Reading 43 - Investing in Hedge Funds: A Survey Flashcards
What are the main hedge fund strategies?
- Arbitrage based
- Convertible Bond Arbitrage
- Equity market neutral
- Event driven
- Risk arbitrage (aka Merger Arbitrage)
- Fixed Income arbitrage
- Medium Volatility
- Global Macro
- Long Short equity
- Managed Futures
- Multistrategy
- Directional
- Dedicated short bias
- Emerging Markets
Describe the Arbitrage based hedge fund strategy
- attempts to profit from security mispricings while matching the characteristics of their short position to those of their long positions
- results in a lower standard deviation of net returns and the highest Sharpe ratios of all hedge fund strategies
- are said to be “short volatility”
- They make money slowly (during stable markets) but lose money rapidly (during market turbulence) which results in negative skewness and fat tails in their return distribution
Describe the Convertible Bond arbitrage hedge fund strategy
- goes long a convertible bond and short the underlying equity
- Perform well when stock volatility increases (b/c the long call option gains value) and when credit spreads decline (b/c the long fixed income position gains value)
Describe the Equity market neutral hedge fund strategy
- Seeks to hedge market exposure in equity investments through long and short positions with equal beta exposure
- The long term goal is zero beta exposure
Describe the Event driven hedge fund strategy
- driven by the outcome of specific expected events
- Ex. Distressed Debt investing
- Have the highest liquidity risk among hedge fund strategies
Describe the Risk Arbitrage (Merger Arb) hedge fund strategy
- Attempts to profit on the eventual outcome of an announced merger
- Takes a long position in the acquired stock and short position in the acquirer
- The price differences reflect the uncertainty of the completion of the merger
Describe the Fixed Income Arbitrage hedge fund strategy
- Goes long lower credit quality bonds and short higher quality bonds. The spread between the two provides income to the fund.
- The spread can shrink or expand based on market conditions
Describe the Medium volatilty hedge fund strategy
- Takes both long and and short positions, however the exposures may differ creating a net long position
- This is a partial hedge which results in volatilty below that of the underlying market
Describe the Global Macro hedge fund strategy
- Make broad bets on indices, currencies, commodities and other asset classes
- B/c of the large unvierse of investment opportunities, correlations within the fund category tend to be low
Describe the Long-short equity hedge fund strategy
- Similar to market neutral but don’t seek zero beta
- a net beta of 0.3 to 0.6 is typical
- Managers have flexibility to adjust need beta based on current market opportunities
Describe the Managed futures hedge fund strategy
- employ quantitative models to speculate in futures (commodities, equities, currencies, interest rates , etc.)
- Risk return is poor on its own, but within a portfolio its provides the most diversification and hedging benefit of all the hedge fund strategies
- Typical hedge fund risks like (liquidity, counterparty and valuation
Describe the Multistrategy hedge fund strategy
- employ a combination of strategies
- Similar to fund of funds but without the second layer of fees
Describe the Directional hedge fund strategy
- makes active bets based on expectations of how security prices are going to move
- B/c no hedging is employed, they experience the full volatility of the underlying markets
Describe the Dedicated short bias hedge fund strategy
- Focuses exclusively on shorting equities
- Beta often close to -1
Describe the Emerging Markets hedge fund strategy
- Invest in equity securities in emergin markets
- Since short expsores is difficult or expensive in these markets, funds tend to have a long bias
What are the 3 biases in reported hedge fund performance?
Backfill Bias - aka incubation bias or instant history bias. When a fund begins reporting performance to an index provider, they will also fill in historical performance. These historical performance return are significantly higher than “live”, current returns
Selection Bias - since reporting performance is voluntary, it is more likely a high-performance fund will report. ** aka self reporting bias. **
Survivorship Bias - funds may chose to stop reporting to an index when they are liquidated or experience poor returns.Adds between 0.6% and 3.6% to reported hedge fund performance.
A hedge fund investor would like to see a fund have a high Alpha or high Beta?
Alpaha. Alpha is the value added return while Beta is the market return
What is the formula for the hedge fund return factor model?
Because hedge fund returns are non-normal, meaning their returns are neither normally distributed or linearly related to traditional market risk exposures, what are the two additional sources of risk to consider?
- Skewness
- Kurtosis
In additional to larger mean returns and lower standard deviation of returns, investor prefer_____ skewness and _____ kurtosis?
Positive skewness, Lower Kurtosis
***Hedge fund returns distributions often have negative skewness and high kurtosis
Which hedge fund strategies can be considered short volatility strategies?
- Short Options
- Merger arbitrage
- Fixed income arbitrage
***These do well during less volatile market conditions
Which hedge fund strategies can be considered long volatility strategies?
- Long Options
- Managed futures
What happens when you add long volatility hedge funds to a portfolio of short volatility hedge funds?
- The portfolio volatility level will typical increase, but the portfolio returns will become more normally distributed. (less negative skewness and lower kurtosis)
- b/c of this the Sharpe ratio decreases and becomes more desirable for investors because of improved skewness and kurtosis.
What a the 3 primary motivations for using a hedge fund replication strategy?
- Lower Cost - if you can use traditional market securities (etfs, indexes), costs can be reduced.
- Lack of Alpha - the factor model of hedge fund returns distinguishes return achieved from taking market risk from value added by hedge fund manager. If manager is not delivering high alpha, a replicating strategy may be more attractive
- Liquidity and transparency - replicating strategies are not subject to lock-ups and require more transparency than hedge funds
What are the three difficulties in applying traditional portfolio analysis to hedge funds?
- _Difficult to develop expected return assumptions _
- Hedge fund performance can be dynamic - beta exposures, volatility and correlations change over time.
- Standard deviation is an incomplete measure of risk - it is often the styles with the best standard deviation and Sharpe measures suffer from higher moment risk exposures.
Why is a portfolios Skewness important to an investor?
Negatively skewed distributions have what statisticians call a long left tail, which for investors can mean a greater chance of extremely negative outcomes. Positive skew would mean frequent small negative outcomes, and extremely bad scenarios are not as likely.
Why is a portfolio’s Kurtosis important to an investor?
Kurtosis measures the “fatness” of the tails of a distribution. Positive excess kurtosis means that distribution has fatter tails than a normal distribution. Fat tails means there is a higher than normal probability of big positive and negative returns realizations
The returns of many hedge fund strategies are not normally distributed; rather they are _____kurtotic and ______ skewed.
Highly Kurtotic
Negatively Skewed
