Session 11 - Alternative Investments for Portfolio Management Flashcards Preview

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Flashcards in Session 11 - Alternative Investments for Portfolio Management Deck (23)
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1
Q

Key characteristics distinguishing hedge funds and their strategies from traditional investments include the following

A

1) lower legal and regulatory constraints;
2) flexible mandates permitting use of shorting and derivatives;
3) a larger investment universe on which to focus;
4) aggressive investment styles that allow concentrated positions in securities offering exposure to credit, volatility, and liquidity risk premiums;
5) relatively liberal use of leverage;
6) liquidity constraints that include lock-ups and liquidity gates; and
7) relatively high fee structures involving management and incentive fees.

2
Q

Equity L/S strategies

A
  • take advt diverse opportunities globally to create alpha via managers’ skillful stock picking
  • typically liquid
  • reliance on fundamental research
  • most managers specialize in a specific geography, sector, or style
  • some are generalist and avoid complex sectors
  • generally net long, with gross exposures at 70%–90% long vs. 20%–50% short (but they can vary)
  • some short using index to reduce mkt risk but most use single name shorts for alpha and more return
  • typically aimed to achieve returns = to a long-only approach but with st.dev that is 50% lower
  • the less risk factor exposure (more market neutral), the more leverage
3
Q

Dedicated short-sellers

A
  • only trade with short-side exposure, moderate short beta by also holding cash
  • tend to be 60%–120% short at all times
  • single equity stock picking, not index shorting
  • use little leverage
  • bottom-up approach (deep dive)
  • lower returns than other HF but with a negative correlation benefit (increasing returns when market declines or decreasing returns when market rises)
  • liquid, returns lumpy and more volatile bc shorting involved
4
Q

Short- biased strategies

A
  • focused on short-side stock picking, but moderate short beta with value-oriented long exposure and cash.
  • short- biased strategies are typically around 30%–60% net short
  • single equity stock picking, not index shorting
  • use little leverage
  • lower returns than other HF but with a negative correlation benefit (increasing returns when market declines or decreasing returns when market rises)
  • liquid, returns lumpy and more volatile bc shorting involved
5
Q

Equity market-neutral (EMN) strategies

A
  • take advantage of short- term mispricing between securities
  • sources of return and alpha do not require accepting the beta risk E(bp)=0
  • especially attractive in periods of market vulnerability/weakness
  • most = purely quantitative managers (diverse holdings)
  • adjusted often bc must balance neutrality with balancing costs
  • often seen as preferred replacements for FI during low return periods or YC flate
  • generally apply high leverage to create meaningful returns
  • exhibit relatively modest return profiles
  • high levels of diversification and liquidity with a lower standard deviation of returns
  • count on mean reversion
6
Q

Merger arbitrage

A
  • relatively liquid strategy
  • gains come from idiosyncratic, single security takeover situations
  • occasional downside shocks can occur when merger deals unexpectedly fail
  • Crossborder M&A and vertical integration (face antitrust scrutiny) carry higher risks and offer wider merger spread returns
  • have return profiles that are insurance-like, plus
    a short put option, with relatively high Sharpe ratios
  • huge LT risk
  • typically apply moderate to high leverage to generate meaningful target return levels
7
Q

Distressed securities strategies

A
  • focus on firms in bankruptcy, facing a potential bankruptcy, or under financial stress
  • returns are at the higher end but more variability
  • high level of illiquidity, low /mod leverage, long-biased
  • seek inefficiently priced securities before, during, or after the bankruptcy process, which results in either liquidation or reorganization
  • In liquidation, the firm’s assets are sold off and securities holders are paid sequentially based on the priority of their claims
  • In re-organization, a firm’s capital structure is reorganized and terms for current claims are negotiated and revised
8
Q

Fixed-income arbitrage

A
  • attractiveness of returns is from high correlations between different securities, yield spread pick-up, and the high # / wide diversity of debt securities across different markets, credit quality, and convexity (valuation differences between securities due to credit quality and/or implied volatility spreads)
  • Yield curve and carry trades within the US government space are very liquid and few mispricing opp.
  • liquidity decreases in other sovereign markets, mortgage-related markets, and across corporate debt markets
  • high leverage usage bc pricing inefficiencies are small but high correlations btw securities
9
Q

Convertible arbitrage strategies

A
  • strive to extract “underpriced” implied volatility from long convertible bond holdings
  • managers will delta hedge and gamma trade short equity positions against their convertible positions
  • works best in periods of high convertible issuance, moderate volatility, and reasonable market liquidity
  • being naturally less-liquid securities due to their relatively small issue sizes, complexities, availability, and cost to borrow underlying equity for short selling
  • typically run convertible portfolios at 300% long vs. 200% short
  • must accept or hedge away interest rate, credit, and market risks
10
Q

Global macro strategies

A
  • focus on correctly capitalizing on trends in global financial markets using a wide range of instruments
  • tend to use more discretionary/fundamental, top-down approaches
  • tend to be anticipatory, often contrarian, but some follow the momentum
  • fairly heterogeneous as a group (not as a consistent source of alpha)
  • highly liquid and use high leverage (6-7x)= higher vol.
  • mean-reverting, low volatility not ideal
  • Returns lumpy and typically exhibit positive right-tail skewness during market stress (diversification) but more heterogeneous outcomes
11
Q

Managed futures strategies

A
  • focus on correctly capitalizing on trends in global financial markets using mainly futures and options on futures, stock, and fixed-income indexes, commodities, and currencies
  • since funds only acquire asset exposures, the majority of capital (85-90%) invested in ST gov’t debt
  • tend more towards systematic trading with a quantitative driven approach to trend identification
    1) time-series momentum trend following (long assets rising in price, short assets falling in price)
    2) cross-sectional momentum - same as TSM but a group of long positions against a group of short positions
  • highly liquid and use high leverage
  • Returns typically exhibit positive right-tail skewness during market stress (diversification)
12
Q

Specialist hedge fund strategies

A
  • require highly specialized skill sets for trading in niche markets
  • aimed at generating uncorrelated, attractive risk-adjusted returns
  • two strategies are volatile trading and reinsurance/life settlement
13
Q

Volatility trading strategies.

A
  • strive to capture relative timing and strike pricing opportunities due to changes in the term structure of volatility
  • relative value volatility arbitrate - buy cheap vol. and sell expensive vol.
  • They try to capture volatility smiles and skew by using various types of options spreads, such as bull and bear spreads, straddles, and calendar spreads
  • using exchange-listed and OTC options, VIX futures, volatility swaps, and variance swaps
14
Q

Life settlements strategies

A
  • pools of life insurance contracts offered by third-party brokers, where the hedge fund purchases the pool and effectively becomes the beneficiary
  • look for:
    1) The surrender value being offered to the insured individual is relatively low;
    2) the ongoing premium payments are also relatively low;
    3) the probability is relatively high that the insured person will die sooner than predicted
  • uncorrelated with other assets classes
  • reinsurance = catastrophe insurance, also uncorrelated with other asset classes
15
Q

Funds-of-funds

A
  • typically offer steady, low-volatility returns via their strategy diversification
  • offer a potentially more diverse strategy mix
  • less transparency, slower tactical reaction time, and contribute netting risk to the FoF investor
16
Q

Multi-strategy funds

A
  • typically offer steady, low-volatility returns via their strategy diversification
  • have generally outperformed FoFs, but they have more variance due to using relatively high leverage
  • faster tactical asset allocation and generally improved fee structure (netting risk between strategies is often at least partially absorbed by the general partner)
  • they have higher manager-specific operational risks
17
Q

Conditional linear factor models

A
  • useful for uncovering and analyzing hedge fund strategy risk exposures
  • a model that incorporates four factors for assessing risk exposures in both normal periods and market stress/crisis periods: equity risk (monthly return to index), credit risk (Baa - Aaa) bond yield, currency risk (monthly return on USD index), and volatility risk (VIXt - VIX t-1)
18
Q

Adding a 20% allocation of a hedge fund strategy group to a traditional 60%/40% portfolio (for a 48% stocks/32% bonds/20% hedge funds portfolio)

A
  • typically decreases total portfolio standard deviation while it increases Sharpe and Sortino ratios (and also often decreases maximum drawdown) in the combined portfolios
  • demonstrates that hedge funds act as both risk-adjusted return enhancers and diversifiers for the traditional stock/bond portfolio.
19
Q

The priority of debt repayment claims

A

senior secured debt, junior secured debt, unsecured debt, convertible debt, preferred stock, and finally common stock.

20
Q

Equity Hedge Fund Classification - expand and the styles inside

A
  • equity market return and risk characteristics
  • long/short equity
  • dedicated short bias
  • equity market neutral
21
Q

Event-DrivenFund Classification- expand and the styles inside

A
  • corporate events (governance, M&A, bankruptcy)
  • merger arbitrage
  • distressed securities
22
Q

Relative Value Classification- expand and the styles inside

A
  • relative valuation between two or more securities, exposed to credit and liquidity risk
  • fixed-income arbitrage
  • convertible bond arbitrage
23
Q

Opportunistic Classification- expand and the styles inside

A
  • top-down approach, the multi-asset opportunity set
  • look atwide range of markets and securities (region and asset lvl vs. indvl securities)
  • look at broad themes, global relationships, market trends, cycle