Financial Education

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.

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.

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.

Managed futures investments are investments in commodities by professional managers using skill-based strategies. The strategies employed may be either systematic trading methods which usually are trend-following or discretionary strategies based on analysis and judgment of the manager.

Managed futures accounts are often classified according to market focus as either:

• Financial – investing in financial and currency futures and options
• Currency
• Diversified – financial and physical commodities

Typically, managers are benchmarked to a group of managers employing a similar style. Investable benchmarks have also been established that rely on mechanical trend-following strategies. When comparing returns, it is important to understand that historical data is affected by survivorship bias.

Private equity funds are typically structured as limited partnerships or limited liability corporations (LLCs). There are a number of reasons for this preference.

• No double taxation (profits taxed at limited partner or shareholder level)
• No liability beyond the initial investment

Typically private equity funds will be structured to have a 7-10 year life, with options to extend this for an additional 1-5 years. The objective is to realize the full value of investments by the liquidation date. Rather than manage pools of uninvested capital, private equity managers typically require commitments that are drawn down as the funds are needed to make investments or cover expenses.

Fees for private equity managers typically include a management fee of 1.5% – 2.0% of assets under management, plus an incentive fee of 15%-20% of the profits retained after capital is returned to the limited partners. The incentive fee may include a hurdle rate of return that must be met before the fee is earned, and also may include a claw-back provision in case later investments do poorly.

The level of the Chicago Board Options Exchange Volatility Index (VIX) has been shown to predict returns on equity indexes, implying either that VIX variables are priced risk factors or that markets are inefficient. In the October 2007 Journal of Banking and Finance, Banerjee, Doran and Peterson show that this relationship is strongest for high-beta portfolios.

Studies have shown that high volatility index scores are positively related to future stock market returns. In an efficient market, an observable variable such as the VIX should not have predictive power. The authors confirm that the predictive power exists, and offer support for both the market inefficiency and the priced risk arguments.

Many studies have questioned the ability of mutual funds and pension funds to time the market. In an article published in the December 2007 Journal of Financial and Quantitative Analysis, Chen and Liang examine the returns of 221 hedge funds self-identified as market timers. They find that, for the 1994-2005 period, evidence supports timing ability – especially in volatile or bear markets.

The results are robust to model specification and volatility timing. They do not appear to result primarily from option-like trading or luck.

The authors conclude that the flexible strategies associated with hedge funds are useful for professional market timers, and that funds promising market-timing results are likely to deliver them.

Various studies have documented that the four-day period starting with the last trading day of a month and ending on the third trading day of the subsequent month accounts for the bulk of stock market returns. In the March/April 2008 Financial Analysts Journal McConnell and Xu show that this effect has persisted, and is not confined to small capitalization or low priced stocks. It occurs in 31 of the 35 countries they examined and does not appear to be caused by month-end buying pressure as measured by trading volume or equity fund money flows.

Portfolio monitoring includes monitoring changes in the characteristics of individual securities or asset classes. Over time, underlying average returns, volatility and correlations with other asset classes can change. Such changes alter the appropriate mix of assets for meeting an investor’s objectives and constraints. If the changes are perceived as temporary, they may also present opportunities to make tactical changes.

The market and economic environment also require monitoring. Of particular importance can be the yield curve, market risk premia, central bank policy, and unusual deviations from normal relationships between securities or asset classes.

High quality securities markets are those that supply liquidity, transparency and assured completion.

Liquidity can be defined a number of ways:

• Tightness (low bid/ask spread)
• Depth (limited price impact from large trades)
• Resiliency (rapid adjustments for discrepancies between market price and intrinsic value)

Transparency means access to quotes is quick, easy and inexpensive. It also requires that trade details (size and price) are rapidly disseminated to the public.

Assurity of completion simply means that the counterparties of a trade can be trusted to honor the trade.