CAIA L2 - 7.1 - Hedge Fund Replication Flashcards
Explain
The basic assumption
behind the creation of
replication products (replication approach)
7.1 - Hedge Fund Replication
Replication approaches
are based on the assumption that
alpha is generated through trading strategies rather than top manager expertise
As a result, they should be able to generate alpha
7.1 - Hedge Fund Replication
Explain
If factor-based replication product
Track HFs distributions
7.1 - Hedge Fund Replication
No, replication products don’t track HFs return distributions (Empirical Research).
R^2 in-sample = not high enough
The average returns on the replicator fund were significantly lower than the hedge fund indices for the out-of-sample data
7.1 - Hedge Fund Replication
Define
Alternative betas
and
List sources
of alternative betas
7.1 - Hedge Fund Replication
Alternative betas are the portion of a return on assets that is not easily separated from the returns based on the risk of traditional assets.
Alternative betas are risk exposures, risk premiums, or types of returns that are not usually attainable from investing in traditional assets.
Beta (risk) of traditional asset that
are typically considered alternative risks.
Examples:
* Stocks have volatility and commodity risk
* time-varying betas /
* ETF in convertible bonds and volatility
* ABS
Sources of alternative beta often involve investments in foreign currency as well as structured products including convertible bonds and asset-backed securities (Equities futures = most traditional between these last 4 assets)
7.1 - Hedge Fund Replication
List
3 potential benefits
to investors of using
replication products
7.1 - Hedge Fund Replication
1. Return enhancer (equity long/short funds, global macro funds; capture risks associated with liquidity and exposure to time-varying betas; Higher returns are sought through exposure to significant systematic risks
2. Risk diversifiers (relative value funds, CTAs; to capture returns with low correlation to traditional assets)
3. Benchmark information sources - Investors can compare HFs
7.1 - Hedge Fund Replication
Define
3 approaches
Hedge fund replication products use
to gaining exposure to alternative risks
7.1 - Hedge Fund Replication
designed to capture both
traditional and alternative betas
of hedge fund benchmarks.
-
Factor-based - use statistical technique - objective: capture the alpha earned by managers relative to benchmark hedge funds. (NOT top managers)
return each period = bench
Correlation of return = High
mean, standard deviation, kurtosis, and skewness = different -
Payoff-distribution replications - use statistical technique - objective: capture the alpha earned by managers relative to benchmark hedge funds. (NOT top managers)
return distribution = bench
Correlation of return = Low
standard deviation, kurtosis, and skewness = similar - Algorithmic (bottom up) replication approach is based on algorithmic trading models designed to capture a simplified version of the trading strategies of active hedge fund managers. SIMPLEST
Replication approaches are based on the assumption that alpha is generated through trading strategies rather than top manager expertise. As a result, replication products should be able to generate alpha.
7.1 - Hedge Fund Replication
Describe
Three theories
for the increased beta
and decreased alpha
in hedge fund returns
7.1 - Hedge Fund Replication
1. Fund bubble hypothesis suggests the supply of hedge fund managers increased as traditional fund managers were enticed by the substantially higher incomes of hedge fund managers. This led to an increase in the number of less-qualified hedge fund managers who generated lower returns, thus lowering the industry average returns.
2. Capacity constraint hypothesis suggests that the generation of alpha is a zero-sum game. In other words, only a few hedge fund managers can generate alpha consistently and as their assets under management grow, alpha becomes even more difficult to obtain.
3. Increased allocation to active funds hypothesis suggests that the growth in popularity of hedge funds led increasing numbers of investors with traditional portfolios to allocate money to hedge funds. This led to an increase in both the correlation between traditional assets and hedge funds and the systematic risk for hedge funds because many of these investors tended to withdraw assets from both traditional and hedge fund accounts during periods of increased financial stress and uncertainty.
7.1 - Hedge Fund Replication
Describe
Relationship of
search costs with
value add of replication products
7.1 - Hedge Fund Replication
- if search costs (to find/ invest in good managers) = low
=> bad managers are removed
=> overall industry performance will improve
(=> replication products can add value?) - if search costs (to find/ invest in good managers) = high
=> bad managers are’t removed
=> overall industry performance will fall
=> replication products doesn’t add value
7.1 - Hedge Fund Replication
Discuss
How replication products
can serve as a
source of alpha
or alternative beta
7.1 - Hedge Fund Replication
Replication Products as a source of alpha
=> if they match bench performance + lower fees = alpha
Replication Products as a source of alternative beta
=> (ETFs) that invest in convertible bonds and volatility
=> traditional assets with time-varying beta
=> can be hard to separate these traditional risks and capture alternative beta
7.1 - Hedge Fund Replication
List
2 Reasons and
2 Issues
to Use
Replication Products
7.1 - Hedge Fund Replication
Reasons:
- An investor is not seeking access to unique sources of return or management skills that would cause them to want to invest in hedge funds directly.
- The investor is seeking exposure to the benchmark’s alpha and beta
Issues:
- Unproven persistence - Can top-tier managers be identified without using empirical data and can their performance persist in future periods? Note that study results vary, as some studies show return persistence for a period of time while others show none.
- Inadequately tracking multiple strategies - Through various market cycles, can replication products adequately track the performance of multiple strategies? In general, studies indicate that replication strategies generate inadequate results.
7.1 - Hedge Fund Replication
List
8 Potential Unique Benefits of
Replication Products
(compared to HFs)
7.1 - Hedge Fund Replication
1. Transparency: they do not have proprietary trading strategies and therefore have more transparency regarding holdings and trades.
2. Liquidity: Replication products invest in liquid securities such as ETFs and futures that provide more liquidity than hedge fund managers. There are typically no lockup periods for investors. In contrast, during periods of market distress, investors in hedge funds often incur a cost of 20% of their assets to exit the fund. The liquidity premiums for replication products are significantly lower. In addition, investors in hedge funds must try to anticipate the early exit of other investors during periods of financial stress.
3. Hedging: Hedging opportunities for investors are created by shorting the replication products that were created with liquid underlying securities. Thus, if an investor is unable to reduce exposure in a hedge fund, hedging with replication products will help mitigate unwanted risk exposures in that market.
4. Cheaper Diversification: Replication products offer diversification benefits with lower costs. Investors who seek diversification benefits through funds of funds or hedge funds incur higher costs of adding managers. In addition, replication products have a lower risk of large drawdowns and lower volatility compared to investing with only a few hedge fund managers.
5. Flexibility: Replication products offer flexibility to investors regarding return and risk profiles. Returns, volatility, and other parameters can be selected based on the replication product’s ability to track various benchmarks. Because the underlying securities are highly liquid, investors can quickly implement unique preferences through the use of replication products.
6. Lower fees: Lower fees are another benefit of replication products. These lower fees make it more difficult for hedge fund managers to outperform replication products after fees. In addition to lower liquidity costs, the monitoring cost and due diligence costs are also lower for replication products, which allow investors to capture a higher proportion of gross returns. For example, investors typically only retain approximately 63% of gross returns for hedge funds and 50% of gross returns for funds of hedge funds. In contrast, 83% of gross returns flow to investors of replication products.
7. Lower costs of due diligence and monitoring Replication products have lower due diligence and monitoring risks as a result of lower operational risk. For example, replication products are designed to track a particular benchmark. In contrast, funds of funds and hedge funds subject investors to style drift risks when managers deviate from original strategies.
8. Benchmarking: Even investors not invested in replication products benefit from them. Benchmarking allows investors to compare the performance of their hedge fund managers to the replication products to determine if managers add value to the portfolio. This may allow investors to negotiate fees with respect to the differential performance of the manager.
7.1 - Hedge Fund Replication
Identify
4 primary issues
in constructing a
factor-based replication product
7.1 - Hedge Fund Replication
1. Choosing an appropriate benchmark. The first issue relates to the construction of a portfolio of long and short positions that will minimize the tracking error relative to a hedge fund benchmark. The choice of benchmark is an important issue and is commonly defined using an equally weighted hedge fund index, such as the HFR or CISDM strategy indices. Tracking errors are reduced for investible hedge fund indices, and it is important that managers included in the benchmark have the same style (i.e., long/short).
2. Choosing a set of investible factors. The manager must choose factors that are investible from a fixed set of K factors or from a statistical approach such as stepwise regression. These factors must be investible in order for the investor to include them in the portfolio. The factors are typically based on excess returns from equity, fixed-income, and commodity ETFs.
3. Determining an appropriate estimation period. An appropriate period for estimating the parameters of the model is another important issue in constructing the replication products. A longer data period normally results in smaller parameter estimation errors. A disadvantage of a longer data period is that characteristics of the benchmark, factors, or market may change over time, and the parameters based on the longer estimation period may not reflect current market conditions.
4. Identifying the appropriate number of factors to include in the model. The manager must determine the appropriate number of factors to include in the model. All factors used must be investible . Using a large number of factors may over-fit the model and result in a very good fit within the sample, but have poor out-of-sample performance. A set of factors that is too small can also be problematic and lead to high tracking errors, both in- and out-of-sample.
7.1 - Hedge Fund Replication
Define
View commonality
and
Exposure inertia
(in a hedge fund index)
7.1 - Hedge Fund Replication
View commonality
Managers common aggregate exposure in an index
“When the exposures of a number of individual hedge fund managers are aggregated in an index, the aggregate exposure is driven by the common exposures of the managers—this is known as view commonality
Exposure inertia
Inertia of common exposure to change => when there are a large number of managers in a hedge fund index
7.1 - Hedge Fund Replication
Contrast
factor-based approach
with
payoff-distribution approach
7.1 - Hedge Fund Replication
factor-based approach (return each period = bench)
* Correlation of return = High
* mean, standard deviation, kurtosis, and skewness = different
payoff-distribution approach (return distribution = bench)
* Correlation of return = Low
* standard deviation, kurtosis, and skewness = similar
7.1 - Hedge Fund Replication
List
Basic characteristics of
algorithmic (or bottom-up) approach
7.1 - Hedge Fund Replication
- Operates the same instruments as the HFs => less liquidity / less flexibility
- no benchmark needed
- uses simplified version of the actual trading strategies implemented in the hedge funds
- works on systematic trading strategies - that don’t rely on active managemement (merger arbitrage, convertible arbitrage, trend-following, momentum, and value-growth strategies)
1. Merger Arbitrage: Long target company / short acquiring company
2. Convertible Arbitrage: Long convertible bonds (with underpriced option) / short stock
3. Momentum Strategies: Long “price > price 30 days ago and price 60 days ago” / Short “price < price 30 days ago and price 60 days ago”
7.1 - Hedge Fund Replication
