Hedge fund strategies characterized as (2)
- Directional strategies (eg market or sector timing)
- Non directional strategies (market neutral, but create security positions motivated by mispricings. Further classify as CONVERGENCE (eg undervalued, capture alpha) or RELATIVE VALUE (eg P/E, Div/ Price, Book/ Price
Distinguish hedge funds from other funds (5) (EXAM MULTI CHOICE TIP)
- HF do not need to satisfy transparent reporting to the general public (REPORTING)
- Relatively exclusive to sophisticated high net worth investors (EXCLUSIVE)
- More flexible investment strategies (FLEXIBLE)
- Access illiquid investments by implementing redemption constraints (ILLIQUID)
- Compensation structure usually involves incentive fee (COMPENSATION)
Active vs passive management
- Active manager seeks to add value by identifying mispriced securities and forecasting future outcomes.
- Passive manager attempts to deliver market (systemic) returns.
For stock selection, could be matching the return pattern of an index. For asset allocation, could be a consistent exposure to a diversified allocation to many markets
When would passive management be optimal (use EMH)
Passive management should be optimal at a semi strong or higher level according to EMH. Attempts to generate excess returns by overweighting a portfolio in any direction would not work since competition for excess returns would ensure profitable opportunities were priced away.
Central benefits of passive management
- Cost effectiveness (fees, transaction costs, lower turnover)
- Free rider effect, competitive effect of active managers will be to quickly embed information and create fair market prices
Challenges of passive strategy
- Choice of index (high degree of correlation betw most indices, structure, liquidity)
- Cost of matching (20pc of stocks represent over half the value of most indices, the cost of covering remaining 80pc can be excessive. Use sampling. Cost minimization, optimization)
What is active management
Active management is taking a position different to an index or asset allocation rebalancing strategy, based on a forecast of future outcomes
3 categories of active managers
- Stock pickers (search for undervalued securities, believe that market value weights are not optimum. Bottom up portfolio construction)
- Market timing (aka global tactical asset allocation, switch betw eq & bonds, or low & high beta eq, according to forecasts of relative performance
- Sector selection (select an industry or sector of the market. Select based on
- industry classification
- product classification
- perceived characteristics
- sensitivity to macro economic factors
Sector selection (active management): market inefficiency due to: (4)
Market inefficiencies under sector selection are due to:
- Size: possibility of earning higher returns from overweighting small stocks
- Value: low PE portfolios may be created in response to the PE ratio effect
- Liquidity: stocks that trade less frequently may be inefficiently priced
- Complexity of operations
How to value timing ability
Perfect timer allocates 100pc of fund to correct asset class at beginning of the month. Equivalent to a call option on the equity portfolio. X(t) = S(0) (1+rf). Payoff is risk free rate if payoff is less than rf rate.
Describe Treynor Black model
Systematic attempt to incorporate active decision making alongside passive strategy. Portfolio is invested partly in the market portfolio and partly in securities that are thought to be mispriced
Avoids any direct or indirect security analysis
Passive strategy and the CML
The capital allocation line is the line between cash and the market portfolio. Passive strategy generates an investment opportunity set represented by the CML.
Why pursue passive strategy?
2. Free rider benefit
Passive management in bonds, 2 types
- Replicate performance of a given index
2. Immunization techniques, shield institution from overall interest rate fluctuations.
Main ways to differentiate active from passive management: (4)
- Tracking error
- Cost ( management fees, transaction fees)
- Belief in the efficiency of the market