Reading 24 Alternative Investments Portfolio Management Flashcards

Question

Risks of distressed securities strategy

Answer 1

Investors need to assess the risks that a particular distressed securities strategy may entail. The risks may include one or more of the following: * **Event risk.** Any number of unexpected company-specific or situation-specific risks may affect the prospects for a distressed securities investment. Because the event risk in this context is company specific, it has a low correlation with the general stock market. * **Market liquidity risk.** Market liquidity in distressed securities is significantly less than for other securities, although the liquidity has improved in recent years. Also, market liquidity, dictated by supply and demand for such securities, can be highly cyclical in nature. This is a major risk in distressed securities investing. * **Market risk.** The economy, interest rates, and the state of equity markets are not as important as the liquidity risks. * **J factor risk** referred to the judge’s track record in adjudicating bankruptcies and restructuring as “**J factor risk**.” The judge’s involvement in the proceedings and the judgments will decide the investment outcome of investing in bankruptcy. The judge factor is also an important variable in determining which securities, debt or equity, of a Chapter 11-protected company to invest in. It is difficult to estimate the true market values of the distressed securities, and stale pricing is inevitable. *Stale valuation* makes the distressed securities appear less risky. The risk of this strategy is probably understated, and its Sharpe ratio overstated. As a result of the inability of some institutional investors to allocate funds to distressed securities, few sell-side analysts cover this area of the market. Given this limited following of distressed securities, undercovered and undervalued market opportunities exist that knowledgeable investors can exploit to earn *high returns*. Although long-term returns for distressed securities show negative monthly returns for 20 percent of all months studied, the maximum 1-month and 12-month drawdowns are smaller for distressed securities than for US and world equities and bonds.

Answer 2

* *Distressed securities* outperform both stocks and bonds absolutely with higher Sharpe ratios than either. It is also poorly correlated with the stock market, so it would diversify a stock portfolio. * *Private equity* has historically delivered better returns than stocks, but it is highly correlated with the stock market and the Sharpe ratios are quite high. * *Direct investments* in real estate generally provide returns lower than those of stocks, though they do provide substantial diversification benefits.

Answer 3

* The principal benchmark used to measure the performance of direct real estate investment in the United States is the *National Council of Real Estate Investment Fiduciaries (NCREIF)* Property Index. * Returns calculated solely on percentage changes in the index suffer from a number of deficiencies, including the tendency to underestimate volatility in underlying values. However, methods have been developed to “unsmooth” or correct for this bias. * The principal benchmark used to represent *indirect investment* in real estate is the index compiled by the NAREIT.

Answer 4

* The moderately high average correlation of private equity returns with publicly traded share returns that has been documented has an economic explanation that is at least plausible: All types of businesses have some exposure to economic and industry conditions, so correlations of public and private equity returns may be expected to be positive. * Private equity bears more idiosyncratic or company-specific risk than the average seasoned public company, however, so any correlation should not be extremely high. * Many investors look to private equity investment for long-term return enhancement. Among the issues that must be addressed in formulating a strategy for private equity investment are the following: 1. *Ability to achieve sufficient diversification*. 2. *Liquidity of the position*. 3. *Provision for capital commitment*. An investor in a private equity fund makes a commitment of capital. The cash is advanced over a period of time known as the **commitment period**, which is typically five years. Therefore, the investor needs to make provisions to have cash available for future capital calls. 4. *Appropriate diversification strategy.* An investor contemplating an exposure to private equity should be clear on the stand-alone risk factors of an investment and also the effect on the overall risk of the portfolio. Each private equity fund will have a different investment focus, which when combined with other funds in the portfolio, modifies the overall risk.

Answer 5

The term “*fallen angels*” refers to debt securities that were originally deemed investment grade when issued by financially healthy companies but have subsequently been downgraded to below investment grade. *In contrast*, companies with high risk profiles and existing senior debt issues can seek additional (subordinated) financing via originally issued high-yield securities.

Answer 6

In a prepackaged bankruptcy filing, the debtor agrees in advance with its creditors on a plan or reorganization before it formally files for protection under Chapter 11. Creditors usually agree to make concessions in return for equity in the reorganized company.

Answer 7

**Private placement memorandum** - a document used to raise venture capital financing when funds are raised through an agent

Answer 8

Investors may access distressed securities investing through two chief structures: 1. *Hedge fund structure*. This is the dominant type. For the hedge fund manager, it offers the advantage of being able to take in new capital on a continuing basis. The AUM fee and incentive structure, particularly when there is no hurdle rate associated with the incentive fee, may be more lucrative than with other structures. Investors generally enjoy more liquidity (that is, can withdraw capital more easily) than with other structures. 2. *Private equity fund structure*. Private equity funds have a fixed term (i.e., a mandated dissolution date) and are closed end (they close after the offering period has closed). This structure has advantages where the assets are highly illiquid or difficult to value. An NAV fee structure may be problematic when it is difficult to value assets. When assets are illiquid, hedge fund–style redemption rights may be inappropriate to offer. Distressed securities managers may themselves invest or trade in many types of assets, including the following: * the publicly traded debt and equity securities of the distressed company; * newly issued equity of a company emerging from reorganization that appears to be undervalued (**orphan equity**); * bank debt and trade claims, because banks and suppliers owed money by the distressed company may want to realize the cash value of their claims. When the company is in reorganization, these instruments would be bankruptcy claims; * “lender of last resort” notes; and * a variety of derivative instruments for hedging purposes—in particular, for hedging the market risk of a position.

Answer 9

The benchmarks for managed futures are similar to those for hedge funds, in that indices represent performance of a group of managers who use a similar trading strategy or style. *! The primary benefit to managed futures is the significant diversification potential (improved Sharpe ratios). For example, some research has even shown that managed futures have exhibited positive correlation to equities and bonds during up markets and negative correlations during falling markets, in particular, private funds seemed to add value whereas publicly traded funds have performed poorly both stand-alone and in portfolios.*

Answer 10

**Increase** All else equal, a *higher convenience yield* (non-monetary benefit from owning the spot commodity) should lead to *higher roll returns*. The rise in the convenience yield should increase the roll yield.

Answer 11

* A FOF may serve as a better indicator of aggregate performance of hedge funds because they *suffer from less survivorship bias*. If a FOF includes fund that dissolves, the FOF includes the effect of failure in the return of the FOF; however, an index may simply drop the failed fund. * A FOF *can suffer from style drift*. This can produce problems in that the investor may not know what he/she is getting. Over time, managers may tilt their respective portfolios in different directions. It is not uncommon that two FOFs claim to be the same style to have returns with a very low correlation.

Answer 12

* The general distinguishing feature of various hedge fund series is whether they report monthly or daily series, are investable or noninvestable, and list the actual funds used in benchmark construction. * Another important feature of the daily indices is that they are generally constructed from managed accounts of an asset manager rather than from the funds themselves. There are many differences in the construction of the major manager-based hedge fund indices. Principal differences are as follows: 1. **Selection criteria**. Decision rules determine which hedge funds are included in the index. Examples of selection criteria include length of track record, AUM, and restrictions on new investment. For example, MSCI, Dow Jones, and Standard & Poor’s have specific rule-based processes for manager selection. 2. **Style classification**. Indices have various approaches to how each hedge fund is assigned to a style-specific index and whether or not a fund that fails to satisfy the style classification methodology is excluded from the index. 3. **Weighting scheme**. Indices have different schemes to determine how much weight a particular fund’s return is given in the index. Common weighting schemes are equally weighting and dollar weighting on the basis of AUM. Many indices report both equal-weighted and asset-weighted versions. 4. **Rebalancing scheme**. Rebalancing rules determine when assets are reallocated among the funds in an equally weighted index. For example, some funds are rebalanced monthly; others use annual rebalancing. 5. **Investability**. An index may be directly or only indirectly investable. The majority of monthly manager-based hedge fund indices are not investable, whereas most of the daily hedge fund indices are investable but often in association with other financial firms.

Answer 13

In reviewing the performance of a hedge fund, some factors an investor needs to consider are: * the returns achieved; * volatility, not only standard deviation but also downside volatility; * what performance appraisal measures to use; * correlations (to gain information on diversification benefits in a portfolio context); * skewness and kurtosis because these affect risk and may qualify the conclusions drawn from a performance appraisal measure; and * consistency, including the period specificity of performance.

Answer 14

* Equity market neutral* is usually the attempt to exploit price discrepancies through long and short positions. This strategy also has the goal of the systematic risks canceling because of the long and short positions. * Hedged equity strategies* take long and short positions in under and overvalued securities, respectively, like equity market neutral strategies. The difference is that hedged equity strategies *do not focus on* balancing the positions to eliminate systematic risks.

Answer 15

Hedge fund structured investments are ususally more liquid than investments in distressed equity using the private equity structure.

Answer 16

Fund selection is largely an exercise in evaluating the capabilities of the general manager’s management team. Factors that should be considered include the following: * historical returns generated on prior funds; * consistency of returns. Has the team had one successful fund or many? * roles and capabilities of specific individuals at the fund. The investor will want to evaluate whether the fund manager has the needed human resources to effectively select and guide private equity investment; * stability of the team. Did the current senior personnel generate the track record of the fund manager, or has there been significant personnel turnover?

Answer 17

Past CTA performance may be valuable in forecasting CTA and multi-advisor CTA portfolios’ return and risk parameters, especially at the portfolio level.

Answer 18

**Long-Only Value Investing** The simplest approach involves investing in perceived undervalued distressed securities in the expectation that they will rise in value as other investors see the distressed company’s prospects improve. When the distressed securities are public debt, this approach is **high-yield investing**. When the securities are orphan equities, this approach is **orphan equities investing**. **Distressed Debt Arbitrage** Distressed debt arbitrage (or distressed arbitrage) involves purchasing the traded bonds of bankrupt companies and selling the common equity short. The hedge fund manager attempts to buy the debt at steep discounts. If the company’s prospects worsen, the value of the company’s debt and equity should decline, but the hedge fund manager hopes that the equity, in which the fund has a short position, will decline to a greater degree. Indeed, as a residual claim, the value of equity may be wiped out. If the company’s prospects improve, the portfolio manager hopes that debt will appreciate at a higher rate than the equity because the initial benefits to a credit improvement accrue to bonds as the senior claim. **Private Equity** The investor usually first becomes a major creditor of the target company to obtain influence on the board of directors or, if the company is already in reorganization or liquidation, on the creditor committee. The investor buys the debt at deep discounts. The investor then influences and assists in the recovery or reorganization process. The objective of this focused active involvement is to increase the value of the troubled company by deploying the company’s assets more efficiently than in the past. If the investor obtains new shares in the company as part of the reorganization, the investor hopes to sell them subsequently at a profit. **Prepackaged bankruptcy** - this type of operation is typically conducted by private equity firms. The firm (or team of firms, because the capital commitment may be major) takes a dominant position in the distressed debt of a public company. Working with the company and other creditors, the firm seeks to have a prepackaged bankruptcy in which the firm becomes the majority owner of a private company on favorable terms (the previous public equityholders losing their complete stake in the company).143 After restoring the company to better health, the firm has a company that can be sold to private or public investors.

Answer 19

* In addition to its potential to add value through active management, real estate has historically been viewed as an important diversifier. * Real estate as an asset class typically responds differently from the way either stocks or bonds do. The reason is that, in the past, directly owned real estate was not highly correlated with the performance of other assets. * Direct real estate investment may provide some diversification benefits to stocks and bonds but benefits *may disappear when hedge funds and commodities are added to the portfolio*.

Answer 20

In evaluating past records of returns of private equity funds, investors often make comparisons with funds closed in the same year (the funds’ **vintage year**). This helps assure the funds are compared with other funds at a similar stage in their life cycle. The effects of vintage year on returns are known as “**vintage year effects**,” and include, in addition to the effects of life-cycle stage, the influence that economic conditions and market opportunities associated with a given vintage year may have on various funds’ probabilities of success. ## Footnote *Vintage year in the private equity and venture capital industries is a year in which the firm began making investments.*

Answer 21

**Spot Return** The *spot return* equals the change in the spot price of $0.15. The *collateral return* equals the money earned by investing the 100 percent margin used to purchase the futures contract in T-bills. The collateral return on $4.15 for one-month at a 3% annual rate is: $4.15 x 0.03 x (1/12) = $0.01 The *roll yield* equals the change in the futures prices between September and October minus the change in the spot price. The roll yield is: ($4.37 - $4.15) - $0.15 = $0.07

Answer 22

In addition to the traditional-or-modern distinction, we can place alternative investments in three groups by the primary role they usually play in portfolios: * Investments that primarily provide exposure to risk factors *not easily accessible* through traditional stock and bond investments. Real estate and (long-only) commodities might be included in this group. * Investments that provide exposure to *specialized investment strategies* run by an outside manager. Hedge funds and managed futures might be placed in this category. Any value added by such investment is typically heavily dependent on the skills of the manager. * Investments that *combine features* of the prior two groups. Private equity funds and distressed securities might be included in this group.

Answer 23

The principal roles that have been suggested for commodities in the portfolio are as: * a potent portfolio *risk diversifier*, and * an *inflation hedge*, providing an expected offset to the losses to such assets as conventional debt instruments, which typically lose value during periods of unexpected inflation. * the returns of commodities have generally been l*ower over the longer period of 1990-2004* than stocks and bonds both absolutely and on a risk-adjusted basis. The *energy subgroup commodities* has had the highest returns, and without it, the broad GSCI index returns would have been much lower.

Answer 24

* The compensation to the fund manager of a private equity fund consists of a *management fee* plus an *incentive fee*. The management fee is usually a percentage of limited partner *commitments* to the fund. (If the investor has made a capital commitment of US$50 million but actually invested only US$10 million, the investor generally pays a management fee on the US$50 million committed.) Management fees are often in the 1.5–2.5 percent range and often scale down in the later years of a partnership to reflect a lower work load. * The fund manager’s incentive fee, the **carried interest**, is the share of the private equity fund’s profits that the fund manager is due once the fund has returned the outside investors’ capital (which may be specified as the capital committed or the capital invested). Carried interest is usually expressed as a percentage of the total profits of the fund. A common value is 20 percent. * In some funds, the carried interest is computed on only those profits that represent a return in excess of a hurdle rate (the hurdle rate is also known as the **preferred return**). A hurdle rate of 6 percent means that only the private equity fund’s profits in excess of an annualized return of 6 percent are subject to the 20 percent carried interest. Because early investments by the fund may achieve high rates of return but later investments do poorly, private equity funds sometimes have a **claw-back provision** that specifies that money from the fund manager be returned to investors if at the end of a fund’s life investors have not received back their capital contributions and contractual share of profits. * In distributing cash flows to investors and the fund manager, a private equity fund first distributes to investors their invested capital and preferred return (if any is specified). Sometimes, the fund manager is allowed to take a small percentage of early distributions. Typically, following the period in which all or most distributions go to investors, there is a *catch-up period* in which the fund manager receives all or the major share of profits.

Answer 25

Commodity classes such as livestock and agriculture exhibit *negative correlation with unexpected inflation* as measured by monthly changes in the inflation rate. Thus they are poor inflation hedges. Storable commodities directly linked to economic activity exhibit positive correlation with changes in inflation and have superior inflation-hedging properties.

Answer 26

In neither the seed nor start-up point. The stages through which private companies pass are the early-stage, later-stage and exit-stage. The *early stage* consists of: * **seed**: the small amount of money provided by the entrepreneur to get the idea off the ground * **start-up**: susally pre-revenue stage that brings the entrepreneur`s idea to commercialization * **first stage**: additional funds if the idea is sound but start-up funds have run out. The *later-stage* occurs after revenue has started.

Answer 27

Changes in commodity futures prices are highly correlated with changes in spot prices. In periods of financial, economic, or political distress, and sometimes after natural disasters, short-term commodity prices tend to rise because most such events create shocks with respect to physical commodities that reduce current supply and cause prices to rise. This is called “*positive event risk*.”

Answer 28

The primary *similarity* between managed futures and absolute-return hedge fund strategies is that they seek positive returns regardless of market direction. Managed futures strategies invest exclusively in the forward and derivatives markets on a leveraged basis by trading futures and options contracts in the financial, commodity, and currency markets. *In contrast*, other hedge fund strategies invest in underlying markets; some, depending on their strategies, also use derivatives.

Answer 29

* The physical real estate market is characterized by relative lack of liquidity, large lot sizes, relatively high transaction costs, heterogeneity, immobility (with the asset fixed at a location), and relatively low information transparency (so the seller often knows more than the buyer). * The lack of reliable, high-frequency transaction data for properties necessitates the use of *appraisal-based valuations*. * Various market and economic factors affect real estate. For instance, interest rates directly or indirectly affect a multitude of factors associated with the demand and supply for real estate, such as business financing costs, employment levels, savings habits, and the demand and supply for mortgage financing. Worldwide, the returns to real estate are positively correlated with changes in gross national product. Population growth is, in the long term, a positive factor for real estate returns. * Real estate values are affected by idiosyncratic variables, such as *location*. Complete diversification in real estate can be achieved only by investing internationally.

Answer 30

* **Contango** is when the futures price is above the expected future spot price. Because the futures price must converge on the expected future spot price, contango implies that futures prices are falling over time as new information brings them into line with the expected future spot price. * **Normal backwardation** is when the futures price is below the expected future spot price. This is desirable for speculators who are "net long" in their positions: they want the futures price to increase. So, normal backwardation is when the futures prices are increasing.

Answer 31

* The compensation structure of hedge funds comprises a percentage of net asset value (NAV) as a management fee plus an incentive fee. The management fee is also known as an “asset under management” or **AUM fee**. The management fee generally ranges from 1 percent to 2 percent. The incentive fee is a percentage of profits as specified by the terms of the investment. * The great majority of funds have a high-water mark provision that applies to the payment of the incentive fee. Intuitively, a **high-water mark** (HWM) is a specified net asset value level that a fund must exceed before performance fees are paid to the hedge fund manager. Once the first incentive fee has been paid, the highest month-end NAV establishes a high-water mark. If the NAV then falls below the HWM, no incentive fee is paid until the fund’s NAV exceeds the HWM; then the incentive fee for a “1 plus 20” structure (a 1 percent management fee plus a 20 percent incentive fee) is 20 percent of the positive difference between the ending NAV and the HWM NAV. The new, higher NAV establishes a new HWM. A minority of funds also specify that no incentive fee is earned until a specified minimum rate of return (hurdle rate) is earned. * Hedge funds also prescribe a minimum initial holding or **lock-up period** for investments during which no part of the investment can be withdrawn. Lock-up periods of one to three years are common. Thereafter, the fund will redeem the investments of investors only within specified exit windows—for example, quarterly after the lock-up period has ended. The rationale for these provisions is that the hedge fund manager needs to be insulated to avoid unwinding positions unfavorably. FOFs usually do not impose lock-up periods and may permit more frequent investor exits. However to offer that additional liquidity, the FOF manager must hold a cash buffer that may reduce expected returns.

Answer 32

One provider of hedge fund benchmarks classifies strategies into the following five broad groups: 1. *Relative value*, in which the manager seeks to exploit valuation discrepancies through long and short positions. This label may be used as a supercategory for, for example, equity market neutral, convertible arbitrage, and hedged equity. 2. *Event driven*, in which the manager focuses on opportunities created by corporate transactions (e.g., mergers). Merger arbitrage and distressed securities would be included in this group. 3. *Equity hedge*, in which the manager invests in long and short equity positions with varying degrees of equity market exposure and leverage. 4. *Global asset allocators*, which are opportunistically long and short a variety of financial and/or nonfinancial assets. 5. *Short selling*, in which the manager shorts equities in the expectation of a market decline. The five most widely used hedge fund strategies, accounting for 85–90 percent of assets under management in the hedge fund industry as of the early 2000s, are three equity-based strategies (equity market neutral, hedged equity, and merger arbitrage), one fixed-income strategy (convertible arbitrage), and global macro, which uses all types of assets, including currencies and commodities.

Answer 33

* Managed futures appear to be useful in diversifying risk even in a diversified portfolio of stocks, bonds, and hedge funds. * It appears that an investor can fairly closely track the performance of a CTA-based managed futures index by using a small random selection of CTAs. * For managed futures fund, a trend-following strategy will offer *lower diversification* than a contrarian strategy. This should be obvious since the trends would be those of the cash markets for which the investor is trying to obtain diversification

Answer 34

Market liquidity risk refers to the low liquiditiy and the fact that there canbe cyclical supply and demand for these investments.

Answer 35

In periods of financial and economic distress, commodity prices tend to rise, potentially providing valuable diversification services in such times. Commodities are generally business-cycle sensitive. The reason commodities behave differently under different economic conditions has to do with the sources of their returns. The determinants of commodity returns include the following: 1. **Business cycle–related supply and demand**. Commodity prices are expected to be sensitive to the business cycle but have little or even negative correlation with stocks and bonds. Three reasons commodity returns have been weakly correlated with stock and bond returns. First, commodities correlate positively with inflation whereas stocks and bonds are negatively correlated with inflation. Second, commodity prices and stock/bond prices react differently in different phases of the business cycle. Commodity future prices are more affected by short-term expectations, whereas stock and bond prices are affected by long-term expectations. Finally, commodity prices tend to decline during times of a weak economy. 2. **Convenience yield**. The theory of storage splits the difference between the futures price and the spot price into three components: the forgone interest from purchasing and storing the commodity, storage costs, and the commodity’s convenience yield. Convenience yield reflects an embedded consumption-timing option in holding a storable commodity. At low inventory levels, convenience yields are high, and vice versa. A related implication is that the term structure of forward price volatility generally declines with **time to expiration** of the futures contract—the so-called Samuelson effect. This is caused by the expectation that, although at shorter horizons mismatched supply and demand forces for the underlying commodity increase the volatility of cash prices, these forces will fall into equilibrium at longer horizons. 3. Real options under uncertainty. Oil futures markets are often backwardated; in these markets, futures prices are often below the current spot price. This may be caused by the existence of real options under uncertainty. A **real option** is an option involving decisions related to tangible assets or processes. In other words, producers are holding valuable real options—options to produce or not to produce—and will not exercise them unless the spot prices start to climb up. Production occurs only if discounted futures prices are below spot prices, and backwardation results if the risk of future prices is sufficiently high. A major consequence of a downward-sloping term structure of futures prices is the opportunity to capture a positive roll return as investment in expiring contracts is moved to cheaper new outstanding contracts. !!! Since producers have the *real option* of producing more oil now or delaying production to any future month, they will choose to exercise this right whenever it’s profitable to them in their estimation, which of course would be cued by the futures curve of prices, if the futures price is lower then more oil will be produced now to take advantage of higher spot, while if the futures price is higher more future delivery contracts will be written to take advantage of higher prices in the future. This latter case may be due to a glut of oil inventories driving down prices in spot

Answer 36

The general investment characteristics of private equity investments include the following: * **Illiquidity.** Private equity investments are generally highly illiquid. Convertible preferred stock investments do not trade in a secondary market. Private equity fund investors have more restricted opportunities to withdraw investments from the fund than do hedge fund investors. This is natural, because the underlying investments are not liquid. * **Long-term commitments required.** Private equity investment generally requires long-term commitments. For direct VC investments, the time horizon also can be quite uncertain. * **Higher risk than seasoned public equity investment.** The returns to private equity investments, on average, show greater dispersion than seasoned public equity investments, although they may be roughly comparable to those of publicly traded microcap shares. The risk of complete loss of investment is also higher. The failure rate of new and young businesses is high. \**A seasoned equity offering or secondary equity offering (SEO) is a new equity issue by an already publicly traded company.* * **High expected IRR required.** Private equity investors target high rates of returns as compensation for the risk and illiquidity of such investments. For venture capital investments, the following also holds: * **Limited information**

Answer 37

* **Private equity** refers to any security by which equity capital is raised via a private placement rather than through a public offering. As private placements, private equity securities are not registered with a regulatory body. To qualify as private placements, securities are generally offered for sale to either institutions or high-net-worth individuals (accredited investors). * **Private equity funds** — the pooled investment vehicles through which many investors make (indirect) investments in generally highly illiquid assets. These investment activities range from financing private businesses, to leveraged buyouts of public companies, to distressed debt investing, to the private financing of public infrastructure projects.

Answer 38

A hedge dund manger may have several goals other than earning a high return, e.g. lowering downside risk. The rationale for incentive fees is obvious: encourage the manager to earn higher profits. There is some controversy concerning fees because a manger may have or should have other goals than simply earning a gross return. For example, the manager may/should be providing limited downside risk and diversification. The basic incentive fee does not reward this service.

Answer 39

* In the United States, a reorganization plan must follow the rule of priority with respect to the order of claims by its security holders. In general, claims from senior secured debtholders (typically, bank loans) will be satisfied first. The debtor’s bondholders come next. The distribution may be split between senior and subordinated bondholders. Last on the list are the debtor’s shareholders. * There is an exception to the absolute priority rule, which is referred to as “the new value exception.” In the new value exception, the debtor’s shareholders seek to retain all or a portion of their equity interest by making what amounts to a capital contribution. In exchange for their contribution, they retain their interest even in the face of a dissenting vote by a senior class of creditors. The US Supreme Court has held, however, that the new value exception does not permit contribution of such value without competitive bidding or some other mechanism to establish the adequacy of the contribution.

Answer 40

Hedgers may pay a risk *premium to liquidity providers* for the insurance they obtain so managed futures may be able to earn positive excess returns. Differential *carrying costs* among investors may permit managed fund traders to take advantage of short-term pricing differences between theoretically identical stock, bond, futures, options, and cash market positions.

Answer 41

The *annualized standard deviation* is usually computed as the standard deviation of the monthly return times the square root of 12, making the assumption of serially uncorrelated returns. The use of the standard deviation of monthly returns as a measure of risk also makes the implicit assumption that the return distribution follows the normal distribution, at least to a close approximation. As already mentioned, however, hedge funds appear to have more instances of extremely high and extremely low returns than would be expected with a normal distribution (i.e., positive excess kurtosis) and some funds also display meaningful skewness. When those conditions hold, *standard deviation incorrectly represents the actual risk of a hedge fund’s strategies*. **Downside deviation**, or semideviation, is an alternative risk measure that mitigates one critique of standard deviation, namely, that it penalizes high positive returns. Downside deviation computes deviation from a specified threshold (i.e., below a specified return, r\*); only the negative deviations are included in the calculation. Using downside deviation instead of standard deviation recognizes a distinction between good and bad volatility: **Downside deviation=SQRT(∑_nⁱ⁼¹[min(r_t−r\*,0)]²/(n−1))** **if monthly returns are used do not forget multipliying by SQRT(12)** Another popular risk measure is **drawdown**. As discussed in the reading on risk management, drawdown in the field of hedge fund management is the difference between a portfolio’s point of maximum net asset value (its high-water mark) and any subsequent low point (until new “high water” is reached). *Maximum* drawdown is the largest difference between a high-water point and a subsequent low. A portfolio may also be said to be in a position of drawdown from a decline from a high-water mark until a new high-water mark is reached. How long this period lasts is relevant to evaluating hedge fund performance—in particular, its record of recovering from losses.

Answer 42

A **vulture fund i**s a private equity fund that uses an "active" approach where the fund of investor aquires positions in the company, and the investment gives some measure of control. The investor can then influence and assist the company and then aquire more ownership in the process of any reorganization. By providing services and obtaining a strategic position, the investors create their own opportunity.

Answer 43

**Advantages** 1. To the extent that the law allows mortgage interest, property taxes, and other expenses to be tax deductible, taxable owners of real estate may *benefit from tax subsidies*. 2. Mortgage loans permit most real estate borrowers to use *more financial leverage* than is available in most securities investing. 3. Real estate investors *have direct control over their property* and may take action, such as expanding or modernizing, to increase the market value of the property. In contrast, an investor who owns a small position in the equity of a publicly traded company has virtually no voice in the management of the company. 4. Geographical diversification can be effective in reducing exposure to catastrophic risks (e.g., the risk of hurricanes or floods). The *values of real estate investments in different locations can have low correlations*; substantial geographical distance is often not necessary to achieve risk-reduction benefits. 5. Real estate returns, on average, *have relatively low volatility* in comparison with returns to public equities—even after correcting for the downward bias that results from the smoothing process associated with real estate appraisals. We discuss this bias later. **Disadvantages** 1. Most parcels of real estate are not easy to divide into smaller pieces. As a result, when such properties are a relatively large part of an investor’s total portfolio, real estate investing may involve *large idiosyncratic risks for investors*. Owners of single-family residences and large institutional investors that buy shopping centers may both experience this problem. 2. The *cost of acquiring information is high* because each piece of real estate is unique. 3. *Real estate brokers charge high commissions* relative to securities transaction fees. 4. Real estate involves *substantial operating and maintenance costs* (e.g., for administration, leasing, repairs, and replacements) and hands-on management expertise, which are expenses or requirements not incurred by securities investors. 5. Real estate investors are exposed to the *risk of neighborhood deterioration*, and the conditions that may lead to that are beyond the investor’s control. 6. Any income tax deductions that a taxable investor in real estate may benefit from are subject to *political risk*—they may be discontinued.

Answer 44

Rolling returns can show how consistent the returns are over the investment period and whether there is any cyclicality in the returns.

Answer 45

Private Investment in Public Entity (PIPE) - through a PIPE, an investor makes a relatively large investment in a company, usually at a price less than the current market value.

Answer 46

**Managed futures** are private pooled investment vehicles that can invest in cash, spot, and derivative markets for the benefit of their investors and have the ability to use leverage in a wide variety of trading strategies. Like hedge funds, managed futures programs are actively managed. Similar to hedge funds, with which they are often grouped, managed futures programs are often structured as limited partnerships open only to accredited investors (institutions and high-net-worth individuals). Compensation arrangements for managed futures programs are also similar to those of hedge funds. The primary distinguishing differences between hedge funds and managed futures is that, for the most part, managed futures trade exclusively in derivative markets (future, forward, or option markets) whereas hedge funds tend to be more active in spot markets while using futures markets for hedging. Because hedge funds often trade in individual securities whereas managed futures primarily trade market-based futures and options contracts on broader or more generic baskets of assets, one can view hedge funds as concentrating on inefficiencies in micro (security) stock and bond markets whereas managed futures look for return opportunities in macro (index) stock and bond markets. In addition, in some jurisdictions, managed futures programs have been historically more highly regulated than hedge funds.

Answer 47

Similarly to market-neutral funds, managed futures programs can replicate many strategies available to cash market investors at lower transaction costs and can also trade on strategies by using derivatives that are unavailable to cash market investors. Research has shown that when returns are segmented according to whether the stock/bond markets rose or fell, managed futures have a negative correlation with cash market portfolios when cash market portfolios post significant negative returns and are positively correlated when cash portfolios reported significant positive returns. Therefore, managed futures may offer unique asset allocation characteristics in different market environments. Also, hedging demands of cash market participants may create investment situations where hedgers are required to offer derivative investors a risk premium, or positive return, for holding open long or short offsetting positions. Option traders may be able to create positions that offer this “risk premium” for holding various option contracts when cash market participants increase purchases of options to protect themselves in markets with trending prices or volatility. This return (i.e., the convenience yield) can be earned simply by buying and holding a derivatives portfolio.

Answer 48

Managed futures programs are an industry comprising specialist professional money managers. In the United States, such programs are run by general partners known as commodity pool operators (CPOs), who are, or have hired, professional commodity trading advisors to manage money in the pool.

Answer 49

_Equity market-neutral_ * Market risk*: little * Credit risk*: low credit risk because their long–short positions result in net low leverage _Convertible arbitrage_ * Market risk*: low market exposure due to hedging * Credit risk*: this strategy also increases credit risk considerably because hedging via derivative instruments creates high leverage exposure _Global maco_ * Market risk*: high market exposure * Credit risk*: given their extensive use of leverage via futures and options, they are also exposed to significant credit (leverage) risk.

Answer 50

Including hedge funds can also frequently lead to *lower skewness* and *higher kurtosis*, which are exactly opposite to the attributes (positive skewness and moderate kurtosis) that investors are presumed to want. The following are techniques for neutralizing negative skewness in a portfolio resulting from hedge fund positions that a portfolio manager may consider: * *Adopt a mean–variance, skewness and kurtosis–aware approach to hedge fund selection*. An example is given in Kat (2005), who discussed combining global macro and equity market-neutral hedge strategies with traditional assets. Global macro funds have tended to have positive skewness with only moderate correlation with equities but relatively high kurtosis and volatility; equity market-neutral strategies tend to act as volatility and kurtosis reducers in the portfolio. In other words, smart hedge fund selection may be able to reduce the problem of negative skewness. * *Invest in managed futures*. Managed futures programs are generally trend following in nature, which tends to produce skewness characteristics that are opposite to those of many hedge funds.

Answer 51

Direct investment in energy—and, to a lesser degree, industrial and precious metals—may provide a significant inflation hedge.

Answer 52

* Many investors are barred either by regulations or by their investment policy statements from any substantial holdings in below-investment-grade debt. These investors must sell debt that has crossed the threshold from investment grade to high yield (so-called **fallen angels**). * Failed leveraged buyouts have also been a source of distressed securities opportunities.

Answer 53

A debtor against whom an involuntary Chapter 7 is filed has a right to convert the case to a Chapter 11 proceeding. Similarly, a Chapter 7 debtor that filed a voluntary petition can convert the case to a Chapter 11, unless the case started as a Chapter 11. In addition, the court can convert a Chapter 11 case to Chapter 7 or dismiss the case for cause (e.g., the inability of the debtor to carry out a plan) at any point in the case. The latter uncertainty adds much risk to bankruptcy investors.

Answer 54

Issuers of venture capital include the following: * *Formative-stage companies*. This group ranges from newly formed companies, to young companies beginning product development (“start-ups”), to companies that are just beginning to sell a product. * *Expansion-stage companies*. This group ranges from young companies that need financing for expanding sales, to established companies with significant revenues (middle-market companies), to companies that are preparing for an IPO of stock.

Answer 55

Managed futures programs are typically run by **Commodity Pool Operators (CPOs)**. CPOs cen themselves be commodity trading advisors (CTAs) or will hire CTAs to acuallty manage all part of the pool. In the United States, both must be registred with the U.S. Commodity Futures Trading Commission and the National Futures Association. Some CTAs may choose to work independently outside of a public or private CPO structure.

Answer 56

* **Distressed securities** are the securities of companies that are in financial distress or near bankruptcy. In the United States, investing in distressed securities involves purchasing the claims of companies that have already filed for *Chapter 11 (protection for reorganization)* or are in immediate danger of doing so. Under Chapter 11 protection, companies try to avoid *Chapter 7 (protection for liquidation)* through an out-of-court debt restructuring with their creditors. * Investment strategies using distressed securities exploit the fact that many investors are unable to hold below-investment-grade securities because of regulatory or investment policy restrictions.

Answer 57

**Alternative investments** comprise groups of investments with risk and return characteristics that differ markedly from those of traditional stock and bond investments. Common features of alternative investments include: * relative *illiquidity*, which tends to be associated with a return premium as compensation; * *diversifying potential* relative to a portfolio of stocks and bonds; * *high due diligence costs* for the following reasons: investment structures and strategies may be complex; evaluation may draw heavily on asset-class, business-specific, or other expertise; reporting often lacks transparency; and * unusually *difficult performance appraisal* because of the complexity of establishing valid benchmarks. In addition, many professional investors believe that *alternative investment markets are informationally less efficient* than the world’s major equity and bond markets and offer greater scope for adding value through skill and superior information. Historically, **real estate** (ownership interests in land or structures attached to land), **private equity** (ownership interests in non-publicly-traded companies), and **commodities** (articles of commerce such as agricultural goods, metals, and petroleum) have been viewed as the primary alternatives to traditional stock and bond investments. However, in recent years, additional investments—hedge funds (relatively loosely regulated, pooled investment vehicles) and managed futures (pooled investment vehicles in futures and options on futures, frequently structured as limited partnerships)—have increasingly been considered “modern alternatives,” not only to traditional investments but also to traditional alternative investments.

Answer 58

The **Sortino ratio** replaces standard deviation in the Sharpe ratio with downside deviation. Instead of using the mean rate of return to calculate the downside deviation, the investor’s minimum acceptable return or the risk-free rate is typically used. The Sortino ratio is **Sortino ratio=(Annualized rate of return − Annualized risk-free rate)/Downside deviation** *!!! Annualized rate of return = geometric mean per year: = ([(1+r₁)(1+r₂)...(1+r₁₂)]^1/12-1)\*_12_* The **gain-to-loss ratio** measures the ratio of positive returns to negative returns over a specified period of time. The higher the gain-to-loss ratio (in absolute value), the better: **Gain-to-lossratio=(Number months with positive returns / Number months with negative returns)×(Average up - month return / Average down-month return)** Two major appraisal measures based on drawdowns as indicators of risk, the *Calmar ratio* and the *Sterling ratio*, have been applied to hedge fund analysis.

Answer 59

A traditional **core–satellite perspective** places competitively priced assets, such as government bonds and/or large-capitalization stocks, in the core. Because alpha is hard to obtain with such assets, the core may be managed in a passive or risk-controlled active manner. (Informally, alpha is the return to skill.) In the satellite ring would go investments designed to play special roles, such as to add alpha or to diminish portfolio volatility via low correlation with the core.

Answer 60

Hedge funds have often been promoted as absolute-return vehicles. **Absolute-return vehicles** have been defined as investments that have no direct benchmark portfolios. Estimates of alpha, however, must be made relative to a benchmark portfolio. The lack of a clear hedge fund benchmark, however, is not indicative of an inability to determine comparable returns for a hedge fund strategy. Hedge fund strategies within a particular style often trade similar assets with similar methodologies and are sensitive to similar market factors. Two principal means of establishing comparable portfolios are: 1. using a single-factor or multifactor methodology and 2. using optimization to create tracking portfolios with similar risk and return characteristics.

Answer 61

**Hurdle rate** may refer to a minimum acceptable rate of return on a project

Answer 62

The statement is correct. When the economy is in a downturn, there are more bankruptcies, thereby increasing the supply of distressed securities at relatively low (or falling) prices.

Answer 63

**Commodity trading advisor (CTA) strategies** can be described as *systematic* or *discretionary*. CTAs that specialize in *systematic trading* strategies typically apply sets of rules to trade according to short, intermediate, and/or long-term trends. They may also trade counter to trends in a contrarian (against the trend) strategy. A *discretionary trading* strategy is based on the discretion of the CTA, in the same way that any active manager seeks value. Managed futures can also be classified according to the markets in which they trade. They apply systematic or discretionary trading strategies in financial markets, currency markets, or diversified markets. In financial markets, they trade in financial (i.e., interest rate) and currency futures, options, and forward contracts. Those that specialize in currency markets trade exclusively in currency derivatives. A fund that trades in diversified markets trades in all the financial derivatives markets described as well as commodity derivatives.

Answer 64

The Sharpe ratio *can be gamed*; that is, the reported Sharpe ratio can be increased without the investment really delivering higher risk-adjusted returns. Specifically, there are the following means to gaming the Sharpe ratio: * **Lengthening the measurement interval**. This will result in a lower estimate of volatility; for example, the annualized standard deviation of daily returns is generally higher than the weekly, which is, in turn, higher than the monthly. * **Compounding the monthly returns** but calculating the standard deviation from the (not compounded) monthly returns. * **Writing out-of-the-money puts and calls on a portfolio**. This strategy can potentially increase the return by collecting the option premium without paying off for several years. Strategies that involve taking on default risk, liquidity risk, or other forms of catastrophe risk have the same ability to report an upwardly biased Sharpe ratio. (Examples are the Sharpe ratios of market-neutral hedge funds before and after the 1998 liquidity crisis.) This is similar to trading negative skewness for a greater Sharpe ratio by improving the mean or standard deviation of the investment.119 * **Smoothing of returns**. Using certain derivative structures, infrequent marking to market of illiquid assets, and pricing models that understate monthly gains or losses can reduce reported volatility. * **Getting rid of extreme returns** (best and worst monthly returns each year) that increase the standard deviation. Operationally, this entails a total-return swap: One pays the best and worst returns for one’s benchmark index each year, and the counterparty pays a fixed cash flow and hedges the risk in the open market. If swaps are not available, one can do it directly with options.

Answer 65

The costs of due diligence in alternative investments may be a limiting factor for smaller portfolios. Chief points of active manager selection process: 1. **Market Opportunity** What is the opportunity and why is it there? We start by studying capital markets and the types of managers operating within those markets. We identify market inefficiencies and try to understand their causes, such as regulatory structures or behavioral biases. 2. **Investment Process** Who does this best and what’s their edge? We identify groups of managers that seek to exploit these inefficiencies. 3. **Organization** Are all the pieces in place? Is the firm well organized and stable? Are research, trading, risk management, and operations properly staffed given the investment process and scale? Is compensation fair? Has there been turnover? What is the succession plan? 4. **People** Do we trust the people? 5. **Terms and Structure** Are the terms fair? Are interests aligned? Is the fund or account structured appropriately to the opportunity? 6. **Service Providers** Who supports them? We verify lawyers, auditors, prime brokers, lenders, etc. We investigate those with whom we are not familiar. 7. **Documents** Read the documents! 8. **Write-Up** Prior to making a manager selection decision, we produce a formal manager recommendation discussing the above steps. Some questions in due diligence and alternative investment selection are unique, or more acute, for advisors of private wealth clients than for institutional investors. These include: * *Tax issues*. This is a pervasive issue in investing for individuals. In contrast to equities and bonds, with alternative investments, the advisor will frequently be dealing with partnerships and other structures that have distinct tax issues. * *Determining suitability*. This is often more complex for an advisor to an individual client or family than for an institutional investor. The advisor often addresses multistage time horizons and liquidity needs. * *Communication with client*. The advisor then faces the difficult problem of communicating and discussing the possible role in the portfolio (and risk) of an often complex investment with a nonprofessional investor. * *Decision risk*. Decision risk is increased by strategies that by their nature have: * frequent small positive returns but, when a large return occurs, it is more likely to be a large negative return than a large positive one, or * extreme returns (relative to the mean return) with some unusual degree of frequency. * *Concentrated equity position of the client in a closely held company*.

Answer 66

* A symmetrical distribution has a *skewness of zero*; all else being equal, a positive value of skewness is desirable. * *Kurtosis* evaluates the relative incidence of returns clustered near the mean return versus returns extremely far away from the mean. If one investment has higher kurtosis than another, it tends to have more instances of extreme returns.

Answer 67

* **Direct commodity investment** entails cash market purchase of physical commodities—agricultural products, metals, and crude oil—or exposure to changes in spot market values via derivatives, such as futures. Cash market purchases involve actual possession and storage of the physical commodities and incur carrying costs and storage costs. Thus, investors have generally preferred to use derivatives or indirect commodity investment. * **Indirect commodity investment** involves the acquisition of indirect claims on commodities, such as equity in companies specializing in commodity production. To the degree that companies hedge a major portion of their commodity risk, even commodity-linked companies may not be exposed to the risk of commodity price movement.

Answer 68

* *US Chapter 7* bankruptcy is conceptually (emphasis ours) similar to the bankruptcy procedures followed in most other countries. That is, when a person seeks protection under Chapter 7, that person’s assets are collected and liquidated and the proceeds are distributed to creditors by an appointed bankruptcy trustee. The debtor is normally discharged from the debts that were incurred prior to bankruptcy. As in most other countries, under Chapter 7, rehabilitation of the debtor is not especially important. It is in this sense that the US Chapter 7 is conceptually similar to other countries. * In contrast, *Chapter 11* emphasizes rehabilitation of the debtor and provides an opportunity for the reorganization (restructuring) of the debtor. This is the distinctive feature of US bankruptcy that separates it from most of the rest of the world. * In Chapter 11, the debtor (a business seeking relief and protection) retains control of its assets (which will immediately pass into a bankruptcy estate under the supervision of the court) and continues its operations. While under this protection, the debtor, now known as a “debtor-in-possession,” seeks to pay off creditors (often at a discount) over a period of time according to a plan approved by the bankruptcy court. Some of the liabilities may be discharged. By filing Chapter 11, a debtor can protect its productive assets from being seized by creditors and have time to plan the turnaround of the business. * A plan of reorganization is submitted to the court for approval. The plan is typically proposed by the debtor with the blessings of creditors, especially the senior creditors. In most cases, the debtor works with its creditors to formulate a plan of reorganization. This plan details how much and over what period of time the creditors will be paid. Prospective distressed securities investors should pay attention to the exclusivity period. The exclusivity period occurs at the beginning of each case. During this time (set at 120 days but often extended by the court), only the debtor can file a plan of reorganization. After the exclusivity period expires, any party with an interest in the bankruptcy can file a plan proposing how the estate’s creditors are to be paid under Chapter 11. Creditors and shareholders of the debtor eventually must approve the plan and have it confirmed by the bankruptcy judge. The judge can refuse to confirm a case if the plan is not proposed in good faith or if each creditor receives less than it would receive in a Chapter 7 liquidation. The judge can overrule the disapproval by some dissenting creditors, however, on economic grounds or for other considerations, such as social or legal grounds. This is commonly referred to as the “cram down.” Thus, a cram down is basically a compromise between the debtor and certain classes of creditors when they cannot come to an agreement on the reorganization plan. Referred to as the “impaired class,” those who object to the reorganization plan are those who believe their interest in the reorganization is impaired by the proposed plan. * Put another way, an approved reorganization plan by the court of law may not necessarily make economic sense, and such an erroneous presumption may be costly to distressed investing. The uncertain nature of the outcome of legal proceedings makes analysis of such investment challenging, and it must be accompanied by extensive due diligence.

Answer 69

Indirect investment includes investing in: * companies engaged in real estate ownership, development, or management, such as homebuilders and real estate operating companies * **real estate investment trusts (REITs)**, which are publicly traded equities representing pools of money invested in real estate properties and/or real estate debt; * **commingled real estate funds (CREFs)**, which are professionally managed vehicles for substantial commingled (i.e., pooled) investment in real estate properties; * **separately managed accounts**, which are often offered by the same real estate advisors sponsoring CREFs; and * **infrastructure funds**, which in cooperation with governmental authorities, make private investment in public infrastructure projects—such as roads, tunnels, schools, hospitals, and airports—in return for rights to specified revenue streams over a contracted period. * Equity REITs* own and manage such properties as office buildings, apartment buildings, and shopping centers. Shareholders receive rental income and income from capital appreciation if the property is sold for a gain. *Mortgage REITs* own portfolios in which more than 75 percent of the assets are mortgages. Mortgage REITs lend money to builders and make loan collections; shareholders receive interest income and capital appreciation income from improvement in the prices of loans. *Hybrid REITs* operate by buying real estate and by acquiring mortgages on both commercial and residential real estate. * CREFs* include open-end funds and closed-end funds (i.e., funds that are closed to new investment after an initial period). In contrast to open-end funds, closed-end funds are usually leveraged and have higher return objectives; they operate by opportunistically acquiring, repositioning, and disposing of properties.

Answer 70

During this time, the investor *cannot redeem* any part of the investment. Additionally, once the lock-up period has expired, redemption rights may be limited to a quarterly or semiannual schedule and the investor generally must give advance notice, ranging from 30 to 90 days, of an intention to redeem.

Answer 71

* The property types that have higher levels of embedded risk, such as large office assets, have generated lower risk-adjusted returns than other sectors and are likely to have more pronounced market cycles. Conversely, those sectors that offer higher risk-adjusted returns, such as apartments, appear to be less volatile and offer more defensive characteristics. * Targeting the apartment sector of the commercial real estate market over the last decade would have yielded better results than simply diversifying across all sectors. The higher returns of apartment real estate can be partially explained by a low correlation with inflation. * Equity real estate returns generally have been found not to follow a normal distribution, in US markets and elsewhere, for both the direct investments and indirect investments. Furthermore, the direct market exhibits a high degree of persistence in returns (positive following positive and negative following negative), whereas the indirect market does not show such persistence.

Answer 72

* Derivative markets are zero-sum games. As a result, the long-term return to a passively managed, unlevered futures position should be the *risk-free return* on invested capital less management fees and transaction costs. For derivative-based investment strategies like managed futures to produce excess returns, on average, there must be a sufficient number of hedgers or other users of the markets who systematically earn less than the risk-free rate. Hedgers, for example, may pay a risk premium to liquidity providers for the insurance they obtain. If that condition is met, managed futures may be able to earn positive excess returns (i.e., be the winning side in the zero-sum transactions). * Most actively managed derivative strategies follow *momentum strategies*. In equity markets, research has begun to support the notion that short-term momentum-based strategies may be able to produce excess returns; the evidence related to the market opportunity in futures markets is less well developed. * Because of the ease with which futures traders take short positions, futures traders can attempt to earn *positive excess returns in falling as well as rising markets*. * Because managed futures can replicate many strategies available to a cash market investor at a lower cost—and allow strategies that are unavailable to cash investors—factor models for this group must include the factors that may be unique to managed futures and hedge fund trading opportunities. To the degree that different factors explain managed futures returns and stock/bond returns, managed futures may provide investors exposure to unique sources of return. The presence of such risk factors also provides an economic rationale for managed futures’ diversification capabilities when added to a portfolio of equities and bonds.

Answer 73

Among the reasons for including commodities in a portfolio are that they are: * “natural” sources of return (i.e., related to economic fundamentals) over the long term, as discussed above, and * providers of protection for a portfolio against unexpected inflation.

Answer 74

The **high-water mark** of the fund—that is, the highest previous NAV. Typically, **drawdowns** (declines/losses in net asset value) must be recouped before any incentive fees are charged.

Answer 75

The Sharpe ratio has a number of *limitations* that the hedge fund investor needs to understand: 1. The Sharpe ratio is *time dependent*; that is, the overall Sharpe ratio increases proportionally with the square root of time. An annual Sharpe ratio will therefore be (12)^0,5 bigger than a monthly Sharpe ratio if returns are serially uncorrelated. 2. It is not an appropriate measure of risk-adjusted performance when the investment has an *asymmetrical return distribution*, with either negative or positive skewness. 3. *Illiquid holdings* bias the Sharpe ratio upward. 4. Sharpe ratios are *overestimated* when investment returns are serially correlated (i.e., returns trend), which causes a lower estimate of the standard deviation. This occurs with certain hedge fund strategies that may have a problem with stale pricing or illiquidity. Distressed securities may be an example. 5. The Sharpe ratio is primarily a risk-adjusted performance measure for stand-alone investments and *does not take into consideration the correlations* with other assets in a portfolio. 6. The Sharpe ratio has *not been found to have predictive ability* for hedge funds in general. Being a “winner” according to the Sharpe ratio over a past period cannot be relied on to predict future success. 7. The Sharpe ratio *can be gamed*; that is, the reported Sharpe ratio can be increased without the investment really delivering higher risk-adjusted returns.

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