historical volatilities of the equities that underline the option
1.short selling
the stock owner may subsequently want his shares returned at potentially bad time.
- credit issue:
it complicates valuation. when there’s a change in credit spread, mismatch appears in the value of stocks and convertible - time decay of call
loss money during the periods of reduced realized equity volatility/ or from a compression market implied volatility level
- extreme market condition
it performs best when issuance is high
market volatility is moderate and liquidity is ample
opportunistic strategies
global macro
managed futures]
seek to profit from investment opportunities
- use both fundamental and technical analysis
- use systematic and discretionary implementation
- take a top-town approach to make macro investments on a global basis across regions, sectors and asset classes.
- returns are impacted by market cycle, global developments, and international interactions
manager use discretionary process instead use their instinct to detainee when to trade.
global macro strategies
opportunistic strategies
focus on a global relationship across a wide range of asset classes and investment instruments
-managers typically hold views in relative economic health and central bank policies of different countries, global yield curve relationships, trends in inflation, and relative purchasing power parity and capital trade flow.
inv. characteristics - right tail skewness
1. due diligence and close attention is required
2. high use of derivative (use of leverage)
3. key source of returns is from capitalizing on trends in global markets
can be directional or thematic
Strategy implementation for
global macro strategies
- both fundamental and technical analysis to value markets
- use discretionary and systematic modes of implementation.
The key source of returns in global macro strategies revolves around correctly discerning and capitalizing on trends in global markets.
managing futures
opportunistic strategies
- crowding aspect
execution slippage in managed futures as AUM grow rapidly - more systematic than global macro
- positive right-tail skewness in market stress provide diversification
global macro delivers similar diversification but with more heterogeneous out comes
demonstrated natural positive skewness that has been useful in balancing negative skewed strategies
inv. characteristics
1. uncorrelated return of managed futures with stocks and bonds
2. return profile tends to be cyclical
3. high leverage is embedded in futures contracts
high liquidity most traded global and continuously
Strategy implementation for
managing futures
volatility increase
lower the size of contract
increase correlation to other ass/futures
lower size
- price target exist methodology
- momentum reversal exist methodology
- time based exist methodology
- trailing stop-loss exist methodology
TSM time series momentum
PM go long asset that are increase in prices and go short assets that are falling in price
-work best when past returns are good predictor of future return
CSM cross-sectional momentum
go long those that are increase in price the most and by shorting asset that are decrease the most
net zero/market neutral position
work well when a market out or underperforming relative to other market is a reliable predictor of its future performance
Specialist strategies
volatility strategies
reinsurance strategies
require high specialized skill sets for trading in niche market
volatility strategies
Specialist strategies
good of relative value volatility arbitrage
- to source and buy cheap volatility and sell more expensive volatility while netting out the time decay aspect normally associated with option portfolio
inv. characteristics:
1. long volatility position exhibits positive convexity which is useful for hedging purposes
2. option sellers extract steadier returns in normal market environments
3. liquidity varies across different instruments
volatility levels tend to go up when equity market fall, with options pricing skew reflecting such a tendency
reinsurance strategies / life settlements
Specialist strategies
a secondary market transaction on an insurance policy
PM look for the following policy characteristics:
- the surrender value being offered to an insured individual is relatively low
- the ongoing premium payments to keep the policy active are also relatively low
- the probability is relatively high that the designated insured person is indeed likely to die within a certain period of time
catastrophe insurance
- obtain sufficient policy diversity in terms of geographic exposure and type of insurance being offered
- receive a sufficient buffer in terms of loan loss reserves from the insurance company
- receive enough premium income
strategy implementation for
volatility strategy
long volatility position exhibits positive convexity
useful for hedging
- build various option strategies, straddle, bull spread, using simple exchange traded options
LT has more absolute exposure to volatility
ST has more delta sensitivity to change of price
- build various option using OTC option tenor and X can be customized
- use VIX futures or options on VIX futures
- purchase on OCT volatility swap or a variance swap from a creditworthy counterpart
multi-manager strategies
3 approaches
FOF
- creating one’s own mix-of managers by investing directly into individual hedge funds running different strategies
- FOF: involve investing in a style FOF manager who the allocates across a set of individual hedge fund managers running different strategies
- multi-strategy funds which entails investing in a single fund that includes multiple internal management teams running different strategies under the same roof
FOF
multi-manager strategy
provide diversification across hedge fund
netting risk because the FoF investor may have to pay performance fees to managers even when they are not earning a positive return overall in the FoF.
Netting risk will not happen in a multi-strategy fund structure because there is a single fund structure with multiple management teams. Performances of different management teams can be offset against each other.
aggregate investor’s capital and allocate it to a portfolio of separate individual hedge funds following different less correlated strategies
- to provide diversification across hedge fund, to make occasional tactical, sector based reallocation decisions to engage in underlying manager selection and due diligence; to perform ongoing pM, risk assessment and consolidated reporting
dis adv:
- double layer of fees
- lack of transparency into individual hedge funds
- no performance fees netting
- addiontal principal-agent issues
inv. characteristics:
- serve as entry-point into HF strategy
- liquidity FOF require a one-year initial lock-up from investor the greater liquidity afterwards
strategy immpmentation FOF
- use fund ab plus personal introductions to become familiar with hedge funds avilable for investor
- choose an appropriate strategies allocation to different hedge fund strategies
- the manager selection process is initiated using both top-down and bottom-up techniques
- cash hedge fund strategy, consider a # of candidates following that strategy
- interview the candidate hedge fund managers
- review relevant materials such as audit reports
- examine the funds’ personal, operational process and risk mgmt
- negotiate with individual fund managers for lower fees, improved liquidity
- ongoing maturity process begins
multi-strategy hedge funds
levered risk
provide steady low volatility return
inv. characteristics
adv:
- can reallocate capital into different strategy areas more quickly and efficiently than would be possible by the FOF manager
- has full transparency and a better picture of the interactions of the different teams’ portfolio risks
- react faster to different realtime market impact
-less complex fee strategy then FOF
GP is responsible for netting risk
only investor level incentive fees paid are those due on the total fund performance after netting the poise and negative performance of the various strategy teams
strategy implementation for multi-strategy HF
- Tailored to each investor’s needs
- allows flexibility within defined parameters
- enables portfolio managers to tactically allocate between asset classes and to seek the best risk-adjusted credit opportunities throughout market cycles.
- generally outperform FOF
explorer to market equity beta
equity l/s
event driven
credit spread risk and market volatility tail risk
arbitrage managers
trendiness of market directional
opportunistic managers
conditional linear factor model
- allows for the analysis in a specific market environment to determine whether hedge fund strategies are exposed to certain risks under abnormal market conditions.
- A conditional model can show whether hedge fund risk exposures to equities that are insignificant during calm periods become significant during turbulent market periods.
unexplained attributed to
alpha skill
committed factors
random errors
stepwise regression process
used in Lipper tass (TASS) and morning star hedge/CMSDM
useful for direct linear conditional factor model that avoid multicollinearity problems by avoiding the use of highly correlated risk factors.
- identify important risk fact
- calculate pairwise correlation
- regress the return series excluding one factor
resulting in higher adj. r^2
portfolio construction of HF
60/40
HF strategies generally increase risk-adjusted return
provide diversification to a rational portfolio of stocks and bonds
when add 20% allocation to most hedge fund strategy to a traditional portfolio
std decrease
sharpe ratio increase
Sorinto ratio increase
max drawdown decrease in approx 1/3 of portfolio
Sharpe ratio
measure risk adjusted performance where risk is defined as std
it penalize both upside and downside variability
Sorinto ratio
a better measure for downside risk
measures risk adj. performance, where defined as downside deviation
realize only downside variability beblow a minimum target return
lowest std strategy
dedicated short-biased
bear market neutral
low std systematic futures
fof
equity market neutral
role of alternative investing
- capital growth
- income generation (ri and real estate)
- risk diversification (overstated)
- safety
real asset mitigate risks to rising unexpected inflation
private equity/vc expected to provide a sufficient return premium due to liquidity risk and heightened structural complexity
role of PE in multi-asset postolio
PE
Return enhancer
-return premium due to iliquidity
- limited diversification due to strong link between private and public company
- use public index to access/ adj. volatility
role of HF
L/S equity:
deliver equity like return with less than full exposure to the equity premium
Short-biased: lower overall equity beta while producing some measure of alpha
arbitrage event drive: exploit small inefficiencies in at the public market while exhibiting low to no correlation with traditional asset classes
- short volatility risk
opportunistic:
very volatile as stand-alone strategies, provide exposures not otherwise readily accessible in traditional stock and bond strategies
role of real asset
underlying is physical assets with a relatively high degree of correlation with inflation broadly or with a sub-comment of inflation
- own commodity as a hedge against a core constituent of inflation
master limited partnerships (MLP)
for energy investment rarely take ownership of energy asset
role of commercial real estate
provide protection against unanticipated increase in inflation
role of private credit (distressed investment and direct lending)
involve ownership of FI
over ST
primary risk: return volatility
required volatility < equity return
correlation with equity return is low, yet biased data for the reason below:
- appraisal based valuation for private held investment, result in smoothing of reported return
- DB: subject to sampling biases, such as survivorship bias and backfire bias which result in downside risk being understated in the reported data
- indexes of alternative investment return reflect some degree of diversification because funds in an index may have low correlation of return with each other. Thus the volatility of returns on the index is less than avg. volatility of returns on index comment
over LT
primary risk:
faling to achieve a minimum required rate of return
bonds have been a more effective volatility mitigator than alternative or ST but in long term, a heavy allocation to bond reduce the prob. of achieving the investment goal
LIMITATION OF BOND TO MITIGATE EQUITY RISK
- inflation in low & stable market, the negative equity/bond correlation should lead to highest reduction in volatility
limitation: negative stock/bond correlation maybe temporary
furthermore, if the bond’s exp(r) is low, a heavy allocation to bonds may reduce the prob. of achieving the LT return objective.
limitation of using HF to mitigate euiqty risk
- HF would reduce an equity dominated portfolio’ overall beta, with higher expected return than bonds, an allocation fo HF would make achieving the LT return target more feasible
limitation: although a well-constructed HF portfolio may reduce portfolio volatility and beta, HF often highly managed, levered and individual HF may stuffer significant and permanent losses during turbulent times
risk-based approaches
involves statistically estimate asset classes sensitives to risk factors
adv:
- common risk factor identification
- integrated risk framework
limitation
- sensitivity to historical look back period
- implementation hurdle involving additional considerations for liquidity planning, manager’s selection, and rebalancing policy
pe ~ public equity t
private credit ~ hy bond
inv. consideration: operational liquidity issue - expense and fee consideration -tax consideration -build vs. buy
traditional approaches
main strength:
- easy to communication
- relevant for liquidity management and operational considerations
limitation:
- over-estimation of portfolio diversification
- uncertain primary drivers of risk
inv. consideration:
- properly defined risk characteristics
- establishing return expectations
- selection of the appropriate investment vehicle
side-pocket
assets that are not subject to fund’s redemption terms are said to be held in a side pocket
gate:
max amount may redeem at once
lock-up
a restriction on redemption during a period of time
challenges in asset allocation
stale pricing
nonnormality
appraisal-based valuations often lead to stale/smoothed returns
stale pricing increase the serial correlation in reported return series
- choose unsmooth the data series
- return distribution is not normally distributed with skewness and fat tails
- analyst can incorporate non-normality into their analysis
- use advanced mathematical models
optimization technique
MVO
MVO cannot easily accommodate the characteristics of most alternative investments.
MVO characterizes an asset’s risk using standard deviation.
Standard deviation, a one-dimensional view of risk, is a poor representation of the risk characteristics of alternative investments for which asset returns may be not normally distributed.
MVO typically over-allocates to alternative asset classes, partly because risk is underestimated because of stale or infrequent pricing and the underlying assumption that returns are normally distributed.
small change in input led to significant change in optimal asset collation
risk factor based approach
sensitivity to risk factor exposure, might not be stable outcomes
capital contribution (c)
= rate of contribution * (capital commitment - PIC)
distribution (d)
navt-1 (1+g)rfd
Expected distribution = [Prior-year NAV × (1 + Growth rate)] × (Distribution rate).
Expected NAV = [Prior-year NAV × (1 + Growth rate) + Capital contributions – Distributions)] × (1 + Growth rate).
Benefit of an equity market neutral strategy over long/short:
- more diversification from a more quantitative methodology
2 lower standard deviation due to the removal of general market movement
- more liquidity since positions are adjusted over shorter time horizon
Because of often high leverage, EMN strategies typically do not meet regulatory leverage limits for mutual fund vehicles. So, limited partnerships are the preferred vehicle.
pair trading
market neutral strategy
step:
shorting the overvalued company
purchasing an equal amount of the fair valued company
based on historical trends, two stocks should converge in the future, at which time the profit of the strategy would be based on the amount of convergence.
self-reported benchmark is not appropriate
use to manager-based hedged fund indices in performance appraisal is based on the premise that the indices neutrally reflect the underlying performance of the strategy.
use to self-reported index is
- not likely to neutrally reflect the underlying performance of the strategy. Manager with better track records may be more likely to report their returns, which would bias index returns upward.
- May also suffer from inconsistent reporting by the component managers over time.
concerns with convertible arbitrage
performed best when convertible insurance is high and when volatility are moderate, liquidity is sufficient.
- short selling
substantial losses during short squeeze - credit issue
when credit spreads widen or narrow, mismatch in the values of the stock and convertible bond positions - time decay of call option
lost money due to time decay embedded call option - extreme market volatility
extreme market volatility implies heightened credit risks and face redemption pressure from investors, create left-tail risk.
specialist
volatility arbitrage
- use exchange traded option
longer dated option have more exposure to volatility
short dated option have more delta sensitivity to price changes - OCT options
strike prices can be customized - VIC futures
pure volatility view without constant debt hedging - purchase OTC volatility swap or a variance swap from a creditworthy counter-party
The hedged portfolio approach constructs portfolio
represent factors through ranking securities by the factor and buying top quantile securities whilst shorting bottom quantile securities.
drawback:
portfolios created are not pure factor portfolios since they will have significant exposure to other risk factors outside the factor being modelled.
