Practice Exam 1 - Theory Flashcards
(10 cards)
Explain why listed private equities have higher volatility than hedge funds.
Aii) Listed PE have higher volatility publically traded and are subject to market volatility in publically traded equities.PE investments involve higher leverage and less liquid asset which can amplify their market movements.
While HF can use leverage, many strategies are designed to be less volataile and manage risk actively aiming for lower net market exposure.
Explain why listed private equities have a higher correlation with equities than hedge funds.
Ai) Listed PE: public companies that invest in PE publicaly traded that invest in a portfolio of PE funds.companies. The per valaulations and stock prices are directly influenced by broader equity markets and economic cycles, they have more direct exposure to equity market particularly in growth-oriented or cyclical sectors leading to high correlation.
HFS: employ a wide variety of strategies and many of these aim for absolute returns and techniques like shorting, derivatives etc to be less dependent on the direction of the market. Diversification in strategies and market-neutral opproaches often result in lower correlation to equity markets.
Explain why listed private equities have higher average returns than hedge funds.
Aiii) the higher average returns for listed private equities often reflect the liquidity premium and risk premium associated with investing in private markets. PE aims to generate higher returns by investing in less liquid companies often undergoing operational changes which demand higher compensation for liquidity and perceived higher risk when listed investors demand compensation for underlying liquidity and higher risk exposure.
Hedge funds often prioritise absolute returns and downside protection over maximising average returns while they see to generate Alpha the strategies designed to reduce market exposure and volatility which can naturally lead to lower returns in higher risk less liquid private equity investments.
Explain if using expected returns to “ tilt” the portfolio will change the risk of the portfolio from the strategic asset allocation. Discussed both total risk and relative risk.
Yes using ER will change relative and total risk.
Total risk (volatility) - TAA changes the exposure to riskier or safer assets which changes the volatility. Correlation between assets may also change which influences total risk.
Relative risk (tracking error) - the tilt is essentially taking a bet that it will deviate from SAA (&BM).
- hence deviation directly increases the portfolio’s tracking error and portfolio’s returns will likely diverge from BM returns –> increasing relative risk. If tilts are wrong then increased relative risk can lead to underperformance.
Why should analysts test the portfolio/SAA using (i) notional dollars instead of only considering portfolio’s historical average return to evaluate the suitability of the portfolio/SAA?
Only historical provides simple % and not the dollar impact. So using notional value such as $100 allows them to track the fund’s absolute growth or decline. This helps visualise how the fund’s capital base would have behaved which is important for endowments which have growth or capital preservation targets. More tangible and relatable than a simple %.
Why should analysts test the portfolio/SAA using (ii) spend and management fee instead of only considering portfolio’s historical average return to evaluate the suitability of the portfolio/SAA?
The historical average return (%for SAA) does not account for real-world outflows from the fund. For ex. expenses, management fees, operational spend.
By incorporating these outflows into back-testing, analysts can determine is the real world outflows are sufficient enough after expenses to meet the required real return objectives. Without it can’t cover expenses and real growth, potentially lead to erosion of the fund’s capital base over time.
What specific information can be gained about ability to reach investment return objective from using a Notional Dollar starting portfolio value.
This allows them to determine the terminal value of the fund at set time frame and reveal whether the SAA would have generated enough returns to cover the spending rate and fees while achieving desired real growth in capital.
Also tells us whether fund’s real purchasing power would have been maintained for grown over the tested period which is better than average % return.
What specific information can be gained about ability to bear investment risk objective from using a Notional Dollar starting portfolio value.
Volatility shows snapshot of the risk, notional $ back testing shows actual dollar value of potential drawdowns over time.
Shows fund path and period of sig. losses and how often (frequency). From this they can assess if the fund can actually handle such losses in real-world scenario even if the average volatility is below the limit.
What is the impact of a 1% increase in yield on US vs EM bonds, and which should be favoured for risk management?
• Bond prices fall when yields rise due to the inverse yield-price relationship.
• US Bonds (with longer duration) experience a larger price drop compared to EM Bonds.
• EM Bonds (with shorter duration) are less sensitive to interest rate increases, so their prices fall less.
• From a risk management perspective, EM Bonds offer better downside protection in rising rate environments.
• However, EM Bonds usually have lower credit ratings, which increases credit/default risk.
✅ Favour EM Bonds when aiming to reduce interest rate sensitivity, but be cautious of their credit risk.
What is the impact of a 1% decrease in yield on US vs EM bonds, and which should be favoured to maximise returns?
• Bond prices rise when yields fall.
• US Bonds, with their longer duration, experience a larger price increase than EM Bonds.
• EM Bonds, having shorter duration, show smaller price gains in falling yield environments.
• US Bonds also tend to have higher credit quality, offering additional capital preservation advantages.
✅ Favour US Bonds when expecting a drop in interest rates and aiming for higher capital gains with lower credit risk.
