Theory Module 1 Flashcards
What are HF?
A HF is a private investment pool, open to institutional or wealthy investors, that is largely expect from SEC regulation and can pursue more speculative investment policies than mutual funds. Although funds follow very different strategies and have different risk and return profiles, the main idea is that sophisticated/wealthy investors need less protection (more buffer to absorb potential financial losses). Hedge fund strategies are focused on absolute returns (not relative to a benchmark).
Why is manager pay tied to performance and managers invest their own capital?
To align interest of managers with investor (minimize agency problems)
What is the aim for MF (active and passive)?
Active - outperform a benchmark; passive - track a benchmark.
Why is capacity limited for HF?
HF are trying to exploit arbitrage opportunities, so if the fund grows too big it has too much price impact to profit from those anomalies.
Why are HF fees large?
To cover transaction costs, but also management fees and research cost.
Why has there been a decline in the number of FoF?
Decline since 2008 due to poor performance, in turn due to their very high costs - there is a double layer of fees when investing in a FoF.
Why has the performance in recent years gone down relative to the performance in early years?
Markets have become more efficient, but also completion in HF industry has increased.
Why is the HF domicile important?
Because they can offer attractive tax and regulatory climates, which allows for increased flexibility in investment strategies, and tax benefits that accrue to the managers and the fund itself.
Why do institutional investors invest in HF?
Mainly for alpha generation and portfolio diversification (particularly important for pension funds, who assume that hedge funds have low correlations with other assets classes like fixed income).
What are the main reasons behind selecting a fund?
Past returns and the source of such returns (a.k.a the strategy).
What are the main concerns about hedge funds?
Crowding, Style drift, lack of liquidity, and lack of communication/transparency, macroeconomic factors.
What’s crowding?
A lot of funds are following very similar strategies and therefore holding very similar positions. If a lot of funds are holding the same assets these might become overpriced and therefore have lower returns.
Another drawback of crowding is that it might lead to an increase of risk: if a lot of funds have to exit a position at the same time there might be a fire sale, which lowers returns for the HF
What does the fee structure of HF look like?
It consists of two components: the management fee (depends on the size of the fund, usually 2%) and the incentive/performance fee (usually 20% of the gains above a so-called hurdle rate). This is a so-called 2/20 scheme.
How can an incentive fee be modeled?
It can be modeled as a call option, with the exercise price S0 being the value of the fund at the beginning of the year, times the hurdle rate.
What is a consequence of the asymmetric payoff structure of incentive fees?
Incentive fees are meant to align investors and managers interests, but due to the asymmetric payoff structure, HF managers may engage in excessive risk taking.
What’s a high water mark?
If the fund experiences losses, the incentive fee is paid only when the fund makes up for the losses. However, this creates an incentives to shut down fund after poor performance and simply start new fund.
What’s a fund of funds and what is the underlying idea?
FoF are hedge funds that invest in other hedge funds. The underlying idea is diversification benefits, provided that the underlying HF follow different strategies. They usually have a 1/10 fee scheme. They also pay incentive fees to the underlying HFs, creating fee-on-fee.
What does the Sharpe Ratio measure?
It measures the return compensation for unit of risk. It’s calculated as returns in excess of the risk free rate, divided by the standard deviation of such excess returns.
Why isn’t the Sharpe Ratio always an accurate measure of risk compensation?
Because hedge funds returns don’t follow a normal distribution and it’s not symmetric.
What’s value-at-risk?
It’s a measure of tail risk of an investment.
What does the high correlation between stock and hf returns signal?
It signals that diversification potential of hf is limited when added to an equity portfolio.
What happens to correlations during recessions?
They increase, meaning that diversification power decreases when it is most needed.
What is the alpha trend between 1990 and 2011? What’s the explanation (3)?
Downward trend over time. Following the initial success of hedge funds, many new hf were launched, so more arbitrage capital was being deployed. Increased competition, decreased transaction costs, and more readily available financial information, anomalies in the market have become smaller. This makes it hard for hf to find such anomalies and make a return.
Another potential explanation is the tightening of regulations and stronger emphasis on compliance after the financial crisis of 2008/09. This has constrained investor flexibility and may have lowered risk appetite of hf managers.
Another explanation is that the financial incentive for hf managers to work hard have decreased due to increase of AuM. In particular, incentive fee has declined in importance relative to management fee as fund size increases; in other words, since the size has grown so much, managers pocket substantial wealth fro the management fee alone.
What is a possible reason for increase in correlation of HF?
Growth of AuM. Because hf have grown, they can’t limit themselves to exploiting obscure anomalies, but have now positions also in stocks like Apple.
HF performance between 1990 and 2018
During beginning of the sample, dot com bubble, and financial crisis in 2008 HFs have outperformed the S&P500. After 2008, the HF index has underperformed the S&P500 for 10 consecutive years.
What asset classes have negative correlation with the S&P500?
Investment grade bonds, currency, funds with so-called dedicated short strategy.
Why do HF underperform?
According to JP Morgan survey, the main reason is that there are too many hedge funds chasing limited opportunities to generate alpha. Moreover, the low interest rate environment doesn’t help because it decreases the expected return on asset classes like bonds.
What are the consequences of such poor performance for HF industry?
Until 2007 number of HF was growing steadily; as a result of poor performance in recent years, many funds have closed down. The total number of funds remains however quite stable because there are also funds being set up - this might be a sign that the HF industry has reached maturity.
What is the alpha?
It’s the abnormal return relative to a set of benchmark factors.
What is beta?
It’s the exposure of hf strategies to benchmark factors.
What are the two main HF strategies?
Directional and non directional
Directional strategies
They bet on the directional of financial or economic variables (e.g. increase in S&P 500). They are often based on fundamental investment approaches. Because of their directional nature, they are typically not market neutral (positive or negative exposure).
Non-directional strategies
They exploit temporary misalignments in security valuations. This typically involves going long in one asset and simultaneously going short in another asset. Often quantitative investment approach, exploiting statistical arbitrage (like pairs trading).
They strive to be market neutral.
What are the two types of non-directional strategies?
Relative value trades and convergence trades. Both aim to exploit mispricing, but in the convergence trades it is known when the misplacing will be resolved (e.g. expiration of futures contract).
What does it mean to be “market neutral”?
It means being a good hedge against equity market downturns (i.e. not loosing money when stock market goes down).
Why do funds that have the worst returns during crisis periods have higher returns in the full period?
The higher returns might be a risk premium.
Why do funds that perform best in crisis periods have lower returns in the full sample period?
It may reflect the insurance premium investors are willing to pay for the hedging ability of these funds.
Why do macro funds seem to be relatively good in hedging during downturns?
Because the HFRI Macro correlation with the S&P 500 falls sharply during recessions.
Why is the systematic beta returns of short bias funds negative?
Because these funds have negative market beta, and the market return over this period was positive (so product of the beta and the factor return is negative).
What is a portable alpha strategy?
A portable alpha strategy earns beta in one asset and alpha in another; often implemented using futures contracts (Futures overlay strategy)
What is the goal of the portable alpha strategy?
Separate asset allocation (beta) from security selection (alpha)
What are the three steps in setting up a portable alpha strategy?
- Invest where you have skill and can find alpha (e.g. Japanese small-caps)
- Hedge systematic risk (beta) away to isolate alpha (e.g. short Nikkei futures) - the perfect hedge ensures you earn risk free rate + alpha)
- Establish exposure to desired asset class by using index futures or ETF
What are the potential reasons for HF outperformance?
- Skills
- Investment flexibility (leverage, short selling, derivatives)
- Fraud (insider trading, etc)
- Data issues (smoothing, backfilling, survivorship, etc)
- Risk (liquidity risk, tail risk, correlation risk) - hf might earn a premium for exposures to risk factors that are not included in standard models of performance measurement.
- Methodological issues when assessing hf performance (skewness, non-linearities).
In other words, measuring true HF performance is complicated.
Elaborate on data issues in HF performance.
HF returns are self-reported and may be smoothed over a few months. It’s possible particularly when the fund holds illiquid assets that are not marked-to-market often (i.e. there is no current market price available simply because said assets are not traded)(->offers flexibility to the manager to come up with an asset value of these assets).
This leads to serial correlation in returns and reduces volatility (making the hf look safer than it actually is).
Implications: Sharpe Ratio overstated and factor betas understated -> alpha overstated if factor premiums are positive.
What’s a possible solution to serial correlation?
Serial correlation is used as a proxy for return smoothing. Because smoothing is done on short-term returns, long-term returns may be more indicative of true hf performance - because return smoothing is not possible over longer time horizons.
Santa effect in data issues
Higher returns reported in December (window dressing) –> 2.5x as large as in other months.
Stronger for lower-liquidity funds close to incentive fee hurdle
Backfill bias (data issues)
HF report returns to data providers only if they choose to (not required to report) –> incentive to start reporting when they have been successful
Survivorship bias (data issues)
Unsuccessful funds that cease operation stop reporting -> only successful HF remain in database. This leads to an upward bias.
Important because of high attrition rate among HF
Liquidity risk (Sadka, 2010)
HF with high loading on liquidity risk factor outperform low-loading funds by 6% p/a on average but underperform during liquidity crises. This suggests that these funds earn higher returns for the full sample as a compensation for bearing liquidity risk - i.e. investing in assets that do poorly when the market liquidity drives up.
Tail risk (JFE, 2017)
Research shows that HF can incur substantial losses in times of market downturns, when investor marginal utility is high - in other words, when investors really need returns.
HF are exposed to systematic tail (downside) risk due to dynamic trading strategies and investing in tail-sensitive stocks and options.
Return spread between HF with highest and lowest tail risk is 4.7% per year after controlling for 7 other factors. This evidence might suggest that hf managers do not earn true alpha, but are simply compensated for bearing downside market risk.
Correlation risk (2014, RFS)
HF have significant exposure to
correlation risk -> HF tend to do poorly when correlations
increase and diversification opportunities decrease.
Correlation risk exposure arises from trading options and
from hedging market risk (hedge ratio sensitive to corr.).
After controlling for systematic correlation risk factor, 40%
of hedge fund categories no longer have significant alpha
-> alpha of average fund goes down by almost half.
Ignoring correlation risk leads to upward bias in alpha
Why can the relation between portfolio management and market performance be non-linear?
Such a relation is option-like. It is due to:
- Market timing (dynamic trading strategies)
- Option strategies (customized payoff structure)
What happens if HF risk exposure (beta) is not constant?
1- Alpha biased if linear index model with constant betas is used.
2- HF investor may underestimate true risk exposure.
What is a solution for non-constant risk exposures (betas)?
Allow for separate up- and down-market betas. If the down market beta is larger than the up market beta, that is bad news for investors.
In the study shown, the alphas are. positive because of the short sample period (1996-1999), a period when hf did very well. R-squared are also very low, so model has low explanatory power for hf returns.
Explain what is happening with the betas when modeling returns like an option.
The patterns in up and down market betas are implicit evidence that hf are writing options.
The low beta (slope of the line) in good times indicates that funds are writing CALL options that reduce their gains, thus their exposure when the market is going up. Conversely, the high beta in bad times indicates that the funds are writing PUT options that increase their losses and thus their exposure when the market is going down.
How can “alpha” be generated with writing options?
The HF writes deep out-of-the-money puts, basically selling disaster insurance. As long as the price of the underlying asset doesn’t drop below the exercise price (i.e. below the flat line), the HF pockets the option premium (put price). This is a small profit independent of stock price, which shows up as “alpha” in linear model.
What skewness to OTM options create?
They create a HF return distribution with negative skewness - small probability of huge loss (tail event); in other words, returns are more likely to be positive.
What consequences does skewness have on performance measure (Sharpe Ratio)?
SR is based on mean variance theory. SR assumes that risk can be measured by std deviation, but it is only valid when returns follow a normal distribution. A consequence is that the fund may have a high SR but extreme downside risk exposure - in other words, SR is overstated.
An alternative measure that takes skewness and downside risk into account is the Sortino Ratio.
What are non-linearities in returns caused by?
- Taking positions in options
- Market timing
What is an example of market timing strategy?
Trend following funds, which invest more when the market rises (synthetical call) but take short position when the market is falling (synthetic put).
What payoff profile to trend following funds have?
They have a payoff profile similar to a straddle, even though trend-following funds do not take option positions.
A straddle consists in a long position in a call and a long position in a put with the same strike price.
What is the correlation between trend-following funds and the market? Why? What about the market beta of these funds?
The correlation is close to zero, because correlation is a linear measure of dependence; however, the relation between the two is non-linear (recall straddle option, v-shaped). As a result, the market beta of these funds tends to be very close to zero; but their up-market beta is positive and their down-market beta is negative.
Why do HF create option-like returns?
Manager behavior is direct response to incentives. HF incentive fees is asymmetric and based on short-term performance (the incentive fee cannot drop below zero if you incur losses). By selling deep OTM puts you boost the one-year SR -> it however exposes investors to downside risk.
What are example of Black Swan events?
- Black Monday crash (October 1987)
- Demise of Long Term Capital Management (1998)
- Subprime Mortgage crisis (2008-2009)
- COVID-19 crisis (2020)
Solutions to HF Incentive Problem
- Fund managers invest fraction of their own wealth.
- Fund managers want to preserve their reputations.
- Transparent strategy and reporting of positions. (reduces risk but may also lower performance due to copycat investors)
- Clawback provision: return fees earned in previous years if subsequent performance is poor -> creates long-term focus. (easy to implement, e.g. Harvard endowment)
