Topic 5 - Alternative Investments (Seminar + Exam Questions)

Question 1

• An analyst is examining the performance of hedge funds.
• He looks at the 90 hedge funds that are in existence today and notes that the average annual return on these during the last 10 years is 25.17 percent. The standard deviation of these returns is 17.43 percent and the sharp ratio is 1.15.
• The analyst also observes that the average of annual
  returns on a stock market index during the last 10 years is 14.83 percent. The standard deviation of these returns is 11.87 percent and the sharp ratio is 0.81.
• The analyst concludes that the hedge funds have substantially outperformed the stock market index.
• Discuss why the comparison by the analyst could be misleading.

Answer 1

• The measurement of the performance of the hedge funds suffers from survivorship bias.
• The 90 hedge funds that the analyst has
  examined include only those funds that have survived during the last 10 years. Thus, any poorly performing funds that have been discontinued due to low return or high volatility, or both, have been excluded. Accordingly, the average return on hedge funds has been overstated, while the volatility has been understated. Consequently, the Sharpe ratio for the hedge funds has been overstated.
• Furthermore, the Sharpe ratio may be a misleading measure of risk-adjusted performance for hedge
  funds because of the optionality in their investment strategies.

Question 2

A hedge fund has compiled a list of French firms that it
believes will outperform the overall French stock market by 7 percent over the year. It also has complied a list of French firms that it believes will underperform the overall French stock market by 7 percent.

The hedge fund wants to invest in a market-neutral long/short strategy on the French stock market. It has a capital of €25 million for this purpose.

However, it would like to retain a cash cushion of €1 million for unforeseen event. The hedge fund can borrow share from a primary broker with a cash margin deposit equal 20 percent of the value of the shares. No additional cost are charged to borrow the shares.

A. outline the strategy for the hedge fund

B. Compute the return on the hedge fund capital of €25 million if the return on both lists of stocks are as expected. Ignore the return on invested cash of €1 million, and assume that dividends on the long stocks will offset dividends on the short stocks.

Answer 2

The hedge fund would sell short the overvalued shares and use the proceeds to buy the undervalued shares.

• The fund has €25 million - €1 million = €24 million to be used toward cash margin deposit.
• Because the cash margin deposit requirement is 20%, the fund could take long and short positions totaling €24 million/0.20 = €120 million.

• So, the fund would do the following:
Keep €1 million in cash
Deposit €24 million in a margin account
Borrow €120 million of overvalued stocks from a broker
Sell the overvalued stocks for €120 million
Use the sale proceeds to purchase undervalued stocks for €120 million

• If the performances of both lists of stocks are as expected, there would be a gain of 7% on the long position of €120 million and a gain of 7% on the short position of €120 million.
• So, the total gain would be 7%  €120 million  2 = €16.8 million.

• Ignoring the return on invested cash of €1 million, and
assuming that dividends on the long stocks will offset dividends on the short stocks, this translates to an annual return of (€16.8 million/€25 million)  100 = 67.2%.

• The return is so high when the expectations are realized, because the position is highly levered.

Question 3

Critically discuss the biases in performance data (not risk measures) from hedge fund databases.

Answer 3

Biases in historical performance data can make it difficult to interpret hedge fund performance.

Some of the biases include:

1. Self-selection bias
2. Backfilling bias
3. Survivorship bias
4. Self-selection bias
   - Hedge Fund managers themselves decide whether they want to be included in a database. Managers with an unimpressive track record will not wish to have that information exposed.
5. Backfilling bias
   - Only hedge funds with good track records enter the database, creating a positive bias in past performance in the database.
6. Survivorship bias
   - In the investment industry, unsuccessful funds tend to disappear over time. Only successful ones search for new clients and present their track records. This trend creates a survivorship bias. It is pretty standard for a manager to only show the funds that are successful, inflating the overall average performance.

Question 4

Critically discuss the style risk factors that influence the stock price behavior of companies worldwide.

Answer 4

3 style risk factors include: value effect, size effect, and momentum effect.

■ Value stocks do not behave like growth stocks. A value stock is a company whose stock price is “cheap” in relation to its book value, or in relation to the cash flows it generates (low stock price compared with its earnings, cash flows, or dividends). A growth stock has the opposite attribute, implying that the stock price capitalizes growth in future earnings. This is known as the value effect.

■ Small firms do not exhibit the same stock price behavior as large firms. The size of a firm is measured by its stock market capitalization. This is known as the size effect.

■ In the short run, winners tend to repeat. In other words, stocks that have performed well (or badly) in the recent past, say in the past six months, will tend to be winners (or losers) in the next six months. This is known as the momentum, success, or relative strength effect.

The observation of these effects, or factors, has led to the development of style investing, in which portfolios are structured to favor some of these attributes (e.g., value stocks). Although this style approach has been extensively used in the United States, there is some practical difficulty in applying it in a global setting. This is best illustrated by looking at the size factor. An Austrian company that is regarded as “large” in Austria would be regarded as medium-sized in Europe and probably as small according to U.S. standards. To construct a global size factor, one must make assumptions on how to measure relative size. Different risk-factor models use different criteria.

Question 5

Critically discuss the biases in hedge fund risk measures

Answer 5

1. Smoothed pricing of infrequently traded assets.
   - Volatility is reduced for assets that are not traded frequently (ex. real estate or private equity)
2. Option-like investment strategies
   - standard deviation and the sharpe ratio are both good measures of risk only if the returns are normally distributed (or close to that). With Hedge Fund returns, they are not normally distributed and exhibit fat tails due to high kurtosis. Sharpe ratio can be an inapropriate measure
3. Fee structure and gaming
   - Hedge funds charge high fees with a fixed fee of about 1% + a high incentive fee of about 20%. Fund managers are paid to take risks. They have even more incentive to take a huge amount of risk if their performance has been bad. However one can also argue that managers might not want to lose their chance at making a comeback by taking on too much risk. Either way, past risk measures can be misleading for forecasting future performance.