Alternatives Flashcards
Equity-related hedge fund strategies
L/S
EMN
Stub trading
Dedicated short selling & Short Biased
Do they use relative value approaches?
equity-oriented risk. Within this equity-related category, long/short equity, dedicated short bias, and equity market neutral (EMN)
L/S funds will typically have a 40%–60% net long exposure, which is beneficial considering that markets generally trend upward over time. They have standard deviation 50% or lower. The net long equity position would have a positive beta. Managers aspire to have a standard deviation about half of a long-only approach.
Equity market-neutral (EMN) strategies seek to attain a near-zero overall exposure to the stock market and MODEST RETURNS. They do this by taking long and short positions in various equities; the betas of these positions should sum to zero. EMN funds can offer significant diversification and low volatility. leverage is generally applied Types: Pairs trading. Stub trading. This EMN strategy involves going long and short shares of a subsidiary and its parent company. Multi-class trading share classes of the same firm, for example non-voting and voting shares. EMN = Relatively high levels of leverage.
Dedicated short selling 60% - 120% short at all times
Short Biased 30 - 60% net short
Low use of leverage and adds negatively correlated alpha to other portfolio positions.
Activist short selling would publicly back the bad findings as reason for their short.
Dedicated short selling = short only
(If net short is more than 0% then there must be long positions too so it would be a short biased fund)
EMN does use a relative value approach albeit not the class of hedge fund.
Event-Driven Strategies
A soft/hard-catalyst event-driven approach
Merger Arbitrage
Distressed Securities
Event-driven hedge fund strategies are those that attempt to profit from predicting the outcome of corporate events, such as bankruptcies, mergers, restructurings, acquisitions,
A soft-catalyst event-driven approach is an investment made before an event is being announced, whereas a hard-catalyst event-driven approach is an investment made after a corporate event is being announced, taking advantage of security prices that have not fully adjusted. Soft-catalyst investing is generally more volatile and, thus, riskier than a hard-catalyst approach..
Merger Arbitrage = a riskless bond, short a put, and long a call. The strategy incorporates the time associated between merger announcement and transaction closing which is discounted at the risk free rate. a merger arbitrage strategy will typically apply 300%–500% leverage in order to achieve low-double-digit return. It provides uncorrelated sources of alpha. Convertible preferred stock.
Distressed Securities = firms that are in financial distress, including firms that are in bankruptcy or near bankruptcy. Long lock up times with no redemptions in first two years. Variable outcomes but usually higher. Generally taking the LONG position and LOW leverage. Capital structure arbitrage is a type extracting mispricings in the debt structure.
Relative Value Hedge Fund Strategies
fixed-income arbitrage
Convertible Bond Arbitrage
Perform best with high or low issuance?
Exploit relative valuation differences between securities. The most common securities used in relative value strategies are hybrid convertible debt, as well as fixed-income securities. Fixed-Income Arbitrage and Convertible Bond Arbitrage
fixed-income arbitrage = long comparatively undervalued securities, and going short comparatively overvalued securities. Idiosyncrasies that might be exploited include yield curve kinks or anticipated changes in the shape of the yield curve. many types, including consumer debt, bank loans, corporate bonds, or sovereign bonds. 400% leverage is not uncommon; even 1500% leverage is not unheard of.
carry trade, the portfolio manager shorts a low-yielding security and goes long a high-yielding security.
Convertible Bond Arbitrage = Long convertible bond. Short equity. One way to view convertible bonds is as a regular bond plus a long call option on the corresponding stock. convertible instruments usually exhibit low implied volatilities. combining a three times long bond exposure with a two times short equity exposure. Issuance size tends to be small from relatively unproven companies and the shares to sell short may be difficult to locate and borrow.
- When conversion value is ABOVE conversion price (price at which it converts) it will trade more like an equity and vice versa.
- Performs best during period of high issuance and moderate volatility.
6 Hedge Fund strategies EEROSM
- Equity related - LS, EMN and dedicated short bias
- Event driven - Merger Arbitrage and Distressed securities
- Relative Value - Fixed Income arbitrage and convertible bond arbitrage.
- Opportunistic - Topdown = Global managed futures and Global macro.
- Specialist = Specific market expertise - Volatility strategies and reinsurance strategies
- Multi-manager = Hedge fund building blocks - Multi-strategy funds and fund of funds.
Note - Global macro and EMN will also use a relative value approach albeit not the Hedge fund strategy.
Opportunistic
Global Macro managers
Managed futures
Positive or negative convexity?
Skewness?
Opportunistic systematic implementation strategy is a rules based approach with little human interaction and low chance of making behavioral errors..
Global macro managers positions that are either directional (e.g., go long companies that are anticipated to benefit from expected interest rate hikes, and short companies that will be disadvantaged), or thematic (e.g., buy firms that will benefit from forthcoming free trade deals.) Leverage, often representing 600% or 700% of fund assets. fund can bring a significant benefit (not only alpha, but also portfolio diversification). Usually top down, macro, trend following. Directional bets may rely on fundamental value to find over/under priced assets. (May also look at relative value in the context of actual value not the hedge fund type)
Managed futures Positions in a wide range of asset classes including futures, forwards, options on futures, swaps, and sometimes currencies and commodities. 1/8 of its capital as collateral on futures contracts. The other 7/8 or so will be invested in some highly liquid security. Extremely liquid. There are a number of ways to implement managed futures strategies. time-series momentum (TSM) trend following, portfolio managers simply follow momentum.. cross-sectional momentum (CSM) strategies, which is carried out within a particular asset class. managed futures have very little correlation with traditional equity and fixed-income assets. the positive RIGHT-TAIL skewness of managed futures provides a significant advantage.
POSITIVE CONVEXITY?
Both exhibit RIGHT TAIL skewness
Specialist Strategies
volatility trading. 3 types
Reinsurance/Life Settlements
Catastrophe insurance
Volatility trading hedge fund managers will trade volatility-related assets globally, across countries and across asset classes, in order to exploit perceived differences in volatility pricing. The overall goal is to purchase underpriced volatility and sell overpriced volatility. VIX index, which tracks the 30-day implied volatility of the S&P 500 index. Approaches: straddles, calendar spreads, bull spreads, etc. over-the-counter (OTC) options. 1. Exchange traded options
2. OTC Volatility swaps (a forward contract on future realised price volatility)
3. VIX Futures
Reinsurance/Life Settlements n a typical life settlement transaction, an insured person will sell (generally through a broker) their insurance policy to a hedge fund. After the investor pays the insured for the policy, the hedge fund then will be liable for the premium payments and will also receive the death benefit upon the passing of the insured. n a typical life settlement transaction, an insured person will sell (generally through a broker) their insurance policy to a hedge fund. After the investor pays the insured for the policy, the hedge fund then will be liable for the premium payments and will also receive the death benefit upon the passing of the insured
PM’s analyze: expected policy cash flows, ongoing premium payment obligations, and the eventual death benefit to be received.
Catastrophe insurance covers the holder against earthquakes, tornadoes, hurricanes, floods, and the like. isk inherent in these strategies is almost entirely uncorrelated with market risks and business cycles
Multi-Manager Hedge Fund Strategies
Mix of managers
Fund-of-funds Hedge Funds
Multi-Strategy Hedge Funds
Q. Two key advantage of multi-strategy hedge funds over fund of funds managers are
Which has netting risk? Which ahs a reserve line of credit? Which has more leverage and general better performance?
Mix of managers involves picking separate managers yourself.
FoF is a single fund and can provide investors with a number of benefits:
Diversification across hedge fund strategies.
Expertise in individual manager selection.
Strategic allocation and style allocation.
Due diligence.
Occasional value-added tactical decisions.
Currency hedging.
Holds a reserve line of credit to manage cash flows
Lower Leverage at the portfolio level vs Multi-strat.
FoF also have the following disadvantages:
NETTING Risk FOF (paying performance fees of winning funds while suffering poor performance of detracting funds at the same time)
A double layer of fees for the investor. 2 and 20” fee structure, indicating management fees of 2% plus performance incentive fees of 20%. On top of this, FoF have historically added a 1% management fee, plus a further 20% incentive fee on the total FoF portfolio.
Lack of transparency into individual hedge funds.
No performance fees netting.
Additional principal–agent issues.
Multi-Strategy is a single fund of Hedge Funds - Unlike a FoF, the sub-funds in multi-strategy hedge funds are run by the same organization, rather than being managed by different hedge fund firms. Like a FoF, multi-strategy funds generally limit investor liquidity using redemption periods and initial lock-ups. Multi-strategy funds additionally often enforce limits on the amount of redemption each quarter.
Multi-strategy funds have an investor-friendly fee structure where netting risk is handled by the general partner.
Historically, multi-strategy funds have generally performed better than have funds-of-funds, due to a superior fee structure. Greater ability to execute on tactical asset allocation reallocating capital more quickly than a FoF and More leverage than FoF.
More transparency than FoF
Less diverse asset mix.
Higher operational risk than a FoF as the whole fund could be wiped out if a manager goes under whereas FoF is mroe diversified outside the fund structure itself.
A. the ability and knowledge to rapidly make tactical reallocation decisions to the firm’s strategic allocation based on changing market conditions, and greater visibility to assess the overall risk exposure.
Conditional Factor Risk Model
aka
Linnear Factor Model
Conditional linnear factor risk models looks at the intrinsic characteristics of a hedge fund to determine risk exposures under normal and abnormal market conditions.
You need all 6 factors to be regressed before you can assume that unexplained returns were generated by 1) alpha 2) random error 3) omitted factors.
Factors include
S&P500
BOND (interest rate changes)
CMDTY (Commodity)
CREDIT (credit)
CURRENCY (USD)
VIX (volatility)
A positive figure suggests positive returns. Ie you would ideally target positive S&P in up markets and negative exposure in a crisis.
You would want positive exposure to VIX in a crisis as this would show your put options have worked.
Hasanhodzic and Lo is a Hedge Fund risk exposure model using six factors in a Conditional Factor Model to identify sources of risk and returns:
The MAIN 4 factors sued:
- Equity risk (SNP500): S&P 500 total return index.
- Interest rate risk (BOND): Bloomberg Barclays Corporate AA Intermediate Bond Index.
- Currency risk (USD): U.S. Dollar Index.
- Commodity risk (CMDTY): Goldman Sachs
Commodity Index (GSCI) total return. - Credit risk (CREDIT): Spread between Moody’s Baa and Aaa corporate bond yields.
- Volatility risk (VIX): CBOE Volatility Index (VIX).
- Equity risk (SNP500).
- Currency risk (USD).
- Credit risk (CREDIT).
- Volatility risk (VIX).
They show how risk exposures during insignificant periods can become significant during volatile periods. You would want long exposure to SNP500 during strong markets and short exposure during a crisis.
Performance contribution to a 60/40 portfolio
SD
Sharpe ratio
Sortino ratio (superior measure of risk adjusted return)
Maximum drawdown
When we add a 20% allocation to most hedge fund strategies to a traditional portfolio, the general result is the following:
Total portfolio standard deviation decreases.
Sharpe ratio increases.
Sortino ratio increases.
Maximum drawdown decreases in approximately one-third of portfolios.
The highest Sortino ratios were attained via allocations to the following hedge fund strategies
Equity market neutral.
Systematic futures.
L/S equity.
Event driven.
Allocations to the following strategies was found to be effective in generating superior risk-adjusted performance, based on the comparatively higher Sharpe and Sortino ratios:
Systematic futures.
Equity market neutral.
Global macro.
Event-driven hedge fund strategies.
On the other hand, it was observed that the following fund strategies do not significantly enhance risk-adjusted performance
Fund-of-funds.
Multi-strategy.
alternative investments as an asset class, reported volatility of returns appears lower than the volatility of equity returns. Why?
Appraisal-based valuations of privately held investments result in smoothing of reported returns.
Databases of alternative investment returns are subject to sampling biases, such as survivorship bias and backfill bias, which result in downside risk being understated in the reported data.
Liquidity-Based Investment Opportunity Set
More liquid: Cash, public equity, reits and futures.
Mid liquid: Equity hedge funds and private real estate
Least liquid: Private equity, private credit and private real assets.
Economic Environment-Based Investment Opportunity Set
Deflation prefers: Non- Inflation linked bonds, public equity, private equity and private credit.
Inflation prefers: Inflation linked bonds, commodities and real assets
A typical structure for an alternative investment vehicle.
Who is the general partner and who is the limited partner?
Decisions rights are held by who under a good alternative governence structure?
Side pocket?
‘Alignment of interest’ risk from a withdrawal would be seen when?
A typical structure for an alternative investment vehicle is a limited partnership.
The investment manager is the general partner. Withdrawals from the GP could show a risk of: alignment of interests
Investors in the fund are limited partners. Limited partners may experience long lock up periods. fund-of-funds manager can pool capital from investors and use it to invest in limited partnerships.
Decision rights should land with investment staff with good knowledge.
A side pocket is where a hedge fund allocates LESS liquid holdings not to be subject to the funds ordinary redemption terms which may have longer redemption periods.
A suggested approach to including alternative investments in an asset allocation decision is to do it in two stages, first with only the traditional asset classes and then also considering alternative investments. The process can be assisted by statistical tools such as:
Monte Carlo simulation.
Mean-variance optimization. When using this technique with alternative investments, the results may produce an excessive allocation to this asset class, particularly to illiquid investments such as private equity, especially when the data are not properly adjusted for smoothed returns.
Risk factor based optimization.
Smoothed or unsmoothed data should be used when using optimisation to determine asset allocation?
Unsmoothed data should be used as it reflects appraisal-based valuations.
What is needed to achieve a target allocaiton toward an alternative investment?
Where should capital pending investment for private equity be invested?
The expected growth rate when planning a capital commitment.
Cash pending investment for PE should be invested in Public Equity as a proxy for PE investment even in the short term > 1 year. Same applies for REITs for property investment and energy for energy investment.
MOIC - Multiple On Invested Capital
Private funds use what measure of return?
Which is more affected by cash flow timing.
MOIC = (Value of fund assets - distributions) / Total invested capital
Private funds use IRR instead of time-weighted rates of return.
MOIC is less subject to manipulation from cash flow timing.
