1. CAIA Level II: Core and Integrated Topics, Institutional Investor, Inc., 2015, ISBN: 978-1- 939942-02-9.Part VIII: Manager Selection, Due Diligence, and Regulation.
A. De Souza, C. and S. Gokcan. “Hedge Fund Investing: A Quantitative Approach to Hedge Fund Manager Selection and De-Selection.” The Journal of Wealth Management, Spring 2004, Vol. 6, No. 4, pp. 52-73.
B. Clare, A. and N. Motson. "Locking in the Profits or Putting It All on Black? An Empirical Investigation into the Risk-Taking Behavior of Hedge Fund Managers." The Journal of Alternative Investments, Fall 2009, Vol. 12, No. 2, pp. 7-25.
C. Tuchschmid, N. and E. Wallerstein. “UCITS: Can They Bring Funds of Hedge Funds On-Shore?” The Journal of Wealth Management. Spring 2013, Vol. 15, No. 4, p. 94- 109.
Reading 1, Article A
Hedge Fund Investing: A Quantitative Approach to Hedge Fund Manager Selection and De- Selection
The process of allocating to hedge funds involves several steps. First, we would decide on the size of overall allocation to hedge funds. Second, we would examine each strategy and decide on the size of allocation to each strategy. Having identified the appropriate strategy mix, the next step of the portfolio construction process, and the subject of this article, is individual manager research and due diligence to identify those hedge fund managers that are the “best-in-class” and suitable to execute each of the selected strategies. Historically, this process has to a large extent been qualitative, with quantitative analysis primarily focusing on the elementary analysis of return series. The scope of this article is to present a number of quantitative tools for different phases of manager selection or de-selection. The authors recognize as practitioners that there are no substitutes for an understanding of the nuances of investment philosophy, risk control, capital management, timely, and accurate information transfer, and ultimately fund level transparency.
The introductory section of the paper makes the case that hedge fund managers belonging to the same strategy still form a rather heterogeneous group. As a result, even if the right strategies have been selected for allocation, the portfolio manager can add substantial value to the portfolio by selecting the best managers from each strategy.
To determine if manager selection can add any value to the process, the authors’ next task is to find out whether there is persistence in hedge fund performance. This topic is discussed in sections 3-4 using varying methods. The paper finds that there is no persistence in certain properties of managers’ returns, while others display significant persistence.
The paper examines characteristics of funds that have been liquidated to determine if failing funds can be identified ahead of time. It proposes a quantitative measure to monitor the performance of selected managers through time. The authors argue in favor of a quantitative
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measure of performance that does not depend on specific assumptions about return distributions and therefore would be suitable for evaluations of hedge fund performance.
Exercises
1. The authors of the article use non-parametric contingency tables to test for persistence.
What do they conclude about the persistence of hedge fund strategies with regard to: (1) returns, (2) standard deviations, and (3) Sharpe ratios?
Solutions
1. When the authors use non-parametric contingency tables, results presented in the study show that none of the strategies display statistically significant persistence in their returns or Sharpe ratios. However, results suggest more persistence in standard deviations (with the exception of fixed income and merger arbitrage).
(Pages 334-355) Reading 1, Article B
Locking in the Profits or Putting It All on Black? An Empirical Investigation into the Risk- Taking Behavior of Hedge Fund Managers
This paper empirically examines the impact of the optionality embedded in hedge fund incentive fees on the risk taking behavior of hedge fund managers. As discussed in CAIA core readings, the incentive fee structure of hedge funds has a payoff that is similar to the payoff from a call option on fund’s profits. There are important reasons for providing hedge fund managers with such a fee structure. The ideal fee structure aligns the incentives of the investor with those of the fund manager. Investors will normally be looking to maximize their risk-adjusted return, while fund managers will seek to maximize the present value of their fees. Perhaps, the most interesting issue is whether the incentive fee perfectly aligns the interests of investors with those of the manager. We know from option pricing models that the value of the option increases as volatility increases. Thus, the manager may have the incentive to increase the fund’s volatility.
The introductory section of the paper introduces the issue, with the next section providing a summary of theoretical findings related to the impact of incentive fees on risk taking behavior of hedge fund managers. The paper discusses that many factors affect the benefits received by the hedge fund manager (e.g., the manager may have his/her own capital invested in the fund), and, therefore, it is not clear that it is in the best interest of the manager to increase the fund’s riskiness. The section titled “Methodology” describes the way the moneyness of the incentive fee option is measured. The paper then uses various methods to determine if for hedge funds there is a relationship between the volatility of funds’ returns and the moneyness of the incentive options. The broad conclusion is that fund managers adjust the return volatility of their fund in reaction to changes in the moneyness of the incentive fee option. In the final two sections, the paper examines the impact of two fund characteristics, namely, size and age, on the above relationship.
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Exercises
1. Do the authors of the article “Locking in the Profits or Putting It All on Black? An Empirical Investigation into the Risk-Taking Behavior of Hedge Fund Managers” find that hedge fund managers adjust the risk profile of their funds in reaction to their performance relative to their peers? Explain.
Solutions
1. Yes, the authors found evidence to suggest that hedge fund managers adjust the risk profile of their funds in reaction to their performance relative to their peers. More specifically, they found that managers of relatively poor (strong) performing funds increase (decrease) the risk profile of their funds. These findings, which are similar to those of Brown, Harlow, and Starks (1996) for mutual funds, are rather surprising as hedge funds have generally been depicted as investment vehicles following absolute returns.
(Pages 356-374) Reading 1, Article C
UCITS: Can They Bring Funds of Hedge Funds On-Shore?
This article analyses UCITS hedge funds. Because this regulatory regime allows for a relatively large degree of latitude, the funds are potentially attractive to hedge-fund manager and may satisfy the call by some investors for greater regulation and oversight of the alternative investment products.
UCITS hedge funds, or alternative UCITS funds, are mainly targeted for European hedge-fund investors. Since UCITS framework is an EU directive, the EU constitution mandates that each EU member state apply the directive into national law within certain time frame. However, each country has some freedom in how to implement each directive. The article explains the impact of UCITS directive on the type of investments that a fund is allowed to have and its requirement regarding risk management at UCITS funds. The article argues that the implementation of risk management directive centers on the VaR measure, and then discusses how the four aspects of risk, concentration risk, leverage, liquidity, and counterparty risk should be addressed in UCITS funds. The article uses performance on UCITS and less regulated funds to examine the impact on regulation of risk-return profiles on UCITs funds. It concludes that alternative UCITS funds do generate performance that is at comparable levels to the less regulated hedge-fund industry.
Exercises
1. Discuss the main objectives behind the European Union (EU) UCITS directive.
2. Discuss regulatory restrictions on alternative UCITS funds’ leverage.
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Solutions
1. The European Union (EU) implemented the UCITS directive with the goal of facilitating cross-border marketing of investment funds while offering a high level of investor protection.
The main pillars of the directive are to regulate the organization and oversight of UCITS funds and to impose constraints concerning diversification, liquidity, and use of leverage.
(Pages 375-390)
2. Leverage through borrowing is prohibited for UCITS funds, but it is allowed in general to achieve leverage through derivatives instruments. There are two approaches to defining limits on leverage levels for UCITS: the commitment approach, or the VaR and stress test. The
commitment approach applies to all non-sophisticated UCITS and defines a limit of 200%
leverage of NAV.
Sophisticated UCITS do not fall under a rule that explicitly limits leverage. Instead, the relative or absolute VaR requirements will limit their leverage. In other words, the 99% monthly VaR may not exceed twice the level of a reference portfolio, or the 99% monthly VaR may not exceed 20% of NAV. If the absolute VaR approach is used, then the stress test may also impose limits on leverage.
(Pages 375-390)
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