Hedge Funds 2 Performance, data and strategies Flashcards
How much do hedge funds invest on behalf of institutional investors and wealthy individuals?
3 trillion USD
3000x1billion
Which type of returns do hedge funds try to deliver?
Absolute returns or alpha which are returns not explained by general market movements
What volatility is high for hedge funds?
Idiosyncratic volatility. Additionally, some risks may remain hidden until it’s too late.
Idiosyncratic volatility.
Idiosyncratic risk is a type of investment risk, uncertainties and potential problems that are endemic to an individual asset (like a particular company’s stock), or group of assets (like a particular sector’s stocks), or in some cases, a very specific asset class (like collateralized mortgage obligations). It is also referred to as a specific risk or unsystematic risk.
What is the Sharpe ratio?
expected return in excess of risk free rate, divided by the volatility of the excess return
another word for risk-averse investor
mean-variance investor
What does a risk-averse investor strive for in relation to the Sharpe ratio?
a maximization of the Sharpe ratio (maximization of the expected returns at a given level of risk)
What is Markowitz portfolio theory?
Modern Portfolio theory. So CAPM
What is the tangency portfolio?
The interception of the Capital Allocation Line and the efficient frontier- The tangency portfolio only contains risk assets (no risk free asset)
How can you get a portfolio on the Capital Allocation Line?
optimally get the tangency portfolio and combine it with the risk free rate
Considering CAMP why could hedge funds be interesting?
They usually do not have very high Sharpe ratios so they are under the efficient frontier. But they have a low correlation with existing asset classes, they may provide attractive diversification opportunities.
What could happen if you have a hedge fund in your portfolio?
If the hedge fund has a positive alpha, then the Capital Allocation line moves upwards and leads to a more attractive Sharpe ratio for the portfolio.
What implication would a negative alpha of a hedge fund have for you?
It would require a short position in the hedge fund
What strategies provide positive alphas relative to the market portfolio?
Overweighting small cap stocks
Overweighting value stocks
Overweighting stocks that had high returns over the past year (momentum)
What is overweight?
Overweight can also refer—in a looser sense—to an analyst’s opinion that a stock will outperform others in its sector or the market. In this sense, it is a buy recommendation, essentially. Conversely, when an analyst suggests underweighting an asset, they refer to it being less attractive to other investments.
What are value stocks?
Value stocks are classified as stocks that are currently trading below what they are really worth and will therefore provide a superior return.
Is CAPM completely accurate?
No, empirically a large number of anomalies where reported (particularly in the equity market)
-> led to a range of multiple-factor models
What is the Fama-French three factor model?
It introduces two new factors to the CAPM, which are SMB and HML.
SMB (size factor)
SMB (small minus big)
return on a portfolio of small stocks minus the return on a portfolio of large stocks (small minus big)
HML (value factor)
(high minus low)
return on a portfolio of high book-to-market value stocks minus the return on a portfolio of low book-to-market value stocks.
What is the challenge for a professional money manager?
To outperform relative to the market portfolio and the factors of Fama-French so + SMB and HML
-> so provide positive alpha in a three-factor linear regression (this is harder than a positive alpha only with CAPM)
What did Carhart introduce to evaluate mutual funds?
He introduced a 4-factor model to incorporate something that even Fama-French couldn’t explain.
What is Carports fourth factor?
momentum (MOMt)
MOM?
the return on a portfolio of past (one-year) winners minus the return on a portfolio of past losers
How many databases are there for hedge funds?
Only five
Survivorship bias
Older databases typically only contain information on hedge funds that are still alive. Working only with surviving funds creates a survival bias because the more successful funds are more likely to survive. Average returns tend to overestimate the true performance
incubation bias
hedge funds may be added to a database after being around for a few years. This will only happen if the fund has been quite successful.
backfill bias or instant history bias
If historical returns of funds that have just entered a database are backfilled this creates un upward bias.
This is because hedge fund managers register their funds when they are successful and have ‘nice’ historic returns
Survivorship bias and incubation bias how much do they influence the return?
survivorship bias: 2.4%
incubation bias: 1.5%
(from 1994-2004)
What is the Rsquared normally for a hedge fund?
half of hedge funds have Required below 25%
-> returns on hedge funds are not well-explained by traditional asset classes
What are the two main approaches of hedge fund managers to achieve their absolute return targets?
- Directional (market timing, tactical trading)
2. Non-Directional (market neutral)
Non-Directional (market neutral)
A market neutral strategy has a very low correlation to the overall
market and is typically long and short in comparable securities.
Includes long/short and relative value (arbitrage) funds.
Directional strategies
Important directional strategies:
- Global macro
- Managed futures (CTAs)
Example of a directional strategy?
Robertson’s Tiger Fund and Soros’ Quantum Fund
–> The Quantum Fund made north of 1 billion betting that the British Pound would drop out of the ERM in 1992
Event-driven strategies
focus on debt or equity of firms that are in a particular stage of their life cycle
subcategories:
- Merger arbitrage
- Distressed securities
Merger arbitrage
a typical trade here is to buy stock of the target company while shorting the stock of the acquirer
Distressed securities
-focuses on firms in financial difficulty
Relative value strategies
take advantage of perceived misplacing between related financial instruments
Could it be a good idea to combine different hedge funds in one portfolio?
Yes. with different trading styles –> higher diversification
