Financial Education

Relative value arbitrage style hedge funds attempt to capitalize on relative pricing discrepancies between related instruments in anticipation of the prices converging over time

Arbitrage is a two sided strategy involving the simultaneous purchase and sale of related securities that are mispriced compared to each other.

Convertible arbitrage style exploits pricing anomalies between convertible bonds and the underlying equity, typically long the convert and short the equity. It is designed to profit from the fixed income security and the short position in the stock. Typically employ leverage (up to 6:1) and face interest rate, credit, liquidity and corporate event risk.

Fixed income arbitrage strategies exploit pricing anomalies within and across global markets. Typically exploit investor preferences, exogenous shocks to supply or demand, or structural features of fixed income market. Include yield curve arbitrage, sovereign debt arbitrage, corporate versus Treasury spreads, muni vs. Treasury spreads, cash vs. futures and mortgage backed securities arbitrage. Typically neutralize interest rate risk and employ substantial leverage.

The equity market neutral style exploits pricing inefficiencies while exactly neutralizing exposure to market risk.Unlike the equity long/short style, market neutral funds seek to have low correlation to traditional assets. Equity long-short funds typically exhibit some beta.

The index arbitrage style exploits mispricings between the index and index derivatives.

The mortgage-backed securities arbitrage style seeks to profit from the pricing difference between a mortgage instrument with uncertain prepayment and credit quality characteristics, and a non-prepayable Treasury security.

Market risks related to the economy, interest rates, and the state of the market are relatively unimportant when considering investments in distressed securities. There are, however, several types of risks that particularly apply to investments in distressed securities.

Event risk relates to unexpected company-specific or situation-specific events that affect valuation.

Market liquidity risk arises because distressed securities are less liquid, and demand runs in cycles.

J-factor risk relates to the judge presiding over bankruptcy proceedings. The track record in adjudication and restructuring can play a significant role in both the overall outcome and determining the optimum securities in which to invest.

When considering an investment in private equity, investors need to consider a number of factors.

• Can a small investor obtain the diversification needed
• Does the investor have liquidity needs that would prohibit tying up funds for 7-10 years
• Will the investor be able to fund promised commitments to the private equity fund when called for
• What mix of sector, stage and geography is required to provide the best diversification

In addition, selecting managers requires special due diligence considerations:

1. Can the investor and manager evaluate prospects for market success
   • Understanding of the markets, competition and sales prospects
   • Experience and capabilities of management team
   • Management’s commitment – ownership, compensation structure, etc
   • Opinion of customers
   • Identity of current investors – do they have particular expertise that lends confidence to outsiders
2. Operational review
   • Have experts validated the technology
   • Consideration of employment contracts
   • What intellectual property rights have been established
3. Financial and legal review
   • Potential dilution of interest
   • Financial statement (or tax returns, or investor-conducted audit)

Buy and Hold

Investors who use a buy and hold strategy set their initial allocation weights and then do nothing. Such allocations are directly related to the market performance of risky assets, and using them implies that risk tolerance is directly related to wealth and market returns.

Consider a 60/40 split between stocks and the risk-free asset. As the stock market rises (falls), stocks represent a larger (smaller) weight in the portfolio and The risk-free asset provides a floor value. Returns are directly related to market performance in a linear relationship.

When markets are trending, buy and hold methods can perform well because the better performing assets get increasingly larger weights and poor-performing assets have less impact.

Constant-mix

Constant mix rebalancing is a dynamic process that requires rebalancing to the intial target allocation by trading whenever market conditions alter the ideal balance. The strategy ensures that the portfolio’s risk characteristics remain stable over time, consistent with a risk tolerance that varies proportionately to wealth.

Constant-mix strategies can be characterized as contrarian, as they sell the best-performing assets to buy the worst-performing. However, when markets are mean-reverting this will perform better than a buy and hold strategy. The shape of returns is concave – return increases at a decreasing rate in positive markets and decreases at an increasing rate in negative markets.

Constant Proportion

In a constant proportion strategy, the target allocation is a function of cushion, where cushion is the difference between the portfolio value and the floor value, and the allocation to risky assets is the product of the cushion and the proportion (m).  A buy and hold strategy represents a special case in which m = 1. This strategy is consistent with having no risk tolerance if there is no cushion.

If m > 1, the strategy is known as constant proportion portfolio insurance, or CPPI. CPPI strategies buy more stocks when markets are rising and sell stocks as markets fall. The dynamic allocations also affect the floor value, as changing the weight of the risky asset necessitates an opposite-direction change in the floor value.

In strong bull markets, CPPI performs well by continually allocating more to stocks. In strong bear markets, CPPI avoids large losses by rapidly reducing the allocation to stocks. Such returns can be described as having a convex shape as the return increases at an increasing rate when market returns are positive and decreases at a decreasing weight when market returns are negative.

When markets are characterized by frequent reversals, the constant changes in allocation result in high transaction costs that erode performance.

Investors seeking exposure to securities issued by companies in distress are typically seeking higher returns in exchange for the added risks. Success in distressed security investment requires unique skills, and typically investors participate via vehicles such as hedge funds or private equity funds. Hedge funds offer greater liquidity for the investor (and greater access to capital for the manager.) However, the illiquid nature of many distressed securities may confer advantages to the fixed term and closed-end structure of private equity funds.

There are a number of security types that relate to distressed companies:

• The publicly traded debt and equity
• Newly issued (orphan) equity of companies recently emerged from reorganization
• Bank debt and trade claims that the original creditor may wish to monetize
• “Lender of last resort” notes

Frequently investors use these securities in conjunction with a range of derivative products to hedge related risks.

The reasons distressed securities can offer high risk-adjusted returns relates to the market opportunity that arises because other investors are either unwilling or unable to participate in the market. Some funds are prohibited from owning speculative grade debt, and are forced to sell holdings that lose an investment grade rating regardless of price. Others do not wish to participate in drawn-out bankruptcy proceedings and will accept a fraction of the value of their claims in exchange for immediate cash. In other cases, failed leveraged buyouts or unduly shunned companies that recently emerged from bankruptcy may create a temporary imbalance of supply and demand for their securities.

Bonds may either be issued as speculative grade bonds (original issue)or become so following a rating downgrade (fallen angels). In either case, their risk-adjusted returns should be similar. However, in an article published in the Fall 2007Journal of Portfolio Management Fridson and Sterling point out that fallen angels have historically delivered far higher risk-adjusted returns, and discuss several explanations for an apparent market inefficiency.

The authors find the correlation between fallen angels and original-issue speculative grade debt to be lower than that between Treasuries and investment-grade corporate bonds, suggesting dissimilar attributes and below the threshold normally used to classify securities as part of the same asset class.

Possible reasons for the disparity include:

• Lack of investor awareness, given that the primary high-yield index only recently began breaking out the performance of the two categories
• Emphasis on security selection and possible overconfidence among managers that they can pick the superior original-issue bonds
• Investability – fallen angels account for just 30% of available speculative-grade debt and trade infrequently
• Lottery-like returns for specific original issue bonds
• Yield appeal due to higher yields typically found with original issue bonds

One way to balance the costs and risks associated with portfolio rebalancing is to set target corridors for asset class weights rather than specific weights. At least five factors should be considered when setting the tolerance ranges:

1. Transaction costs – higher transaction costs should result in a wider corridor so that rebalancing occurs less frequently
2. Risk tolerance – higher risk tolerance also justifies wider corridors
3. Correlation with the rest of the portfolio – when assets move in the same direction as the rest of the portfolio they are unlikely to drift further from target weight. This, in turn, allows for a wider target corridor.
4. Asset class volatility – the more volatile the asset class, the more likely a wider divergence from the optimal weight. This requires a tighter corridor.
5. Volatility of the rest of the portfolio can also lead to large divergences from optimal weights and the need for tighter corridors.

Once a target corridor is breached, the portfolio may be rebalanced to the target weight or to some level within the target corridor. The latter methods allow for more control, particularly with regard to illiquid assets. The alignment to strategic asset allocations would be less, but transaction costs would be lower.

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.

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.

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.