AI 2.4

Question 1

How are hedge funds strategies classified?

Answer 1

In six categories:
1. Equity related - Focus is on stocks and the primary source of risk is equity risk.
2. Event driven - Related to major business events as M&A, bankruptcies & governance activities.
3. Relative value - Seek profit from price differentials between related securities (mostly debt securities). For debt securities -> valuation differences which are exploited span across credit quality & liquidity.
4. Opportunistic - Employ a top-down approach & are spread across multiple asset classes, vary with market conditions.
5. Specialist - As the name suggests, these strategies require specialized market expertise or knowledge.
6. Multi-Manager - Using other hedge funds strategies as building blocks, combining different strategies together & re-balancing exposure over time.

Question 2

What are the sub-classifications of Equity related hedge fund strategies?

Answer 2

1. Long/Short Equity
2. Dedicated short-bias
3. Equity market neutral

Question 3

Explain Long/Short Equity strategy

Answer 3

Investment characteristics: It’s a combination of long positions on some stocks with short positions on some stock (as the name suggests). They don’t seem to eliminate market exposure entirely and usually have 40-60% long positions as markets generally tend to move upwards.

Strategy Implementation: successful implementation requires the managers to identify undervalued & overvalued stocks, the majority of L/S equity funds take a sector-specific focus, choosing securities from a particular industry that they’re familiar with. May also use index funds to achieve a desired exposure.

Role in a Portfolio: The goal of managers is to derive an alpha from the long/short positions in individual stocks, while also benefiting from a moderate overall long exposure in the market.

Question 4

Explain Dedicated short-bias strategy

Answer 4

Investment characteristics: As the name suggests, dedicated short-selling fund is where managers seek to sell the overvalued securities short. Short-biased managers use a similar strategy except the short exposure is somewhat offset by a long exposure. ‘Activist short-selling’ refers to manager not only taking short positions but also providing research for why they believe the price will fall. Managers seek to create a negative correlation with conventional securities and compared to other HF strategies, these tend to have lower returns. Have more volatility compared to L/S strategies.

Strategy Implementation: Managers just go ‘short’ on the equity securities. Major challenge is to identify securities that will lose value. A Dedicated-short seller doesn’t hold any long positions and has 60-120% exposure to short selling. A short-bias manager might have some exposure to long positions, while remaining net short with 30-60% short exposure.

Role in a portfolio: The primary goal is to produce returns which have a negative correlation with conventional portfolio assets. When successful, they do provide a diversification benefit but most often expected returns for short strategies are relatively low.

Leverage: For both dedicated short sellers and short-biased managers, relatively little leverage is used.

Question 5

Explain Equity Market neutral strategy

Answer 5

Investment characteristics: EMN strategies seek to attain zero overall exposure to the stock market. The alpha lies in taking positions in securities that are currently mispriced (expectations of the market price to move towards the calculated intrinsic value). The overall goal is to create a portfolio that is immune to the movements in the overall market. Thus expected returns are modest and EMN funds offer significant diversity and low volatility.

Strategy Implementation: Basically, take long positions in stocks which are temporarily undervalued and short in the ones which are temporarily overvalued and when mean reversion occurs, an alpha is generated. EMN managers can be discretionary (which rely on intuition) or quantitative (which operate based on some fixed set of rules). Some subtypes of EMN funds are Pairs trading - Two stocks with similar characteristics are identified and monitored, where one is undervalued and the other is overvalued and when an unusual divergence in price is observed, the oppurtunity is exploited.
Stub Trading - going long and short of a subsidiary and its parent. Generally, positions taken correspond to the % of sub held by the parent.
Multi-class trading - Going long & short with the shares of the same firm but of different classes (one with voting power & other with no voting rights).
Aside from stock investments, derivatives or stock index futures can be used to create a zero beta exposure.

Role in a portfolio: An attempt to create alpha without beta (market exposure). EMN funds are less volatile and perform well when the markets are very volatile or are performing poorly.

Leverage: Leverage must generally be applied in order to achieve acceptable levels of return.

Question 6

How are Event based strategies sub-classified?

Answer 6

Into two categories:
1. Merger Arbitrage
2. Distressed Securities
Event driven strategies are those which try to produce a return from the outcome of specific corporate events. soft-catalyst refers to pre-event strats (more volatile) & hard-catalyst refers to post-event strats (prices are yet to fully adjust). The risk is the event risk.

Question 7

Explain Merger Arbitrage

Answer 7

Investment characteristics: Attempt to earn a return based on the uncertainty of pricing when an acquisition is announced or after the acquisition has been completed & till the price adjustments are completed. In case a merger fails, the expected price movements will reverse - price of target will fall & price of acquirer will rise resulting in a huge loss for the fund and thus Merger Arbitrage funds tend to have left-tail risk. However, it tends to be more liquid compared to other hedge fund strategies.

Strategy Implementation: In the most common scenario, take long positions in the target and sell short the acquirer are practices of the manager. In some cases where a manager expects the merger to not go through (maybe due to govt intervention to prevent a strong company in the sector) they take reverse positions of the common scenario. One example can be cross-border mergers & acquisitions, which are seen as more risky as two different regulatory authorities are involved.

Role in a portfolio: Usually produce steady returns, but have a significant left-tail risk.
Leverage: Typically require a lot of leverage (300-500%).

Question 8

Explain Distressed Securities

Answer 8

Investment characteristics: Taking positions in firms that are experiencing financial difficulties like bankruptcy or near-bankruptcy. Firms can find themselves in distress for a no. of reasons like too much leverage, difficulty competing in the sector or accounting irregularities. Relative to other event-driven hedge fund strategies, the returns are greater but time taken for an investment to value can be long with lock-up periods of up to 2 years.

Strategy Implementation: Can take different forms. Some managers only take passive positions in securities of distressed companies while some attempt to buy a majority of a certain class to achieve creditor control. Distressed event strategy implementation requires a broad range of skills to understand legal aspects of the strategy related to bankruptcy and reorganizing proceedings.

Role in a portfolio: Greater returns than other event-driven strategies but are most often illiquid. They are unpredicatbale and sensitive to declines in the overall market.

Leverage: Majority of distressed investing take long positions with low use of leverage.

Question 9

How are relative value strategies classified?

Answer 9

There are two classifications:
1. Fixed-Income arbitrage
2. Covertible-bond arbitrage

Question 10

Explain Fixed-Income arbitrage

Answer 10

Investment characteristics: Relative value strategies attempt to exploit valuation differences which occur in a similar type of securities, mostly hybrid convertible debt and other fixed-income securities. They often earn a premuim for liquidity, credit and volatility.
Basically, fixed-income arbitrage deals with going long on underpriced fixed income securities and going short on overpriced fixed income securities. Some other types include yield curve kinks or anticipated changes in the shape of a yield curve. Leverage is substantially high (300-1500%) & the amount of return that can be earned is relatively limited. Liquidity depends on the particular strategy (US T-bills based will be high whereas MBS or foreign bonds based will be low)

Strategy Implementation: Two major ways:
1. Yield curve trades - Manager forms a view of how the yield curve will change shape over time based on macroeconomic factors. Then as per the expectaion of curve flattening or steepening, the manager will take long & short positions.
For positions in securities of the same firm, only interest rate risks exists. For different firms, credit, liquidity and interest rate risks exist.
2. Carry Trades - shorting a low-yield security and going long on a high-yield security where results are two-fold. One from the yield differential and the other from price conversions over time.

Role in a portfolio: heavy use of leverage can cause modest price volatility is a drawback and return distributions tend to be similar to the returns from writing puts.

Leverage: Fixed-income arbitrage strategies often make use of significant leverage, in order to produce sufficient levels of return.

Question 11

Explain convertible bond arbitrage

Answer 11

Investment characteristics: The goal is to generally generate a profit from the implied volatility of convertible bonds - most often is underpriced. To achieve this without taking excess potential for a loss is by an attempt to hedge delta and gamma risk of convertible bonds.

Strategy Implementation: Underlying equity is sold short and a long position is taken for the bond. A lot of leverage is used. The challenge is to hedge away other sources of risk embedded in a convertible security like credit risk, market risk and interest rate risk.

Role in a portfolio: Perform well in normal market conditions -> liquidity is high and volatility is low. May not perform well in periods of illiquidity or acute credit weakness.

Leverage: Significant amounts of leverage are typically applied in implementing convertible bond strategies.

Question 12

What are Opportunistic Hedge Funds Strategies and it’s classifications?

Answer 12

Opportunistic hedge fund strategies are a broad class of investing approaches that attempt to extract profits using a wide range of techniques in a broad range of securities. Rather than being focused on individual securities, these strategies take a top-down approach to make macro investments on a global basis across regions, sectors, and asset classes.
The returns of opportunistic hedge fund strategies may be impacted by market cycles, global developments, and international interactions. The risks will depend on the particular strategy and asset classes involved.
Are sub-classified as:
1. Global Macro Strategies
2. Managed Futures

Question 13

Explain Global Macro Strategies

Answer 13

Investment characteristics: Managers of global macro strategy funds attempt to make correct assessments and forecasts of various global economic variables including inflation, currency exchange rates, yield curves, central bank policies, and the general economic health of different countries. Then, global macro managers use a broad range of security types and global asset classes to take positions on these views. They take positions that are either directional (long/short) or thematic(where maybe one company can benefit from the new regulation). Returns are based on predictions about global markets to work and thus are uneven & volatile. Uses leverage and very heavily.

Strategy Implementation: Global macro strategies are generally based on top-down analysis, beginning with analysis of the global economy, then macro trends within economies, and so on, in order to identify potential opportunities. Global macro managers tend to use discretionary approaches more than do managed futures managers.

Role in portfolio: When added to a portfolio of traditional assets, a global macro hedge fund can add not only alpha, but also portfolio diversification. During times of market stress, global macro funds have historically delivered right tail skewed returns, which is beneficial from a portfolio diversification perspective. However, this behavior cannot always be relied upon, and such diversifying outcomes are not always realized.

Leverage: One commonality between global macro funds is that most tend to apply leverage, often representing 600% or 700% of fund assets. (Very High)

Question 14

Explain Managed Futures Strategy

Answer 14

Investment Characteristics: Hedge funds that pursue a managed futures strategy take long and short positions in a variety of derivatives contracts including futures, forwards, options on futures, swaps, and sometimes currencies and commodities. Managed futures strategies can be as simple as trading index futures on a particular sector, or it can involve very exotic contracts such as futures on the weather.
Managed futures funds do not buy and sell assets; rather, they enter into derivatives contracts in order to gain the desired exposures. Because of the mechanics of futures contracts (requiring only a small amount of upfront collateral), managed futures funds can easily apply great amounts of leverage. Typically, a fund will use perhaps 1/8th of its capital as collateral on futures contracts. The rest of its capital will be invested in some highly liquid security (such as short-term government bonds) that can also serve as collateral for the futures clearinghouse. Managed futures funds are extremely liquid, because futures contracts themselves are highly liquid: they trade globally and continuously. Taking long or short futures positions allows a hedge fund manager easy access to exposures across a range of asset classes.

Strategy Implementation: There are a number of ways to implement managed futures strategies. In perhaps the most popular method, time-series momentum (TSM) strategies, portfolio managers simply follow the trend: they buy securities that have been rising in price and sell securities that have been trending downward.
Another similar methodology is cross-sectional momentum (CSM) strategies, which is carried out within a particular asset class (a cross section of assets). Again, the securities rising fastest are purchased while falling securities are shorted.
The high liquidity of futures contracts allows hedge fund managers to pursue a wide selection of trading strategies.
Generally, portfolio managers will rely on a signal trigger—most often based on volatility or momentum—to prompt a trade.
The size of position too will be based on the same factors.
In addition to using trade signals, portfolio managers will also have rules for closing a position. Exit methodologies can be based on: Price targets, Momentum reversal, Time, Trailing stop-loss, or, some combo of these approaches.

Role in a portfolio: Perhaps the most appealing feature of managed futures is their interaction with other investments. Overall, managed futures have very little correlation with traditional equity and fixed-income assets. The result is that when added to a portfolio, managed futures will generally improve the total risk-adjusted return.
This diversifying characteristic has proven its worth during times of market stress. While other strategies exhibit negative asymmetry during such periods, the right skewed return distribution of managed futures provides a significant advantage.

Leverage: Great amounts!

Question 15

What are specialist strategies & what are the classifications?

Answer 15

Portfolio managers for specialist hedge fund strategies use their knowledge of a particular market to pursue niche investment opportunities. The goal of specialist strategies is to generate high risk-adjusted returns that are uncorrelated with those of traditional assets. The risks of such strategies are often unique to the particular niche securities being invested in.
There are two classifications:
1. Volatility Trading
2. Reinsurance/Life Settlements

Question 16

Explain Volatility Training

Answer 16

Investment characteristics: Volatility trading hedge fund managers trade volatility-related assets globally, across countries and across asset classes, in order to exploit perceived differences in volatility prices. The overall goal is to purchase underpriced volatility and sell overpriced volatility.
Another volatility trade involves acting as the counterparty to market participants that consistently seek long volatility. Because the negative correlation between stock market returns and equity volatility is high, equity investors seek to buy volatility as a hedge. A hedge fund that is willing to sell volatility will earn an insurance-like premium as compensation for taking on this risk; however, an upturn in volatility can cause such a strategy to unravel in a dramatic fashion.
The investment characteristics of a volatility trading strategy will vary depending on the securities invested in and the positions taken.
The liquidity of a volatility trading strategy will depend on the instruments used. (Futures vs OTC)
The use of futures contracts makes it easy to apply leverage to a volatility trading strategy. The convexity of volatility derivatives means that sometimes large gains can be made from long volatility strategies while taking little risk. (Use of leverage is easy). Benchmarking is difficult because of their unique nature.

Strategy Implementation: Hedge fund managers wishing to pursue volatility trading have several options.
One possibility is to construct various option strategies, such as straddles, calendar spreads, bull spreads, or bear spreads, using basic exchange-traded options.
A second possibility is to make use of over-the-counter (OTC) options, which are customized to meet the portfolio manager’s specific needs. A drawback of this method, however, is that it introduces counterparty risk, plus potential liquidity issues.
A more straightforward method of trading volatility is to use futures on the VIX index. An advantage of this approach is that it is a very direct way to express a view on volatility, without the need for hedging. There are some limitations. First, the VIX Index tends to be mean-reverting, which means that trend-following trades tend to be unprofitable. Second, many traders and investors crowd into the VIX futures in order to sell volatility and capture the associated premiums, making it difficult to proit from that strategy.
A fourth method of implementing a volatility trading strategy is to enter into an OTC volatility swap, or alternatively a variance swap. These derivatives provide a relatively pure exposure to volatility. (Note that the name “swap” here is somewhat misleading. Volatility swaps and variance swaps are actually forward contracts with a payoff based on the difference between observed variance and the expected variance specified in the contract, multiplied by some notional amount.)

Role in Portfolio: In a portfolio, a long volatility strategy can be a potent diversifier, because stock market volatility is highly negatively correlated with market returns. The disadvantage of maintaining a long volatility position, however, is that a premium must be paid to the volatility seller.

Question 17

What is catastrophe risk & catastrophe insurance?

Answer 17

Catastrophe risk reinsurance is another area where hedge funds are increasingly active. Catastrophe insurance covers the policy holder against earthquakes, tornadoes, hurricanes, floods, and the like. In order to diversify and decrease risk, insurance companies in their normal course of business will sell off some of their risk to reinsurance companies, who may then resell these risks to hedge funds.
Reinsurance can be a rewarding investment for a hedge fund if sufficient diversity can be obtained (i.e., the risks should vary by geography and types of insurance), if the insurance company provides sufficient loan loss reserves, and if the policy premiums are adequate. When considering an investment in catastrophic insurance, a hedge fund evaluates both typical and worst-case outcomes against the insurance premiums to be received. Geographic diversity is important, because a specific catastrophic event will tend to affect only a particular part of the world.

Question 18

Explain Reinsurance/Life Settlements

Answer 18

Investment characteristics: In a typical life settlement transaction, an insured person will sell (generally through a broker) their insurance policy to a hedge fund. The hedge fund then will be liable for the premium payments —and will also receive the death beneit upon the passing of the insured. Strategies that involve investments in insurance contracts are illiquid, because insurance policies are somewhat dificult to sell after initiation.

Strategy Implementation: The term “life settlement” refers to a secondary market transaction on an insurance policy. A hedge fund that invests in life settlements will analyze various pools of life insurance contracts that brokers offer, and invest in the ones that they expect to produce an attractive return. After investing, the hedge fund then becomes the beneficiary of these contracts. The investment is successful if the present value of the future insurance payout exceeds the present value of the payments made by the hedge fund.
In selecting which insurance policies to invest in, a hedge fund will seek out policies with the following characteristics:
- The purchase price of the policy is low.
- The ongoing premium payments are low.
- The insured person is likely to die relatively soon.
One major prerequisite to profiting from life settlements is an accurate alternative estimate of life expectancies. Appraising a life settlement requires a significant amount of skill and knowledge and requires comparing individual policyholders’ outlooks to actuarial averages.

Role in a Portfolio: An appealing feature of insurance investments in a portfolio is that the risk inherent in these strategies is almost entirely uncorrelated with market risks and business cycles. For example, floods and earthquakes usually have little correlation to financial markets. Thus, hedge funds that invest in such instruments may be able to increase portfolio alpha, while simultaneously adding return diversification.

Leverage: Not much info

Question 19

What are Multi-Manager Hedge Fund Strategies?

Answer 19

Up to this point in the topic review, we have been considering various individual hedge fund strategies. In reality, most investors put money into not just a single hedge fund category, but into a diverse set of strategies. The notion behind multi-manager hedge funds is to assemble in a deliberate way a portfolio of diverse hedge fund strategies and to adjust the holdings strategically over time.
The most common styles of multi-manager hedge funds are:
1. Funds-of-funds
2. Multi-strategy funds

Question 20

Explain FoF

Answer 20

A fund-of-funds (FoF) takes capital from various individual investors and invests in a number of different hedge funds, generally each pursuing a different strategy.
There are many benefits of doing this like - diversification across many hedge fund strategies, due diligence, expertise in individual manager selection, currency hedging, leverage at portfolio level, better liquidity, research expertise, access to certain closed hedge funds.
Disadvantages include - A 2nd layer of fees, lack of transparency into individual hedge funds, additional principal-agent issues.

Investment characteristics: One important benefit that FoF offer is making an investment in hedge funds practical for smaller investors, such as small institutions or moderately wealthy individuals. Serves as an entry point into hedge fund investing.
Liquidity can be a challenge for portfolio managers of funds-of-funds. Typically, a FoF will require a one-year initial lock-up for investors, and then will allow somewhat greater liquidity afterwards (e.g., monthly or quarterly).
Another drawback of funds-of-funds relates to netting risk: investors could be required to make substantial incentive payments to a small number of successful underlying funds, even if the overall performance of an FoF is poor.

Strategy Implementation: Just like stocks, we begin with looking at the funds database to discover and choose the hedge funds which are available for investment. Then a strategic allocation to different hedge fund strategies. Select a manager (who follows the strategy), then negotiate for lower fees, improved liquidity or other terms. After all of this, an ongoing monitoring process begins.
The FoF’s strategic allocation determines the percentage of total capital that will be invested in each hedge fund style. In addition to this strategic allocation, there may also be a tactical allocation, whereby the FoF manager will at various times underweight or overweight the various hedge fund strategies to reflect the FoF manager’s perception of a changing market environment.

Role in a Portfolio: When an FoF manager takes a number of relatively uncorrelated hedge funds and combines them together in the same portfolio, the resulting FoF should produce a number of advantages: greater diversification, steady returns, less concentrated exposure to risks, less volatility, and less exposure to the downside risk of any individual fund manager.

Question 21

Explain Multi-Strategy Hedge Funds

Answer 21

Like an FoF, multi-strategy hedge funds are funds that hold a number of other hedge funds where these various funds are pursuing diverse strategies. Also similar to an FoF, multi-strategy hedge funds are intended to use this diversification of strategy to produce steady, low-volatility returns.
Unlike an FoF, the sub-funds in multi-strategy hedge funds are run by the same organization, rather than being managed by different hedge fund firms.

Investment characteristics: Operational risk isn’t diversified as compared to FoF, because all of the operational processes of multi-strategy funds are performed under the same roof.
Furthermore, the diversity of strategies represented by the different funds in multi-strategy funds are often somewhat limited, because the managers employed by a specific multi-strategy fund tend to have similar investment viewpoints and methods.
A major advantage of multi-strategy funds over an FoF is the speed and relative ease with which tactical allocations can be made. Because each of the multi-strategy funds are managed in-house, it is relatively easy for the multi-strategy manager to reallocate capital from one strategy to another. The high internal transparency and fast response time makes tactical reallocations of multi-strategy funds practical, which could explain why multi-strategy funds have historically been perceived as superior to funds-of-funds for protecting investments.
Investor fees for a multi-strategy fund are often more attractive than those of an FoF. While FoF investors are subject to netting risk (where hefty performance fees can be paid to some successful sub-fund managers, despite overall poor FoF performance), multi-strategy funds are more likely to absorb this netting risk internally. In this arrangement, the investor only pays an incentive fee on the total fund performance.
(Though some multi-strategy funds do use an FoF-like “pass-through” fee model, which will expose investors to netting risk.)
Like an FoF, multi-strategy funds generally limit investor liquidity using redemption periods and initial lock-ups. Multi-strategy funds often additionally enforce limits on the amount of redemption each quarter.

Strategy Implementation: One key advantage of multi-strategy funds is their ability to make tactical reallocations, in addition to the funds’ strategic allocation. Furthermore, the multi-strategy fund’s internal teams are likely to be well informed about why and when capital and leverage should be reallocated, versus a FoF manager for whom the various funds are more opaque.
Risk management can be more effective with a multi-strategy fund because (unlike FoF managers) multi-strategy managers should have a solid understanding of correlations and common risks between the various funds.
Multi-strategy funds also enjoy efficiencies that come from several hedge fund teams sharing the same administrative resources.
Multi-strategy funds often make greater use of leverage than does the average FoF.
Normally, leverage in multi-strategy funds does not pose much of a hazard; however, during periods of market stress, small sources of danger can become significant left tail risks that threaten the survival of the fund. Compared to FoF, Multi-strategy funds have more varied performances.

Role in a Portfolio: Multi-strategy funds are intended to improve an investment portfolio by adding diversification and steady, low-volatility returns.
Historically, multi-strategy funds have generally performed better than have funds-of-funds, due to a superior fee structure and greater ability to execute on tactical asset allocation. However, the leveraged nature of multi-strategy funds can sometimes lead to a left-tail blow-up during times of stress.

Question 22

What is a conditional linear factor model and what is it used for?

Answer 22

A conditional linear factor model to quantify the risk exposures of various hedge fund strategies. By conditional, we mean a model that takes into account that a fund may behave one way during normal market conditions, but perform differently during a period of market turbulence.
A ‘stepwise’ regression process is useful for creating linear conditional factor models that avoid multicollinearity problems, because it avoids the use of highly correlated risk factors. When this ‘stepwise’ regression process was run by the authors of the original reading, the process resulted in the BOND and CMDTY factors being dropped due to multicollinearity issues.
This left the following four factors for measuring risk exposures:
1. Equity risk (SNP500).
2. Currency risk (USD).
3. Credit risk (CREDIT).
4. Volatility risk (VIX).
Each hedge fund strategy has different exposures to these various risk factors. These risk factors stem from taking long or short positions in financial instruments that are exposed to these risks.
*The curriculum variously refers to this conditional factor risk model as a “factor model,” “linear factor model,” “conditional risk model,” etc. These terms are all intended to refer to the same idea.

Question 23

What is the impact of adding a hedge fund to a conventional portfolio?

Answer 23

For most strategies, when added to a conventional portfolio:
Total portfolio standard deviation decreases.
Sharpe ratio increases.
Sortino ratio increases.
Maximum drawdown decreases (in approximately one-third of portfolios)
The interpretation of these results is that hedge fund strategies generally increase risk-adjusted return and provide diversification to a traditional portfolio of stocks and bonds.
While all of the hedge fund strategies expose the overall portfolio to various kinds of additional portfolio risks, allocating a portion of a stock/bond portfolio to hedge funds generally reduces risk and increases returns.
On the other hand, it was observed that the following fund strategies do not significantly enhance risk-adjusted performance:
Fund-of-funds and Multi-strategy.

Funds that were found to have little positive impact on reducing standard deviations of the overall portfolio include:
Event-driven: distressed securities.
Relative value: convertible arbitrage.

Other hedge fund strategies did little to mitigate the traditional portfolio’s maximum drawdown:
Long/short equity.
Event-driven: distressed securities.
Relative value: convertible arbitrage.