Financial Education

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.

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.

Duration measures the change in value for a bond given a 100 basis point change in interest rates. However, since international rates are not perfecltly correlated with domestic rates, the duration of a foreign bond does not have the same impact on value and portfolio duration for a change in domestic interest rates.

Instead, the relationship between domestic and foreign rates can be estimated empirically to determine a country beta.

The percentage change in a foreign bond due to a change in domestic interest rates would be estimated as the product of country beta and duration. The portfolio’s weighted average duration would also be affected by the weight of the foreign bond multiplied by the product of country beta and duration.

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.

Persistent mispricings should attract profit-seeking investors to exploit them. This, in turn, should eventually cause the anomaly to disappear. There are several potential reasons for anomalies to persist.

Misunderstood Mispricings

Certain anomalies may not have a logical explanation, causing investors to be wary of trying to exploit them.

Costly Arbitrage

Particularly for less liquid securities, there may be significant costs involved in trading them. The higher the costs, the greater a mispricing must be in order for arbitrageurs to try to exploit it.

Insufficient Profit

Large investors, in particular, may find that certain mispricings do not offer a significant return for the time involved in identifying and exploiting them.

Trading Restrictions

Many investors have limits imposed on their activity, such as a prohibition on short selling. Such prohibitions can prevent investors from exploiting opportunities when identified.