Manager selection and other Flashcards
Due diligence on investment manger
emphasize the sources and reasons behind the actual returns generated in the past
- must be an evaluation on the probability of repeated earnings sufficient or better returns in the future using the same inv. process.
Manager universe
consist of only those manager who are subtle for the portfolio in terms of the objectives and constraints of the IPS, style and will reconcile between active and passive approaches.
approaches to assign a pm to a benchmark
- 3rd party categorization
- return-based style analysis
- Holding’s based style analysis
- manager experience
Quant analysis
- evaluate objectively in terms of distribution of past returns
- perf attribution and appraisal
- capture ratio examine performance in both good and weak market conditions
= check for any significant drawdowns (peak-through decline in terms for specific time period)
quantitative analysis issue
- what is the likelihood that the same level of returns will continue in the future
- does the manager’s inv. process accurate for all the relevant risks
Philosophy:
focus on a specific arcade of market inefficiency to earn excess returns
process / people
determine whether the strategy is feasible and if it’s possible to execute the strategy with given knowledge and skills of the employees
portfolio
must be built in way that is consistent with the philosophy and process
Type I Error
reject null, no value added
ho: no value added
retain the manager with no skill
receive much more attention than type iI because:
- notion of regret aversion by the decision maker
- an error of commission
- result exploit cost
- transparent to investor
type iI error
null is not rejected, when in fact there was value added
fire the manager with skill
- errors of omission
- result in implicit/ opportunity cost
- not measurable
- not transparent
preventing type iI error
indicative of problems with the hiring and firing of managers
solution:
track the subsequent performance of managers who were not hired as well as those who were fired.
It is important not to hire or fire managers because of short term performance or because of behavior bias.
cost of type I and II errors
the greater the different in sample size and mean, the greater the cost of Type i and iI errors
- the wider the dispersion of returns between strong and weak managers, the easier its to distinguish between their relative skills
- decrease the difference in sample size and mean, increase std, the decrease the expected cost
- more efficient markets exhibits smaller difference in the dispersion of skilled and unskilled PM, result in lower costs
Type ii error occur i mean-reverting markets when strong managers are fired or managers who have weaker ST performance are fired and they subsequently outperform when market goes up.
Returns-based style analysis RBSA
Top-down approach that involve estimating the risk exposure from a n actual return rises for a given period.
adv:
straightforward, typically does not require a large amount of additional data, or difficult to acquire data
disadvantage:
- lack precision
- may not reflect the current or future portfolio exposures
- if the portfolio contains liquid securities, stale, prices may understate the risk exposure
Holding-based style analysis HSBA
(most appropriate for equity based strategies)
Bottom up approach that estimates the risk exposures from the actual securities held in the portfolio at a point in time.
adv:
- it allows for the estimation of current risk factors, proving an accurate view of the PM’s risk exposure
- comparable across PM and through time
disadvantage:
1. more computational effort required
2. high dependence on the degree of transparency provided by pM
3. stale pricing and window dressing
4. not appropriate if the portfolio has high turnover
capture ratio
> 1 POSTIVE asymmetry convex
determine how suitable a manager is with respect to the investor’s risk tolerance and time horizon
UC (upside ) look at capture when benchmark has positive return
UC > 1 outperformance
DC look at capture when benchmark has a negative return
DC < 1 outperformance
- can be used to confirm investment strategy
high beta, momentum-driven strategies, should have increase UC than value driven strategies, high UC and DC
low beta will have low UC and DC.
Drawdown
a low-beta strategy may have lower absolute return but low risk in the form of lower drawdowns may result in better risk-add returns
- useful for identifying poor/poorly executed investment strategies, weak internal controls, and operational problems
investment philosophy
exploit inefficiencies in financial market to generate excess return
behavioral inefficiency
mis-pricing caused by other investors and their behavior bias, st in nature
Structural inefficiency
offer because of laws and regulations, which can make them LT in nature
Given the amount of inefficient assets compared with the AUM of managers likely to exploit them provides some assurance that the inefficiency is repeatable. It would likely take some time for the inefficiency to converge to efficient valuation. The infrequent nature of the inefficiency and the zero marginal return suggest that the inefficiency is probably not worthwhile to pursue.
Idea generation
unique info adv, trendy, and interpreted differently
idea implementation/ signal capture
idea transformed into a investment position
2 key concerns:
repeatability process
its consistent with investment philosophy to determination and approval of investment position
portfolio constitution
risk mgmt
consistent with inv. philosophy and process
allocation of long and short position
AUM increase overtime
monitor the portfolio
hard stop losses, program make decisions
soft stop loses, human engagement required
operational due diligence
i. firm
must operate as a successful business to ensure sustainability
a small firm that is independent owned may have greater flexibility than a large organization, but it may have a higher cost structure and lack financial support during market events
ii. investment vehicle SMAs vs. pooled investment
iii. evaluation of investment’s streams
pooled investment
- bring together funds from all investors in one (MF, ETFs, HF)
- no custimization
- payment of accrued taxes in unrealized gains maybe required
SMA:
- hold funds of 1 investor in a separate account
- higher transaction costs
- provide control, customization, tax efficiency, separate reporting and greater transparency
- allow client- specific objective/ constraints
- require an extra layer of due diligence
disadvantage:
- cost additional operation burden
- tracking risk: large asset required to fully replicate the index performance
- investment behavioral: subject to behavioral bias as they are unprofessional
investment streams
liquidity from high to low:
- close-end fund
- ETFs
-open-ended funds
- HF (redemption lockup period and gates)
adv: ability to have long inv. horizon not allowing investor to overreact to ST
-invesmtnt in liquid premium
disadvantage - impaired ability to change portfolio allocations in response to change in the market
- PE
- VC fund due to capital calls
fee structure/ performance fees
symmetrical structure with full upside and downside exposure
fee = base + performance sharing
the greater alignment between investor and manager incentives, but higher risk to manager due to full downside exposure
bonus with full upside and limited downside exposures
fee = max( base, base + sharing of positive perf)
bonus with limited upside and downsize potential
fee = max ( base, base + sharing of positive performances with limit)
STD underestimate downside risk
(BEI active return - base fee) * sharing
= performance fee / base fee
= total billed fee
= long call on the portfolio return with a strike = based fee
liquidity profiling and time-to-cash tables
- determine potential cash in/outflows
- establish a timeline that involves constrains a liquidity classification schedule (time-to-cash table)
- amount of time needed to convert asset to cash
- liquidity classification level
- liquidity budget
rebalancing and commitment
systematic rebalancing policies
-maintain LT strategies asset allocation
calendar and % range rebalancing with pre-determined acceptable ranges for various asset classes
automated adj. mechanisms - keep the portfolio risk profile relatively constant if there’s change from the target commitments
street testing
based on any combination of history, statistical model, and scenario analysis
derivatives
ideal method for rebalancing
a future overlay for rebalancing of many (but not all) asset classes without altering any of the asset allocation.
liquidity premium increase with time horizon
value of put option
where the strike price is the marketable price of the liquidity asset
illiquid asset price = marketable asset- put price
illiquidity premium % = expected return on illiquid asset % - expected return on market asset %
taking a long future position requires only minimum cash requirement for magin
form of leverage investment
any cash not require for margins can be used to inv. in other assets with differing levels of liquidity, or to meet other liquidity requirement
options can be purchase at premium that are
only a fraction of the cost of underlying asset, thereby securing as a form of leverage.
Options can be sold to earn premium income that helps to generate liquidity.
For P/E, capital calls are greater than capital distributions
resulting in a greater concentration of private equity
certain investment made by pm may restrict investors from withdrawing the funds during stressed market conditions, which decrease the polio’s overall liquidity.
PE are not valued as frequent as public equity
activation of gates
the smoothing effect
Time weighted return original Dizfz = R=
(EMV- BMV- CF)
/ (BMV+ 0.5 CF)
Modified Dizfz: R-
(EMV-BMV-CF)
/ (BMV+ SUM OF wi* CFi)
Aggregated method Rbmv+cf
= sum of EMV - sum of bmv - sum of cash flow
/ sum of BMv + sum(cash flow * wi)
3 reasons deterioration may occur
- for private equity capital calls are greater than capital distribution, resulting a greater concentration of PE in the portfolio
- certain investment made by the pm may restrict investor from withdraw their funds during stressed market conditions, which decrease the portfolio overall liquidity
-PE investment are not valued as frequent. The lagged valuation mean there is a relation increase as % of portfolio and a relative low liquidity asset as a % of portfolio during stressed market condition. The % of asset available for meeting liquidity needs is reduced.
Tracking error perspective
ETF face tracking error for reasons such as cash drag, and mandatory diversification
futures : liquidity and interest rate differentials
total return swap: have no tracking error
