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CAIA > CAIA - 31 - Hedge Fund Replication > Flashcards

CAIA - 31 - Hedge Fund Replication Flashcards

1
Q

___ ___refer to exposure to risk, risk premiums, and sources of return not typically available with traditional assets.

A

Alternative betas refer to exposure to risk, risk premiums, and sources of return not typically available with traditional assets.

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2
Q

These are designed to capture traditional and alternative betas of hedge fund benchmarks.

A

Hedge fund replication products

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3
Q

Hedge fund replication products are also referred to as:

A

clones or trackers

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4
Q

There are 3 broad approaches to hedge fund replication:

A
  1. Factor based
  2. Payoff distribution
  3. Bottom-up or algorithmic
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5
Q

Factor-based approaches to hedge fund replication are what type of technique?

A

statistical

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6
Q

Payoff distribution approaches to hedge fund replication are what type of technique?

A

statistical

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7
Q

What is the aim of bottom up or algorithmic approaches to hedge fund replication?

A

Capture the trading approach used by most managers of a given strategy

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8
Q

Hedge fund replication strategies can benefit a portfolio in 2 broad ways:

A
  1. enhance returns
  2. diversify risk
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9
Q

What types of hedge funds are return enhancers?

A
  1. long-short
  2. some global macro
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10
Q

What are the 3 most common examples of hedge funds that are risk diversifiers

A
  1. CTAs
  2. Some Global Macro
  3. Most relative value funds
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11
Q

What has happened to hedge fund alpha over the past decade?

A

It’s been positive, but has declined

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12
Q

What are the 3 explanations for the decline in alpha?

A
  1. Fund bubble hypothesis
  2. Capacity constraint hypothesis
  3. Increased allocations to active funds hypothesis
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13
Q

What is the fund bubble hypothesis?

A

Mediocre traditional managers entered the hedge fund space to earn more

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14
Q

What is the capacity constraint hypothesis?

A

Alpha is a zero sum game and as capital has increased, alpha has decreased.

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15
Q

What is the increased allocation to active funds hypothesis?

A

As hedge funds become more widespread, investors that have traditional and hedge fund exposure cause higher correlations because of liquidity needs.

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16
Q

Can a replicating product created with liquid securities provide exposure to illiquidity risk?

A

No

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17
Q

Can convertible bond arbitrage and volatility trading strategies be replicated using ETFs?

A

Yes

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18
Q

Can the dynamic, or time-varying beta of hedge funds be replicated?

A

Yes

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19
Q

Should replication products be used if the goal is to access unique sources of risk (e.g. illiquidity) or top-tier managers?

A

No

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20
Q

What should be the goal of utilizing replication products?

A

Capture the alpha and beta of the replication products’ underlying benchmark.

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21
Q

Per academic studies, can top-tier managers be identified priori?

A

Evidence is mixed. Studies that show return persistence still show a decline over time.

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22
Q

What are the 8 unique benefits of hedge fund replication products?

  1. L
  2. T
  3. F
  4. L
  5. H
  6. L
  7. D
  8. B
A

What are the 8 unique benefits of hedge fund replication products?

1. Liquidity

2. Transparency

3. Flexibility

4. Lower fees

5. Hedging opportunities

6. Lower due diligence and monitoring risks

7. Diversification

8. Benchmarking

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23
Q

What is the factor based approach to hedge fund replication?

A

Based on the fact that a fund’s returns can be explained by asset-based factors. Approach involves constructing long and/or short portfolio to replicate factor risks of a manager or several managers

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24
Q

What is the typical manager structure of a factor-based benchmark?

A

Sometimes 1 manager, but typically an equal weighting of several managers

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25
Q

What are the 4 components of constructing a factor-based replication product?

A
  1. Choice of benchmark
  2. Choice of factors
  3. Length of estimation period
  4. Number of factors
26
Q

What are the advantages/disadvantages of using a large number of factors?

A

Generally results in good in-sample fit, but may result in poor out-of-sample performance

27
Q

Beyond the main 4, what are 4 other examples of decisions to be made for constructing a factor based replication product?

A
  1. Adjusting for stale prices
  2. Adjusting for fees
  3. Selecting correct econometric teqchnique
  4. Whether to use overlays
28
Q

What are the 3 steps for setting up a factor-based replication program?

A
  1. Estimate weights of risky assets
  2. Estimate weight of cash
  3. Invest in different areas
29
Q

What is the equation to measure a model’s in-sample fit?

A
30
Q

What are the 2 key concepts that address how hedge fund returns can be replicated using only a small number of factors and how mimicking weights can be accurately esimated?

A
  1. View commonality
  2. Exposure inertia
31
Q

What is view commonality

A

The overall performance will be driven by the managers’ common exposures, or views

32
Q

What is exposure inertia?

A

Exposures to factors in aggregate tend to be more stable than individual hedge funds’ exposures.

33
Q

Karavas, Kazemi, and Schneeweis (2003) discovered what in general?

A

Factor replication was difficult and had low correlation to strategies

34
Q

How did Agarwal and Naik (2004) identify factors?

A

Used stepwise regression to identify factors for 8 HFR indices

35
Q

What was the conclusion of Agarwal and Naik (2004)

A

There was a wide range of in sample R squareds and the one year out of sample results were too short to draw meaningful conclusions.

36
Q

Lo and Hasanhodzic (2007) used what approach to replication? What was the conclusion?

A

24-month rolling window of an equally weighted portfolio that was dynamically balanced.

The conclusion was that replication is difficult and does not always work

37
Q

What was the conclusion of Lee and Lo (2014)?

A

Hedge fund beta replication achieves its goal and outperformed the Barclay Hedge Fund of Funds index.

38
Q

What method did Amenc et al. (2010) use and what was the conclusion?

A

non-linear models. The models produced better in-sample results but still mixed out of sample results

39
Q

What is over the overall conclusion of several factor based hedge fund replication studies?

A

replication is difficult and did not yield satisfactory results

40
Q

What is the payoff-distribution approach to hedge fund replication?

A

It aims to generate a return distribution that matches the distribution of a hedge fund benchmark.

41
Q

Is factor-based or the payoff-distribution approach better at tracking a hedge fund’s monthly returns?

A

The factor-based approach

42
Q

Is the factor-based or pay-off distribution approach better at replicating a hedge fund index’s higher order moments (standard deviation, skewness, kurtosis)

A

pay-off distribution

43
Q

What is the payoff-distribution approach motivated by?

A

The Black-Scholes option pricing theory

44
Q

Kat and Palaro (2005, 2006) did what?

A

Proposed a procedure to create a payoff function that matches returns and correlations

45
Q

Amenc et al (2008) found what 6 conclusions, regarding payoff distribution strategies?

  1. Average returns were ___ and always ___ than index
  2. ___ were generally close but ___ and ___ results mixed
  3. Replication was best for ___-___ and worst for ___-___
  4. Sharpe ratios for indices ___ , VAR ___
  5. Many replication strategies only worked over very ___ ___ ___
  6. Replication was poor in terms of ___
A

Amenc et al (2008) found what 6 conclusions, regarding payoff distribution strategies?

  1. Average returns were different and always lower than index
  2. Volatilities were generally close but skewness and kurtosis results mixed
  3. Replication was best for short-selling and worst for market-neutral
  4. Sharpe ratios for indices higher, VAR similar
  5. Many replication strategies only worked over very long time periods
  6. Replication was poor in terms of correlation
46
Q

The algorithmic, or bottom-up, approach is best for what strategies?

A

Well-defined strategies that don’t include manager discretion

47
Q

What are the drawbacks of the bottom-up replication approach?

A

Does not offer liquidity and flexibility of other approaches

48
Q

What is essential for replicating a merger arbitrage strategy?

A

Assessing whether or not a merger will be completed

49
Q

When is convertible arbitrage generally carried out?

A

When the convertible bond is in the money

50
Q

A convertible bond’s implicit call option has positive/negative gamma exposure and positive/negative theta exposure?

A

A convertible bond’s implicit call option has positive gamma exposure and negative theta exposure.

51
Q

A convertible arbitrage’s returns comes from what?

A

volatility, positive gamma and periodic trading to restore delta-neutrality

52
Q

when is a convertible arbitrage strategy successful?

A

when the underlying equity’s realized volatility exceeds the implied volatility

53
Q

how are a convertible arbitrages returns impacted by cash flows and leverage?

A
  1. Coupons additive. Dividends substract
  2. Considerable leverage used. interest payments reduce returns
54
Q

what risks can convertible arbitrage strategies hedge?

A

interest rate and credit risks. liquidity risk can be reduced but not eliminated

55
Q

how much leverage do alternative mutual fund strategies use?

A

a limited amount and do not apply fixed-income arbitrage strategies

56
Q

What is the fastest growing segment of mutual funds?

A

Alternative Mutual Funds (AMFs)

57
Q

What are the 3 advantages of alternative mutual funds (AMFs) for hedge fund managers

A
  1. raise more capital
  2. access retail investors
  3. regulation benefits
58
Q

What are the 6 benefits of alternative mutual funds (AMFs) to investors

  1. L
  2. T
  3. C
  4. L
  5. L

6 D

A

What are the 6 benefits of alternative mutual funds (AMFs) to investors

  1. Liquidity
  2. Transparency
  3. Compliance with 1940 Act
  4. Lack of minimum
  5. Low fees

6 Diversification

59
Q

What is good about companies having to comply with the 1940 US Investment Company Act?

  1. Limit ___ to ___%
  2. Invest at most ___% in ___ ___
  3. Don’t charge ___ ___
  4. Derive ___% of income from permitted sources
A

What is good about companies having to comply with the 1940 US Investment Company Act?

  1. Limit leverage to 33%
  2. Invest at most 25% in single asset
  3. Don’t charge incentive fee
  4. Derive 90% of income from permitted sources
60
Q

What are the 3 risks of alternative mutual funds (AMFs) to investors?

A
  1. Large redemptions can cause liquidity to spiral
  2. Leverage can be implicit in securities purchased
  3. HF managers may favor trades to more lucrative HF over AMF
61
Q

What are the 3 advantages of ETFs over AMFs?

A
  1. inter-day liquidity
  2. daily disclosures of holdings
  3. tax advantages due to lower turnover and in-kind redemptions
62
Q

How do the costs of alternative ETFs compare to traditional ETFs?

A

They are higher

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