Several steps are needed to construct a custom benchmark for a portfolio.
- Identify prominent aspects of the manager’s investment process
- Select securities that are consistent with that process
- Devise a weighting scheme for the benchmark securities, including an appropriate allocation to cash
- Review the preliminary benchmark and make modifications
- Rebalance the benchmark portfolio on a predetermined schedule
Posted on 6th July 2008
Under: Active Management, Asset Allocation, Investment Returns, Performance Measurement, Portfolio Management | No Comments »
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:
- The structure of the fund
- Legal entity
- Identity of manager
- Regulatory regime
- Instruments used
- Current holdings
- Performance data since inception for all funds under management
- Risk management
- What risks are measured
- How are they measured
- How are they controlled
- How is leverage employed
- Has the firm’s research led to changes in strategy
- Strength of research efforts
- Research budget
- Employee turnover
- Disaster recovery plans
- Legal and Regulatory
- Fee structure
- Lock-up period
- Minimum and maximum subscription amounts
- Drawback provisions
- Other investors in the fund
Posted on 28th June 2008
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Buyout funds represent a significantly larger market segment within private equity compared to venture capital. Mega-cap buyout funds typically will take public companies private through a leveraged buyout. Mid-market funds will purchase private companies or divisions of larger companies.
Buyout funds add value by restructuring operations, by buying opportunistically when companies are selling at less than their intrinsic value, or by capturing gains by adding to or restructuring existing debt. They can realize these gains through a later public offering, selling the company to another buyer or by recapitalizing (borrowing and using the proceeds to pay a special dividend).
Buyout funds differ from venture capital funds in a number of ways:
- They are usually highly leveraged
- Cash flows to investors are typically more stable and start sooner
- Returns are not as subject to measurement error
Posted on 27th June 2008
Under: Active Management, Alternative Assets, Asset Allocation, Institutional Investing, Investing in Private Equity, Portfolio Management | No Comments »
When investing or considering investments in International assets, investors should consider the following special issues:
Currency risk: This affects both return and volatility. Investors must decide whether to hedge this risk.
Correlations with other assets: Although international assets frequently have low correlations with domestic assets, the correlations increase during times of stress. Times of stress are exactly the times in which a low correlation (higher diversification benefit) is most needed.
Emerging markets: Emerging markets tend to be less liquid and less transparent than developed markets. Their investment return distributions tend to be non-normal, which is significant for investors employing mean-variance optimization strategies.
Posted on 20th June 2008
Under: Asset Allocation, FInancial Planning, International Investing, Investment Returns, Portfolio Management | No Comments »
Cash managers can earn higher returns by accepting longer-dated maturities or credit risk. The yield curve reflects the consensus expectation for future interest rates. Managers must distinguish between future events that are reflected in the yield curve adn those that will surprise the market.
Nominal Default Free Bonds
Conventional government bonds of developed countries have little or no default risk. Return can be disaggregated into real return and an inflation premium. The investor must compare his own forecast for inflation with that imbedded in the yield. If the investor believes inflation will be lower than expected, the bonds are a good buy.
Default risk in commercial bonds is reflected in a premium yield relative to Treasuries. This spread tends to widen in recessions as economic stresses increase the likelihood of default. Understanding when a bond is pricing in greater default risk than is necessary can help determine whether securities are attractively priced.
Emerging Market Bonds
The sovereign debt of non-developed countries is often priced in foreign currencies. Since the issuer cannot print the money needed to cover repayment such bonds are subject to default risk, similar to corporate debt of similar ratings. A country risk analysis often involves an understanding of local politics.
Inflation Indexed Bonds
Inflation indexed bonds allow investors to directly observe the consensus inflation forecast by comparison with the yield of conventional bonds. The yield curve will still vary with the real economy and according to supply and demand. However, higher volatility of inflation will increase their hedging value and can result in lower real yields.
The economy affects earnings (cash flows) and interest rates in opposite directions. Trend growth depends on labor growth, investment and productivity while the business cycle affects profitability. In emerging economies, ex-post risk premia have been higher and more volatile than in developed countries.
Returns are affected by growth in consumption, real interest rates, the term structure of interest rates and unexpected inflation. Economic cycles can also affect the cost of building materials and construction labor, but the net effect of lower interest rates is positive for real estate valuations.
Exchange rates reflect the balance between supply and demand. Imports increase currency supply, usually reducing its value. Capital flows for investment purposes, however, may outweigh the effect of trade imbalances. Differences between local interest rates can also affect exchange rates, as the higher yielding currencies attract capital and thus the currency value.
Posted on 19th June 2008
Under: Asset Allocation, Economic Analysis, FInancial Planning, Institutional Investing, International Investing, Investment Returns, Portfolio Management | No Comments »
Historical averages incorporate many different types of economic environments, only some of which may be relevant to current conditions. One of the most important areas for investors to apply subjective judgment and insights is in “conditioning” historical data or choosing the periods that best reflect current conditions.
Even when using conditioned data, itÂ is important for the analysis to incorporate any new facts that may be relevant to the decisions being made.
Posted on 18th June 2008
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A Monte Carlo approach takes the probability distribution to generate multiple “paths” of possible return outcomes over time. It is superior to steady-state (deterministic) approaches to forecasting because it incorporates variability over long time horizons and illustrates how the resulting paths affect ending wealth.
Monte Carlo simulations generate probability estimates of ending wealth rather than a single point estimate. As a result, they more closely approximate likely investment outcomes.Â They also provide insight as to the trade-off between short term risks and long-term potential of failing to meet the investment objective. The simulations can also incorporate multiple tax scenarios.
Posted on 12th June 2008
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Over time, small capitalization stocks have been shown to outperform large-capitalization stocks. However, timing changes in the relative performance between the two groups could lead to still-better performance. In the Fall 2007 Journal of Portfolio Management, L’Her, Mouakhar and Roberge test three nonparametric techniques derived from artificial intelligence and using 20 macroeconomic and financial variables as inputs.
The three approaches are recursive partitioning, a neural network and a genetic algorithm.
Each of the three techniques outperforms a naive small-minus-big strategy, but the best results are derived from taking the consensus of the three techniques.
Posted on 10th June 2008
Under: Active Management, Asset Allocation, Economic Analysis, Institutional Investing, Investing in Stocks, Investment Returns, Momentum Strategies, Portfolio Management, Research, Risk Management | No Comments »
With the growth in the hedge fund industry has come a decline in the value added by hedge fund managers. Given the high fees typically charged by hedge funds, some have questioned whether passive approaches can be constructed that would provide returns similar to those of hedge funds while offering greater transparency and liquidity.
In the Winter 2007 Journal of Wealth Management Harry Kat discusses three general approaches to hedge fund replication:
- Factor Models
- Mechanical Trading Rules
- The author’s FundCreator product
In a factor model, linear regressions determine the market exposures experienced by a hedge fund or hedge fund index. Factors may include stock, bond, commodity and currency returns, or changes in credit spreads and market volatility. These exposures can then be taken via index products or derivative instruments.
In the case of funds that add value by timing short-term changes in market exposure, the investor’s trading behavior can be compared to mechanical trading rules.
The FundCreator product is a risk management tool that allows the investor to target the risk and correlation properties desired in order to maximize diversification potential.
Posted on 6th June 2008
Under: Active Management, Alternative Assets, Asset Allocation, Hedge Funds, Institutional Investing, Investment Returns, Passive Management, Research, Risk Management | No Comments »
Investors measure performance against a number of metrics, some of which can be considered valid benchmarks and others of which cannot.
Absolute return can be an objective (I want to earn 10% annually.) However, a 10% return is not investable and therefore does not make a valid benchmark.
Manager universes are useful comparisons after the fact. But they investments made by the manager universe are not specified in advance so managers cannot use skill to perform better.
Broad market indices meet most of the criteria for benchmarks, and are suitable provided they reflect the manager’s style.
Style indices (such as the S&P 500 Growth Index) are well known, easily understood and widely available. They are generally appropriate as benchmarks, with a couple of caveats:
- Style definition can be ambiguous and may be inconsistent with the manager’s investment process
- Some style indices have larger weights in particular securities or sectors than a manager would consider prudent
Benchmarks based on factor models relate one or more systematic sources of return to the returns on the account. The capital asset pricing model is a single-factor model in which the factor is the market risk premium. Factor models can be useful for performance evaluation because they identify the sources of return and can provide insight as to a manager’s style. However, they are ill suited as benchmarks because the securities are not specified in advance, they are ambiguous, and managers probably do not think in terms of factors when making their decisions.
Returns based benchmarks compare a manager’s return to the returns of several style indices to solve for the combination of styles that best explains the manager’s return. They meet many criteria for being valid benchmarks, but the mix of underlying styles may not reflect the manager’s investment process.Â If the manager rotates among styles rather than keeping a relatively constant mix it would be inappropriate.
Custom benchmarks weight the manager’s universe in a fashion that reflects the manager’s weighting style. Custom benchmarks meet all criteria of valid benchmarks and are useful for performance evaluation. However, they can be expensive to construct and maintain, and lack of transparency could be a concern.
Posted on 6th June 2008
Under: Asset Allocation, Investment Returns, Performance Measurement, Portfolio Management | No Comments »