Archive for September, 2008

Extensions and Supplements to Value at Risk (VaR)

The risk management concept of Value at Risk (VaR) has met with wide acceptance and has spawned a number of extensions and supplements to the original concept. These include cash flow at risk, earnings at risk and tail value at risk.

Cash flow at risk and earnings at risk measure the risk to either cash flow or earnings (rather than market value) for a given risk factor. It can be useful when assessing assets that generate cash flow or earnings but are difficult to value. It can also be used as a sensitivity test for valuation models.

Tail value at risk adjusts VaR to not only express the minimum loss but also the expected loss when extreme outcomes occur. It is expressed as VaR plus the expected loss in excess of VaR. For example, the tail value at risk for a 5% VaR would be the average of the worst 5% of outcomes.

Posted on 29th September 2008
Under: Governance, Portfolio Management, Risk Management | No Comments »

Characteristics of Managed Futures Investments and Their Role in a Portfolio

Derivative markets are zero-sum games, with each long position offset by a corresponding short. As such, the aggregate return to all participants in the futures market is the risk-free rate, less any management fees. In order for managed accounts to earn a positive risk-adjusted return after fees implies other market participants who systematically earn less than the risk-free rate. This is possible because many participants in the futures markets are hedgers, who may be willing to accept the lower return as an insurance premium protecting them from outlying events.

Managed futures managers can also exploit mispricing opportunities that arise when certain contracts are not trading at the proper relationship to other contracts.

Even with limited return opportunities, managed futures may play a role in the portfolio due to a low correlation of returns with those of traditional investments such as stocks and bonds. The diversification benefits have been shown to accrue even for portfolios that include other alternative assets such as hedge funds.

The Sharpe ratios of portfolios that include managed futures dominate those that do not. However, the benefits may be specific to the investment vehicle, time period and strategy under consideration. Managers have been shown to demonstrate short-term persistence in returns and a manager’s beta relative to his benchmark is often a good indicator of future returns.

Since futures involve leverage and derivatives, particular consideration should be paid to risk management strategies.

Posted on 28th September 2008
Under: Active Management, Alternative Assets, Asset Allocation, Futures, Investing in Commodities, Investment Returns, Personal Finance | No Comments »

Benchmarks for Private Equity Investments

Benchmarking the returns of private equity investments is complicated by the fact that events that would indicate a change in market value (such as a new financing, acquisition, IPO, or failure of the business) occur infrequently.

Cambridge Associates and Thomson Venture Economics provide overall indices for VC and buyout funds. They typically calculate the internal rate of return based on cash flows since fund inception. Often firms are compared by vintage year for comparability across the stage of financing and any macroeconomic influences.

Since the venture capital must provide appraisals of some assets, stale valuations can result in a smoother return appearance than is actually realized.

Posted on 27th September 2008
Under: Active Management, Alternative Assets, Institutional Investing, Investing in Private Equity, Investment Returns, Portfolio Management | No Comments »

Neoclassical Growth Theory

Growth theory seeks to explain the rate of GDP growth in different countries.

Neoclassical growth theory assumes that the marginal rate of productivity of capital declines as more capital is added. It predicts that the long-term level of GDP depends on the country’s savings rate, but that the long-term growth rate in GDP does not. This is because as the level of GDP increases, additions to capital provide a diminishing impact and the economy reaches a steady state.

Countries operating below their steady state should experience accelerating growth, while those operating above it will see the growth rate slow.

Posted on 25th September 2008
Under: Economic Analysis | No Comments »

Breakeven Spread Analysis

Changes in the spread between domestic and foreign interest rates can diminish the return on a foreign bond investment. Breakeven spread analysis quantifies the amount of spread widening (W) that would eliminate a given yield advantage.

For example, if a foreign bond offers a 300 basis point yield advantage (75 basis points per quarter) adn has a duration of 5:

  • The change in the price of the foreign bond would be 5 X the change in yield or 5W
  • Breakeven = 0.75% X 5W
  • W = 0.13% or 13 basis points

Posted on 24th September 2008
Under: Fixed income investments, International Investing, Investing in bonds, Portfolio Management | No Comments »

Model Uncertainty and Input Uncertainty

Model uncertainty is the risk that a selected model is inappropriate or incorrect for the purpose used.

Input uncertainty relates to whether the inputs fed to a model are accurate.

Input and model uncertainties make it difficult to evaluate potential inefficiencies or market anomalies.

Posted on 18th September 2008
Under: Active Management, Fundamental Analysis, Industry Analysis, Institutional Investing, Portfolio Management | No Comments »

Flow of Funds Indicators

Flow of funds measures analyze the financial positions of various types of investors to determine their potential capacity to buy or sell stocks. Since every buy order must be matched with a sell order of equal magnitude, flow of funds indicators are not interested so much in the ex-post balance between supply and demand, but with the implications of ex-ante supply and demand imbalances on price.

Although flow of funds measures can indicate an ability to buy or sell, they do not give any sign of the willingness to do so. Furthermore, some of the data is reported with a lag and may no longer be relevant by the time it is available.

Posted on 10th September 2008
Under: Technical Analysis | No Comments »

Why Do Hedge Funds Stop Reporting Performance?

Hedge funds are not required to report their performance, and those who voluntarily report can opt out of reporting at any time. There are at least two possible reasons a hedge fund might choose to stop reporting results:

  • Poor performance, possibly including fund closure
  • Very good performance has eliminated the need to attract capital

In the Fall 2007 Journal of Portfolio Management, Grecu Malkiel and Saha examine both hypotheses, and find a pattern of declining performance in the months leading up to cessation of reporting. Further the probability that a fund will stop reporting increases rapidly during the first five years of a fund’s life and then gradually declines from the peak. Funds with high Sharpe ratios, more assets and peer-beating performance are less likely to stop reporting.

The authors conclude that hedge funds stop reporting results due to poor performance, rather than strong performance.

Posted on 6th September 2008
Under: Active Management, Alternative Assets, Hedge Funds, Investment Returns, Performance Measurement, Portfolio Management, Research | No Comments »

Forecasting Fund Manager Alphas

Because the investment returns of all managers, on average, will be average paying higher fees for active management is justified only if the superior managers can be identified in advance.

In the March/April 2008 Financial Analysts Journal Waring and Ramkumar write that the expected alpha from active fund managers can be forecasted, as long as investors pay heed to the rules of zero-sum-game investing.

The forecasts are based on two equations derived from the fundamental law of active management. Variables for the equation are estimates of the manager’s skill, estimates of the sponsor’s assessment of its own skill in identifying skilled managers, the cross-sectional standard deviation of manager skill, portfolio breadth, implementation efficiency, expected active risk, and fees.

Posted on 5th September 2008
Under: Active Management, Institutional Investing, Investment Returns, Performance Measurement, Portfolio Management, Risk Management | No Comments »

Portfolio Rebalancing: Cost/Benefit Analysis

Portfolio rebalancing requires a trade-off between the cost of rebalancing and the cost of not rebalancing. Costs of rebalancing include trading costs and taxes, which must be weighed against:

  • the reduction in expected portfolio value resulting from suboptimal asset allocation
  • exposure to greater risk as the riskier assets typically earn more and become a larger percentage of the portfolio
  • shifting risk factors as asset weights change
  • using rebalancing to reduce exposure to the assets that have risen most and may be overvalued

To reflect this trade-off, rebalancing is typically performed in a disciplined fashion, based either on the calendar or on tolerance corridors.

Calendar rebalancing takes place at specific times, and as such does not require constant monitoring. However, it is insensitive to market conditions and may allow weights to drift substantially between rebalancings.

Tolerance corridors call for rebalancing whenever an asset class drifts out of proportion to a pre-specified range around the target weight. It allows tighter control as it is directly related to market performance, but also requires continuous monitoring.

Posted on 4th September 2008
Under: Active Management, Asset Allocation, FInancial Planning, Investment Returns, Passive Management, Portfolio Management, Risk Management | No Comments »