TOPIC 10 - HEDGE FUNDS Flashcards by caitlin douglas

Directional funds take a stance on

the performance of broad market sectors.

How well did you know this?

Not at all

Perfectly

Nondirectional funds establish

market-netural positions on relative mispricing. However, even these hedged positions still present idiosyncratic risk.

How well did you know this?

Not at all

Perfectly

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.

How well did you know this?

Not at all

Perfectly

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

How well did you know this?

Not at all

Perfectly

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.

How well did you know this?

Not at all

Perfectly

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.

How well did you know this?

Not at all

Perfectly

Hedge funds typically charge investors both a management fee and

an incentive fee equal to a percentage of profits beyond some threshold value.

How well did you know this?

Not at all

Perfectly

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

How well did you know this?

Not at all

Perfectly

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

How well did you know this?

Not at all

Perfectly

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

How well did you know this?

Not at all

Perfectly

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

How well did you know this?

Not at all

Perfectly

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%)

How well did you know this?

Not at all

Perfectly

hedge fund directional strategies

bets one sector or another will outperform sectors of the market

How well did you know this?

Not at all

Perfectly

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

How well did you know this?

Not at all

Perfectly

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

How well did you know this?

Not at all

Perfectly

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.

How well did you know this?

Not at all

Perfectly

style analysis for equity market neutral funds

Uniformly low and statistically insignificant factor betas

How well did you know this?

Not at all

Perfectly

style analysis for dedicated short bias exhibit

substantial negative betas on the market index

How well did you know this?

Not at all

Perfectly

style analysis for distressed firm funds

have significant exposure to credit conditions as well as the market index

How well did you know this?

Not at all

Perfectly

fixed index income arbitrage funds style analysis show

positive exposure to the differential return on corporate vs treasury bonds

How well did you know this?

Not at all

Perfectly

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