Session 11 - Alternative Investments for Portfolio Management Flashcards
1
Q
Key characteristics distinguishing hedge funds and their strategies from traditional investments include the following
A
1) lower legal and regulatory constraints;
2) flexible mandates permitting use of shorting and derivatives;
3) a larger investment universe on which to focus;
4) aggressive investment styles that allow concentrated positions in securities offering exposure to credit, volatility, and liquidity risk premiums;
5) relatively liberal use of leverage;
6) liquidity constraints that include lock-ups and liquidity gates; and
7) relatively high fee structures involving management and incentive fees.
2
Q
Equity L/S strategies
A
- take advt diverse opportunities globally to create alpha via managers’ skillful stock picking
- typically liquid
- reliance on fundamental research
- most managers specialize in a specific geography, sector, or style
- some are generalist and avoid complex sectors
- generally net long, with gross exposures at 70%–90% long vs. 20%–50% short (but they can vary)
- some short using index to reduce mkt risk but most use single name shorts for alpha and more return
- typically aimed to achieve returns = to a long-only approach but with st.dev that is 50% lower
- the less risk factor exposure (more market neutral), the more leverage
3
Q
Dedicated short-sellers
A
- only trade with short-side exposure, moderate short beta by also holding cash
- tend to be 60%–120% short at all times
- single equity stock picking, not index shorting
- use little leverage
- bottom-up approach (deep dive)
- lower returns than other HF but with a negative correlation benefit (increasing returns when market declines or decreasing returns when market rises)
- liquid, returns lumpy and more volatile bc shorting involved
4
Q
Short- biased strategies
A
- focused on short-side stock picking, but moderate short beta with value-oriented long exposure and cash.
- short- biased strategies are typically around 30%–60% net short
- single equity stock picking, not index shorting
- use little leverage
- lower returns than other HF but with a negative correlation benefit (increasing returns when market declines or decreasing returns when market rises)
- liquid, returns lumpy and more volatile bc shorting involved
5
Q
Equity market-neutral (EMN) strategies
A
- take advantage of short- term mispricing between securities
- sources of return and alpha do not require accepting the beta risk E(bp)=0
- especially attractive in periods of market vulnerability/weakness
- most = purely quantitative managers (diverse holdings)
- adjusted often bc must balance neutrality with balancing costs
- often seen as preferred replacements for FI during low return periods or YC flate
- generally apply high leverage to create meaningful returns
- exhibit relatively modest return profiles
- high levels of diversification and liquidity with a lower standard deviation of returns
- count on mean reversion
6
Q
Merger arbitrage
A
- relatively liquid strategy
- gains come from idiosyncratic, single security takeover situations
- occasional downside shocks can occur when merger deals unexpectedly fail
- Crossborder M&A and vertical integration (face antitrust scrutiny) carry higher risks and offer wider merger spread returns
- have return profiles that are insurance-like, plus
a short put option, with relatively high Sharpe ratios - huge LT risk
- typically apply moderate to high leverage to generate meaningful target return levels
7
Q
Distressed securities strategies
A
- focus on firms in bankruptcy, facing a potential bankruptcy, or under financial stress
- returns are at the higher end but more variability
- high level of illiquidity, low /mod leverage, long-biased
- seek inefficiently priced securities before, during, or after the bankruptcy process, which results in either liquidation or reorganization
- In liquidation, the firm’s assets are sold off and securities holders are paid sequentially based on the priority of their claims
- In re-organization, a firm’s capital structure is reorganized and terms for current claims are negotiated and revised
8
Q
Fixed-income arbitrage
A
- attractiveness of returns is from high correlations between different securities, yield spread pick-up, and the high # / wide diversity of debt securities across different markets, credit quality, and convexity (valuation differences between securities due to credit quality and/or implied volatility spreads)
- Yield curve and carry trades within the US government space are very liquid and few mispricing opp.
- liquidity decreases in other sovereign markets, mortgage-related markets, and across corporate debt markets
- high leverage usage bc pricing inefficiencies are small but high correlations btw securities
9
Q
Convertible arbitrage strategies
A
- strive to extract “underpriced” implied volatility from long convertible bond holdings
- managers will delta hedge and gamma trade short equity positions against their convertible positions
- works best in periods of high convertible issuance, moderate volatility, and reasonable market liquidity
- being naturally less-liquid securities due to their relatively small issue sizes, complexities, availability, and cost to borrow underlying equity for short selling
- typically run convertible portfolios at 300% long vs. 200% short
- must accept or hedge away interest rate, credit, and market risks
10
Q
Global macro strategies
A
- focus on correctly capitalizing on trends in global financial markets using a wide range of instruments
- tend to use more discretionary/fundamental, top-down approaches
- tend to be anticipatory, often contrarian, but some follow the momentum
- fairly heterogeneous as a group (not as a consistent source of alpha)
- highly liquid and use high leverage (6-7x)= higher vol.
- mean-reverting, low volatility not ideal
- Returns lumpy and typically exhibit positive right-tail skewness during market stress (diversification) but more heterogeneous outcomes
11
Q
Managed futures strategies
A
- focus on correctly capitalizing on trends in global financial markets using mainly futures and options on futures, stock, and fixed-income indexes, commodities, and currencies
- since funds only acquire asset exposures, the majority of capital (85-90%) invested in ST gov’t debt
- tend more towards systematic trading with a quantitative driven approach to trend identification
1) time-series momentum trend following (long assets rising in price, short assets falling in price)
2) cross-sectional momentum - same as TSM but a group of long positions against a group of short positions - highly liquid and use high leverage
- Returns typically exhibit positive right-tail skewness during market stress (diversification)
12
Q
Specialist hedge fund strategies
A
- require highly specialized skill sets for trading in niche markets
- aimed at generating uncorrelated, attractive risk-adjusted returns
- two strategies are volatile trading and reinsurance/life settlement
13
Q
Volatility trading strategies.
A
- strive to capture relative timing and strike pricing opportunities due to changes in the term structure of volatility
- relative value volatility arbitrate - buy cheap vol. and sell expensive vol.
- They try to capture volatility smiles and skew by using various types of options spreads, such as bull and bear spreads, straddles, and calendar spreads
- using exchange-listed and OTC options, VIX futures, volatility swaps, and variance swaps
14
Q
Life settlements strategies
A
- pools of life insurance contracts offered by third-party brokers, where the hedge fund purchases the pool and effectively becomes the beneficiary
- look for:
1) The surrender value being offered to the insured individual is relatively low;
2) the ongoing premium payments are also relatively low;
3) the probability is relatively high that the insured person will die sooner than predicted - uncorrelated with other assets classes
- reinsurance = catastrophe insurance, also uncorrelated with other asset classes
15
Q
Funds-of-funds
A
- typically offer steady, low-volatility returns via their strategy diversification
- offer a potentially more diverse strategy mix
- less transparency, slower tactical reaction time, and contribute netting risk to the FoF investor
