Reading 25 - Investment Manager Selection

Question 1

Capture Ratio

Answer 1

examines performance in both good and weak market conditions

Question 2

drawdowns

Answer 2

peak to trough decline in percentage terms for a specific time period

Question 3

Type 1 error null hypothesis - what is it, what if it is rejected and what if not rejected

Answer 3

Null: manager did not add any value
Null rejected: manager added value
null not rejected: type II error - null not rejected,, but manager did add value.

Question 4

Active versus passive strategies

Answer 4

passive believe markets are efficient and aim to earn risk premium

active believe markets are inefficient

Question 5

types of market inefficiencies

Answer 5

1. behavioral: mispricing caused by other investors and their behavioral biases (eg trend following). these are very short term in nature and therefore must be quickly exploited prior to market correction
2. structural: occur because of laws and regulations, which can make them long term in nature.

Question 6

hard lockup

Answer 6

does not permit redemptions

Question 6

soft lockup

Answer 6

permits redemptions for a fee

Question 6

gates

Answer 6

provide for a limit in the redemption amount for any given redemption

Question 7

what are they key advantages and disadvantages of limited partnerships?

Answer 7

Key advantages
1. Ability to have long investment horizon, thereby not allowing investors to overreact to short term aberrations.
2. allowing for the earning of illiquidity premiums by investing in illiquid assets and not being forced to sell assets at depressed prices due to redemption requests

Key disadvantages:
1. impaired ability to change portfolio allocations in response to changes in the market
2. impaired ability to meet sudden liquidity demands

Question 8

What are the 4 Ps to assess continuity of returns?

Answer 8

Philosophy, process, people and portfolio

Philosophy: focuses on a specific area of market inefficiency to earn excess returns.

Process and people: determines whether the strategy is feaible and if it is possible to execute the strategy with the given knowledge and skills of the employees.

Portfolio: must bst be built in a way that is congruent with the philosophy and process

Question 9

Type 1 and Type 2 Errors in manager selection?

Answer 9

Left: no skill and hire!

Question 10

Which errors get more attention - type 1 or type 2?

Answer 10

Type 1 - hiring or retaining a manager with no skill

Question 11

Why do Type I errors get more attention than Type II?

Answer 11

1. Type I: error of commission whereas Type II is error of omission
2. Type I errors are easier to determine because can see manager performance
3. Type I errors are much more visible to clients who can easily determine that their investments have underperformed the benchmark over a specific time period

Question 12

Is it easier or harder to distinguish between Type I and Type II errors in an efficient market?

Answer 12

In an efficient market, the dispersion of return distributions between the 2 groups is probably smaller due to greater difficulty in achieving alpha through active management, which would lessen the costs of hiring or retaining weak managers (weak I error)

Question 13

What is an upside capture ratio?

Answer 13

Looks at capture when the benchmark has a positive return.

Based on the benchmark return, UC that is higher than 100% is indicative of outperformance and UC that is lower than 100% is indicative of underperformanceW

Question 14

What is downside capture ratio?

Answer 14

Looks at capture when the benchmark has a negative return

Based on the benchmark, DC that is lower than 100% is indicative of outperformance and DC that is higher than 100% is indicative of underperformance

Question 15

What is the formula for capture ratio?

Answer 15

UC ratio/ DC ratio

if more than 1 = positive asymmetry (convex shape)
If less than 1 = negative asymmetry (concave shape)

Question 16

Drawdown duration

Answer 16

Total time from when the drawdown begins to when the total drawdown recovers to zero (the latter achieved with offsetting gains)

Question 17

What are the 2 main types of inefficiencies?

Answer 17

1. Behavioral: because of behavior and reverse within seconds
2. Structural: because of laws and regulations and can be long term in nature

Question 18

What is the capacity of an inefficiency?

Answer 18

The amount, repeatability and sustainability of the inefficiency

Question 19

What are the 2 important issues dealt with in quantitative analysis?

Answer 19

1. What is the likelihood that the same level of returns will continue in the future?
2. Does the manager’s investment process account for all the relevant risks?