Financial Education

A target rate of return that is not based on market returns. It could be a specific return, such as 10%, as opposed to exceeding the return on the S&P 500.

Hedge funds can choose to report their results to database providers who report the overall performance of hedge funds in various categories.

Since performance disclosure is voluntary, peer performance is not a reliable measure. Poor performing managers are not likely to disclose performance (biasing performance upward) and large established managers may not want the trouble (or may want to make their performance stand out rather than be averaged into the peer group.) The aggregate effect is probably that database returns are overstated.

Hedge funds are sometimes criticized as lacking transparency. There are a number of reasons for this.

For one thing, they are privately organized entities with minimal regulatory oversight. They are not required to disclose their holdings and strategies, so they do not.

Closely related to the lack of regulation is the fact that they are only marketed to qualified investors – those who presumably have both the sophistication to understand the strategies and the capacity to accept losses. These qualified investors may be able to glean information about the fund, but public investors, who are not able to invest in the fund anyway, are not.

Perhaps the most significant reason, however, is competitive secrecy. Hedge funds are competing both for investment funds and for investment opportunities. They often employ sophisticated techniques that could be compromised if they were widely known.

Hedge funds are not subject to investment restrictions and thus have greater breadth of investment instruments at their disposal. These typically include leverage, short sales, derivatives, and concentrated or illiquid positions.

Hedge funds are privately organized, loosely regulated and professionally managed pools of capital not widely available to the public.

The business cycle refers to the swings in gross domestic product from recovery to recession. There are several factors influencing the business cycle.

Consumers tend to be the most important, reflecting 60-70% of GDP in developed countries. Trends in consumer spending can be monitored through retail sales and personal income data.

Business spending on inventories and investment is a smaller but more volatile component of GDP. It can be tracked using surveys such as PMI or ISM.

Monetary policy is used by governments to dampen the overall business cycle. The ability to use monetary policy as a business cycle lever is dampened by inflation, the pace of growth, unemployment levels and capacity utilization.

Inflation has different effects on different types of assets. As a result, it is important both to diversify assets in terms of their response to inflation and to form expectations of inflation in order to overweight the assets that will respond best to future conditions.

Cash – inflation causes rising interest rates, and therefore cash tends to earn a higher return when inflation is higher.

Bonds – inflation erodes the fixed payments and terminal values of bonds. Therefore, bonds perform worse when inflation is higher.

Stocks – inflation can increase asset values but erode real cash flows. Rising interest rates can reduce the present value of future cash flows. Stocks tend to do best when inflation is low and predictable, and to fall in either high inflation or deflation.

Real estate – higher cash flows and asset values tend to result in a positive relationship between real estate and inflation.

The N-firm concentration ratio is an intuitive measure of industry concentration. Industries with high (or low) levels of concentration have few (or many) competitors.

The N-firm concentration ratio is found simply by adding the market shares of the N largest firms in the industry. For example, in an industry with six competitors with respective market shares of 30%, 20%, 20%, 10%, 10% and 10% the three firm concentration ratio would be 30% + 20% + 20% = 70% and the 5-firm concentration ratio would be 90%.

The N-firm concentration ratio is an intuitive measure, but the Herfindahl index provides a greater degree of discrimination. As a result, when the two indicators offer differing signals the Herfindahl index is likely more reliable.

The typical business cycle can last as long as 10 years or more. It is typically represented by several stages.

In the recovery stage, there is still a large gap between output and capacity. Bond yields are bottoming and stocks often surge. Taking risk (cyclical and risky stocks, high yield bonds) tends to offer above-average rewards.

In the early upswing, the economy experiences robust growth without causing inflation because output is still below capacity. As the capacity utilization improves, so does profitability. Short rates begin to rise, though long-term rates remain stable.

In the later stages of the upswing, the output gap closes and overheating becomes a danger. Inflation can pick up, resulting in rising interest rates and stock market volatility.

In a slowdown, the slowing economy becomes sensitive to potential shocks. Interest rates are peaking, and interest-sensitive stocks tend to perform well.

In a recession, declining GDP leads to falling short-term interest rates and bond yields. The stock market bottoms out and often starts to rise well ahead of the business cycle recovery.

Derivative agreements are contracts between two parties, under which at least one of the parties faces a financial obligation to the other. Each counterparty to a contract can be subjected to credit risk, or the possibility that the other party fails to meet its obigation.

In a forward contract, commitments are made at the contract outset but settlement is due at expiration. Consider an agreement under which party A agrees to buy the S&P 500 index from party B for 1,500 in one year. If  the S&P 500 is at 1,400, party A owes party B 100, and party B faces potential credit risk (prior to settlement) and actual credit risk (at the time of settlement.) When the S&P 500 is higher than 1,500 it is party A that is subject to credit risk.

Swap contracts are similar to a series of forward contracts, with interim payments occurring along the way. Each payment exposes one party to credit risk. As each payment is made, the total potential credit risk is reduced.

Option contracts have unilateral credit risk – only the seller is obligated to make a payment, so only the buyer is exposed to credit risk once the initial premium has been paid.