CAIA L2 - 7.2 - Diversified Access to Hedge Funds Flashcards
Compare
Returns and risks of
HFs vs equities
7.2 - Diversified Access to Hedge Funds
Comparing returns (1998-2018)
1. In general, hedge fund returns have been decreasing.
2. Equity returns do not fully explain hedge fund returns.
3. Over the 1998 to 2018 period, hedge fund returns have underperformed equity indices.
Comparing risks
1. Most individual hedge fund strategies offer approximately 1/2 the total risk and 1/3 of the systematic risk exposure of equity markets.
2. Average hedge fund returns offer approximately 1/3 of the total risk and 1/6 of the systematic risk exposure of equity markets.
7.2 - Diversified Access to Hedge Funds
List and explain
3 approaches
used by investors to gain
hedge fund exposure
7.2 - Diversified Access to Hedge Funds
Direct Approach
* Direct investment in single-manager hedge fund.
* High net worth needed
* Advantages: < fees (only 1 layer); Access to consultants to facilitate the search process; Due Diligence + allocation control
Delegated Approach
* professional third party selects the hedge funds
* 5 primary services of Fund of HFs:
1. Sourcing managers
2. Due diligence
3. Strategy and selection
4. Portfolio construction
5. Risk management
Index Approach
* Investing in index that replicate the performance of a hedge fund index
* Advantages: smaller fees, greater transparency, and higher liquidity
7.2 - Diversified Access to Hedge Funds
Identify
4 ways
that funds of hedge funds
can be grouped or categorized
7.2 - Diversified Access to Hedge Funds
High-level Funds of hedge funds categorizations:
1. Diversified - allocate to a large number of hedge funds with many different strategies with low correlations to each other. These funds of hedge funds may invest in 30 to 50 different funds.
2. Concentrated - allocate to a small number of funds, generally in a range of 5 to 10 funds.
3. Single-strategy - allocate across a moderate number of hedge funds following the same strategy or theme. The goal of this approach is exposure to a specific subset of the hedge fund universe. Exposure is generally created with 5 to 15 underlying funds.
4. Tactical - allocate to a small number of funds with the goal of exposure to a very specific market factor. This is an opportunistic strategy and typically requires only 5 to 10 funds. An example would be credit-based strategies during the financial crisis of 2007–2009.
7.2 - Diversified Access to Hedge Funds
Identify
4 ways
that funds of hedge funds (FO HFs)
reduce performance reporting bias
(of HFs)
7.2 - Diversified Access to Hedge Funds
FO HFs = more accurate data on returns
Individual HF = more survivorship bias
‘–
1. No HF survivorship bias. Single-manager hedge funds may self-select to be dropped from database inclusion, but their records remains if they are held within a fund of hedge funds.
2. No selection bias. Because funds of hedge funds record the historical performance of all member funds, the universe of hedge fund information is expanded.
3. No instant history bias. When a fund of hedge funds adds a new fund to its portfolio, the historical performance of the fund of hedge funds is not altered as a result.
4. Reduced survivorship bias. The mortality rate for funds of hedge funds is much lower than for single-manager funds. Liang finds annual survivorship bias for single-manager funds to be +2.32% and only +1.18% for funds of hedge funds
7.2 - Diversified Access to Hedge Funds
Contrast
Funds of Hedge Funds (FO HFs)
vs.
Multistrategy Funds
7.2 - Diversified Access to Hedge Funds
Funds of Hedge Funds (FO HFs) usually have…
1. Higher Fees
Funds of hedge funds charge a second layer of fees, which is not a factor for multistrategy funds. However, fund of hedge fund managers are often able to negotiate fee discounts with constituent funds. Overall, multistrategy funds usually have a lower fee structure.
2. Lower Leverage risk
Both funds of hedge funds and multistrategy funds use leverage. For a fund of hedge funds, if an individual fund falls apart, then leverage can cause significant losses. However, those loses are contained to one fund and do not necessarily spill over to other funds. On the other hand, leveraged losses in a multistrategy fund can put the whole fund at risk.
3. Slower Tactical strategy
Fund of hedge funds make tactical moves very slowly because they must follow a series of steps, including giving notice to redeem a fund, waiting for receipt of the disbursement, and then redeploying the cash to another asset. However, multistrategy funds can make tactical moves very quickly because all assets are held in-house.
4. Different Compensation.
FO HFs = 2 layers; Multistrategy = netting risk
Fund of hedge funds have one layer of fees paid to its manager and a second layer of fees paid to each constituent fund manager factoring their individual fund’s performance. Multistrategy funds have two potential compensation schemes. The first option is to pay fees to internal strategy managers based on aggregate fund performance. The more common option is for each internal strategy manager to be paid based on their own strategy’s performance. When this occurs, investors have netting risk because they may pay performance fees to one strategy/fund even if the aggregate position is losing money.
In general:
* funds of hedge funds tend to offer more diversification (large universe of managers), enhanced knowledge transfer to investors, no pass-through expenses.
* However, multistrategy funds usually offer better after-fee performance.
7.2 - Diversified Access to Hedge Funds
List and explain
4 approaches
in constructing (weighting) a portfolio
of fund of hedge funds (FO HFs)
7.2 - Diversified Access to Hedge Funds
1. Assets Under Management-Weighted Approach
=> based on the AUM of each constituent fund
=> 3 challenges: 1) Declining alpha (good strategies atracts funds, reducing alpha); 2) Biased AUMs (AUM is self-reported - bias for funds that want to attract capital); 3) Flawed classifications (tendency for style drift)
2. Equally Weighted Approach
=> “=naïve allocation”
3. Equal Risk-Weighted Approach
=> portfolio weights = inverse proportion to each strategy’s volatility
=> weight = (1/σ) / ∑(1/σ)
=> Downside semivolatility may be a better measure
=> Drawback = future <> past
4. Mean-Variance Optimization -
=> Objective: maximize ex post Sharpe ratios
=> Also viewed as error maximizer (overweight strong inv. / under weak)
=> Assumes normal distribution (Not the case for HFs)
=> 3 types:
* Unconstrained
* Constraints on Higher Moments
* Personal constraints
7.2 - Diversified Access to Hedge Funds
List and explain
3 approaches
used by funds of hedge funds managers to
add value for their investors
7.2 - Diversified Access to Hedge Funds
1. Strategic allocation.
Good in stressed markets: ~80% of funds outperformed control by +3.5%
But < 50% outperforming control in normal markets
This level was shown to add value through positive skew in both normal and stressed market environments. In normal markets, strategic allocation led 48.4% of funds to outperform a neutral control portfolio by 1.54%, but in stressed markets, strategic allocation caused 77.7% of funds to outperform the control by 3.5%. Strategic allocation clearly matters, and it matters most when markets are stressed.
2. Tactical allocation.
0 added value
Tactical allocation provided limited added value in either normal or stressed market regimes.
3. Fund selection.
Good in normal markets: ~93% of funds outperformed control by +3.9%
But < 50% outperforming control in stressed markets
In normal markets, fund selection caused 92.9% of funds to outperform a neutral control portfolio by 3.89%, but in stressed markets it was responsible for only 48.4% of funds outperforming the control portfolio by 4.18%. The impact is substantial, but the likelihood of having an impact is greater under normal market conditions.
FO HFs:
- Pro: Lower drawdowns and volatility
- Con: return =~50% of average hedge fund index (2 reasons: 2nd layer of fees; index may be subject of survivorship bias); Lower information ratio
7.2 - Diversified Access to Hedge Funds
List and explain
Alternative Mutual Funds (AMF)
Characteristics
3 Benefits
and
3 Risks
to Investors
7.2 - Diversified Access to Hedge Funds
Alternative Mutual Funds (AMFs)
* Retail product for retail investor access HFs strategies
* Daily liquidity
* Only hedge fund strategies that focus on liquid strategies such as equity long/short and managed futures are able to exist in a mutual fund structure.
3 Benefits of AMFs:
1. Operational risk reduction
Because AMFs are required to meet federal regulations, there is less operational risk for investors relative to traditional hedge funds.
2. Access.
AMFs afford investors access to the diversification benefits of hedge fund strategies through a retail product.
3. Lower fees
Investors will pay considerably lower fees to access hedge fund strategies through an AMF than through a traditional hedge fund. AMFs generally only charge fees based on AUM and do not impose performance fees common with traditional hedge funds.
3 Risks of AMFs:
1. Liquidity
Retail investors may request more frequent redemptions than accredited investors. This can be a significant constraint even when they are limited to only 15% in illiquid assets. Too many redemption requests could lead to selling liquid assets at the wrong time and depressing NAV, which could cause even more redemption requests.
2. Leverage
AMFs are limited to a maximum of 33% leverage, but they can amplify this further by investing in leveraged ETFs or futures contracts. The potential for excess leverage is a risk for unsuspecting retail investors.
3. Trade allocation bias
If a manager operates both a hedge fund and an AMF, then there is an incentive to allocate the most profitable trades to the hedge fund were incentive fees are involved.
7.2 - Diversified Access to Hedge Funds
List and explain
3 Advantages
of Exchange-Traded Alternative Funds
(Alternative Mutual Funds-AMFs offered as ETFs)
vs
Alternative Mutual Funds (AMF)
7.2 - Diversified Access to Hedge Funds
1. Intraday trading.
All products that are exchange-traded can trade continuously while the market is open. This presents easier trading access than a mutual fund and more price transparency for investors.
2. Holding disclosure.
ETFs report daily vs quarterly of MF
their holdings at the start of every trading session. Mutual funds report quarterly. An exchange-traded format provided better transparency for investors.
3. Tax advantages.
ETFs enjoy less turnover than mutual funds which makes them potentially more tax friendly. They also offer in-kind redemptions for further tax management.
7.2 - Diversified Access to Hedge Funds
