CAIA L2 - 8.1 - Active Management and New Investments Flashcards
Formula
Fundamental Law
of Active Management (FLOAM)
8.1 - Active Management and New Investments
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 => ease to apply strategy: 1 = no restrictions
- IC and BR are usually correlated in real life. There is however no direct correlation between breadth and IC
- IC tends to be much higher for asset classes than for individual securities
8.1 - Active Management and New Investments
Define
Foregone loss carryforward
8.1 - Active Management and New Investments
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
List
2 Potential Costs
of Staying With a Manager
Below Its High-Water Mark
8.1 - Active Management and New Investments
- 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.
- 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
List
2 Potential Costs of
Replacing Managers
Unrelated to Incentive Fees
8.1 - Active Management and New Investments
-
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 -
Administrative and due diligence costs
Costs related to hiring a new manager.
8.1 - Active Management and New Investments
Contrast
Unconditional Analysis
vs
Conditional Analysis
give examples for Strategic and Tactical Allocations
8.1 - Active Management and New Investments
- 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
List
3 Key Features
of Robust
TAA model development
8.1 - Active Management and New Investments
- 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.
-
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. -
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
Goals in the structure
and
general characteristics
in
Private Equity funds
8.1 - Active Management and New Investments
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
Strategic Asset Allocation vs Tactical asset allocation
SAA - Investor’s long-term investment preferences and investment selection
TAA - investor placing more emphasis on various asset classes in the portfolio that are expected to outperform on a risk-adjusted basis in the near term. That can exploit occasional market inef iciencies, but it is also susceptible to risks.
LO 8.1.1
When calculating breadth, the forecasts made by the manager are considered independent if
The forecast errors are independent and the correlation between securities is low.
Correlation can be negative and is not bound by zero.
There is no direct relationship between breadth and manager skill (IC)
LO 8.1.2
By which year of the life of a private equity fund is most of the committed capital from the limited partners drawn down?
Year 4.
Most, although perhaps not all, of the committed capital is drawn down in the first three to five years of the life of a private equity fund.
LO 8.1.5
