Due Diligence and Selecting Strategies Flashcards
Conditions for TAA to add value
(1) short- to medium inefficiencies in the market, (2) a systematic approach can be designed to exploit these inefficiencies
Central relationship of the Fundamental Law Of Active Management (FLOAM)
IR = IC * √BR
IR = estimated alpha / volatility alpha (ie risk adjusted) IC = Measure of a managers skill BR = Number of bets
Transfer coefficient
Measures the ability of a manager to implement her recommendations, and has a upper limit of 1
IR = IC * √BR * TC
Three important characteristics of sound TAA model development
- Use of meaningful economical signals
- Absence of data mining
- Avoidance of overfitting
unconditional empirical analysis approach to asset allocation
Uses historic mean and volatility within an SAA approach to form asset weights without regards to the current condition of the economy
conditional empirical analysis approach to asset allocation
uses current condition of the economy and market (along with historic mean/volatility) within a TAA approach to form asset weights
consequence of adverse selection in PE funds
both unproven GPs and inexperienced LPs will form relationships with each other
GP Life Cycle
- Entry & establish (Fund I)
- Build & Harvest (Fund II)
- Decline or exit (Fund n)
Evidence Regarding Fund Performance Persistence
- Performance persistence until the late 1990’s and has been in decline since the 2000s
This implies a greater focus on aspects of manager selection
Six challenges to performance persistance hypothesis
- Ambiguities regarding definition of top performance
- Secular market trends
- Performance dispersion is heterogeneous in PE
- Is the performance luck or skill
- Comparing heterogeneous funds
- Effect of changes in fund size
A SPICE Girl challenges return persistence
Three detailed questions regarding the investment objective of a fund manager
- In which markets and assets does the fund manager invest?
- What is the fund manager’s general investment strategy?
- What is the fund manager’s benchmark?
Four detailed questions regarding the investment process
- Who makes investment decisions
- Who are the key people in committees
- How are decisions actually made
- How are portfolios and positions monitored
Investment process risk
potential loss from failure to properly execute the stated investment strategy
Two detailed questions regarding the value added by fund managers
- What enables a manager to identify alpha
2. What reasons are there to believe the alpha will persist?
Two primary information-based explanations for superior investment performance
Information-gathering: (create access to superior information)
Information-filtering: (use data available more efficiently than others)
Two critical decisions regarding a performance review
When should a performance review be executed and how much weight should be given to past performance
Bias blind spot
Tendency to underestimate to which biases you possess
Five classic issues with statistical return data
- Accuracy
- Gaming
- Representativeness
- Appropriateness
- Stationarity
Five statisticians are laying in A GRAS field
Classifications of management teams
- Blue Chip (top performance all funds over 2 cycles)
- Established (top performance most funds 2 cycles)
- Emerging (limited history)
- Reemerging (Previously established/Bluechip that has been through a restructuring process)
Three fund activities/function categories
Investment, operational, business
Time to review a fund manager
75-100 hours
Investment strategy/mandate
objectives, principles, techniques and procedures of a fund uses to construct/modify its portfolio
Level 1, 2, 3 assets
Level 1 - unadjusted market price from actively traded assets
Level 2 - nonactive market price quotes
Level 3 - fair value
Three general questions for a risk review
- What are the types and levels of risk involved in the fund manager strategy.
- What risks are measured, monitored and managed
- How and with what measures are risks monitored and managed
The Risk Alert noted four “warning indicators or awareness signals” regarding investments
- Lack of transparency
- Investment returns inconsistent with the investment strategy.
- Lack of clarity in the investment process.
- Lack of controls and segregation of duties.
The Risk Alert noted four “warning indicators or awareness signals” regarding risk management
- Concentrated positions.
- Insufficiently knowledgeable investment personnel.
- Investment strategy drift.
- Overly complex or opaque investment descriptions.
Rogue trader
Intentionally departs from the investment mandate in due to incentives to generate performance or recoup losses
Operational fraud from the investors’ perspective
Any intentional self-serving, deceptive behavior in the operational activities of a fund
Key operational areas reviewed during ODD
Post-investment operational process such as valuation, fund and firm service providers, legal documentation, BoD, client concentration.
Three major components controlling operational risk
Prevention, detection, and mitigation
Three conclusions from Christory, Daul, and Giraud (2006) regarding operational risk mitigation
- A portfolio of 40 funds provides reasonable diversification against operational fraud.
- ODD that takes into consideration main risk factors of funds in general
- Proper ODD can be valuable in developing a more accurate risk and return profile for the fund
Four primary functions of Noninvestment operational activities
Reconciliation
Allocation
Posting and Settlement
Execution
Trading execution
proces by which a fund completes a securities trade
Trade blotter
list of all trades that are desired
Two-way reconciliation
reconciliation between fund’s trading records and that of the prime broker (triangular if the administrator is included)
Four primary purposes of fund cash
- Cash for fund expenses
- Cash to facilitate trading
- Cashflow to and from investors
- Unencumbered cash (cash that may be used for trading but is not at the moment)
Three models of selecting personnel for investigation
- Equity ownership model (persons who have equity)
- Investment-decision making model (who can make investment decisions like PMs, traders)
- Risk control model (everyone who controls risk)
Five areas used in background investigations
(1) criminal searches (2) civil searches, (3) regulatory searches, (4) media searches, (5) factual information searches
Four areas overseen by compliance
- initial and ongoing compliance training
- testing of implementation of compliance policies
- monitoring and managing COI’s
- ensuring adherence with regulatory requirements
Pre-clearance/post-clearance
Pre-clearance: Employees must seek approval prior to trading
Post-clearance: collecting of brokerage statements to reconcile pre-clearance requests
Five operational fund committees
- Operations Committee
- Valuation Committee
- Business Continuity and Disaster Committee
- Best execution committee
- Compliance committee
Role of the BoD of a Fund
Fulfill regulatory obligations, exercising legal rights, and provide limited independent oversight.
Common duties for BoD members
- Overseeing the enforcement of redemption gates
- Reviewing and approving AFS
- Approval of legal documents
- Approving of manager’s use of certain mechanisms
- Reviewing valuations and overseeing enforcement of valuation practices.
- Reviewing the ongoing performance of service providers
primary equity investor motivations of designing fund legal structures
(1) Facilitate the implementation of tax efficiency
(2) Limit liability among entity involved
purpose of the master trust
Tax neutrality, not evasion
Most important link of investors to the fund
CFO as he is responsible for reporting the fund’s performance numbers
Difference hard vs soft lockup
Hard lockup: no redemptions during lock-up period
Soft lockup: Pay redemption fee if redemption happens during the lock-up period
Good leaver clause
Allows investors to cease additional funding of the partnership with a vote requiring a qualified majority
Four key functions of a PPM
- limited partner education
- risk disclosure
- risk assignment
- assignment of decision-making authority
