Alts Flashcards
Linear Factor Model
A linear factor model can provide insights into the intrinsic characteristics and risks in a hedge fund investment. Since hedge fund strategies are dynamic, a conditional 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. During normal periods when equities are rising, the desired exposure to equities (S&P 500 Index) should be long (positive) to benefit from higher expected returns. However, during crisis periods when equities are falling sharply, the desired exposure to equities should be short (negative).
Equity Market-Neutral Strategy
EMN managers are more useful for portfolio allocation during periods of non-trending or declining markets. EMN hedge fund strategies take opposite (long and short) positions in similar or related equities having divergent valuations while attempting to maintain a near net zero portfolio exposure to the market. EMN managers neutralize market risk by constructing their portfolios such that the expected portfolio beta is approximately equal to zero. Moreover, EMN managers often choose to set the betas for sectors or industries as well as for common risk factors (e.g., market size, price-to-earnings ratio, and book-to-market ratio) equal to zero. Since these portfolios do not take beta risk and attempt to neutralize many other factor risks, they typically must apply leverage to the long and short positions to achieve a meaningful return profile from their individual stock selections.
EMN strategies typically deliver return profiles that are steadier and less volatile than those of many other hedge strategy areas. Over time, their conservative and constrained approach typically results in a less dynamic overall return profile than those of managers who accept beta exposure. Despite the use of substantial leverage and because of their more standard and overall steady risk/return profiles, equity market-neutral managers are often a preferred replacement for fixed-income managers during periods when fixed-income returns are unattractively low.
Concerns regarding convertibal bond arbitrage
Short selling: The fund buys the convertible bond and takes a short position in the underlying security. When short selling, shares must be located and borrowed; as a result, the stock owner may want his/her shares returned at a potentially inopportune time, such as during stock price run-ups or when supply for the stock is low or demand for the stock is high. This situation, particularly a short squeeze, can lead to substantial losses and a suddenly unbalanced exposure if borrowing the underlying equity shares becomes too difficult or too costly for the arbitrageur.
Credit issues: Credit issues may complicate valuation since bonds have exposure to credit risk. When credit spreads widen or narrow, there would be a mismatch in the values of the stock and convertible bond positions that the convertible manager may or may not have attempted to hedge away.
Time decay of call option: The convertible bond arbitrage strategy can lose money due to time decay of the convertible bond’s embedded call option during periods of reduced realized equity volatility and/or due to a general compression of market implied volatility levels.
Extreme market volatility: Convertible arbitrage strategies have performed best when convertible issuance is high (implying a wider choice among convertible securities as well as downward price pressure and cheaper prices), general market volatility levels are moderate, and the liquidity to trade and adjust positions is sufficient. Extreme market volatility typically implies heightened credit risks. Convertibles are naturally less-liquid securities, so convertible managers generally do not fare well during such periods. Because hedge funds have become the natural market makers for convertibles and typically face significant redemption pressures from investors during crises, the strategy may have further unattractive left-tail risk attributes during periods of market stress.
Path for implementing relative value volatility arbitrage
1. Simple exchange-traded options. The maturity of such options typically extends to no more than two years. In terms of expiry, the longer-dated options will have more absolute exposure to volatility levels than shorter-dated options, but the shorter-dated options will exhibit more delta sensitivity to price changes.
2. OTC options. In this case, the tenor and strike prices of the options can be customized. The tenor of expiry dates can then be extended beyond what is available with exchange-traded options.
3. VIX futures or options on VIX futures as a way to more explicitly express a pure volatility view without the need for constant delta hedging of an equity put or call for isolating the volatility exposure.
4. OTC volatility swap or a variance swap from a creditworthy counterparty. A volatility swap is a forward contract on future realized price volatility. Similarly, a variance swap is a forward contract on future realized price variance, where variance is the square of volatility. Both volatility and variance swaps provide “pure” exposure to volatility alone, unlike standardized options in which the volatility exposure depends on the price of the underlying asset and must be isolated and extracted via delta hedging.
Advantage of Multi-strategy fund over Fund-of-funds
Multi-strategy managers can reallocate capital into different strategy areas more quickly and efficiently than would be possible by a fund-of-funds (FoF) manager. The multi-strategy manager has full transparency and a better picture of the interactions of the different teams’ portfolio risks than would ever be possible for FoF managers to achieve. Consequently, the multi-strategy manager can react faster to different real-time market impacts—for example, by rapidly increasing or decreasing leverage within different strategies depending upon the perceived riskiness of available opportunities.
The fees paid by investors in a multi-strategy fund can be structured in a number of ways, some of which can be very attractive when compared to the FoFs’ added fee layering and netting risk attributes. Conceptually, FoF investors always face netting risk, whereby they are responsible for paying performance fees due to winning underlying funds while suffering return drag from the performance of losing underlying funds. Even if the FoF’s overall performance is flat or down, FoF investors must still pay incentive fees due to the managers of winning funds.
Short Biased Style
- Short-biased strategies are expected to provide some measure of alpha in addition to lowering a portfolio’s overall equity beta.
- Short-biased equity strategies help reduce an equity-dominated portfolio’s overall beta. Short-biased strategies are believed to deliver equity-like returns with less-than-full exposure to the equity premium but with an additional source of return that might come from the manager’s shorting of individual stocks.
Activist Short-Selling
Take short positions and publicly share their negative fundamental views
Dedicated short-selling
- Take only short positions
- Focus primarily on the equity markets, and the majority of their risk profiles contain equity-oriented risk.
- Dedicated short bias managers look for possible short selling targets among companies that are overvalued, that are experiencing declining revenues and/or earnings, or that have internal management conflicts, weak corporate governance, or even potential accounting frauds.
Capital Structure Arbitrage
Capital structure arbitrage involves taking long and short positions in the debt and equity of individual companies to extract misvaluations. It falls under distressed security strategies
Traditional vs. Risk-Factor-Based Asset Allocation Approach
- Traditional approaches have the advantage of being easier to communicate relative to risk-factor-based approaches.
- Traditional approaches often commingle assets with very different risk characteristics in the same asset classes, resulting in portfolios with the same asset allocation but very different risks—for example, when high-yield fixed-income securities and government bonds are both included in a portfolio’s fixed-income allocation.
- Systematic risk-factor approaches typically explain most or all of the risk and return patterns of public assets but far less of those patterns for private assets. This is due to the widespread use of appraisal-based valuation for private assets and the idiosyncratic risks present in individual funds.
Equity Market-Neutral Strategy
- EMN managers are more useful for portfolio allocation during periods of non-trending or declining markets.
- EMN hedge fund strategies take opposite (long and short) positions in similar or related equities having divergent valuations while attempting to maintain a near net zero portfolio exposure to the market.
- EMN managers neutralize market risk by constructing their portfolios such that the expected portfolio beta is approximately equal to zero. Moreover, EMN managers often choose to set the betas for sectors or industries as well as for common risk factors (e.g., market size, price-to-earnings ratio, and book-to-market ratio) equal to zero.
- Since these portfolios do not take beta risk and attempt to neutralize many other factor risks, they typically must apply leverage to the long and short positions to achieve a meaningful return profile from their individual stock selections.
- EMN strategies typically deliver return profiles that are steadier and less volatile than those of many other hedge strategy areas. Over time, their conservative and constrained approach typically results in a less dynamic overall return profile than those of managers who accept beta exposure.
- Despite the use of substantial leverage and because of their more standard and overall steady risk/return profiles, equity market-neutral managers are often a preferred replacement for fixed-income managers during periods when fixed-income returns are unattractively low.
Global Macro Strategy
- Global macro managers use both fundamental and technical analysis to value markets, and they 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.
- Global macro strategies are typically top-down and employ a range of macroeconomic and fundamental models to express a view regarding the direction or relative value of a particular asset or asset class. Positions may comprise a mix of individual securities, baskets of securities, index futures, foreign exchange futures/forwards, fixed-income products or futures, and derivatives or options on any of the above. If the hedge fund manager is making a directional bet, then directional models will use fundamental data regarding a specific market or asset to determine if it is undervalued or overvalued relative to history and the expected macro-trend.
Volatility Trading Strategy Implementation
Volatility trading strategy can be implemented by following multiple paths:
- One path is through simple exchange-traded options. The maturity of such options typically extends to no more than two years. In terms of expiry, the longer-dated options will have more absolute exposure to volatility levels than shorter-dated options, but the shorter-dated options will exhibit more delta sensitivity to price changes.
- A second, similar path is to implement the volatility trading strategy using OTC options. In this case, the tenor and strike prices of the options can be customized. The tenor of expiry dates can then be extended beyond what is available with exchange-traded options.
- A third path is to use VIX futures or options on VIX futures as a way to more explicitly express a pure volatility view without the need for constant delta hedging of an equity put or call for isolating the volatility exposure.
- A fourth path for implementing a volatility trading strategy would be to purchase an OTC volatility swap or a variance swap from a creditworthy counterparty. A volatility swap is a forward contract on future realized price volatility. Similarly, a variance swap is a forward contract on future realized price variance, where variance is the square of volatility. Both volatility and variance swaps provide “pure” exposure to volatility alone, unlike standardized options in which the volatility exposure depends on the price of the underlying asset and must be isolated and extracted via delta hedging.
