CAIA L2 - 8.1 - Active Management and New Investments

Question 1

Formula

Fundamental Law
of Active Management (FLOAM)

8.1 - Active Management and New Investments

Answer 1

IR = IC × √BR
IR = IC × √BR × TC
Where:
IR = Information Ratio => risk-adjusted value added = alpha/vol(alpha)
IC = Information coefficient => Manager Skill (predicting returns)
BR = Breadth => number of independent selections in which the skill can be applied
TC = Transfer Coefficient => easiness to apply strategy: 1 = no restrictions

• IC and BR are usually correlated in real life
• IC tends to be much higher for asset classes than for individual securities

8.1 - Active Management and New Investments

Question 2

Define

Foregone loss carryforward

8.1 - Active Management and New Investments

Answer 2

cost
that occurs when a manager liquidates a fund
and the investor suffers from the
resetting of the high-water mark

8.1 - Active Management and New Investments

Question 3

List

2 Potential Costs
of Staying With a Manager
Below Its High-Water Mark

8.1 - Active Management and New Investments

Answer 3

1. The manager may lack motivation to perform well because of the requirement to return to the high-water mark before earning additional incentive fees. Instead, the manager may devote more time to other opportunities and clients. Underperformance may continue indefinitely.
2. If a manager is underperforming, other investors may withdraw their funds, causing an undesired increase in the investor’s ownership of the fund (i.e., concentration risk). For example, a sizable redemption transaction in the future may cause an unfavorably large price impact.

8.1 - Active Management and New Investments

Question 4

List

2 Potential Costs of
Replacing Managers
Unrelated to Incentive Fees

8.1 - Active Management and New Investments

Answer 4

1. Lost earnings on cash balances
   investors not receiving cash on a timely basis to invest, given a lag between the striking of the NAV for liquidation and a lag when the cash distribution occurs in two parts (which is usually the case). Undistributed cash often pays below market interest
2. Administrative and due diligence costs
   Costs related to hiring a new manager.

8.1 - Active Management and New Investments

Question 5

Contrast

Unconditional Analysis
vs
Conditional Analysis

give examples for Strategic and Tactical Allocations

8.1 - Active Management and New Investments

Answer 5

• Unconditional approach does not factor in current market conditions. considers past mean returns, volatilities, and correlations => used to generate SAA weights
• Conditional approach produces expected returns based on a function of current data points of its variables => used to generate TAA weights

8.1 - Active Management and New Investments

Question 6

List

3 Key Features
of Robust
TAA model development

8.1 - Active Management and New Investments

Answer 6

1. Use of economically sound signals. Economically sound signals have logical explanations for their return predictions that make sense. For example, models that are based on economic inputs such as interest rates (including the slope of the interest rate term structure) or GDP growth can be used to signal a potential change in the economy.
2. Absence of data mining.
   (do not look at many models/variables and select the ones that best explain past data)
   A sound model should be effective, and its predictions should not occur because of data mining. Data mining occurs when the manager looks at many models and/or variables and selects only the one(s) that best explain(s) past data. However, unless there are economic reasons for selecting a model, there could be evidence of cherry-picking data and as a result, the model should not be used. A logic check is to ask whether there are legitimate economic reasons a model would have given a proper result. Often, out-of-sample data (e.g., other time periods) is used for model validation.
3. Avoidance of overfitting
   (do not keep adding more variables to increase R-squared for in-sample that doens’t help predicting future returns)
   It is important to use an appropriate number of variables when constructing a model. Models with more variables may seem to have good fits (i.e., high R-squared) for in-sample data, but they do little in terms of being able to predict future returns. Models that include less variables have a better chance of being more consistent, more accurate, and less sensitive in the long run.

TAA aims to earn the highest risk-adjusted return in a targeted asset class
TAA may be subject to unfavorable taxation impacts

8.1 - Active Management and New Investments

Question 7

Goals in the structure
and
general characteristics
in
Private Equity funds

8.1 - Active Management and New Investments

Answer 7

The structure of the investments are driven by
* legal
* regulatory
* tax requirements

and have goals of
* limiting liability
* reducing taxation, and
* increasing transparency

General characteristics
* 10-year life, with a 2- to 3-year extension provision
* committed capital is drawn down in the first 3- to 5-year typically
* Distributions can be in cash or in-kind securities
* some funds may allow reinvestments of proceeds (no distribution)

8.1 - Active Management and New Investments