Sep 22

FRM 2008 Episode #14 (Hedge funds)

by David Harper, CFA, FRM, CIPM

FRM |

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In this issue

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Every week I publish short (< 10 min) screencasts to give you a financial learning boost. Get your daily fix! Since the last newsletter, I recorded the following screencasts:

About Episode #14 (Investment Risk B)

We just published the latest screencast episode (Episode #14, Investment Risk B). Investment Risk B reviews hedge fund risk. This screencast episode has a 128-page PowerPoint you can download.

Please find links to the thirteen previous episodes (#1 to #13) at the end of this note.

This concludes the regular season of 2008 FRM episodes; we have published almost thirty hours of video tutorials for this FRM season. We've covered virtually all of the 2008 AIMs! And I have built over seventy-five EditGrid/XLS learning spreadsheets. I am delighted customers continue to find the learnings spreadsheets useful. Often times, especially for the more difficult ideas, reading is inferior to the "aha!" moment we get when we study the illustrated mechanics of an interest rate swap valuation, CDS valuation, or Basel IRB.

My next e-mail to you will give information about the cram sessions. Last year many customers said the cram sessions were key to passing. If you feel behind in your preparation, these cram sessions should be helpful. I am collecting a core list of high-density themes. We will binge together on a high-calorie feast of FRM concepts.

In regard to this episode, please note the following key themes:

Factor Models

factor_model

This year's FRM has shifted away from alternatives as a broad category (e.g., real estate, private equity, VC) and toward a specific focus on hedge funds. Except for PWG on private capital pools, all of the assignments are about hedge funds.

Further, with the addition of two Andrew Lo papers, the most important theme here is the use of factor models.

For the FRM, you must get conceptually comfortable with the idea of a deconstruction of a security or fund's return into a linear combination of: factor exposures (betas) to common factors plus an unexplained (by the multivariate regression model) residual (alpha). Note the high incidence of factor models in the FRM:

  • The capital asset pricing model (CAPM) is a pervasive single factor model: a security's excess return is a function of exposure to (beta) the equity risk premium, a single risk factor.
  • In the Traditional Investment section, Grinold's Performance Analysis uses a factor model to deconstruct excess portfolio returns (i.e., returns over the riskless rate) into active systemic risk, specific skill (alpha) and exposure to common industry and risk index factors. Note the flexibility, if Y (dependent) = [exposure]*[factor]+[exposure][factor]+ ... + residual, we can put many different things on the left-hand side (e.g., return, excess return, active return) and an infinte variety of fators on the right-hand side.
  • In Basel II internal ratings based (IRB) approach, the ASRF approach reduces an obligor's credit risk to its systematic risk; i.e., it's correlation with a single risk factor.
  • Hedge fund replication is the attempt to mimic an active hedge fund strategy by identifying the strategy's exposure to common risk factors

Hedge Fund Strategies as common factor exposure

hedge_as_factor

The hedge fund replication reading looks more difficult than it really is: they regressed fund returns agains common factors; e.g., exposure to equities (S&P 500) explained 18% of the returns for the long/short strategy. The intercept in the multivariate regression, being "left-over" and unexplained by factors, is the alpha.

The strategies have varying common exposures and alphas. A strategy with a high alpha ought to be very hard to replicate with a linear clone (a portfolio invested in the same factors as the strategy). A strategy with low alpha and high factor exposure, in theory, is a candidate for linear clone. But note, even here, where the factor exposure is high, the authors are not religious about clones. There are problems and drawbacks.

Trends in Hedge Funds

hf_trends

The Stulz reading on hedge funds has historically given candidates high bang-for-your-reading buck. It is a rich source for hedge fund questions. Please note how his balanced view includes decisive advantages for absolute return strategies (e.g., significantly higher Sharpe ratios). Further, the predicted trends continue to be worth savoring.

Hedge Fund Strategies

hf_strategy

The Jeager reading on hedge fund strategies has been in the cirriculum for a few years. I like to recommend two passes through these strategies:

  • First, a pass through to comprehend the mechanics of each strategy; e.g., how is equity long/short different than market neutral? what is an event strategy and why should it be uncorrelated (in Lo's paper, 80% of returns are due to alpha with low contribution by common factors. This is expected.)
  • Second, armed with a comprehension of the strategy mechanics, now review each strategy with an eye toward the ultimately testable question: Each strategy aims to profit by some combination of skill (alpha) and deliberate exposure to well identified risk(s); which risk premia are targets for each strategy?

Screencast Tutorial

Paid member access the screencast in the member section. In addition to the viewable screencast:

  • You can downloadable the underlying Power Point slides (in PDF format). For this episode, there is a single 112 page deck.
  • An ipod format (.m4v)
  • A downloadable version of the screencast in a .zip file. (Save to new directory on local and launch the .html file.)

Non-members can sample the start of the screencast tutorial here.

Practice Questions

As always, I wrote some engagement-type questions to provoke your thinking on the episode.

Question #1

Rene Stulz compares hedge funds to mutual funds.

(i) From the perspective of performance, why is the comparison difficult?
(ii) Citing research, Stulz generally affirms both hedge fund alpha ("positive insignificant alpha after fees" on average, with demonstrable alpha for above average funds) and, even more clearly, superior risk-adjusted returns. What enables hedge funds to produce superior results (several reasons given)?
(iii) What future does Stulz predict for hedge funds?

Question #2

In regard to Andrew Lo's "Can Hedge-Fund Returns Be Replicated?"

(i) Why does he introduce (what is the point of) the fictional CDP & CMP strategies?
(ii) Under the linear multifactor model employed, what are the sources of RETURN and the sources of RISK?
(iii) Among the several hedge funds strategies, which are BEST replicated with clones? Which LEAST afford themselves to clone replication?
(iv) How does Lo measure illiquidity?

Question #3

In regard to "What happened to the Quants in August 2007?"

(i) What is the unwind hypothesis and do the authors believe it explains August 2007?
(ii) Do the authors implicate quantitative strategies? If not, who or what is to blame?
(iii) What lessons do the authors offer. In particular, what lessons for the common (beta) factor exposures analyzed in the hedge fund replication paper?

Question #4

Jaeger catalogs hedge fund strategies (Chapter 5, Individual Hedge Fund Strategies). We are keenly interested in viewing each strategy through the prism of its compensated risk premia (i.e., to which risks does the strategy deliberately seek exposure and, consequently, compensation in the form of excess returns).

(i) Based on the risk premia discussed, which strategies are MOST amenable to Andrew Lo's linear clone replication method?
(ii) Which hedge fund strategies are LEAST amenable to the linear clone replication employed by Lo?

My answers to these questions

Previous newsletters

Here are links to Episodes #1 through #13:

Thanks very much.

David-Harper_100w

David Harper, CFA, FRM, CIPM
Founder
www.bionicturtle.com

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