Financial Education

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.

A number of factors affect performance evaluation for hedge funds, particularly with respect to using the Sharpe ratio to measure risk-adjusted return.

Starting with return, typically monthly returns are compounded to an annualized rate of return. However, entry and exit opportunities may be permitted only quarterly or even less frequently. In addition, some measures of downside risk such as the maximum drawdown are not compounded. Measures comparing return (compounded) and drawdown (not compounded) may not fully reflect the risk/return profile.

The Sharpe ratio is defined as:

• Numerator is the difference between annualized return and the annualized risk-free rate
• Denominator is the annualized standard deviation of returns

The Sharpe ratio increases proportionately with the square root of time, and is not appropriate when returns are asymmetrical. In particular, the Sharpe ratio tends to be overestimated when returns are serially correlated or assets are illiquid. Furthermore, the correlations between the fund and an investor’s other portfolio assets are not considered.

There are a number of ways managers can “game” the Sharpe ratio, including:

• Lengthening the measurement interval
• Compounding monthly returns but calculating standard deviations without compounding
• Writing out of money put or call options to produce asymmetric returns
• Smoothing returns
• Using swaps to eliminate extreme outlying returns

In part because of these deficiencies, the Sharpe ratio has not been found to be a good predictor of hedge fund returns.

International bond managers can seek excess return from a variety of sources:

1. Bond market selection - choosing the best country in which to invest
2. Currency selection - deciding whether to hedge or retain currency risk
3. Duration/yield curve management - getting the most favorable returns within the selected market
4. Sector selection - choosing among government, corporate, local currency or dollar-denominated bonds
5. Issuer credit analysis - being able to identify improvement or deterioration in advance of changes in rating
6. Benchmark mismatches - investing in markets that are not included in the benchmark index

Investor Specific Concerns

Strategic asset allocation starts with the investor’s objectives, constraints, net worth and attitudes toward risk. A risk tolerance function can be applied to determine the investor’s specific risk tolerance.

Capital Market Situation

The current state of the market must be identified, and some procedure used to generate a set of expected returns, risks and correlations between asset classes.

Joint Investor-Market Relationship

Given the investor’s situation and the capital market outlook, an optimizer can be used to determine an allocation suited to the investor’s risk tolerance. The asset mix can be selected, and actual returns fed back into the process as feedback.

Purchasing Power Parity

Purchasing power parity (PPP) is based on the belief that movements in exchange rates should offset any difference in inflation between two economies. Over longer time horizons, purchasing power parity does tend to hold, in part because governments take the concept seriously and act to control relative inflation rates. In the short term, however, other factors such as capital flows can overwhelm the impact of PPP.

Relative Economic Strength

This concept focuses on investment flows rather than trade flows. It suggests that strong economies attract capital, which causes the currency to appreciate. Foreign investors must always weigh whether the higher yield offsets the risk of inflated currency values. Relative Economic Strength indicates how currencies should respond to economic news, but does not imply a “true” currency value. Because of this, many investors use it in conjunction with PPP to form a complete theory of interest rate movements.

Capital Flows

Focuses on expected capital flows, particularly with respect to long-term capital investments. Capital flows can reverse the normal relationship between currencies and short-term interest rates, as the stimulative effect of a lower interest rate may outweigh the lower yield.

Savings-Investment Imbalances

This theory explains currency movements in terms of savings relative to capital investment. If domestic savings are insufficient to cover capital investments, the remainder must come from foreign sources. To the extent that foreign investment is not offset by a trade imbalance, the currency must rise.

Suppose an analysis finds that semiconductor sales have a strong relationship with semiconductor equipment sales. There are three possible explanations for the relationship:

1. Higher semiconductor sales result in a need for more semiconductor equipment (A predicts B)
2. Having more equipment to make semiconductors results in higher sales (B predicts A)
3. Some other factor (such as economic conditions) results in higher need for both semiconductors and semiconductor equipment (C predicts A and B)

Without investigating and modeling the underlying linkages, using correlations relationships in a prediction model can lead to significant errors.

Equally important, suppose that no correlation is found between semiconductors and semiconductor equipment. They may still have a strong (but nonlinear) relationship that should be considered. Such relationships may be found by using multiple regression techniques.

For individuals drawing on retirement funds, a 4% withdrawal rate is generally recommended to result in only a small chance of the portfolio running out of money. In the October 2007 Journal of Financial Planning Spitzer, Strieter and Singh simulate thousands of 30-year periods to assess the overall probability of running out of funds.

They find that a standard 50/50 split between stocks and bonds can allow for a 4.4% withdrawal rate with just a 10% chance of depleting funds. Withdrawal rates of up to 6% can be supported with stock allocations of 75% or more.

Portfolio management theory asserts, based on the variance between a given asset and the rest of the portfolio, that as few as 8-20 stocks are sufficient to provide most of the benefits of diversification.

In the November 2007 Financial Review Domian, Louton and Racine challenge this assumption by proposing that long-term investors are likely to be more concerned with shortfall risk (failure to reach a target ending wealth) than with return variance.

Based on the returns of 1,000 stocks and a safety first criterion, they find that at least 164 stocks are necessary to reduce shortfall risk to no more than a 1% chance of underperforming Treasury bonds. Although smaller portfolios can be enhanced by diversifying across industries, the benefit is not as powerful as that provided by simply adding more stocks to the portfolio.

Several steps are needed to construct a custom benchmark for a portfolio.

1. Identify prominent aspects of the manager’s investment process
2. Select securities that are consistent with that process
3. Devise a weighting scheme for the benchmark securities, including an appropriate allocation to cash
4. Review the preliminary benchmark and make modifications
5. Rebalance the benchmark portfolio on a predetermined schedule

Since reported hedge fund performance is of doubtful significance and risk monitoring is difficult, due diligence takes on special significance when investments in hedge funds are being considered. Some of the things investors must determine include:

1. The structure of the fund
   • Legal entity
   • Identity of manager
   • Domicile
   • Regulatory regime
2. Strategy
   • Style
   • Instruments used
   • Benchmark
   • Niche
   • Current holdings
3. Performance data since inception for all funds under management
4. Risk management
   • What risks are measured
   • How are they measured
   • How are they controlled
   • How is leverage employed
5. Research
   • Has the firm’s research led to changes in strategy
   • Strength of research efforts
   • Research budget
   • Personnel
6. Administration
   • Lawsuits
   • Employee turnover
   • Disaster recovery plans
7. Legal and Regulatory
   • Fee structure
   • Lock-up period
   • Minimum and maximum subscription amounts
   • Drawback provisions
8. References
   • Professional
   • Other investors in the fund