Basic 2 Flashcards
How has the hedge fund industry changed in terms of risks?
- increased transparency and regulation (UCITS, TER, …)
- Lower fees and vehicles with lower fees
- Industry leverage has decreased since the breakdown of LTM (Long-Term Capital Management). According to prime brokers levels in 2012 were on average at 2.5 times, however have slightly risen again.
- Advise remains: Employ professional, instutional Due Dilligence
Leverage depend on the strategy: what does that mean?
- hedge funds can employ leverage in order to increase the size of their market bets
- leverage involves purchasing securities on margin - borrowing money to strengthen buying power in the market.
- Margin can also be used to make short bets or to make trades in derivatives such as futures and swap contracts.
What kind of risks do exist?
- Manager risk
- Business risk
- Legal risk
- Operational risk
- Credit risk
- Financing risk
- Market risk
- Liquidity risk
What are the typical Hedge Fund Strategies?
- Relative Value: Focus on exploiting price inefficiencies between related financial instruments. These strategies tend to be market-neutral and rely on statistical relationships.
- Event Driven: Centered around corporate events like mergers, bankruptcies, or reorganizations. The performance depends on the outcomes of specific events.
- Tactical Trading: Includes strategies that take advantage of macroeconomic trends or use systematic (rule-based) models to predict price movements.
- Directional: Bet on the direction of the market or specific securities. These strategies have significant exposure to market risks.
What HFR (Hedge Fund Research) Strategy Classification do exist?
What types of positions do directional hedge funds hold?
Long positions in undervalued securities and short positions in overvalued securities.
How do directional hedge funds generate profits?
By profiting from market directionality and security-specific price developments
What are the purposes of implementing short positions in directional hedge funds?
To reduce market exposure (hedging) and/or risk.
What is the liquidity profile of directional hedge funds?
Generally moderate to high, depending on the underlying securities traded.
What is the typical payoff profile of directional hedge funds?
Asymmetric – profits depend on the accuracy of market predictions and security price movements.
How do Tactical Trading hedge funds react to market regimes?
They react dynamically to market regimes and situations.
What types of markets do Tactical Trading hedge funds profit from?
They profit from trending and volatile markets.
What type of strategy do Tactical Trading hedge funds typically employ?
The strategy is typically opportunistic, as they try to anticipate market trends.
What is the liquidity profile of Tactical Trading hedge funds?
Generally moderate to high, depending on the instruments traded (e.g., futures, currencies).
What is the typical payoff profile of Tactical Trading hedge funds?
Variable – payoff depends on the successful identification and timing of market trends.
What do Event-Driven hedge funds profit from?
Corporate events such as mergers, acquisitions, bankruptcies, restructurings, or spinoffs.
What causes valuation inefficiencies that Event-Driven hedge funds exploit?
Market reactions to significant corporate events.
What is a typical M&A strategy for Event-Driven hedge funds?
- Go long the company being acquired.
- Go short the company making the acquisition.
What is the liquidity profile of Event-Driven hedge funds?
Moderate, depending on the event timeline and securities involved.
What is the typical payoff profile of Event-Driven hedge funds?
Asymmetric, based on the successful completion of the event and accurate market analysis.
What do Relative Value hedge funds profit from?
Price discrepancies between related financial instruments.
How do Relative Value hedge funds generate returns that are independent of the underlying market?
By exploiting price inefficiencies between financial instruments.
What is commonly employed in Relative Value strategies to profit from small price differences?
Leverage.
What is the goal of Relative Value hedge funds when constructing portfolios?
To create market-neutral portfolios.
What is the liquidity profile of Relative Value hedge funds?
Moderate to high, depending on the instruments and their availability.
What is the typical payoff profile of Relative Value hedge funds?
Steady and low-risk returns, often uncorrelated with the broader market.
How do you calculate Net and Gross exposure?
A fund shows you in his factsheet: Net Exposure: 80%, Gross Exposure 185%. What is the Long exposure and Short exposure of the fund?
L = 132.5%
S = 52.5%
Definition: Factors
Systematic sources of variance that cause stocks to move together
Definition: Market Beta
Return you as an investor get for being exposed to the risks of the overall market
Definition: Alpha
Additional return a manager generates through “skilled” investment
Definition: Factor premia
Factors that earn a premium as rational compensation for taking additional risk
What is Alternative Beta?
returns derived from non-traditional risk factors
examples:
1. Momentum factor: stocks that have performed well in the past tend to conitniue performing well
2. Value factor: stocks that are undervalued tend to deliver higher long-term returns compared to overvalued stocks
What are some factor in the Fung & Hsieh Model?
1. Equity market factor
Captures the general equity market exposure
2. Size factor
Differentiates return of small-cap vs. large-cap stocks
3. Bond Market Factor
Track exposure to bond market movements
4. Credit Spread Factor
Captures sensitivity to credit spreads
5. Trend-Following Factors
Are broken down into three trend-following factors that capture performance related to momentum strategies in: Currencies, Commodities, Fixed Income
6. volatility factor
Some implementation also include a measure of volatlity exposure through implied volatility indexes like the VIX
Do Hedge funds have to report?
Hedge funds do not have to report.
Voluntarily they report to databases such as:
- HFR Database: HFRI and HFRX Indices
- Eurekahedge Database: Eurekahedge Indices
- TASS / Lipper TASS Database
- CISDM Database
- DJ Credit Suisse Indices
There are investable and non-investable indices
Most indices are equal weighted, b ut there are also asset-weighted indices such as DJ Credit Suisse Index
What is Selection Bias in hedge fund databases?
Definition:
Only a subset of hedge funds (usually successful ones) is included in the database.
Problem:
Skews performance upward, as underperforming funds are often excluded.
Example:
Funds with poor returns never report to the database.
What is Backfill Bias in hedge fund databases?
Definition:
Historical performance is added to the database after a fund chooses to report its results.
Problem:
Funds typically report only after achieving good returns, inflating historical performance.
Example:
A fund starts reporting after 3 years of strong performance, making its track record look better.
What is Survivorship Bias in hedge fund databases?
Definition:
Only surviving funds (those still in operation) are included, while failed or closed funds are excluded.
Problem:
Overstates average returns because poorly performing funds are ignored.
Example:
A database lists only active funds, ignoring those that shut down due to poor performance.
Why is Independent NAV verification important for hedge funds?
Definition:
Refers to whether a fund’s Net Asset Value (NAV) is independently verified by a third party.
Problem:
Funds without independent verification may overstate returns or understate risks.
Example:
A fund internally inflates NAV figures to attract investors.
What does it mean if a hedge fund index is not investable?
Definition:
Indicates whether the hedge fund index or the underlying funds are open to new investments.
Problem:
Some indices are theoretical and include funds closed to new investors, making their performance irrelevant.
Example:
An index includes a top-performing fund that no longer accepts new investors.
What are the 7 factors in the Fung & Hsieh model?
Equity market factor
Size spread factor
Bond market factor
Credit spread factor
Currency factor
Commodity trend-following factor
Interest rate factor
Which of them are traditional betas, and which are alternative betas?
- Traditional betas: Equity market factor, bond market factor, credit spread factor, interest rate factor.
- Alternative betas: Currency factor, commodity trend-following factor, size spread factor.
Explain net exposure and gross exposure, and how they are linked.
- Net Exposure = Long exposure – Short exposure
- Gross Exposure = Long exposure + Short exposure
Link
Net exposure indicates market directional risk (long or short bias), while gross exposure measures the fund’s total investment activity and leverage.
What is the role of hedge fund indices, and why are they important for investors?
- Role: Hedge fund indices track and benchmark hedge fund performance across various strategies.
- Importance: They help investors compare performance, analyze trends, and evaluate the relative success of strategies.
What is survivorship bias in hedge fund databases?
Survivorship bias occurs when only successful funds are included in a database, excluding those that have failed or closed, leading to overestimated historical performance.
How does backfill bias affect hedge fund performance reports?
Backfill bias happens when funds add historical performance data to a database only after achieving strong results, inflating average reported performance.
What are qualitative and quantitative factors to consider in hedge fund due diligence?
- Qualitative: Manager experience, operational setup, regulatory compliance, transparency, fund strategy.
- Quantitative: Historical performance, risk-adjusted returns, exposure levels, alpha generation, liquidity profile.
Why is portfolio concentration an important consideration for hedge fund analysis?
Concentration indicates diversification. A highly concentrated portfolio may deliver outsized returns but also carries higher risk, while a diversified portfolio reduces idiosyncratic risk.
What performance metrics should investors focus on in hedge fund analysis?
- Sharpe ratio
- Alpha
- Beta
- Maximum drawdown
- Volatility
