Session 11 - Alternative Investments for Portfolio Management

Question 1

Key characteristics distinguishing hedge funds and their strategies from traditional investments include the following

Answer 1

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.

Question 2

Equity L/S strategies

Answer 2

• 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

Question 3

Dedicated short-sellers

Answer 3

• 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

Question 4

Short- biased strategies

Answer 4

• 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

Question 5

Equity market-neutral (EMN) strategies

Answer 5

• 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

Question 6

Merger arbitrage

Answer 6

• 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

Question 7

Distressed securities strategies

Answer 7

• 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

Question 8

Fixed-income arbitrage

Answer 8

• 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

Question 9

Convertible arbitrage strategies

Answer 9

• 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

Question 10

Global macro strategies

Answer 10

• 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

Question 11

Managed futures strategies

Answer 11

• 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)

Question 12

Specialist hedge fund strategies

Answer 12

• 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

Question 13

Volatility trading strategies.

Answer 13

• 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

Question 14

Life settlements strategies

Answer 14

• 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

Question 15

Funds-of-funds

Answer 15

• 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

Question 16

Multi-strategy funds

Answer 16

• typically offer steady, low-volatility returns via their strategy diversification
• have generally outperformed FoFs, but they have more variance due to using relatively high leverage
• faster tactical asset allocation and generally improved fee structure (netting risk between strategies is often at least partially absorbed by the general partner)
• they have higher manager-specific operational risks

Question 17

Conditional linear factor models

Answer 17

• useful for uncovering and analyzing hedge fund strategy risk exposures
• a model that incorporates four factors for assessing risk exposures in both normal periods and market stress/crisis periods: equity risk (monthly return to index), credit risk (Baa - Aaa) bond yield, currency risk (monthly return on USD index), and volatility risk (VIXt - VIX t-1)

Question 18

Adding a 20% allocation of a hedge fund strategy group to a traditional 60%/40% portfolio (for a 48% stocks/32% bonds/20% hedge funds portfolio)

Answer 18

• typically decreases total portfolio standard deviation while it increases Sharpe and Sortino ratios (and also often decreases maximum drawdown) in the combined portfolios
• demonstrates that hedge funds act as both risk-adjusted return enhancers and diversifiers for the traditional stock/bond portfolio.

Question 19

The priority of debt repayment claims

Answer 19

senior secured debt, junior secured debt, unsecured debt, convertible debt, preferred stock, and finally common stock.

Question 20

Equity Hedge Fund Classification - expand and the styles inside

Answer 20

• equity market return and risk characteristics
• long/short equity
• dedicated short bias
• equity market neutral

Question 21

Event-DrivenFund Classification- expand and the styles inside

Answer 21

• corporate events (governance, M&A, bankruptcy)
• merger arbitrage
• distressed securities

Question 22

Relative Value Classification- expand and the styles inside

Answer 22

• relative valuation between two or more securities, exposed to credit and liquidity risk
• fixed-income arbitrage
• convertible bond arbitrage

Question 23

Opportunistic Classification- expand and the styles inside

Answer 23

• top-down approach, the multi-asset opportunity set
• look atwide range of markets and securities (region and asset lvl vs. indvl securities)
• look at broad themes, global relationships, market trends, cycle