Leture 3 Flashcards
(67 cards)
1
Q
How is the History of Hedge funds?
A
- in 1949, Alfred Winslow Jones invented hedged fund
- aim: protect from downside market risk, by short-selling stocks
- borrowed capital to increase his positions (leverage)
- his funds increased by 670% between 1955 - 1965
- same year: Richard Donchian established the first commodity trading advisor that traded futures based on moving average trend detection
2
Q
What are the drivers of hedge fund returns
A
3
Q
What are Hedge funds?
A
4
Q
What different Styles do exist in Hedgefund? What what are the underlying Strategies?
A
5
Q
Relative value: What are Key characteristics?
A
- Exploit price differences between two similar or related instruments
- Mostly operate within fixed income space
- Rely on a wide variety of fundamental and quantitative models
6
Q
Relative value: What are key return drivers?
A
- corporate activity
- manager skill in researching and picking thos events that are most likely to reach completion is the key element
7
Q
Relative value: What are the key risk drivers?
A
- Illiquidity - although a source of return, it can make it difficult to unwind position
- the highly leveraged nature can cause serious losses in times of adverse markets or in the case of wrong trading decisions
8
Q
Relative value: Asset Class overview, what are some examples?
A
- convertible bond arbitrage
- fixed income arbitrage
- EMN & Stat Arb
- Multi-strategy
9
Q
Event driven: What are Key characteristics?
A
- Focus opportunities arising from corporate transaction events
- uncertainty about such events create mis-pricings, which they can exploit
- generally use stocks / derivates as their tools
10
Q
Event driven: What are the Key return drivers?
A
- corporate activity
- manager skill in researching and picking those events that are most likely to reach completion is the key element
11
Q
Event driven: What are the Key risk drivers?
A
- Transaction risk is the primary risk
- once invested in a deal, should the deal fall apart, the manager risks losing significant capital
- sudden market downturns can lead deals to fall apart
12
Q
Event driven: What are some examples?
A
- merger arbitrage
- special situations
- distressed debt
- activist and Multi-Strategy
13
Q
Tactical Trading: What are the key characteristics?
A
- opportunistic managers that invest in emerging trends across asset classes.
- make use of the full spectrum of available instruments to exploit htese trends.
- most use relatitvely liquid instruments
- historically generate excellent returns in times of greater market volatility and/or illiquidity
14
Q
Tactical Trading: What are the key return drivers?
A
- The univers of macro / trading hedge fund investment opportunities and approaches is very broad
- manager skill is paramount to a successful strategy
15
Q
Tactical Trading: What are the key risk drivers?
A
- Illiquidity - although a source of return, it can make it difficult to unwind positions
- The highly leveraged nature can cause serious losses in times of adverse markets or in case of a wrong trading decisions
16
Q
Tactical Trading: What are some examples?
A
- Systematic traders
- Discretionary macro
17
Q
Directional: What are some Key characteristics?
A
- the oldest hedge fund investment style
- promising equities and/or equity derivatives are purchased
- to hedge the investment, less promising stocks are shorted
18
Q
Directional: What are some key return drivers?
A
- stock selection is the primary driver, hence manager skill is paramount
- market movements and company specific factors such as earnings, market sentiment or equity multiples
19
Q
Directional: What are some key risk drivers?
A
- manager selection is paramount as stock selection is so important
- stock market sentiment, especially bear sentiment
- Liquidity can be a concern for those trading mid or small caps
20
Q
Directional: What are some examples?
A
- long / short
- regional focus
- market sector or factor focused
- long or short bias
21
Q
What is the difference between systematic and discretionary trading?
A
22
Q
What are some quantitative strategies?
A
Trend following strategies
- Initially, easiest and simplest to apply as they do not make predictions or forecast prices
- Based on occurrence of desirable trend
Trading Range (Mean Reversion)
- Strategy based on the idea that stocks and assets revert to their mean periodically
- Algorithms place traders when the price breaks in and out of its predefined range
Arbitrage Opportunities
- Buying and selling related instruments simultaneously
- Takes advantage of prices differing in two instruments or markets
Execution: Volume Weighted Average Price
- Breaking up large orders, releases smaller chunks into the market based on stock profile
- Relies on the stock’s historical volume profiles and aims to execute close to this VWAP
23
Q
What is momentum in finance?
A
- Momentum is the tendency for rising asset prices to rise further and falling prices to keep falling.
- It is a market anomaly difficult to explain using traditional finance theories.
- Often attributed to cognitive biases (behavioral economics) or underreaction to new information.
24
Q
What is cross-sectional momentum?
A
- Stocks are ranked by performance during a formation period.
- Top-performing stocks (e.g., top 33%) go into the winner portfolio.
- Worst-perorming stocks (e.g., bottom 33%) go into the loser portfolio.
25
What is quantitative investing (systematic investing)?
* Uses mathematical modeling, computers, and data analysis to calculate the probability of profitable trades.
* Examples: High-frequency trading, statistical arbitrage, cross-sectional momentum, quality factors, and sentiment trading.
26
Why has quantitative investing become more widespread?
* Computational power and data storage have become cheaper.
* Tools like machine learning, alternative data, and factor investing are now used by institutional investors for trading and portfolio decisions.
27
What is **Statistical Arbitrage (Stat Arb)**?
* Originated in the mid-1980s at Morgan Stanley.
* Aims to identify temporary mispricings in statistically proven short-, mid-, and long-term relationships.
* Often relies on mean reversion principles.
28
What are examples of **Statistical Arbitrage strategies**?
**1. Pairs Trading**
* Exploits deviations in relationships between two securities (e.g., BMW vs. Mercedes).
**2. Cross-Market Arbitrage:**
* Exploits price discrepancies of the same company across markets (e.g., ADR arbitrage).
**3. Cross-Asset Arbitrage:**
* Bets on price discrepancies between a financial asset and its underlying (e.g., stock index vs. component stocks, or gold vs. gold miners).
**4. ETF Arbitrage:**
* Identifies discrepancies between the value of an ETF and its underlying assets.
29
How does Statistical Arbitrage differ in theory vs. practice?
* **Theory**: Arbitrage should allow risk-free profits.
* **Practice**: Focuses on identifying temporary mispricings and exploiting statistical relationships, with no guaranteed risk-free profit.
30
How does mean reversion relate to Statistical Arbitrage?
* Stat Arb often bets that prices deviating from a historical mean will revert over time.
* Example: Pairs trading identifies when the price ratio between two securities deviates significantly from the mean.
31
What is **factor investing,** and how does it relate to hedge fund strategies?
* Factor investing combines **market returns** (passive investing) and active returns (active management).
* Involves rule-based and transparent implementation to capture systematic factors like value, **momentum**, and **quality**.
32
What are the three types of hedge **fund replication strategies**?
**1. Distribution Replication:**
Focuses on statistical properties of returns (not monthly tracking).
**2. Rules-Based Replication:**
Uses trading rules to mimic hedge fund styles (e.g., mechanical replication from 13F filings).
**3. Factor Replication:**
Clones return streams of hedge fund sub-styles by regressing traditional market factors on returns.
33
What are **common systematic factors** in factor investing?
* **Value:** Captures excess returns from undervalued stocks.
* **Size (Small Cap):** Exploits returns from smaller firms.
* **Momentum:** Focuses on stocks with strong recent performance.
* **Low Volatility:** Targets stable, low-risk stocks.
* **Dividend Yield:** Invests in high-dividend stocks.
* **Quality:** Prioritizes financially strong firms (e.g., low debt, high earnings stability).
34
What is factor cyclicality, and why is it important in factor investing?
* Factor returns exhibit cyclicality, with periods of strong and weak performance (e.g., **Value** vs. **Growth** across years).
* Diversification is key since no factor consistently outperforms.
35
What are the advantages of replication strategies?
* Reduces risks like illiquidity, lack of transparency, and fraud compared to direct hedge fund investments.
* Provides access to **Hedge Fund Beta**, avoiding the zero-sum alpha game.
36
What caused **Black Monday** in 1987?
* U.S. markets fell over **20% in a single day** (October 19, 1987).
* Triggered by **portfolio insurance strategies** using computer-driven trading models.
* Selling pressure created a **pricing imbalance** as futures markets opened but stock markets were closed.
37
What **regulatory** measures were introduced after Black Monday?
* **Circuit breakers** were installed to halt trading during extreme price drops.
-> 7% drop: 15-minute pause.
->20% drop: Market shuts for the day.
* Aimed to prevent panic selling and allow markets to stabilize.
38
What caused the 2007 **quant crash**?
* **Sudden liquidation** by a multi-strategy fund or trading desk triggered cascading losses.
* Hedge funds using **long/short equity strategies** were impacted due to margin calls and stop-loss triggers.
* Highlighted issues of **crowded trades, illiquidity**, and **leverage**.
39
What was the recovery after the 2007 quant crash?
* A significant rebound occurred by August 10, supporting the hypothesis of a temporary liquidity-driven event.
* Exposed risks in quantitative strategies relying on high leverage and speed.
40
What was the Dodd-Frank rule, and how did it impact markets?
* Banned **proprietary trading desks** in banks.
* Reduced dealer inventories, impacting market liquidity and depth.
* Shifted market-making to **private entities** with less regulatory obligation.
41
What systemic **risks** emerged after the Global Financial Crisis (GFC)?
* Increased **central bank balance sheets** and sovereign wealth fund activity.
* Significant growth in **outstanding debt** with less market liquidity.
* **Hedge funds** now compete directly, adding risks due to leverage and reduced market making.
42
What trend occurred with U.S.-listed companies from 1996 to 2016?
* The number of U.S.-listed companies halved during this period.
* Since 2016, it has stabilized at ~4,000.
* Meanwhile, the number of ETFs and derivatives grew significantly.
43
How has the number of listed companies in China changed since 1995?
The number of China A-Share listed companies grew from **323 in 1995** to over **5,000 today**.
44
What is the level of concentration in the S&P 500 index?
* The top 10 companies now make up >30% of the S&P 500's market cap.
* Concentration is driven by U.S. tech mega-caps.
45
How did index concentration affect stock performance during COVID?
* Few stocks (e.g., FB, AMZN, AAPL, MSFT, GOOGL) outperformed significantly, driving the index higher.
* Most S&P 500 companies underperformed.
46
What impact has algorithmic trading had on market structure?
* Algo-trading dominates daily volume in U.S. and global exchanges.
* Expanded to asset classes like FX and fixed income.
47
What is Payment for Order Flow (PFOF)?
* Controversial practice where brokers (e.g., Robinhood) route customer trades to specific market makers for a fee.
* Came under scrutiny during the 2020/2021 meme stock craze.
48
Who dominates market making today?
* Firms like Citadel and Jane Street handle significant U.S. equity volume.
* They now overshadow traditional Wall Street banks.
49
How much data does the world create daily?
* **90% of the world’s data** was created in the last two years.
* Google processes **8.5 billion searches/day.**
* Twitter (X) handles **500 million tweets/day.**
* "Data is the new oil."
50
What is **alternative data** in finance?
* Data used by investors outside traditional sources (e.g., financial statements).
* Examples: **Website scraping, satellite imagery, geolocation, and credit card tracking.**
51
What are some examples of alternative data sources?
* **Website Scraping:** Consumer trends via reviews, pricing data.
* **Satellite Imagery:** Crop yields, parking lot activity.
* **Geolocation:** Foot traffic at stores and restaurants.
* **Credit Card Tracking:** Real-time consumer spending trends.
52
Why is machine learning critical in finance?
* Handles the exponential growth of data.
* Captures **non-linear relationships** that traditional statistics miss.
* Applications: **Fraud detection, algorithmic trading, sentiment analysis.**
53
What is a regime-shifting model in machine learning?
* Adjusts strategies to align with market conditions.
* Example: Adapting portfolio weightings in response to changing environments.
54
Which firms use machine learning in finance?
* The Voleon Group
* Edgestream Partners
* Voloridge Investment Management
55
What is **high-frequency trading** (HFT)?
* Uses algorithms for rapid trading, often within milliseconds.
* Key needs: Minimal data latency and full automation.
56
What are the advantages of HFT?
* Exploits small price inefficiencies.
* Relies on high-speed data analysis and execution.
57
What caused the collapse of Long-Term Capital Management?
* Over-leveraged convergence trades on mispriced securities.
* Lost $1.9 billion in a month, jeopardizing global markets.
* Required a Federal Reserve-organized bailout.
58
What were the key lessons learned from LTCM's failure?
* Risks of **excessive leverage** and **poor risk management**.
* Importance of **regulating OTC** derivatives.
* Highlighted the **"too big to fail" doctrine.**
59
Why did Amaranth Advisors fail in 2005?
* **Brian Hunter** bet on natural gas futures (long on winter, short on summer).
* Extreme market moves led to **$6.6 billion in losses.**
* Could not meet **margin requirements**
60
What was the mechanism of Bernard Madoff's Ponzi scheme?
* Promised consistent high returns using split-strike conversion strategy.
* Paid old investors with funds from new ones.
* Defrauded investors of $65 billion over decades.
61
Who exposed Bernard Madoff's fraud and how?
* **Harry Markopolos** submitted reports to the SEC years before the scandal.
* Highlighted red flags: Unexplainable returns, poor transparency, no visible trades.
62
What was John Paulson's strategy during the 2008 crisis?
* Shorted the U.S. housing market using **credit default swaps** on subprime mortgages.
* Made $15 billion for his fund in 2007 alone.
63
What makes Renaissance's Medallion Fund exceptional?
* Sustained **66% annual returns** over 30 years.
* Uses **mathematics, algorithms, and data** to identify patterns.
* Relies on **proprietary models** and cheap leverage.
64
What are the key takeaways from Renaissance's success?
* Superior talent and **unique management approaches.**
* **Execution infrastructure** keeps costs low.
* Emphasis on **data cleaning** and iterative improvements.
65
What are key philanthropic contributions from hedge fund leaders?
* **George Soros:** Billions to charities; supports Tanzanian orphans via Hakuna Matata.
* **Chris Hohn:** Donated £4 billion to climate and children’s causes; major donor to Extinction Rebellion.
* **Paul Tudor Jones:** Founded Robin Hood Foundation, donating $2 billion to NYC poverty programs.
66
How have hedge funds contributed to conservation and wealth pledges?
* **Louis Bacon:** Spent **$400 million** conserving **202,000 acres** in the U.S.
* **Ray Dalio & Seth Klarman:** Pledged **$20 billion** and **$2 billion**, respectively, via the Giving Pledge.
67
What are other notable hedge fund donations?
* **Ken Griffin:** Donated **$300 million** to **Harvard University** (2023).
* Foundations by **Mandel**, **Englander**, and **Renaissance** lead in U.S. philanthropy.
