Chap 18 - Equity Hedge Funds

Question 1

At their heart, equity hedge funds of all styles share a common strategy focused on
taking long positions in undervalued stocks and short positions in overvalued stocks.
A major difference among equity hedge fund strategies is the typical net market exposure maintained by managers. Positive systematic risk levels are typically maintained by equity long/short hedge funds.

Question 2

What are Equity long/short funds?

Answer 2

Equity long/short funds tend to have net positive systematic risk exposure from taking a net long position, with the long position being larger than the short positions.

Question 3

What are Equity market-neutral funds ?

Answer 3

Equity market-neutral funds attempt to balance short and long positions, ideally matching the beta exposure of the long and short positions and leaving the fund relatively insensitive to changes in the underlying stock market index.

Question 4

Whar are Short-bias funds ?

Answer 4

Short-bias funds have larger short positions than long positions, leaving a persistent net short position relative to the market index that allows these funds to profit during times of declining equity prices.

Question 5

What is taking liquidity ?

Answer 5

More generally, taking liquidity refers to the execution of market orders by a market participant to meet portfolio preferences that cause a decrease in the supply of limit orders immediately near the current best bid and offer prices. The institution is trading to attain its preferred long-term positions.

Question 6

What does it mean “Providing liquidity” ?

Answer 6

Providing liquidity refers to the
placement of limit orders or other actions that increase the number of shares available to be bought or sold near the current best bid and offer prices. These providers of liquidity are trading with the primary purpose of making short-term trading profits, not to adjust their positions toward long-term preferences.

Question 7

What is a market maker and how does he profit ?

Answer 7

A market maker is a market participant that offers liquidity, typically both on the
buy side by placing bid orders and on the sell side by placing offer orders. A market
maker meets imbalances in supply and demand for shares caused by idiosyncratic
trade orders. Typically, the market maker’s purpose for providing liquidity is to earn
the spread between the bid and offer prices by buying at the bid price and selling at
the offer price.

Question 8

If a hedge fund or other provider of liquidity notices a quick price movement and provides liquidity, the provider is taking the risk that the price movement will trend rather than revert toward its previous level. A provider of liquidity succeeds or fails based on the ability to distinguish between liquidity-driven price movements that will reverse and fundamentally driven price movements that will continue to trend.

Question 9

Abnormal profit opportunities tend to come from market inefficiencies, and
market inefficiencies tend to come from reduced competition. Theoretically, the
competition for finding overvalued securities is less than that experienced in the
search for undervalued securities, as fewer market participants can or do engage in
short selling. The reduced competition for short selling is evidenced in the volume of
short interest.

Question 10

What is short interest ?

Answer 10

Short interest is the percentage of outstanding shares that are currently
held short.

Choie and Hwang demonstrate that stocks with high short interest tend
to underperform the market, with the implication that short sellers are skilled at
selecting overpriced securities.

Question 11

What is Asynchronous trading ?

Answer 11

Asynchronous trading is an example of market inefficiency in which news affecting more than one stock may be assimilated into the price of the stocks at different
speeds.

Question 12

What is the Overreacting/ underreacting strategy ?

Answer 12

Overreacting/ underreacting, in which short-term price changes are too large or too small, respectively, relative to the value changes that should occur in a market with perfect informational efficiency.

Question 13

Consistently superior returns from market inefficiencies are a transfer of wealth
to the market participant recognizing the inefficiency from the market participant on
the other side of each trade. Efforts by market participants to exploit market inefficiencies by purchasing underpriced assets and selling overpriced assets drive prices toward their efficient levels. In a society in which resources are allocated by prices, informationally efficient pricing provides substantially improved resource allocation.

Question 14

What is a complexity premium ?

Answer 14

A complexity premium is a higher expected return offered through
the consistently lower prices of securities that are difficult to value with precision and
therefore must be priced to offer an incentive to market participants to perform the
requisite analysis.

Question 15

What is speculation ?

Answer 15

Speculation is defined as bearing abnormal risk in anticipation of abnormally high expected returns.

Question 16

What is a market anomaly ?

Answer 16

Investment strategies that can be identified based on available information and
that offer higher expected returns after adjustment for risk are known as market
anomalies, which are violations of informational market efficiency.

Consequently, to be seen as a valid market anomaly, a perceived anomaly needs to earn excess returns using a well-regarded model of returns.

Question 17

A reasonable explanation for the anomaly should
include (1) from whom the excess returns are being earned, and (2) why the entity
on the other side of the trade is willing to transact at prices that the fund manager
perceives as beneficial to the fund and harmful to the other trader.

Question 18

What is an accounting accrual ?

Answer 18

An accounting accrual is the recognition of a value based on anticipation of a transaction. Sloan contrasts the cash flow of a firm with its net income. Net income includes the effects of accounting accruals. For example, sales of products on credit enter into the calculation of net income but have very little or no impact on free cash flow. According to this anomaly, investors seem to focus too much on net income, even though free cash flow appears to be the main driver of long-term returns.

Question 19

Bradshaw, Richardson, and Sloan conduct an empirical analysis that indicates
that firms with especially large accruals, in which net income is significantly higher
than operating cash flow, tend to have negative future earnings surprises that lead
to stock price underperformance. The implication is that equity hedge fund managers can buy stocks with negative accruals (higher ratio of free cash flow to net
income) and sell short stocks with positive accruals (lower ratio of free cash flow to
net income). To the extent that this is a true anomaly and that the anomaly continues,
the strategy would generate superior risk-adjusted returns.

Question 20

What is price momentum ?

Answer 20

Price momentum is trending in prices such that an upward price movement indicates a higher expected price and a downward price movement indicates a lower expected price.

Question 21

If a hedge fund manager through hard work and detailed analysis discovers that a particular firm is undervalued, rather than buying a large number of shares immediately, the optimal strategy would be to build a position in the stock a little at a time so that the price impact of its purchase is minimized. The stock of the firm is still likely to increase gradually through time, especially if it is a small cap. Eventually, the rest of the market learns about the firm and the stock price increases further, leading to the presence of momentum. This line of reasoning is consistent with available empirical evidence.

Question 22

What are earnings momentum and suprise ?

Answer 22

Earnings momentum is the tendency of earnings changes to be positively correlated.
Earnings surprise is the concept and measure of the unexpectedness of an earnings
announcement.

Question 23

What is a post-earnings-announcement drift anomaly and how can traders profit from it ?

Answer 23

However, a post-earnings-announcement drift anomaly has been documented, in which investors can profit from positive surprises by buying immediately after the earnings announcement or selling short immediately after a negative earnings surprise.

Question 24

These company insiders may also be subject to trading windows, which restrict trades
to only those times when they are assumed to not have material information regarding sensitive topics, such as profitability or an upcoming merger. Such windows may occur immediately after an earnings announcement, because known accounting results have recently been disclosed and it is too early in the quarter to have strong knowledge of future results.

Question 25

Insider buying can also be used to forecast the direction of the stock market as a whole, as insider buying across firms tends to be more prevalent near a bottom in the stock market.

Question 26

What is pairs trading ?

Answer 26

Pairs trading is a strategy of constructing a portfolio with matching stocks in terms
of systematic risks but with a long position in the stock perceived to be relatively
underpriced and a short position in the stock perceived to be relatively overpriced.
The approach is designed to hedge systematic risks (beta) and exploit patterns in
relative idiosyncratic returns (ex-post alpha).

Successful pairs traders have automated systems constantly searching for abnormal price movements in thousands of pairs, probably trading dozens of pairs each
day in reaction to short-term performance divergences.

Question 27

What are limits to arbitrage ? what does it refer to

Answer 27

The limits to arbitrage refer to the potential inability or unwillingness of speculators, such as equity hedge fund managers, to hold their positions without time constraints or to increase their positions without size constraints. Taking higher portfolio risks through higher leverage increases expected return but there is a limit to the risk that an arbitrager can tolerate and/or is allowed to take. This provides a limit on the level of arbitrage activity by a single manager.

Another limit to arbitrage is restrictions on short selling in some stocks or even
in entire markets. Some countries do not allow short selling. Even in developed
markets, short-term bans on short sales may be enacted. Stocks floating recent IPOs
or spin-offs may not have shares available to be shorted.

Question 28

How does a Equity long/short work ?

Answer 28

Equity long/short managers build their portfolios by combining a core group of long stock positions with short sales of stock, or bearish positions in stock index options and futures. Their net market exposure of long positions minus short positions tends to have a positive bias. That is, equity long/short managers tend to be long market exposure by typically having a larger long position than short position.

This is a much higher return than that predicted by the CAPM. The ability to
go both long and short in the market is a powerful tool for magnifying idiosyncratic risk without necessarily magnifying systematic risk.

Question 29

How does a equity long/short funds work ?

Answer 29

Like equity long/short funds, equity market-neutral hedge funds establish both long
and short positions in the equity market. The difference is that equity market-neutral
funds maintain integrated portfolios that are designed to neutralize equity market
risk, bringing beta risk to zero. This generally means a target of being neutral not just to the overall stock market but also across sectors. The idea of equity market-neutral funds is to neutralize market and industry risk and concentrate purely on
stock selection in both the long and short positions. Although equity market-neutral
fund managers seek alpha through security selection, unlike equity long/short managers they strive for market neutrality rather than engaging in market timing.

Question 30

What is Mean neutrality ?

Answer 30

Mean neutrality is when a fund is shown
to have zero beta exposure or correlation to the underlying market index.

Question 31

What is Variance neutrality ?

Answer 31

Variance neutrality is when fund returns are uncorrelated to changes in market risk,
including extreme risks in crisis market scenarios. The concept of variance neutrality can be extended into other measures of risk, such as value-at-risk neutrality or tail neutrality. Patton found evidence that perhaps one-fourth of funds failed to be independent from market risk.

Question 32

What are the Equity markets risk on equity hedge funds and its risk ?

Answer 32

Long/short equity funds typically maintain net long exposure to equity markets, whereas short-bias equity funds maintain net short exposure. As such, long/short equity funds can post losses in bear markets, and short-bias funds can post losses in bull markets.

Question 33

What are the Quantitative versus
fundamental risk on equity hedge funds and its risk ?

Answer 33

Quantitative, or black box, models assume that stock prices behave according to a specified factor model. If stock prices do
not react as expected, equity hedge fund strategies may produce a negative alpha. Similarly, fundamental strategies rely on the judgment of a person or a team, which may or may not add value in a given market environment.

Question 34

What are the Concentrated positions
and liquidity risk on equity hedge funds and its risk ?

Answer 34

As position sizes become larger and the market capitalization of the stocks declines, managers may find that their trades have
significant market impact. As a risk management tool, a limit on position sizes relative to average daily volume in a specific stock should be implemented.

Question 35

What are the Regulatory risk on equity hedge funds and its risk ?

Answer 35

Restrictions on short selling, from the uptick rule to periodic bans on short positions, can have a substantial impact on equity hedge fund strategies.