TOPIC 10 - HEDGE FUNDS Flashcards
Directional funds take a stance on
the performance of broad market sectors.
Nondirectional funds establish
market-netural positions on relative mispricing. However, even these hedged positions still present idiosyncratic risk.
Statistical arbitrage is the use of quantitative systems to
uncover many perceived misalignments in relative pricing and ensure profits by averaging over all of these small bets.
Portable alpha is a strategy in which one invests in positive-alpha positions, then
hedges the systematic risk of that investment and finally establishes market exposure where desired by using passive indexes or futures contracts
Performance evaluation of hedge funds is complicated by what 4 things?
1) survivorship bias,
2) potential instability of risk attributes,
3) the existence of liquidity premiums
4) unreliable market valuations of infrequently traded assets.
what makes performance evaluation super tricky?
when the fund engages in option positions. Tail events make it hard to assess the true performance of positions involving options without extremely long histories of returns.
Hedge funds typically charge investors both a management fee and
an incentive fee equal to a percentage of profits beyond some threshold value.
The incentive fee charged by hedge funds is akin to
a call on the portfolio. Funds of hedge funds pay the incentive fee to each underlying fund that beats its hurdle rate even if the overall performance of the portfolio is poor
transparency for hedge funds vs mutual funds
hedge funds - minimal disclosure of strategy and portfolio composition (good and bad)
vs mutual funds way more transparent due to regulation
investment strategies - hedge fund vs mutual fund
hedge: v flexible, use shorting leverage options
mutual: predictable, stables strategy, can’t chop and change as much
liquidity of hedge funds vs mutual funds
hedge: often have lock up periods
mutual: investments can be moved in and out of fund more easily
compensation of hedge vs mutual funds
hedge: management fee of 1-2% of assets + incentive fee (can be large!)
mutual: usually fixed % of assets (0.5%-1.25%)
hedge fund directional strategies
bets one sector or another will outperform sectors of the market
hedge fund non-directional strategies
exploits temporary misalignments in relative pricing
- often involves long position in 1 security hedged with a short position in a related security
- strives to be market neutral
3 steps of portable alpha strategy
1) invest in positive alpha positions
2) hedge the systematic risk of that investment
3) establish market exposure where you want it by using passive indexes
In simple terms, portable alpha is a strategy that involves investing in areas that have little to no correlation with the market. Portfolio managers separate alpha from beta by
investing in securities that are not in the market index from which their beta is derived. Alpha is the return on investment achieved over and above the market return—beta—without taking on more risk.
style analysis for equity market neutral funds
Uniformly low and statistically insignificant factor betas
style analysis for dedicated short bias exhibit
substantial negative betas on the market index
style analysis for distressed firm funds
have significant exposure to credit conditions as well as the market index
fixed index income arbitrage funds style analysis show
positive exposure to the differential return on corporate vs treasury bonds
Equity market neutral funds commonly use
long/short hedges.
Typically controls for industry, sector size and establishes market neutral positions designed to exploit some market inefficiency. Commonly involves leverage.
dedicated short bias funds have what position in equities?
net short position usually in equities as opposed to pure short exposure
fixed income arbitrage
attempts to profit from price anomalies in related interest rate securities.
In a short-hedged position, the entity is seeking to
sell a commodity in the future at a specified price.
The company seeking to buy the commodity takes
the opposite position on the contract known as the long-hedged position.
hedge funds tend to hold more or less illiquid assets than other institutional investors
more illiquid assets
Aragon’s study suggests that part of any “alpha” exhibited by hedge funds may in fact be an XXXX rather than a sign of stock-picking ability
equilibrium liquidity premium
backfill bias in hedge funds arises bc
hedge funds report returns to database publishers only if they choose! prior performance of funds eventually included in the sample may not be representative of typical performance
survivorship bias arises when
unsuccessful funds that cease operation stop reporting returns and leave a database leaving behind only the successful funds
Incentive fees in hedge funds are effectively call options, where the manager gets
the fee if the portfolio value rises sufficiently, but loses nothing if it falls –>
Strike price = current portfolio value × (1 + benchmark return)
High water mark is the previous value of a portfolio that must be reattained before
a hedge fund can charge incentive fees - o Give managers an incentive to shut down funds that have performed poorly
what are funds of funds?
investment funds that invest in other funds rather than investing directly in securities (stocks or bonds)
With all market risk hedged away, the standard deviation of the monthly
return of the hedged portfolio is equal to
the standard deviation of the residuals. The standard deviation of the residuals for the stock is the volatility that cannot be hedged away. For a market-neutral (zero-beta) position, this is also the total
standard deviation.
The expected rate of return of the market-neutral position is equal to
the riskfree rate plus the alpha
if you’re market neutral you’ve hedged away all the risk
expected return of the market-neutral position is equal to the
riskfree rate plus the alpha
Why does the misestimation of beta matter so much more for the 100-stock portfolio
than it does for the 1-stock portfolio?
The market exposure from improper hedging is far more important in contributing to total volatility (and risk of losses) in the case of the 100-stock portfolio because the idiosyncratic risk of the diversified portfolio is so small in this case.
When idiosyncratic risk is minimal, the market risk that results from underestimating
beta has a much greater proportional impact on the total risk of the portfolio.
READING Illiquid assets
in Asset management: After taking into account biases induced by infrequent trading and selection, it is LIKELY OR UNLIKELY that illiquid asset classes have higher risk adjusted returns that traditional liquid stock and bond markets
unlikely that illiquid asset classes have higher risk-adjusted returns than traditional liquid stock and bond markets
READING Illiquid assets
in Asset management:
whilst it’s unlikely that illiquid asset classes have higher risk adjusted returns than traditional illiquid stock & bond markets, there are still
significant illiquidity premiums within asset classes. Portfolio choice models incorporating illiquidity risk recommend that investors should retain only modest holdings of illiquid assets and demand high risk premiums for investing in them
Convertible arbitrage - hedge fund style
hedged investing in convertible securities, typically long convertible bonds and short stock
dedicated short bias - hedge fund style
net short position, usually in equities as opposed to pure short exposure
emerging markets - hedge fund style
goal is to exploit market inefficiencies in emerging markets. Typically long-only bc short-selling ins’t feasible in many of these markets
equity market neutral - hedge fund style
commonly uses long/short hedges. Typically controls for industry, secotr, size adn other exposures and establishes market-neutral positions designed to exploit some market inefficiency
equity market neutral strategy commonly involves what? ( - hedge fund style )
leverage!!
event driven - hedge fund style
attempts to profit from situations like M&A, restructuring, bankruptcy or reorganisation
fixed-income arbitrage - hedge fund style
attempts to profit from price anomalies in related interest rate securities, incl, interest rate swap arbitrage, US vs non-US gov bond arbitrage, yield curve arbitrage and mortgage backed arbitrage
Global macro - hedge fund style
involves long and short positions in capital or derivative markets across the world. Portfolio positions reflect views on broad market conditions and major economic trends
Long/short equity hedge - hedge fund style
equity oriented positions on either side of the market (ie long or short) depending on out-look
are long/short equity hedges meant to be market neutral?
no, may est a concentrated focus regionally or on a specific sector, can also use derivatives to hedge positions
managed futures - - hedge fund style
uses financial currency or commodity futures, may make use of technical trading rules or a less structured judgmental approach
multistrategy - hedge fund style
opportunistic choice of strategy depending on outlook
fund of funds - hedge fund style
fund allocates its cash to several other hedge funds to be managed
