Week 4 - Hedgefunds Flashcards
1
Q
What is Dogs of the Dow?
A
- buy the 10 dow components with the highest yields: get more dividend income and hoping last year’s laggards outperform
- -> it outperformed the bear market of 2000 to 2002, and it beat the broader market in 2010, but lagged simply holding the dow between 2006 and 2009
- -> one shortcoming is that it does not put any weight on financial strength or apply any fundamental analysis with regard to the sustainability of the dividend
2
Q
What is GARP?
A
- an investment strategy that combines tenets of both growth and value investing by finding companies that show consistent earnings growth but don’t sell at overly high valuations
- PEG Ratio; price/earnings growth
- -> LOOK for stocks with a PEG ratio <1
- GARP seeks to avoid the disadvantages or pitfalls of pure growth and pure value stocks
- -> growth stocks can form a bubble by rising very high and crashing very fast while value stocks can go nowhere for a long time
- -> by finding a GARP middle ground, investors seek to enjoy rising prices w/o being vulnerable to a price crash
- GARP stocks can underperform growth stocks in a growth market and underperform value stocks in a value market
- However, GARP can outperform in mixed markets and over the long-term
3
Q
For the U.S stock market, what factors have researchers found to have had the greatest effect on expected stock returns?
A
- one month excess return (-)
- 12-month excess return (+)
- trading volume/market cap (-)
- earnings to price (+)
- BV of equity to price (+)
- return on equity (+)
- variability in cash flow to price (-)
4
Q
What have been the most statistically powerful and stable predictors of future stock returns in Canada?
A
- 12 month price momentum, one month reversals, and operating margin
- -> past winners continued to do well
- -> stock returns experience strong one-month mean reversion
- -> stock returns are positively related to firm profitability
- -> risk-based factors are negatively related to future stock returns
5
Q
What are some common investment mistakes?
A
- no plan (including exit plan), not being prepared
- chasing performance
- blindly following mechanical systems/softwares
- failing to adapt to changing
- trying to outsmart the market
- trading too much
- holding onto losses too long
- use too much margin/leverage
- overexposing a position
- waiting too long to start
- favouring short-term needs over long-term goals
- letting your emotions control you
- letting hindsight influence your trading
- overconfidence after a profit
- blaming others for your inability to make money
- media addiction
- expecting to get rich quick
- counting on luck
- paying too much in fees
6
Q
What are hedge funds?
A
- private investment vehicles open to a limited number of wealthy or professional investors
7
Q
What are characteristics of hedge funds?
A
- limited number of investors (accredited and qualified purchasers)
- minimum capital requirements are high –> typically $1 M in liquid requirements
- usually limited liquidity –> lockup period
- usually put some restrictions on when investors can withdraw their money
- often employ leverage and use of derivatives. Invest in a wide-range of strategies often not available in other investment vehicles
- manager fees are very high and often have a performance component
- unregulated
- not transparent
8
Q
Differences between hedge funds and mutual funds
A
- Transparency - mutual funds are regulated by a series of National Instruments adopted by provincial and territorial regulators. Hedge funds usually provide minimal information about portfolio composition and strategy to their investor only
- Investors - hedge funds typically are available only to accredited or sophisticated investors, in practice usually defined by the minimum net worth and income requirements.
- Investment Strategies - mutual funds lay out their general investment approach in their prospectus. Mutual funds limit use of short selling and leverage and their use of derivatives is highly restricted
- Liquidity - hedge funds often impose lock-up period. Many also employ redemption notices that require investors to provide notice weeks or months in advance of their desired redemption.
- Compensations structure: hedge funds differ in their fee structure. Whereas mutual funds assess management fees equal to a fixed percentage of assets, hedge funds charge a management fee plus a substantial incentive fee equal to a fraction of any investment profits beyond some benchmark
9
Q
Positions that Hedge Funds take
A
- mutual funds are subject to the Investment Company Act of 1940, required to disclose to the investing public info about the funds and investment objectives
- Hedge Funds are EXEMPT from the regulatory controls of the Investment Company Act
- DO NOT have to disclose their holdings, not even to their investors
- not usually 100% long
- often take some short positions and utilize leverage
- not always market-neutral; average HF beta w/ the market is ~0.3
10
Q
Famous hedge funds
A
- Soros fund management: bet $10 billion by shorting pounds and buying Marks
- LTCM blew-up: Russian debt crisis
- Amaranth blew up September 2006 after losing $6 billion on NG futures
- Renaissance Technologies Medallion Fund: Sharpe Ratio>20
- Man Group: fund you can invest in that invests in hedge funds
11
Q
Details in Hedge Fund Fees
A
- Standard 2/20: expense ratio of 2%, performance fee of 20% –> outperformance is shares 80/20
- performance fee is calculated net of a benchmark, e.g. LIBOR or the S&P500
- a high-water mark is often applied to the performance fee. Performance fees are levied only when the NAV exceeds the highest NAV previously achieved…e.g. NAV(0) = 100, NAV(1) = 120, NAV(2) = 110 –> no performance fee is payable at t=2 and none applies until NAV>120
- incentive fees are linked to higher performance: Ackermann report a Sharpe ratio increase of 0.15 moving from a fund with no performance fee to 20% performance fee
12
Q
Hedge Fund Historic Performance
A
- Do hedge funds deliver alpha? Evidence in literature is mixed, but the general consensus points to the existence of alpha among hedge funds
- No: Ackermann, McEnally and Ravenscroft (1999): HFs easily beat mutual funds but do not outperform market indexes
- Yes: estimates of HF alphas are around 3%-5% per annum. Jagannathan, Malakov, and Norikov: strong persistence in the HF performance
13
Q
A
Hedge funds limited losses during the financial crisis
14
Q
A
HF alpha has been on a downward trend
overtime, HF industry correlation w/ S&P500 increasing –> higher correlation; look more and more like index
smart beta; in between mutual funds/hedge funds
15
Q
What are the two main hedge fund styles?
A
- Discretionary: relies on a person’s judgement to determine trades
- Systematic: more rules-based and relies on quantitative models. I.e. quant black-box frequency trading
16
Q
What is convertible arbitrage?
A
- fund managers purchase a portfolio of convertible securities, generally convertible bonds, and hedge a portion of the equity risk by selling short the underlying common stuck. Capital structure arbitrage
- typically long convertible bonds and short stock
17
Q
What is event driven?
A
- attempt to profit from situations such as M&A, restructuring, bankruptcy, or reorganization
18
Q
What is global macro?
A
- 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
–> employs forecasts of interst rate trends, internationalt rade and payments, political changes, government policies, intergovernment relations
19
Q
What are the two hedge fund strategies?
A
- two main approaches: market timing and non-directional
20
Q
What is market timing?
A
- range from specialists in certain sectors to global macro sekking to capture global market trends. This style is directional and is net long or short
21
Q
What is non-directional?
A
- aims to be market neutral and usually extracts value from a diversified set of “arbitrage opportunities”
22
Q
What is a relative value trade?
A
- involves the purchxase of an undervalued securtiy and the simulatenous short sale of an overvalued security.
23
Q
What is a pairs trade?
A
- stocks are paired up based on an analysis of either fundamental similarities or market exposures (betas). The general approach is to pair up similar companies whose returns are highly correlated but where one company seems to be price more aggresively than the other
24
Q
Pure plays
A
bets on particular mispricing between two sectors or securities, with extraneous sources of risk such as general market exposure hedged away
25
Hedge Fund Returns = Short Put
- many common dynamic hedge fund strategies can be considered to be replicating option payoffs (e.g., selling out-of-money put options)
- shorting 'out-of-money' puts --\> positive payoff if stock market goes up, option will finish out of money fifn't go down much, if the market crash, will finish in the money and lose money
26
Volatility strategy vs. S&P500
- average return is about the same at around 10%
- dispersion as measured by S.D. =15%, is also about the same
- but the volatility strategy exhibits large **negative skewness,** that is prone to occassional frightful losses
- selling out-of-money put options = volatility strategy because by sellin gput options, you short volatility...lose money when there is voaltility
- selling an option negative exposure to volatility
- on the long-side, personj makes money in volatility
- short-exposure, selling out-of-money put negative exposure
27
Hedge Fund Skewness Preference
- most investors prefer positive skewed return profiles
- buying/selling options changes the distribution of returns
- selling an option truncates the RHS of the payoff distribution and results in negative skewness, which is undesireable
- some stocks have positive skewness, while others have negative
